Investigations of Fund Fees (and Fees and Fees)

With the Blackstone settlement from earlier this week (see below), now is as good a time as any to start a list of investigations into fund fees.  If we're missing any, let us know!

1. August 2018: 18-229MR Update on financial advice institutions' fees for no service refund programs: "AMP, ANZ, CBA, NAB and Westpac have now paid or offered customers $222.3 million in refunds and interest for failing to provide advice to customers while charging them ongoing advice fees."


2. June 2018: THL: Accelerated Fees: "This matter arises from inadequate disclosures by private equity fund adviser THL regarding THL’s potential future receipt of lump sum fees from the portfolio companies of two THL-managed private equity funds launched in 2000 and 2006."


3. April 2018: A.G. Schneiderman Releases New Report On Mutual Fund Fees, Announces Agreement By 13 Major Firms: "NEW YORK – Attorney General Eric T. Schneiderman announced that after an industry-wide investigation into mutual fund disclosures and fees, 13 major mutual fund firms—including those run by some of the largest players in the mutual fund industry—have agreed to voluntarily publish important information about their mutual funds to all retail investors."


4. Dec. 2017: TPG: Accelerated Monitoring Fees: "From at least April 2013 through April 2015 (“Relevant Period”), upon either the private sale or an initial public offering (“IPO”) of a portfolio company, TPG terminated certain portfolio company monitoring agreements and accelerated the payment of future monitoring fees pursuant to the agreements. Although TPG disclosed that it may receive monitoring fees from portfolio companies held by the funds it advised, and disclosed the amount of monitoring fees that had been accelerated following the acceleration, TPG failed to disclose to its funds, and to the funds’ limited partners prior to their commitment of capital, that it may accelerate future monitoring fees upon termination of the monitoring agreements."


5. April 2017: SEC Charges Credit Suisse and Former IA Representative With Breaches of Fiduciary Duty: "The [SEC] today announced that [Credit Suisse] and one of its former investment adviser representatives have agreed to pay almost $8 million to settle charges that they improperly invested clients in more expensive “Class A” shares of mutual funds rather than less expensive “institutional” shares for which they were eligible. The SEC’s orders find that Credit Suisse and Sanford Michael Katz breached their fiduciary duties and failed to adequately disclose the conflict of interest created by such investments as they enriched themselves at their clients’ expense."


6. September 2016: ING Bank compensates Living Super customers due to potentially misleading costs and fees statements


7. August 2016: SEC fines Wilbur Ross firm $2.3 million over fees: “Billionaire investor Wilbur Ross' investment firm WL Ross & Co agreed on Wednesday to pay a $2.3 million fine to the Securities and Exchange Commission to settle charges that it did not properly disclose some fees it charged investors."


8. August 2016: Apollo to Pay $52.8 Million Over Fee Practices: “A common theme in our recent enforcement actions against private-equity firms is their failure to properly disclose fees and conflicts of interest to fund investors,” said Andrew J. Ceresney, director of the SEC Enforcement Division.


9. August 2016: Suits Target University Retirement Plans: "Many of the cases challenge 403(b) plans’ use of retail share classes of mutual funds, rather than lower-cost institutional versions of the same investments. They also contend that the plans’ arrangements with multiple record keepers cause participants to pay excessive administrative fees"


10. August 2016: SEC Probes Silver Lake Over Fees: "Investigation is part of regulator’s broad push to make sure buyout firms are being upfront with investors"


11. July 2016: Investors Are Getting Ripped Off on Index Fund Fees, Lawsuits Say 


12. Feb. 2016: George K. Baum Overcharged School District, Regulator Says: “Municipal-bond underwriter George K. Baum & Co. agreed to pay a $100,000 fine over allegations it charged a school district four times the typical fee to sell debt, in part to help cover the cost of bond elections, a regulator of securities dealers said.”


