Risk Without Reward

At least not all administrator's think the same...

2009-12-19T09:50:10-05:00

Plenty of our recent posts have focused on the declining degree of oversight and responsibility accepted by many of today's hedge fund administrators.

In light of this trend, we were very interested to see a recent paper published by a smaller admin, Crederian. We are unfamiliar with this firm, but certainly like their philosophy, as expressed in a list of eight administrator "best practices":

Administrator’s Best Practices:

1. Maintains accounting records on a comprehensive General Ledger system.

2. Receives an independent trade blotter directly from the hedge fund.

3. Reconciles cash balances, portfolio trades and security positions against the Custodian and/or Prime Broker accounts on a daily basis.

4. Market values of securities are independently priced by a third party, with complete documentation on any security that is fair valued.

5. Subscription receipts are deposited into an “escrow” account.

6. Contributions and withdrawals are independently confirmed to the investor by the Administrator.

7. The Administrator cosigns any transfer of money from the fund’s trading account.

8. A complete monthend accounting report package that includes each general ledger account reconciled with complete documentation, be prepared, reviewed and signedoff by the Administrator.

Crederian also emphasize the need for administration work to completed by qualified chartered accountants / CPAs, which is another area where many current admins fall down.

This paper, and Crederian's positioning, suggests two potential trends going forward. The first is whether investors will be prepared to have the same degree of confidence in hedge funds which have appointed a smaller, less well-known administrator. Certainly, for highly complex funds, there remains an argument for a "brand name" admin, if only because of weight of resources: some funds have a dedicated 25 person plus team working solely on their behalf at one of the major administrators. Generally, however, we're often of the view that a fund may be better being a "larger fish in a smaller sea". To be blunt, the standard of servicing from many larger administrators is so varied, and can be so poor, that we are always open to examining the service quality provided by a smaller firm. If key metrics are met - daily accounting, sourced from the manager, daily recs, independent valuation - then investors can take strong confidence from the procedures performed, even if the admin is smaller and less well known. Indeed, one of the biggest dangers in the industry remains investors' "check the box" mentality, irrespective of actual service quality: as one example, hiring a "top tier" admin, if all that admin does is take data from the PB, import it into their accounting system, and reconcile back to the PB, is hardly worth the basis points the investor has to pay. This is, however, the accounting model adopted by several of the largest fund administrators for many clients.

The second trend is whether the administration industry will start to differentiate itself based on service model and service quality. It would certainly be encouraging if we saw more firms look to position themselves based on their ability to provide meaningful, independent, "best practice" servicing. To this point, Crederian's efforts to emphasize the need for traditional "quality" is certainly a welcome trend. We hope more administrators follow.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

"Risk Without Reward" is a trademark of Entreprise Castle Hall Alternatives. Inc.

Do you invest in the fund or in the manager?

2009-12-18T07:05:56-05:00

Many of our recent posts have touched on various elements of the push and pull between manager and investor. Certainly, several of our recent comments related to service providers, be they auditors, administrators, or lawyers, have focused on the question of who is the client....Is the client the manager, who hires and fires the service provider, or the investor who pays the bill (or to be technically accurate, 80% of the bill if the fund goes up, with the particular twist of footing 100% of the bill if the fund goes down).

We have accumulated a number of observations around this topic over recent weeks and will touch on several topics in future posts. However, we wanted to start our comments by referencing a very interesting article from the Hedge Fund Law Report (an excellent legal resource) which raised a slightly different distinction - do you invest in the fund, or in the manager? The HF Law Report's article was focused on the question of the risk of an investor bringing an action for style drift, but we were particularly drawn to the phrase we have emphasized in bold:

"In the hedge fund context, strategy drift (also known as style drift) broadly may be defined as a material deviation from the investment strategy represented to an investor – in the fund’s governing documents as well as orally, for example, in marketing meetings – prior to and during the investor’s investment in the fund. Implicit in this definition is the notion that a hedge fund investor purchases a product. But there is a competing, often more apt, view of the hedge fund investment process which holds that sophisticated investors do not invest “in a fund,” but rather “with a manager.”

The question of whether you invest in a fund or a manager is a very interesting - and critical - distinction. In reality, there is no "right" answer: as an investor, your answer depends on your own preferences and sensitivities.

In broad terms, the hedge fund industry has long been dominated by the view that you invest in the manager. When the industry was still the "secret club of the super rich", relationships and investor confidence in individual investment professionals was the mantra that drove industry growth. Performance was the only consideration: the fund itself was no more than an administrative convenience (or, more accurately, inconvenience) put in place to allow the manager to make money for the investor.

In today's market, many investors continue to share this broad view - that hedge fund investing is driven by the skill needed to identify managers with genuine and sustainable ability to generate performance. Inherent to that process is also the ability to identify honest managers. For these investors, weasel words in the offering document, liability disclaimers, broad abdication of responsibility by service providers are just not high priorities: they know, and have decided to trust, the manager. That is absolutely fine - these investors gladly accept the principle of caveat emptor.

