Thursday, November 20, 2008

Unequal Hedge Fund Disclosure - How "Fair Value" May Become Unfair

The Problem

All hedge fund disclosures are equal, but some investors apparently have more equal transparency than others.

Perhaps, for a tough sale, a hedge fund manager may be inclined to show certain procedural documents to a certain investor, while the less inquisitive investor may not be privy to the same information. That's just a guess, but whatever the case may be, let's call this situation "Preferential Treatment."

For example, fund-of-funds ABC knows that hedge fund HF would exit strategy STR if situation XYZ occurs. Suppose fund-of-funds DEF doesn't isn't privy to this exit strategy.

An Accident Waiting to Happen

From a fair value perspective, should ABC's investment in HF be accounted for equally with DEF's investment?

I would argue they're not equal, even though the HF's NAV is obviously the same for both funds-of-funds. ABC clearly has optionality that DEF lacks. Knowledge of HF's procedures gives ABC the option to either invest more or redeem, as it may see fit, whereas DEF is unaware of any changes. For the financial engineers out there, you all know that options cost money. ABC is long an additional option in this example, and so ABC's investment in HF should be greater than or equal to that of DEF.

Similarly, as an investor, knowing about your hedge fund's side pockets or ability to ring-fence part of its portfolio is crucial knowledge, as it affects your "redeemability."

Whereas the imposition of gates is highly publicized, the usage of side pockets is not well publicized: GLG Partners, and to an extent JB Global Rates Hedge Fund, being notable exceptions (see, for example Side Pockets - Keeping Hedge Fund Capital in Their Pockets).

A Litigation Disaster

Here's how this all went wrong for some firms (including Bear Stearns), according to certain excerpts from the SEC's: "Lessons Learned from Significant Examination Findings and Recent Enforcement Actions."


November 13, 2008


DELMAGE: ... we've seen situations where firms have failed to consistently apply these redemption policies.

Again, this is primarily in private funds. As everyone's well aware, firms have opposed gates. They've curtailed other abilities for people to extract liquidity from their underlying investments.

And again it comes out to disclosure. The [SEC] staff is gonna be looking at what's in the private offering documents, what's in the marketing materials, what's been in the ADV regarding the process for handling redemptions.

Timing, you know -- when certain times, certain dates, how much notice people need to give before they want their -- get their redemption proceeds -- and I guess, as part of that, one thing we will be looking at is to make sure there is no preferential treatment. Obviously, one of our concerns is, you know, maybe in days leading up to the announcement of the gate being imposed -- certainly the insiders of the investment advisor or maybe larger investors who have
a sizable stake in -- in the underlying funds -- are allowed to get their money out on different terms than other investors before the gates have been imposed.

And we've actually been seeing that in a number of examinations where, in this situation, the firm didn't impose the gate but they created a side pocket for a pretty sizable portion of the portfolio and had informed investors, and I believe they actually had sent out notice and people agreed to it, that they would be able only to redeem from the liquid portion of their investments up to a certain percentage.

And what we actually had seen -- looking at journals, e-mails again -- we had seen, you know, certain investors being able to redeem 100 percent of their investment. We had seen -- or saw situations where redemption requires had been backdated to certain investors.

Again, in certain situations, certain funds, depending on their asset class, have suffered some liquidity problems. There were other funds that didn't have that same problem and it appeared that the more liquid fund was funding the illiquid fund's redemption request; again, not disclosed to investors, nowhere in the offering documents.

... I think the lesson to be learned is, obviously, when the [SEC] staff sees a fund -- has imposed gates or somehow curtailed liquidity -- we are going to be looking at the disclosure documents. We're gonna be looking at how redemption requests have been handled, especially the period leading up to the announcement of that event.

... obviously, you have a fiduciary duty -- giving people preferential treatment, you know -- engaging in practices, you know -- backdating and other things, obviously, does not meet that test.

CHRETIEN-DAR: Just to emphasize Bill's point about preferential redemption not only is that a problem, in terms of your fiduciary obligation to your clients, but your insider [trading] procedures probably should be affected by this type of activity. There were -- in private litigation -- we saw that there were shareholders in the reserve fund made claims of inside information, in that some investors got out before the money markets fund broke the buck.

So there were a lot of private claims about insider training. The commission brought an action against the two portfolio managers of the Bear Stern hedge funds that invested in subprime-related securities.

And redemptions were also a big issue in that case, not only in terms of the commission's allegations regarding the representations on the status of redemptions, which was important to investors to know about, but on the criminal side there were allegations that the portfolio manager pulled out of the fund as he was reassuring investors about the fund.

So not only is it, you know, what you tell your investors, in terms of the status of redemptions, but also what you were doing with your own stake in those funds. Bear, apparently, had a policy at the time that portfolio managers in the funds that they mentioned should have a personal stake.