13. Jan. 2016: SEC: Alternative Fund Manager Overcharged Fees, Misled Investors 


14. Oct. 2015:  Blackstone to pay about $39 million to settle SEC charges over fees: the payments Blackstone received "essentially reduced the value of the portfolio companies prior to sale, to the detriment of the funds and their investors."


15. Sept. 2015: CalPERS: Tensions rise over private equity fees


16. Aug. 2015: Private equity industry sees more federal regulation: OICE...examiners had turned up widespread "deficiencies" in how private equity firms charge clients for fees and expenses and the agency had found "violations of law or material weaknesses in controls over 50% of the time."


17. June 2015: Earlier this year, a senior executive of the California Public Employees’ Retirement System, the country’s biggest state pension fund, made a surprising statement: The fund did not know what it was paying some of its Wall Street managers.


18. April 2015: N.J. pension fund heads to investigate investment fees and bonuses to private companies.


19. Dec. 2014: Two of the biggest private-equity firms are disclosing fees that had largely been hidden as U.S. regulators demand increased transparency from the industry.


20. Dec. 2014: With private equity firms under the regulatory microscope, the balance of power may be shifting — at least a bit — away from fund executives and toward investors.
    


21. Nov. 2014: Blackstone Group, which manages $279 billion, no longer will pocket extra consulting fees when selling or taking public companies it owns.


22. Sept. 2014: SEC reviews completed as part of a two-year effort involving nearly 200 funds have found cases where potential investors were given only the most favorable description of past performance rather than full disclosure of winning and losing bets.


23. Sept. 2014: SEC Charges New York-Based Private Equity Fund Adviser With Misallocation Of Portfolio Company Expenses: "An SEC investigation found that while Lincolnshire Management integrated the two portfolio companies and managed them as one, the funds were separately advised and had distinct sets of investors. Despite developing an expense allocation policy as part of the integration, it was not followed on some occasions, resulting in the portfolio company owned by one fund paying more than its fair share of joint expenses that benefited the companies of both funds."


24. July 2014: Federal regulators are looking at commissions that buyout firms receive for helping companies they control get goods and services at discount prices, as part of a stepped-up probe of private-equity fees.


25. May 2014: The Deal’s Done. But Not the Fees: “In some instances, investors’ pockets are being picked,”


26. May 2014: BlackRock faces lawsuits over “disproportionately large” fees.


27. May 2014: The SEC found illegal fees or severe compliance shortfalls in more than half of the firms it examined since starting a review of the $3.5 trillion industry two years ago.


28. April 2014: More than half of about 400 private-equity firms that SEC staff have examined have charged unjustified fees and expenses without notifying investors,


29. March 2014: Muni Investors Getting Fleeced On Trading Costs: Investors typically pay twice as much in trading commissions for municipal bonds as they would pay for corporate bonds.

High Frequency (Non) Trading

This week's release of Michael Lewis' new book, Flash Boys, has renewed focus on a little understood area of the market, an area that has garnered the recent attentions of market regulators, New York's Attorney General, and more recently the FBI -- but never as much attention as it garnered from Michael Lewis' interview on 60 Minutes on Sunday, with his book pending release the following day.

Without going into too many specifics, one of the central themes that Lewis discusses is the potential for high frequency traders (or HFTs) to take advantage of certain market information -- like bids and offers -- that are unknown to many other market players.

Defenders of HFTs have come out aggressively, with claims that HFTs increase market activity and liquidity, and have lowered trading costs.  The WSJ published an extensive opinion editorial by hedge fund guru Cliff Asness and his colleague Michael Mendelson of AQR, which energetically claims that much of what HFTs do is "make markets" and that they do it best because "their computers are much cheaper than expensive Wall Street traders, and competition forces them to pass most of the savings on to us investors."

