Investing in Hedge Funds - Red Flags and Spotting the Real Storm Warnings
By Jane Wareham, Stuarts Walker Hersant, Cayman Islands and Oliver Assersohn, Outer Temple Chambers, London

 Experience shows that few fund managers can beat the markets year on year.  During the period 1997 to date, only a quarter of investment funds were able to return more than the compound cost of borrowing for investment at a rate of 5%.  Current fee structures encourage risk taking or, in the extreme, actual cheating or outright fraud.  Mortality rates in the hedge fund population are high and managers face a daily battle to retain investor funds.

The rise in popularity of hedge funds continues and some have done well. Traditional investments have not delivered the desired returns to investors and the search for yield and protection against declining markets continues. Increasingly, the new money entering the hedge fund space is institutional (and often fiduciary) and demands greater transparency, discipline and accountability. Such investors cannot afford to be victims of a repeat of the mistakes of the past.

The size and complexity of funds is growing to such an extent that assessing risk becomes more difficult. The increasingly popular use of esoteric derivatives instruments makes understanding where the financial risk lies a profession in itself.

Risk management and valuation practices are an important consideration for any investor keen to protect the value of his initial investment. Fund managers themselves must understand the risks they are taking in order to make informed risk-return trades. Equally, those investing in a fund, whether institutional investors or otherwise, need to be aware of their own risk parameters.

So what can investors and managers learn from the past? Several of the unsuccessful funds have been subject to extensive reporting revealing certain common patterns. Essentially, if it seems too good to be true, it probably is.

The Warning Signs

A global study published by Deloitte identified as potential “Red Flags” for hedge fund advisers, investors and regulators, the following areas in terms of risk management:

• Lack of position limits;
• tracking liquidity without stress and correlation testing;
• measuring off-balance sheet leverage without stress testing;
• failure to track liquidity;
• holding assets with embedded leverage and
• the use of leverage off balance sheet.

In terms of valuation, important indicators included the lack of review procedures on preparation of valuation of net asset value (NAV) by independent third parties; no written valuation policy, no information regarding material changes and no due diligence procedures.

Other obvious indicators are unrealistic performance projections in marketing material and an overly complex fund structure, e.g. numerous investment holdings; investment management style "drift"; significant positions in illiquid/hard to value securities/OTC derivatives and changes in offering documents.

Both the UK’s Financial Services Authority and the International Organisation of Securities Commissioners (IOSCO) have recently focused on the integrity of valuations and how best to address the inherent conflict between internal and independent verification, an area that has long been under review by the Alternative Investment Management Association (AIMA), and in relation to which it has published several guides to sound practices, asset pricing and the valuation of funds.

Comments, from the US Federal Reserve on risk management and transparency, reflect a focus of attention by the major regulatory bodies, as regulators seek to weigh perceived threats that the hedge fund industry poses to the financial system. EU Ministers are, at the time of writing, due to meet to discuss ways of regulating funds, in addition to the existing indirect regulation.

We briefly review below some recent high profile examples (with names redacted).

Lack of position limits/redemption restrictions

Our first example concerns a multi-strategy fund which took a sizeable interest in energy futures that represented 50% of the fund’s total risk exposure. The investment strategy was conducted with the knowledge of investors and transparency was not an issue. However, due to the rigidity and restrictive style of the investment policy coupled with complex capital structures, most investors were unable to react in time to avoid the damage. Understanding how long it will take to liquidate underlying positions and having realistic cash return expectation is fundamental.

Illiquid/hard to value securities

In another instance, fund managers allegedly depleted funds by investing in a small number of unlisted, infrequently traded OTC companies. Portfolio assets were allegedly used to acquire controlling stakes in virtually worthless companies by purchasing securities with restrictions through private transactions. Unrestricted shares were then allegedly purchased at a much higher price. The allegation is that all shares were then registered at a higher value inflating the fund’s NAV.