However, for many other investors - and particularly institutions - the starting point is to emphatically invest in the product, not the manager. For these investors, hedge funds are just one, relatively small component of a broader asset allocation policy and should be selected and judged in accordance with criteria applied consistently across other asset classes. The industry has a profound problem if it expects such allocators to rip up the rule book that applies to all their other investments the moment we start thinking about hedge funds.

To this point, it's always very helpful to remember that, in the long only world, an asset manager is hired to do a specific job, generally in a managed account format under terms of an investment management agreement. Implicit in such an agreement is the view that the manager, while a valuable partner, is still "hired help" who can certainly be fired if they don't do their job properly. In Q4 2008, for example, the "long only" mindset would not have thought a second about replacing poorly performing hedge fund managers with either a transition manager or a new, permanent advisor on the grounds that the investment decision makers who got a portfolio into a loss making position may not be the best people to get it out. That is, of course, hardly an action which is commonplace in the hedge fund industry.

It is also critical to remember that most institutions are fiduciaries and, moreover, have reputational risk across a very broad range of stakeholders. Indeed, reputational damage may exceed direct, monetary losses should one of their hedge fund investments get into their difficulty. For these investors, it's not too hard to suggest that many institutions may be notably more sensitive to an unexpected loss on the downside than they are to outperformance on the upside: quite the opposite of the "performance is everything" viewpoint. Sure, performance is great, but don't lose us money (especially by stealing it) before you start thinking about making any.

For such investors, therefore, the "product" view is central. Firstly, as above, this matches the rules of the game in the rest of the portfolio; secondly, as a fiduciary, you need to allocate your beneficiaries' capital to investments which are clearly defined, structured and protected.

Thinking about these points, our expectation is that the industry will become more bifurcated between investors and managers who adhere more closely to either the "invest in the manager" or "invest in the fund" viewpoint. As we have already stated, there is no right or wrong here - rather, the issue is to correctly match investors and managers who share the same priorities and investment decision making framework.

We do have two points to make, however. Firstly, the trend of the industry - as we all know - is for an increasing proportion of hedge fund capital to come from institutions. Set against this progressive shift of capital sources, the progressive shift of hedge fund attorneys to develop structures which have more indemnifications, less service provider responsibility and more "broad and flexible" provisions is directly opposite to the needs and preferences of the investor group that is driving ongoing industry growth. This is the real stress point and something our firm grapples with on a daily basis.

Our second point refers back to the article at the top of the page, and specifically to the comment that it is "sophisticated" investors who are ready to invest "with a manager" rather than in a fund. The sophisticated investor argument is one we have heard several times recently: as an example, we were recently speaking with a senior audit partner from one of the Big 4 firms. We raised the well worn topic of auditor confirmations and received the well worn response of privity (see our earlier post). However, we found it very interesting when the audit partner commented that there are plenty of safer investment choices, such as regulated mutual funds, if investors were not "sophisticated" enough to allocate to hedge funds. The point being made, therefore, is that of course hedge funds are imperfect, and you need to be "sophisticated" if you are to play with the big boys without a comfy safety net.

This argument is, quite simply, an insult to the intelligence of every "sophisticated", institutional investor. It is precisely because we are sophisticated that we know what are the tough questions to ask: and it is precisely because we are sophisticated that we can quickly recognize unsatisfactory - and unsophisticated - answers.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

"Risk Without Reward" is a trademark of Entreprise Castle Hall Alternatives Inc.

Directors...Can You Open the Mail, Please?

2009-11-24T22:31:34-05:00

As a quick addendum to our last post on the roles and responsibilities of directors, we wanted to give one more example of "prospectus creep". This one is more humorous - until you realize that this is an actual example of current, "best practice" offering memo disclosures. Our ire in this instance is directed firmly at the attorneys who drafted this language, not the manager - if a top tier law firm tells you that this type of language is "standard", then it's hard to argue otherwise.

Handling of Mail

"Mail addressed to the fund and received at its registered office in the Cayman Islands shall be forwarded unopened to the Investment Adviser to be dealt with. None of the Fund, its directors, officers or service providers will bear any responsibility for any delay whatsoever caused in mail reaching the Investment Adviser. In particular, the Directors will not receive, open, or deal directly with mail addressed to the Fund."

Well, thanks guys - that one's really helpful.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

Are Directors Responsible for Valuation?

2009-11-23T22:18:44-05:00

Risk Without Reward frequently focuses on the issue of security valuation within a hedge fund. One of the thorniest questions is, of course, who is actually responsible for valuation.