Of course this sounds altogether too convincing.  Unfortunately, Asness and Mendelson provide little or no evidence (although their business as long term traders relies heavily on evidence, and they claim in the article to spend considerable energies looking into their trading costs) and they admit that they actually don't have too much conviction in the premise of their exposition:

"We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars. We can't be 100% sure. Maybe something other than HFT is responsible for the reduction in costs we've seen since HFT has risen to prominence, like maybe even our own efforts to improve." (emphasis ours)

But this aside, no doubt all forms of HFTs bring liquidity.  They're a good thing.  Let's focus our attention elsewhere.  

Or not?

Might there be another type of HFT, that doesn't always bring liquidity for the greater good of the market ...  perhaps a type that uses obscure mechanisms to change the look and feel of the market -- to make people think there is a bid, think there is an offer, without there being one?  

This is what Flash Boys, and the interest it has invigorated in HFTs, really concerns itself with -- understanding market maneuvers like spoofing or pinging: the submission of phantom orders, immediately cancellable, that have the potential to create a false impression of market levels.

Are we creating a whole lot of (potentially fictitious) orders, but not a whole lot of activity?  Are there high-frequency non-traders?  Are we mis-marking our portfolios as a result? We continue to investigate.  But we couldn't help but bring you back to a 2013 chart from Mother Jones, which highlights the growing contrast between actual trades (in orange) and quotes/orders (in red).

Hedge Funds and Rabid Regulation

With Obama urging Congress to empower regulatory units and quicken regulation, one is encouraged to ponder on philosophically.

Are we simply overcompensating for having been under-regulated or poorly regulated? Are we ready to impose and adopt new regulation? Is regulation even a cure?

As one can imagine, poor regulation in its abundance may have a similarly negative effect to poor regulation in its absence. Perhaps there's a covenient middle ground. But the speedy (raging) imposition of new regulation simply cannot be the answer: it hinders growth and poses significant operational burden at a time when the U.S. -- no, world -- economy simply cannot support it. And it's expensive.

Now we don't contend that all regulation is bad. Some of it, for example the rating agency debate, is healthy. But when the political maneuvering becomes extreme it can undo much of the good work that came before it. Hedge funds, for example, are appealing due to the leverage and return they can achieve. But they become infeasible under certain regulatory and disclosure regimes. We are, in effect, ensuring that very few hedge funds can and would want to continue existing. The move towads being an asset manager, consulting firm, or bank would be much more appealing: if you're going to be heavily regulated anyway, why not take the upside?

The hedge fund industry certainly has a few items worthy of an additional eye (i.e., some form of supervision). We've spoken a little about sidepockets and challenges in consistently presenting fair value. Side letters, as an aside, and redemption gates are also obviously problematic and requiring attention.

And so too are fund documents: not only the restrictions they impose, but more importantly the capabilities and flexibilities their language allows. As Risk Without Reward (RWR) points out, the idea of "buyer beware" is only useful if the documents have not been drafted in such a way that allows just about anything "in the sole discretion of the investment manager."

For example, CDO indentures for managed deals have various sections describing what are acceptable Substitute Collateral Debt Securities. Fund documents, less so.(Even today we saw -- and it's not necessarily a bad thing -- two of Eaton Vance's funds approving investment in alternative new asset classes, with one fund allowing investments in commercial mortgage-backed securities (CMBS) and the short-selling of sovereign bonds subject to certain limits. For another way managers get around regulation see Regulatory Capital Arbitrage.)

Aside from investment criteria investors should look at operating expenses for the fund. Does the hedge fund pass legal and formation fees onto the fund owners? Okay. Are investors alone paying for data and vendor tools that are used for the manager's other (possibly prop capital) funds? Is that sharing pro-rata? And is the fund paying for the marketing of its shares? (Hat tip to RWR for this catch). Data and analytical tools are expensive, as can be the fund marketer's traveling expenses. Frustrating indeed. But time to ask those tough questions. While we still have hedge funds.