Allegedly the administrators of the fund failed to act despite the apparent increase in the fund’s value at a time of poor market performance. In addition, a substantial increase in a small number of thinly traded securities with inflated values attributed to large blocks of restricted securities and small trades in stocks that apparently served no business purpose.

Lack of independent verification of valuations

In one case liquidators filed a complaint alleging that fund managers had ignored extensive independent broker values, by substituting internal valuation methods that failed to reflect security values. Allegedly, “hedge adjusting” pricing was applied that did not evaluate the securities truthfully; that additional manipulation of security prices was used to misrepresent the value of the portfolio and the fund’s auditors did not ask as to the valuation methods applied, nor was a comparison made between internally generated values and those by the third party prime broker. It was further alleged that the fund administrators failed to perform independent valuations or testing and relied upon the fund manager’s valuations without questioning the valuation methodology. All claims against the firm’s auditors were later dismissed.

Lack of meaningful independent service providers

An illustration of the danger of a lack of meaningful independent service providers concerned a fund which had allegations made against it that investors were repeatedly misled, over a nine year period from 1996 to 2005, to disguise losses whilst informed that the funds continued to gain. The CFO of the fund formed a sham company to provide false financial statements showing fake profits that were used to retain current investors and attract potential parties. Retention of independent third parties would have ensured greater transparency for the investors at risk against the fraudulent behaviour of the fund managers.

Failure of due diligence by prime broker

In a further example, the allegation was made against a securities broker that he had ignored red flags indicating fraudulent activity on the part of the fund manager. Margin payments of US$125 million were paid to the broker in the year prior to bankruptcy. Transfers took place after the broker first became aware of the problems, at which time the broker received information regarding the fund’s profit levels, greatly at odds with internal figures that had been received during risk-related conference calls that suggested the fund was losing money.

A breakdown in due diligence procedures occurred, following internal confirmation by the portfolio department of a significant loss of money in the accounts held on behalf of the fund.  No action was taken by the broker until 2000, at which time the fund was asked to leave the firm and the SEC informed.

Apparent failure by independent service providers

In one instance it was alleged that the operators of the fund failed to disclose the existence of a second account that was used to conceal trading losses from investors. The administrators were responsible for the calculation of the fund’s NAV (upon which the administrators’ fees were paid), together with the distribution of valuation information directly to shareholders.

Third party brokers for the fund alleged that the administrator failed to follow its own policies and procedures with respect to ascertaining independent support; did not ensure access to all trading accounts and breached its fiduciary duties by recklessly calculating the NAV in a manner that did not allow the administrator to identify suspicious conduct by the investment manager.

Another case was one of Canada’s fastest growing hedge funds with 26,000 customers who invested C$800 million. The Ontario Securities Commission sued the management company over questionable transactions in March 2005, a year before it went bankrupt. Allegations have been made against the company of various regulatory breaches and of misleading investors.
Among the allegations made, is that the management company routinely pooled investor’s money with frequent transfers offshore. This made it difficult to trace the flow of funds. The allegation has also been made that tens of millions of dollars passed through another management company, which allegedly made spurious book entries when no shares were bought or delivered. The case is ongoing.
 

Conclusions

These noteworthy cases show that the prudent investor needs to ensure that the fund is properly structured and transparent; that the various key players are of the highest integrity and experience and robust enough to perform the tasks they have been set. The recent due diligence questionnaires developed by AIMA, as part of their commitment to improving transparency and building on sound practices, are an excellent tool for investors, providing a measure of protection against the mistakes of the past. If the fund sponsors can deliver transparency and integrity in tandem, with a strong investment performance, all stakeholders will be well pleased.

Disclaimer: This article appeared in the AIMA Journal (Summer 2007), which is published by The Alternative Investment Management Association Limited (AIMA). No quotation or reproduction is permitted without the express written permission of The Alternative Investment Management Association Limited (AIMA) and the author. The content of this article does not necessarily reflect the opinions of the AIMA Membership and AIMA does not accept responsibility for any statements herein.