Many investors assume that, if an administrator has been appointed, then it is the administrator who will be responsible for pricing. As we have often noted, this is not true - today's administrators argue that they are a "verification" not "valuation" agent. Indeed, current "best practice" guidance for the administration industry makes this clear: as we noted in a recent post,

"It should be noted that while some HFAs [Hedge Fund Administrators] have people, teams and service models which are capable of, and expert in, the calculation of recommended prices for individual securities, many others are not. A hedge fund manager or investor should not automatically assume that the HFA offers this service, employs this expertise or takes this responsibility."

So if the admin is out of the question, we are left with the hedge fund manager and, if we are looking at an offshore fund, the Board of Directors. Many recent best practice documents (see Castle Hall's resources page), notably AIMA guidance and the IOSCO paper on hedge fund valuation, identify the Directors, as the "Governing Body" of the fund, to be the entity with ultimate responsibility for valuation. Indeed, the Hedge Fund Standards Board guidance asks the hedge fund manager to "do what it reasonably can to enable and encourage the fund Governing Body" nearly 50 times: seems pretty clear that it's not the UK domiciled hedge fund manager driving the bus (now, that wouldn't have anything to do with UK tax rules, would it??)

It is against this background that we have been very interested to read a couple of recent hedge fund offering documents. Both used directors provided by one of the usual suspect group of Cayman law firms who, in these instances, were also the offshore counsel for the funds in question. In both cases, the offering documents contained a specific disclosure stating that the Directors were not responsible, in any way, for:

the commercial structuring of the fund (fair enough - even though the same law firm was very responsible for the commercial structuring of the fund)
the purchase and sale of any investment on behalf of the fund
the valuation of assets of the fund
any loss or damage, unless such loss or damage is caused by the fraud or wilful default of the Directors (we note that this clause specifically does not hold the directors to a gross negligence standard, but we guess that's a topic for another day)

Where, then, does this leave investors? On one level, it is hardly surprising that the Directors of a Caymanian hedge fund are now saying that they are not responsible for the valuation of the fund's assets: after all, if you serve on several hundred boards, it's pretty difficult to keep track of current valuation issues on fund 132.

On the other, this explicit attempt to disclaim any responsibility for valuation is new. In our view, this illustrates, clearly and specifically, that the directors of an offshore hedge fund cannot be expected to provide anything more than a basic, corporate secretarial service designed to meet local filing requirements and comply with local business law. There is, it is clear, no attempt to provide any form of meaningful, active corporate governance.

As always, caveat emptor.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

And will the auditors identify themselves, please....

2009-11-19T08:43:10-05:00

It is not a new issue for due diligence practitioners to grapple with the challenges of getting the auditors to confirm that they are, in fact, actually the auditor of a hedge fund.

The issue for the audit firms is, surprise surprise, liability. The auditors are desperate to navigate around the concept of privity, which basically states that only the parties to a contract have rights and obligations - and can then sue if things turn south.

As such, the auditors sign an engagement letter and contract with the fund as a distinct, individual legal entity. There is no direct contract with the shareholders, collective or individual.

The legal problem arises if an audit firm confirms their relationship with an individual investor - especially (gasp!) if that investor is conducting pre investment due diligence and is not yet actually a shareholder of the fund (we will discuss this issue on the assumption that we are looking at an offshore fund structured as a corporation). Any direct communication with the investor could, it is argued, create a contractual relationship which could then be enforced through a court of law.

As such, what should be a basic, utterly reasonable due diligence step - to confirm a key service provider relationship - can turn out to be slightly more painful than root canal surgery.

In fairness, most auditors outside the Big 4 are eminently reasonable - you can call the partner and get an immediate, verbal confirmation that the auditor has been engaged. Job done in 2 minutes - excellent - and our ongoing appreciation for each audit firm that does adopt this approach.

However, the fun starts with the Big 4. Most auditors will allow investors to confirm with the auditor that that they are, in fact, the auditor in question - upon signature of a quite laughable disclaimer letter under which the investor signs away all rights and obligations.

However, the auditors have yet to agree a standard process and procedures differ by firm, and then by office within each firm. We recently encountered a situation where a specific office of a Big 4 auditor will only provide a letter to the fund's board of directors (who are, needless to say, members of the Cayman "usual suspect" group serving on hundreds of individual boards - as an aside, our new rule is that if a director cannot, from memory, name all the entities they are a director of...then they are not fit to be a director).

This letter is then to be furnished to investors by the manager. However, it goes without saying that, unless investors contact the auditor, they cannot confirm that the letter given to them by the manager is genuine! It is patently ridiculous for an audit firm to expect investors to rely on this type of confirmation especially as (we hope!) an auditor would not rely on a PB statement or other confirmation given to them by the manager during the GAAP audit. Yet investors are meant to be happy with this type of confirmation when they are about to invest tens of millions of dollars into a hedge fund?