Deleveraging by Leveraged Funds-of-funds

The calling of Allianz’s EUR300 million Phenix CFO -- purportedly the first to be liquidated -- augurs poorly for the hedge fund industry, adding a further redemption burden to their tally of existing difficulties: staving off general investor fear and redemption requests; reserving against price markdowns and margin/haircut postings; deleveraging in a difficult market; establishing new and maintaining current sources of funding; combating higher funding costs; complying with increased accounting and regulatory demands; mitigating against rating agency downgrades; ...

And now a new source of redemption requests - by CFOs

CFOs -- collateralized fund obligations -- are essentially leveraged bets against the performance of a (oftentimes managed) portfolio of hedge funds. As is the case with CDOs, investors in CFOs go "long" the performance of a set of receivables (usually from debt). For CBOs, these receivables are the coupons of bonds (hence the "B" in CBO). For CLOs, loans. For ABS CDOs, the underlying are ABS (really, RMBS) tranches. For CFOs, the return of the funds, with the underlying typically comprising direct purchases in hedge funds or referenced exposures via total return swaps.

CFOs differ from typical CDOs in a few ways (e.g., similar to market-value CDOs, overcollateralization tests measure market value coverage - as opposed to par/principal coverage; there's no real notion of interest coverage ratios; existence of minimum net worth tests with various curing and/or liquidation procedures, such as the issuance of additional preference shares).

In the case of Phenix CFO, according to Bloomberg, more than 75 of the 80 hedge funds invested in by the structure have either liquidated or limited (or completely suspended) client withdrawals from their funds. With this in mind, Phenix's bondholders voted to liquidate the deal.

This notification, which came out on Friday, ends a tough month for hedge funds and banks in general, as can be seen from the graph below (click on it to enlarge).


UPDATE - February 2, 2009: Fitch Ratings Announcement

To address short-term volatility in CFO performance as well as reporting delays from underlying hedge fund investments, Fitch's [newly updated] analysis applies a 10% haircut upfront to the most recent reported portfolio NAV. The 10% haircut was derived using the worst monthly return decline reported by Fitch-rated CFOs.

...

Hedge fund returns, as represented by several multi-strategy indices, declined approximately 20 to 25% in 2H 2008. As well, Fitch has observed reductions to hedge fund CFO liquidity (including gating, restructuring, side pockets) in a range of approximately 5% to 40% of net asset value(NAV) in fourth-quarter 2008.

Interestingly, this final paragraph bring us back to our October '08 piece (Jack of All Trades?), highlighting the underperformance of multi-strategy hedge funds.

UPDATE - March 26, 2009: Moody's downgrades all tranches issued by SVG Diamond Private Equity II. SVG is a CDO somewhat similar to CFOs, but is backed by returns to shares of (principally) private equity (PE) funds, as opposed to a diversified pool of hedge funds.

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."

TRANSCRIPT

November 13, 2008

SECURITIES AND EXCHANGE COMMISSION

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.

An Investor's Guide to Hedge Fund Leverage (Part 1)

Leverage (more specifically deleveraging) difficulties have caused more than their fair share of pain of late in the hedge fund world.

We're going to explore the concept of leverage by way of an example for now; let's suppose:

1. we're in a simple world (let's call it Wonderland) in which the price of a bond or a loan remains constant at $100 per $100 of par;
2. managers can only buy (go long) assets, and no naked shorting is allowed;
3. AA bonds carry coupons of LIBOR + 90 basis points (i.e., L + 0.9%); and
4. A bonds carry coupons of LIBOR + 125 bps (i.e., L + 1.25%).

Imagine these bonds are fairly illiquid and so the manager's strategy is to buy them and hold them to maturity. Assuming zero defaults, the manager who buys AA bonds will earn L + 90 bps on his/her investment, while the manager who took on more risk with single A bonds will earn L + 125bps.

Let's put aside our feelings about whether LIBOR + 1% or so is a "good" return. One thing we know for certain: unless LIBOR goes crazy and hits the 29% mark, your hedge fund is never going to earn 30% annually by simply buying and holding bonds, even if there are never any defaults. We're not going to invest in a hedge fund that targets L + 1%; to compensate for the limited upside potential of bonds/loans, relative to equity, fixed-income hedge fund managers need a little more zip. To "hit" the big numbers (assuming no shorting for now), they need leverage.

