Monday, August 15, 2016

Buy-Side Pricing Alerts

The money center banks have for years been heavily criticized for their pricing operations going awry. 

Many of these issues occur in the fixed income or over-the-counter (OTC) markets, where transparency is limited, secondary market liquidity near invisible, and pricing discrepancies sometimes easily and innocently explained away.

The banks have had their troubles and issues with consistent pricing across different divisions.  The "London whale" saga at JPMorgan was one of the big ones.  

Anybody who watched The Big Short recently will remember the palpable frustration in the air as the "shorts" waited anxiously for RMBS and CDO price depreciation, which lingered endlessly, much to their frustration, despite the obvious downward change in fundamentals.  In the book, Scion Capital’s Michael Burry is quoted as saying: 
“Whatever the banks’ net position was would determine the mark,” ... “I don’t think they were looking to the market for their marks. I think they were looking to their needs.”
Pricing Concerns ... Coming to a Fund Near You

In the Big Short, the focus on pricing was on banks' failure to lower prices quickly enough.  But pricing concerns are more typically focused in the other direction: asset price inflation. And nowadays the buy-side is taking the brunt of the investigative interest ... with the focus being drawn on their valuation of private companies.

First, let's step back.  Everybody who owns a computer (even a smartphone) can see where Apple's stock trades.  Yes there are off-exchange venues (including dark pools) but generally there is plenty of price transparency for liquid large-cap stocks.  

Importantly, all institutions would hold Apple stock at the same value on their balance sheets, whether they're long or short, expecting it to rise or fall.  Each institution's opinion doesn't matter: the market dictates.

In OTC and private company's equity valuation worlds, there isn't necessarily a ready market...so instead of marking-to-market the world more generally marks-to-model.  Each firm can hold the same security at a different price.

But the problem is, well, funds charge fees based on performance.  Higher asset prices translates into better performance.  Ergo, mark your assets higher and you'll make more money.  Voila!  Next, funds advertise their performance.  Higher marks therefore means better performance; marketing of stronger performance can translate into higher capital inflows from investors, which means more money under management, which means more fees.  Brilliant!

So that's the problem (the incentive/motivation is too compelling!).

The news pieces are coming in thick and fast.

On Friday, Reuters published a piece called: U.S. mutual funds boost own performance with unicorn mark-ups which explained that:
"The Securities and Exchange Commission (SEC) has been asking mutual fund companies how they value their stakes in companies like Uber, Pinterest Inc and Airbnb...  The regulator is worried investors could get hurt in case of a sharp tech downturn, according to two people familiar with the SEC's queries."
The WSJ had written a similar piece back in November 2015: Regulators Look Into Mutual Funds’ Procedures for Valuing Startups, noting that:
"According to a Journal analysis of data provided by fund-research firm Morningstar Inc. of startups worth at least $1 billion, there were 12 instances over the past two years in which the same company was valued differently by more than one mutual fund on the same date."  
And BloombergBusinessweek, back in March 2015, had put together perhaps the most entertaining read of all:  We Tried to Re-Create JPMorgan’s Mutual Fund Returns and Gave Up: "The bank’s impressive mutual-fund-group performance figures come with little explanation ."


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We're keeping a close eye on asset pricing issues, especially in the credit space.  If you notice anything we're missing, let us know.  Click here for a compilation of pricing issues we have seen recently, including specific investigations.

1 comment:

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