However, there is an even bigger issue at play. Even if an investor can get some form of confirmation that the audit relationship is genuine, the auditors will not send a copy of the financial statements direct to the investor because of privity. In most instances, the accounts come from the manager; if the accounts come from the administrator, admins are, in turn, not stepping up to enforce a policy that the financial statements should be given to them by the auditor, not the manager - some do, some don't. Even with the the audit confirmation, therefore, it is still not guaranteed that an investor is looking at a set of genuine accounts.

Clearly, this situation is unacceptable and, if the industry is going to evolve and institutionalize, we need to find a workaround. To that point, we'd like to be a little contrarian and think out of the box.

We recently heard a leading audit partner make the comment that it was surprising and probably unfair that hedge fund investors seem to apply a different standard of care to a hedge fund audit, and certainly have different expectations, than they do when dealing with a public company. This is certainly true - if I hold 100 GE shares, I do not phone up GE's auditor to confirm that the set of accounts I received through the mail are genuine.

However, this perspective goes, in our view, to what is really the heart of the problem. A hedge fund is not a public company, it is not subject to meaningful regulatory oversight, it does not have deep pockets and it does not offer itself to hundreds of thousands of individual shareholders. Instead, a hedge fund is a very small, private entity designed to pool significant assets from a very small number of investors. Very, very few funds have more than a couple of hundred investor relationships - many have less than a couple of dozen.

An audit of that hedge fund is, therefore, disproportionately important to each of those investors as compared to an investor in a Fortune 500 public company. Given the lack of transparency in a pooled hedge fund vehicle, the audit is a key tool to provide confidence that assets actually exist (the audit should have a full confirmation process). The audit also gives some confidence over asset valuation given the auditor's testing (but certainly not independent repricing) of the manager's marks. As such, it is entirely reasonable - and should be entirely expected by hedge fund auditors - that they are playing a different role, and have different functions, than if they are working on the audit of Pfizer.

If you have elected to invest via a managed account and have created your own managed account platform, you get round all of these issues. The investor creates a fund entity to hold the assets, managed by a third party hedge fund manager; the investor appoints the directors of that entity (or may serve him / herself) and the investor - not the manager - appoints the auditor. In this case, the auditor is now clearly working for you and the investor has direct confidence as to the identity of the auditor and the fact that the final financial statements are genuine.

Looking at the current challenge of working with auditors through a commingled hedge fund, this has to be a very material advantage for a managed account structure.

However, let's be really heretical. Do investors in a hedge fund actually need an audit? Or, to be more accurate, do they actually need a GAAP audit?

Would investors not be better with some form of agreed upon procedures engagement which results in the preparation of financial statements presented in accordance with GAAP, but whereby the audit work is conducted in accordance with an AUP engagement letter? In that way, investors (and potential investors) could sign to confirm the adequacy of procedures and thereafter get financial information direct from the auditor. The twist here, of course, is that the auditor is now working for the investor, changing the nature of the relationship.

A heretical idea, we agree. But not as heritical as a state pension plan losing $100 million when it turns out that a hedge fund gave them a fake set of accounts....and Deloitte / PwC / EY / KPMG refused to confirm that they were the auditor of the fund.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

High Frequency Trading

2009-11-08T18:06:38-05:00

The Canadian National Post newspaper has just run an article on high frequency trading, which has made its way north of the border in spectacular style. According to the Post, the Toronto Stock Exchange (the TSX) was the venue for some 99.5% of trades in the largest 60 Canadian quoted companies one year ago: in a mere twelve months, this percentage has fallen to just 69%. The winners are new, so called "alternative exchanges", which appear to be favoured by high frequency traders.

Such a shift in trading patterns is pretty dramatic by any measure. When thinking about this, we certainly agree that any trading strategy which increases exchange volumes can be good - more volume can increase price transparency, make it easier to fill orders (especially smaller orders from retail investors), and reduce bid ask spreads.

On the other hand, you have to take a step back and ask how high frequency traders make their money. Exactly why is it that these traders need a computer data centre of the size usually reserved for manned space missions? Exactly what informational, mathematical or regulatory advantage are these traders exploiting to make money as they place orders for millions of shares a day, in and out of names many times during each trading session?

The SEC has already focused on the practice of "flash orders" whereby certain investors could access information about order flow a half second ahead of other market participants. At first glance, you have to ask what possible difference a half second could make - until you realize that a half second is a very long time when you have Google levels of computing power. Dark liquidity pools and other off exchange trading also seems to be an area of current regulatory focus (see a recent Bloomberg article for a summary of these developments.)

The National Post quotes Joe Saluzzi of Themis Trading, who comments: "What these guys are about is speed, and they are getting access to quotations before the general public…so, in essence, they are re-engineering the quotes by jumping between you and the seller". He continues: "most investors don't even realize they are losing money, because their pockets are getting picked without them even knowing it. The price you paid may have been inflated during the day, because they are taking advantage of the order flow and you don't even know it."