Leverage can be "achieved" in various forms, such as total return swaps and repurchase agreements ("repos"); for now let's examine the essence of the mechanism.

Suppose hedge fund HARRY has $10mm of capital and wishes to buy a $10mm position in that AA bond paying L + 90 bps. HARRY could buy it, after which HARRY is fully invested and yielding L+ 0.90%.

Alternatively HARRY enters an agreement with bank that wants to sell HARRY the bond. The agreement says that bank will LEND HARRY $10mm to buy the bond, subject to the following conditions:

1. HARRY must post the purchased bond to the bank as collateral for the loan;
2. HARRY must pay bank LIBOR + 10 bps on the loan, as long as it's outstanding; and
3. HARRY must post 5% haircut against the AA-rated collateral (to mitigate the bank's risk that the collateral defaults or depreciates in value).

Summary: HARRY's collects L+90 on this bond, pays L+10 to the bank, and has to put down $500K capital (5%) as haircut. Thus, he captures L+ 90- (L+10) = 80 bps on this transaction (of size $10mm). Since he's posting 5% haircut, he can logistically (we're still in Wonderland) perform this operation 20 times (20 x $500K = $10mm = HARRY's total capital). In so doing, he's making:

20 x 80bps x $10mm = a handy 16% return p.a. on capital

Some market terminology for you:

• HARRY is 20 times levered;
• HARRY manages $10mm capital, but has $ 200mm of assets under management (AUM);
• The bank's lending rate to the hedge fund is often termed the "Pricing Rate"; and
• The "haircut" described may also be referred to as initial margin, but bear with me here - we haven't yet breached the topic of "variation margin."

The better the collateral quality, the lower the haircut. Using a 1% haircut in the above example, would allow HARRY to lever up 100 times in Wonderland. Municipal bonds -- historically typically AAA rated and often insured -- are an example of collateral that could be highly leveraged on the back of this strong credit quality.

Now let's have a look at some actual (slightly historical) numbers, while remaining for a while in Wonderland...

(Click on the table to enlarge it)

This concludes Part 1. Part 2 will follow shortly, and will discuss, among other things:

• deleveraging, and its effects
• variation margin - and what happens with 2008 numbers
• leverage facilities: diversification, termination
• and possibly, the cases of Bear Stearns Asset Management (and Merrill Lynch), and the municipal arbitrage deleveraging nightmare

Back to the (Hedge Fund) Future

So the hedge funds are struggling.

Name the fund, pick the strategy; it's struggling. It doesn't matter if you're an academic playing the curve (Myron Scholes' Platinum Grove) or a contrarian macro-fund manager (Peter Thiel's Clarium).

Don't get me wrong here - I'm not suggesting all hedge funds are equal. Indeed some are more equal than others. The access to funding and execution resources may be material differences (although these funds often tend to be more highly leveraged on the back of their support system, and in this deleveraging nightmare are subsequently underperforming their peers despite the availability of this backing - see for example Highbridge Capital, Goldman's Global Alpha, UBS's Dillon Read, and various Citigroup hedge funds).

And despite all the blah blah about 2 & 20 fees being problematic, let's face it - it's not the fees causing 20%, 50% or 80% losses. And it's not regulation either: almost by definition, hedge funds are not having to mark-to-market (MtM) their illiquid/hard-to-value securities. (I'm not strictly correct here, particularly for Och-Ziff, Blackstone and Fortress, which are publicly traded.)

So what is it?

If you're a hedge fund, you're net long; if you're trading OTC securities, you're subjected to comparatively massive bid-offer spreads; and if you're levered, you're dependant on the banks for financing.

What does this all mean?