To be clear, our comments are as an interested observer rather than an informed opponent (or proponent) of high frequency trading. As above, volume and liquidity have many powerful advantages, and perhaps high frequency orders are the "wave of the future".

On the other hand, we do hold our hand up as professional skeptics. The fact that a small group of trading entities with Fortune 500 style IT budgets can make a very profitable business out of high frequency trading raises our common sense antennae. The reason, of course, is that there is no retail investor who could deploy the same trading technique - a Dell desktop simply won't cut it. High frequency traders therefore have an advantage which is unavailable to the "average" investor.

It's always good to bear in mind that much of investing is a zero sum game - someone makes money, with the unavoidable implication that someone else has lost it. The skeptic in us, therefore, is reminded that it isn't always a great idea to bet too heavily on strategies which allow a small group of investment insiders to make money at the expense of the little guy.

That, of course, was the lesson of mutual fund timing.

Agreed Upon Procedures

2009-10-24T10:59:13-04:00

A number of our recent posts have focused on the challenges of the hedge fund administrator's role in relation to security valuation. We will, of course, return to this topic - but, in the meantime, wanted to focus on some of the alternatives to administrator pricing.

One of the more common comments from today's administrators is that, while an admin may be able to price Level I and Level II securities, they do not necessarily have information to price Level III instruments. (To recap, the US accounting standard FAS 157 divides portfolios into three levels, being Level I, liquid instruments readily priced from a pricing feed (typically exchange traded); Level II, instruments priced using inputs from "comparable" securities (essentially mark to model, albeit with mainstream models); and Level III, everything else).

This leaves investors with a challenge - if administrators cannot price Level III instruments, who can? Moreover, to repeat one of our frequent comments, it is self evident that if a hedge fund manager wishes to deliberately mismark securities, they would most likely misprice a Level III instrument. It is, of course, very hard to fake the price of IBM common stock, but much easier to mismark emerging market private loans.

Two of the most common tools available to hedge fund managers looking for third party oversight over pricing for Level III instruments - assuming the administrator has washed their hands of the problem - are third party pricing agents and auditor agreed upon procedures, or "AUP". We will return to the strengths and weaknesses of third party pricing agents in a subsequent post, but wanted to focus this discussion on AUP.

In an Agreed Upon Procedures engagement, the auditor completes specific procedures which have been dictated by the client. The procedures are specified and the auditor then prepares a report outlining the findings of that specific work.

We have two comments here: the first is to take a high level view as to the adequacy of these procedures, and the second is to dig a little more deeply into the actual audit guidance that covers this type of work.

Our first comment is, unfortunately, an Emporer Has No Clothes observation. The significant majority of hedge fund AUP engagements we have seen require the auditor to test a fund's pricing on a quarterly basis. This usually involves (i) obtaining a portfolio list from the investment manager and (ii) testing the pricing support for those positions.

There are, however, generally two snags. Firstly, many AUP only test a sample of prices, not the whole portfolio. Sample testing clearly provides much less assurance than a price review of all positions: the administrator, for example, is usually expected to price the entire book (would any investor accept a NAV which has been priced on a "sample" basis???)

The bigger problem, however, is the type of testing completed by the auditor. In way, way too many cases, the auditor tests security prices back to the manager's own pricing support and makes no attempt to obtain independent pricing information.

This type of work is, clearly, somewhere between minimal and absolutely no value for investors. If the auditor receives a spreadsheet from the manager showing the matrix of broker quotes received, how does the auditor know that the manager has not adjusted that spreadsheet to exclude quotes which were uncomfortably low? Even more importantly, if all the auditor does is to check prices back to pieces of paper in the manager's own pricing file, how does the auditor know that those pieces of paper are genuine? As we have said before, and will keep on saying, it only costs $500 to buy a copy of Adobe Photoshop if you are of a mind to alter documentation.

When discussing this type of work, the manager typically notes that, if the auditor was to complete a full, independent pricing review, it would be too costly and too time consuming to be practical on a quarterly basis. A full, GAAP audit review is, of course, performed at year end - this does include independent pricing (although - investor fyi - auditors will still only sample test many portfolios.)

While these are fair points, it remains the case that this type of AUP provides minimal protection against pricing fraud. In the meantime, the manager gets the marketing benefit of being able to claim enhanced scrutiny and oversight from a Big 4 firm each quarter.

Which leads to our second point. Why would an auditor accept to complete agreed upon procedures when any reasonable accountant would rapidly conclude that the typical scope of these AUP provide pretty much nil controls assurance? Why does the auditor not insist that, if their name is to be associated to this work, then the procedures must be meaningful and sufficient to meet an actual control standard?