As a hedge fund you've got capital and you're being paid to put that capital to work. Even if you're long/short equity, you're typically net long at least the same amount as your capital, unless you're holding substantial portions in cash. As an investor in a hedge fund, you don't want your manager charging you hedge fund fees to invest in cash. You can do that yourself. For free.

In a down-cycle, the equity hedge fund manager would have to be a pretty impressive stock picker and seller just to cut even. It's tough to be consistently correct, especially in a fear-driven, volatile market.

But it's the fixed-income hedge funds that have to deal with large bid-offer spreads on OTC-traded securities to cover the market's illiquidity premium/discount and the intermediary's (bank's/broker's) risk that it can't off-load the security and may become subjected to downside MtM pricing risk. You have to be pretty good just to come out even.

And then there's that little issue of leverage. With hedge funds going under all over the place, the banks are understandably being ultra careful about who they lend to (not to mention spending extraordinary amounts of time reverse-engineering the value of their clients' portfolios, to get a better idea of any pending client defaults). If you're looking like defaulting, your haircuts are going to go out of the roof and/or they may draw their line completely. So your hedge fund's default probability -- or more accurately your leverage providers' perceptions of your default probability -- adds an additional burden to the deleveraging nightmare (see our piece Illiquidity: Self-perpetuating Phenomenon). But a blog on this will have to wait for another day...

Where to from here?

We can't pretend to have all the answers; let's call these guesses for now:

Similar to the increased regulatory demands Goldman and Morgan now face as bank holding companies (subject to the Fed), hedge funds are suffering from increased scrutiny and, with it, criticism of their investments and operations - not to mention decreasing investor confidence and redemptions skittishness.

(Even New York City Mayor Michael Bloomberg endorsed the U.S. Treasury's recent recommendation of a new "market stability regulator," that would be able to step in when markets got out of control, having oversight over firms that generally escape regulation, like hedge funds and private equity firms.)

In the absence of "free reign" we envision the natural progression (particularly among the larger hedge funds) towards advisory or asset-management-esqe businesses (think PIMCO, Blackrock): the move away from bank dependency to the unleveraged world of asset management seems an appealing option; alternatively, the move into the advisory space is quite cheap and relatively swift a process, especially as they already have the expertise in-house.

Illiquidity: Self-perpetuating Phenomenon

This relates to our earlier piece Jack of All Trades which talks about why multi-strategy hedge funds are amongst the worst performing hedge funds, in this down-cycle. With the help of some UBS research we read a while ago, we've put together a chart describing the downward spirals we're seeing at high-yield companies and -- more particularly -- hedge funds.

It is downward spirals such as these that bring down leveraged hedge funds like LTCM, and highly-levered companies like Lehman and Bear Stearns, and which keep the SEC and insurance Superintendent Eric Dinallo busy chasing down any market participants who spread false rumors that may initiate or perpetuate such a cycle.

(Click on it to enlarge the graph)


On the corporate side, the difficult market conditions manifest themselves in a re-pricing of credit risk across the board. Corporate debt and equity suffer with the onset of illiquidity. (The more illiquid the asset, the higher its illiquidity "premium" to the discount margin, the lower its price.) The general widening of credit spreads translate into a higher cost of funding for the company, which, coupled with the limited access to funding (debt/equity), may encourage rating-agency downgrades, as the corporation's default probability is increased. Downgrades, then, further decrease the value of the company's debt/equity, increase the cost of funding, and so the vicious cycle perpetually fulfills itself.

For leveraged funds, the self-perpetuating tendencies are more acute; with price deterioration, leveraged funds are typically forced to post additional variation margin (often one-for-one, as the collateral backing their funding is worth less). Obtaining additional cash to post as margin may require the highly levered fund to sell assets ("forced sale").

(As an aside, when forced-sales are occuring en masse in the market, they cause the value of these assets to decrease, as investors can wait for opportune moments to buy assets, at a discount, from forced sellers.)