To this point, the actual audit standard applicable to AUP is available here. The standard states:

An agreed-upon procedures engagement is one in which a practitioner is engaged by a client to issue a report of findings based on specific procedures performed on subject matter. The client engages the practitioner to assist specified parties in evaluating subject matter or an assertion as a result of a need or needs of the specified parties. Because the specified parties require that findings be independently derived, the services of a practitioner are obtained to perform procedures and report his or her findings. The specified parties and the practitioner agree upon the procedures to be performed by the practitioner that the specified parties believe are appropriate. Because the needs of the specified parties may vary widely, the nature, timing, and extent of the agreed upon procedures may vary as well; consequently, the specified parties assume responsibility for the sufficiency of the procedures since they best understand their own needs. In an engagement performed under this section, the practitioner does not perform an examination or a review, as discussed in section 101, and does not provide an opinion or negative assurance. Instead, the practitioner's report on agreed-upon procedures should be in the form of procedures and findings.

In practice, this all gets horribly circular. Per the standard, a client requests an auditor to complete AUP to assist "specified parties" to "evaluate subject matter or an assertion". In our case, the assertion would be "are hard to value securities valued correctly at quarter end."

However, the specified party is usually the manager itself, making the client and specified party the same person. The particular trick applied, in many cases, is for the auditor to seek to prevent the investor from actually seeing the AUP in the first place! However, if the investor is to have access to the AUP, the auditor universally requires the investor to sign a Catch 22 document which requires the investor to acknowledge that the AUP are "sufficient for their needs". So, even if the investor believes that the AUP are not "sufficient for their needs" - which is hardly a long stretch - the investor has to sign that the procedures are sufficient if they are to even see the auditor's work. With this magic piece of paper, the auditor has met its requirements and can sleep easy. Meanwhile, the auditor will send a bill to - guess who - the fund, meaning that investors have, once more, had to foot the bill.

As always, Caveat Emptor.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

Kroll Fraud Report

2009-10-22T11:08:11-04:00

Kroll publishes an annual fraud report - we commented on the prior year edition here, and the new document is available from Kroll's website. Data was prepared in conjunction with the Economist Intelligence Unit.

As always, this is an interesting read, and we particularly agreed with the comments provided in the introduction:

"Fraud, corruption, and all that go with it may not have precipitated recession, but they certainly made its impact all the more painful. Losses, prosecutions, litigation, bankruptcies, were all sparked or exacerbated by the actions of groups or individuals in the years before; actions that went undetected and unpunished until too late.

The conventional wisdom is that fraud goes up in a recession. That isn’t necessarily true, as our survey shows. What goes up is the discovery of fraud, not always the same thing. Just like legitimate businesses, fraudsters are threatened by loss of income or the financial weakness of their businesses; Ponzi schemes are especially vulnerable. But other fraudulent areas – management conflict of interest, corruption, employee theft – also come to light when business conditions sour.

The data we have collected this year clearly highlights the industry hardest hit by fraud and wrongdoing: financial services. Over half of the respondents in this sector reported that the global financial crisis had increased levels of fraud at their companies – the highest figure for any industry.

Nearly 90 percent of firms reported being victims of some kind of fraud in the last three years. This sector also had the second highest proportion suffering from each of internal financial fraud and management self-dealing.

Unfortunately, though, over one in five financial services companies saw their internal controls weakened through cost cutting. It is understandable that in today’s climate, they should seek economies. But these will be false economies over the longer term if they lead to the resurgence of the same issues that so deeply damaged the industry in 2008-9.

“Tighter controls” will not be a popular rallying cry in Wall Street, the City or Nariman Point. The associated costs can be hard to bear in difficult times – but the cost of non-compliance can be harsher."

Exactly.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

A salary survey...from the real world

2009-10-12T21:21:59-04:00

Back in January 2009, we published a post entitled "The Bonus Debate: Investment Banker or Heart Surgeon". Our target was the compensation structure of the investment banking industry - and pretty much the same applies in the world of hedge funds.

As we said at the time:

"It is not hard to agree that one of the primary causes of the global economy's rollercoaster ride from excess to catastrophe has been compensation. We have commented before on the many inconsistencies of hedge fund compensation and the fundamental weaknesses of the "2 and 20" structure. Indeed, Castle Hall's White Paper, "Hedge Fund Investing in a New World", discussed these issues in October 2008.

Another compensation issue is, of course, the pay structure in the world of Wall Street's investment banks. According to Bloomberg today, "Wall Street bonuses may go the way of the dodo" and, yesterday, President Obama was widely reported as saying that the $18 billion bonus pool Wall Street paid itself at the end of 2008 was "shameful".

And yes, Wall Street's bonuses are shameful. Particularly, they are asymmetric: you get paid on the way up but have no obligation to pay anything back on the way down. It's like a balloon blowing contest where the person who blows the biggest balloon gets paid the most, but doesn't have to repay anything if it bursts a moment later.

What is really shameful - and what really is the root problem here - is the finance industry's sense of entitlement. Progressively, it would seem that those working at the top of the finance "system", including many investment bankers and hedge fund managers, have developed their own value system, and their own, ever more inflated baseline for "normal" compensation. Never has the gap between the psychology of Wall Street and Main Street been so wide.

Hedge fund investment professionals, just like investment bankers, need to remember that $500,000 a year - let alone $5 million - is not a threshold level of "acceptable" compensation. It is also the case that the compensation you make in your best year is not your baseline minimum for what you expect to get next time - a bonus may well be a highly generous recognition of being fortuitously in the right place at the right time."

Against this background, we have been amused to read about Mr. Andrew Hall, the Phibro commodity trader who has a contractually bomb proof potential $100 million pay packet. Yet, on CNN this evening, there is a list of "top paying jobs": per CNN - "what other great careers from CNN Money's and payscale.com's list of Best Jobs in America offer great paychecks?"

The list is as follows:

1. Anesthesiologist: Median Salary $292,000, Best Salary $408,000

2. Physician/Obstetrician/Gynecologist: Median Salary $222,000, Best Salary $338,000

3. Psychiatrist: Median Salary, $177,000, Best Salary $279,000

4. Nurse Anesthetist: Median Salary, $157,000, Best Salary $214,000

5. Sales Director: Median Salary, $140,000, Best Salary $239,000

6. Actuary: Median Salary, $129,000, Best Salary $257,000

7. Finance Director: Median Salary, $121,000, Best Salary $214,000

8. Software Architect: Median Salary, $117,000, Best Salary $166,000

9: Attorney / Lawyer: Median Salary, $115,000, Best Salary $262,000

10: Insurance Broker: Median Salary, $114,000, Best Salary $273,000

To put all this in perspective, if you were a stellar commodity trader with compensation of $100 million per year, you would earn the annual salary of the median anesthesiologist in roughly 5.5 hours. So, arrive at work at 8:30 on January 1, you're done by 2pm.

As we said earlier this year, never has the gap between Main Street and Wall Street (or in this case a nice farmhouse in Connecticut) been so wide.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

Rethinking Fund Administration 1.5

2009-10-02T07:09:36-04:00

In one of our last posts, we began a series of comments discussing the current state of the hedge fund administration industry, with a particular focus on valuation. We promised that our next post would address some solutions to the "valuation dilemma", and we will return to this topic shortly.

However, we were interested to read the new version of the AIMA Guide to Sound Practices for Hedge Fund Administrators, published in September (available here). This includes, as would be expected, commentary as to the role and responsibilities of the administrator regarding valuation.

Before we go to our second post on solutions, we thought that it would be useful to make some comments on the AIMA paper - which holds itself out as the central benchmark of administrator "sound practice" - as an addendum to our prior post. We hence have some comments on rethinking hedge fund administration 1.5.

The point we would like to make is to compare what AIMA now say in 2009, with what they used to say in the first version of the administrator sound practices guide, which was published back in September 2004.

In Section 3.2, Security Pricing, the "Old Guide" stated:

Security pricing is a high-risk area for administrators, managers and prime brokers. It requires high quality data feeds, automated price validation systems and highly experienced staff. The risk of applying the wrong prices to a fund is ever present and extreme care is required to avoid this and any consequent reputational damage to the manager, administrator and prime broker.

It is also vitally important to consider the independence of the pricing process. Wherever possible, the administrator must independently price the assets of the fund. This is essential to preserve the actual and perceived independence of the NAV process and to protect the manager from accusations of bias. If the pricing environment of the fund is not rigorous, then the investors could be exposed to the risk of incorrect pricing.

However, there will be occasions when valuations of certain instruments can only be made by the manager and the issuer of the instrument, or by the manager alone. In such situations, it is important that the method of valuation is agreed with the administrator and the auditor before the fund is launched and that there is some way for both of them to check the pricing of the instruments during the life of the fund. The administrator should be able to assess the “reasonableness” of the manager’s and/or product issuer’s price.

We would completely agree that it is "vitally important to consider the independence of the pricing process". Moreover, even for the hardest to value securities, AIMA's 2004 guidance states that the administrator (and auditor) must find "some way for them both to check the pricing of instruments during the life of the fund."

When getting to the very hardest to price securities, the Old Guide states:

In some cases, the administrator may be required to rely on prices determined by the manager, using its own pricing model for some specific complex derivatives instrument, for example. Although this is not desirable, there may be no alternative. In such cases, the administrator should:

1. ensure that the valuation procedure whereby the administrator is obliged to value the fund’s portfolio on prices based on the manager’s pricing model or formula is fully disclosed in the offering documents and the administration agreement;

2. ensure that the manager discloses both to the administrator and the fund’s auditor how the pricing model works and permits the auditor to carry out spot checks from time to time, to verify correct application of the pricing model; and

3. if possible, install the pricing model on its own system so that it can check the prices provided by the manager.

Armed with their own sources and the counterparty’s valuation, the administrator should be in a position to value the OTC position competently.