Once you're a forced seller, you become an increasingly likely default possibility, and so your lender will likely raise haircuts, which causes further forced selling (deleveraging), price deterioration, margin calls, &c.

Jack of All Trades?

We are brought up with the mantra that, while substantially limiting the upside, diversification saves us on the downside. Being by nature (partly subconsciously) risk-averse we tend to diversify endlessly, protecting against losing our dinner, even if it means a lesser chance of a royal dinner with the Queen.

Possibly true for the individual - not necessarily for the managed funds. Let's dig deeper...

Our investigations into recent hedge fund performance bring us back to our deliberations on whether diversification really is always such a good thing. (Remember, the monolines, in an attempt to diversify their portfolios, moved away from being purely muni-bond insurers, and were stung by their participation in the structured finance market. See Muni Bond Insurance (for the short term) for more on this.)

This chart (click on it to enlarge) shows us that multi-strategy hedge funds are among the worst performing in the down cycle.


Some thoughts and possible explanations/justifications:
(1) Multi-strategy funds tend to be more highly leveraged on the back of this diversification (just like certain ABS, CDOs)
(2) As you have more strategies under management, you may tend to lose asset-specific expertise
(3) Perhaps better managers like to keep it clean and simple...

Summary opinion: perhaps diversification is truly a good thing if it's not mis-used or mis-applied. If the diversified fund or portfolio is able to be more aggressively managed purely due to the benefits of diversification, the plain vanilla option, often cheaper, may just become more enticing.

IOSCO's Call for Comments

The International Organization of Securities Commissions (IOSCO) put out this Consultation Report this morning -- with a request for comments -- on Best Practices for Funds of Hedge Funds. The comment period ends January 5, 2009.

This report develops their prior piece with respect to guidelines relating to (a) a fund of hedge funds' management of liquidity risk, and (b) their due diligence processes performed before and during the investment.

Side Pockets - Keeping Hedge Fund Capital in Their Pockets

In the light of increased regulation, we’re seeing a fair share of interest in side pockets. Without further ado, here’s the low-down:

Side pockets are essentially segregated sub-accounts used by some funds (think hedge funds) to allow them flexibilities in dealing with, and accounting for, illiquid and non-marketable instruments (think CDOs), and potentially other assets.

How, Why?
The fund’s offering and organizational documents should disclose pro forma the extent to which it may transfer fund investments to side pockets.

Side pockets provide a structural mechanism for transferring certain (typically illiquid or hard-to-value) investments into a separate class of the fund. The fund investors’ participation interests are separated in tandem with the assets: only those investors having ownership interests at the time the side pocket is created for a specific investment are exposed to the performance of that “side-pocketed” investment.

This accounting arrangement allows the fund to defer valuation of side-pocketed securities until a valuation or liquidation event occurs, such as the disposal of the security, the bankruptcy of the issuer, or the manager’s transfer of the side-pocketed security back into the fund’s main pool of (liquid) securities.

Caveats…

Importantly, an investor’s liquidity is limited while any investment to which she is exposed is side pocketed.
In other words, an investor cannot fully withdraw from the fund until all side-pocketed investments to which she is exposed are removed from the side pockets. She retains her proportionate share in these side-pocketed investments -- even after completely withdrawing from the fund’s primary investment portfolio -- and is subject to an unlimited lock-up period on this portion, during which she will generally not receive any distribution proceeds.

Management Fees, Accounting Repercussions…

Side pocket investments have typically been valued at cost (as opposed to being marked-to-market) for the period they remain in the side pocket, and so generally excluded from the fund’s NAV calculation for determining performance, fees, redemptions, etc. When side-pocketed assets are not marked-to-market, the fund’s financial statements will not be GAAP compliant; this ability to circumvent evaluating a side-pocketed asset at “fair value” -- and thus the avoidance of certain accounting standards -- may be a primary reason for placing it in a side pocket.

UPDATE - November 7, 2008: Public announcement that GLG Partners ringfenced illiquid investments from its European equities hedge fund