These provisions, therefore, provide specific guidance to the administrator when looking at OTC trades and, overall, create a "do as much as you possibly can" mindset. The guide continues:

Security pricing is a highly skilled area, requiring highly trained and knowledgeable staff. It should not be done by “part-timers” nor should there be duplication of effort. Ideally, each security should be priced once for all funds holding that security at that time. Control of this function is one of the central obligations of the administrator, who should be employing common pricing procedures across all of the funds it administers.

This again suggests that there is a clear responsibility for the administrator to both disclose any manager pricing and, moreover, do all that is possible to derive independent valuations. We particularly like the comment that "control of the [pricing] function is one of the central obligations of the administrator." Moreover, the Old Guide makes it clear that this work should be supported by suitably skilled resources within the admin's organization.

Well, what a difference five years makes. These are the key comments on valuation from the New Guide:

In all cases, it is important to consider the independence of the pricing process. Wherever possible, but subject in all cases to the fund’s pricing policy, the administrator should seek independent sources for the valuation of the assets of the fund. However, there will be occasions when valuations of certain instruments can only be made by the manager and the issuer of the instrument, or by the manager alone. In such situations, it is important that the method of valuation is documented, checked where a secondary source is available and reported to the pricing committee or board, periodically.

OK. So now it is "important", not "vitally important" to consider the independence of the pricing process. There is also a big difference between "wherever possible, the Administrator must independently price the assets of the fund" (which means that the administrator's prices would be used in the NAV) and "wherever possible, but subject in all cases to the fund's pricing policy, the administrator should seek independent sources for the valuation of the assets of the fund." Note also that we are now in a world where there "will", rather than "may" be occasions where valuations can only be made by the manager. We continue:

The pricing policy document should be approved by the board or governing body of the fund on a regular basis (annually or when altered).

It should be noted that while some HFAs have people, teams and service models which are capable of, and expert in, the calculation of recommended prices for individual securities, many others are not. A hedge fund manager or investor should not automatically assume that the HFA offers this service, employs this expertise or takes this responsibility.

Particular attention should be given to the governance aspects of the AIMA Guide to Sound Practices for Hedge Fund Valuation, as the observance of their principles should avoid any misunderstanding or lack of clarity around pricing and responsibility.

The Guide notes that the area of valuation has been topical and, in some cases, controversial. The role of the HFA has regularly been questioned and many investors and other industry participants have asked: “Is the HFA responsible for valuations?”

The Guide notes (and agrees) that both the AIMA and IOSCO documents suggest that it is the governing body that is ultimately responsible for the valuation of assets. In most cases, this is a board of directors or a general partner. Typically, the board will set a pricing policy.

The main thrust of the new document, therefore, is to revert attention to the pricing policy (and how many funds actually have one which really is detailed and comprehensive?) and place the administrator in a secondary, reactive role. The guidance is much more vague, and there is certainly not the same emphasis on the "essential" need for administrators to "independently" value assets. Moreover, there is now room for "many" administrators not to be "capable" and "expert" in the calculation of recommended prices for individual securities.

Our biggest comment though, is one we have made before. It remains utterly, utterly and utterly ridiculous to suggest that a Board of Directors comprised of two gentleman in the Cayman Islands with corporate secretarial backgrounds, who serve on the boards of hundreds of other hedge funds, can be "ultimately responsible for the valuation of assets" and "set a pricing policy". For investors who allocate tens of millions - or hundreds of millions - of dollars to individual hedge funds, this comment can best be described as disingenious fallacy. In fact, it is an insult to the intelligence of everyone concerned.

We would also point out that investors can pay the administrator millions of dollars per year for their services on some larger funds, while the average Cayman director gets $5-10,000 per fund. That would seem to place some framework around who has the better knowledge and who is better placed to get involved.

Perhaps the best comment, however, is the final "sound practice" guideline.

The governing body and the HFA, together with the investment manager, will then agree on how that pricing policy is to be executed. There may be specific responsibilities placed on the HFA in the execution of this policy but investors should not automatically assume a standard model.

AIMA, therefore, leaves us in exactly the same place as our own experience of current administration servicing. While some administrators do complete thorough and robust servicing, including detailed pricing, many do not. The message from the industry to investors, though, appears to be fairly casual - don't take anything for granted, or "automatically assume" a standard model. In other words, caveat emptor.

The real issue here - and one that must be addressed, sooner rather than later - is that post Madoff, post financial crisis, and post the greatest stress period the hedge fund industry has ever seen, hedge fund investors have increasing, not decreasing, exposure to managers pricing their own securities. We would have thought that all this pain would leave us with more protections - but no, we continue with all the evident risks that go along with managers marking their own books. Moreover, everyone concerned - managers, administrators, auditors - seem to assume that this is an entirely satisfactory state of play and, indeed, is "sound practice".

As the boy said to the naked emperor, it is not.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence