Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding.
The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more.
For a list of available titles, visit our Web site at www.WileyFinance.com.
Practical Operational Due Diligence on Hedge Funds
John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom
For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please visit our website at www.wiley.com.
The right of the author to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher.
Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.
Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. It is sold on the understanding that the publisher is not engaged in rendering professional services and neither the publisher nor the author shall be liable for damages arising herefrom. If professional advice or other expert assistance is required, the services of a competent professional should be sought.
Library of Congress Cataloging-in-Publication Data is Available
A catalogue record for this book is available from the British Library.
ISBN 978-1-119-01875-9 (hardback) ISBN 978-1-119-01873-5 (ePDF)
ISBN 978-1-119-01874-2 (ePub) ISBN 978-1-119-01872-8 (obk)
In the business world, the rearview mirror is always clearer than the windshield.
–Warren Buffet
We all talk about blow-ups in the world of hedge funds. Indeed, it is a word that strikes fear in the heart of any due diligence professional. Yet it is a loose term which means different things to different people.
To some it may be catastrophic losses from a trade, to others an inability to make a strategy viable. Often it may be a failure to recover from cumulative or even one-off trading losses. It may be caused by operational failure, the unexpected loss of key staff or a service provider failing. Frequently it is the impact of leverage, or sometimes because fraudulent activity is exposed.
This book is an attempt to consolidate collective experience on issues that arise in hedge fund due diligence and covers more than just “blow-ups”, as it is intended to address structural issues and problems that may have been identifiable during the due diligence process and which investors should arguably have known about prior to investment. The book is based on the premise that often (but not always), most of the information to make due diligence judgements is available to investors who are prepared to do the work – particularly institutional investors – but factors such as career risk, remuneration policies and governance practices mean that the realities of the risks and dangers may be ignored. This can make it difficult to challenge views which are sometimes no more than “received wisdom” against the probabilities of a problem occurring around an identified issue. When issues cannot be challenged and addressed openly then in such an environment the fable of the emperor's new clothes is likely to flourish – such as in the case of Madoff, where the issues and risks were arguably well known to many investors but where few dared to challenge the status quo and point out that the emperor had no new clothes.
It is of course much easier to apply the benefits of hindsight to problems that have eventually transpired, but this book's contention is that even though there are cases where it would have been difficult if not impossible to identify potential failure or problems, it is often the case that some, if not all, the signals to pay attention to were available prior to the making of investment decisions in many instances, and that these were more often than not ignored. In order to learn from those experiences, applying hindsight is no bad thing – particularly where it is clear that the evidence would have been available to make the right judgement calls.
This book is not just about fraud but also includes situations – commercial and otherwise – that perfectly legitimate businesses have found themselves in. Some have managed to navigate through them and come out at the other end having survived either in their original form or through a change in shape and direction. Others have had to close and exit from the business. The focus of the book is to use these situations as case studies for what the due diligence teams should have been able to identify. It is also important to acknowledge why in some cases it would not have been possible to do anything. The book also tries to assess what impact each set of circumstances had. Failures of investment strategies and the inability to raise capital are also discussed in terms of their operational impact. Some case studies have little or no information about them but appear nonetheless because they are examples of businesses that started and closed in short order. Many have similar themes.
The case studies also include plenty of examples of fraud. No amount of due diligence is likely to prevent someone minded to commit fraud, and inevitably mistakes do get made. But if investors are prepared to invest resource in due diligence functions and, more importantly, pay attention to what they unearth, then it should be possible to recognise many of the indicators to avoid. Indeed, there are now consultants who are beginning to collate signals that may constitute red flags ahead of investment for precisely that reason. Of course, some of the problems cited may be evident in many hedge funds that continue to operate and generate returns for their investors today, such as in relation to some of the conflict of interest issues raised here. However, in these circumstances, I would argue that investors have either had to invest blindly or by taking a leap of faith. I believe that there should be very little justification for investments – particularly by institutional investors responsible for managing the money of others – to proceed in this way.
Analysing what we know of problems linked to hedge funds, it is often possible to identify some basic steps that investors might have taken in their due diligence to avoid the issues they were confronted with. Many funds of hedge funds in the early 2000s made much of their due diligence processes to explain why they had avoided investing in Long Term Capital Management (LTCM) – one of the first of the “too big to fail” blow-ups. Some failures such as Madoff are simpler to classify as failures of investor due diligence. Any analysis also needs to take into account how markets and market practice have evolved as only 10 years after LTCM, Amaranth's problems barely caused a ripple in the market.
As an insolvency practitioner I have been lucky during the course of my working life to work in one form or another on some of the major failures arising from or resulting in insolvencies in the UK. The exposure I had in the 80s and 90s to companies such as Polly Peck, BCCI, Maxwell Communications and Frazer Nash, to name a few, provided the best possible training grounds for the direction my career eventually took, giving me a ringside seat in the world of hedge funds, where I have worked since 2000 and where I have even had the opportunity to deal with some of those who feature in this book. In writing a book such as this I have had to tread a fine line to ensure that the access I had to highly sensitive information was respected and I have therefore restricted the analysis to just those matters that can be easily accessed from information found in the public domain such as on the internet. I have been mindful of the fact that a lot of information continues to remain behind closed doors. This has meant that some of the analysis is limited, but I hope it will still shed light on the possible approaches one might choose to adopt on what was publicly available.
I am also conscious that many names of managers mentioned in the context of a book such as this may view their inclusion as being unfair or pejorative because they continue to be successful businesses where investors remain invested – but the case studies have been chosen because the problems faced by the hedge funds managed by these managers were the subject of press comment at the time, and, in some cases, caused investors problems because of a wide range of issues including trading losses, structural problems such as key man risk, client redemptions, insolvency and formal regulatory actions which investors should, in many instances, have been able to identify prior to investment. Whilst there is always a risk that a manager views its inclusion as a case study pejoratively, I hope that the facts that I have accessed and analysed and drawn conclusions from will stand on their own. Ultimately the responsibility for including or excluding a name is dependent on the research I did and is mine alone.
Acknowledgments
The case studies in this book would not have been possible without the vast library that is the internet and all those who post information on it.
I have been immensely privileged to be involved in the industry that is the world of hedge funds. It is full of interesting people. But it is also a world populated by some people prepared to take shortcuts in the name of expediency, where nothing is necessarily ever quite as it seems and where the stakes can be immensely high.
It is for those whose job it is to conduct operational due diligence on funds and who are responsible for verifying the claims of others and identifying potential problems for which they may even eventually be held responsible, that this book has been written. The consequences for them of the problems that can arise can be significant. It would be good to think that this work might help to point them in the right direction and that they might be able to benefit from my experience.
There are far too many people to name individually who have contributed to the making of this book – whether through discussions on due diligence within my teams or in making investment decisions or indeed in arriving at practical solutions to problems. Without them there would be no experience to reflect in this book – and for that I am immensely grateful to all of them.
Finally, my thanks to Dr Chris Jones, who breathed life into this book through his introductions to John Wiley and to the Naked Short Club – a radio programme – which was to lead me to Matthias Knab, who very kindly reintroduced me to John Wiley and triggered this publication, and of course to Thomas Hyrkiel at John Wiley, who persevered with its publication.
About the Author
Rajiv Jaitly is the managing partner at Jaitly LLP a consultancy that provides independent fund governance expertise and due diligence services to global clients. He set up and managed due diligence and investment management (middle and back office) operations for major groups of companies such as UBS, Santander and AXA. More recently he has also worked with the Regulatory Policy team of the UK Pensions Regulator advising on matters including asset protection, fund costs, employer covenants, capital adequacy and auto-enrolment for 2012. He was appointed an expert by the Office of Fair Trading in 2013 for its market study on defined contribution pensions. He was also commissioned by the UK Financial Services Consumer Panel to write a report on fund costs, which was published in November 2014.
Disclaimer
While the author has used his reasonable efforts in preparing this book, he makes no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaims any implied warranties of merchantability or fitness for a particular purpose. The advice and strategies contained herein may not be appropriate for your particular circumstances or for the legal environment within which you operate and it does not constitute legal, financial or investment advice.
Whilst the author has used his reasonable endeavours to ensure the accuracy of the material as described herein at the time of writing this, the author is not responsible for checking the up-to-date position of the law, technical matters or facts relating to situations discussed in the book after the date of writing.
The rules and regulations relating to matters discussed in the book are continuously evolving and other subsequent events may have occurred on the case studies discussed such as further developments on the case law referred to, which may not be publicly available or has occurred since the time of writing. Many of the matters discussed in the book are based on internet research that was accessible without registration and which was not behind paywalls. No warranties are given on the accuracy, completeness or up-to-date position of the material accessed and no liability is accepted to any party for the discussions in relation to such material. The material by its very nature is difficult to verify and is based on reports and papers published on the internet and because of the changing nature of the internet no warranties can be given that URLs or other references and contents therein remain accurate or continue to be maintained or remain accessible.
This book is designed to assess the impact of those reports and papers for due diligence professionals by presenting the author's views on reported matters and processes. You should always consult with a professional who understands your circumstances and the up-to-date position relating to applicable rules and regulations and technical matters prior to taking any action relating to matters discussed herein. Neither the author nor the publisher shall be liable for any loss of profit or any other commercial damages including but not limited to any special, incidental, consequential, or other damages whatsoever or howsoever arising.
Part I Processes and Procedures
Chapter 1 What is a Hedge Fund?
In the investment world, “I run a hedge fund” has the same meaning as “I'm a consultant” in the rest of the business world.1
Whenever I have interviewed staff for roles in operational risk and due diligence for alternative investments – one of the questions I tend to ask is “what is a hedge fund?” The responses in my view provide a good indication of the way someone approaches this industry and the range of answers has been a source of much discussion amongst members of my teams. It is not an easy question to answer and formal definitions are scarce.
Alternative investments themselves appear easy enough to identify by eliminating traditional investing but even here the boundaries continue to blur with 130/30 funds, REITs and the ability to use derivatives beyond just efficient portfolio management as regulators have come to accept the use of such instruments. The Alternative Investment Funds Directive (AIFMD) in Europe makes the definition even more interesting as possibly everything that is a collective investment but not an Undertaking in Collective Investments in Transferable Securities (UCITS) is now likely to be an Alternative Investment Fund if it does not fall under one of the specified exemptions.
To quote Circuit Judge Randolph in Phillip Goldstein, et al v Securities and Exchange Commission: “‘Hedge funds’ are notoriously difficult to define. The term appears nowhere in the federal securities laws, and even industry participants do not agree upon a single definition.” He also refers to an SEC Roundtable on Hedge Funds in 2003 where David Vaughan, a partner in law firm Decherts, cited 14 different definitions for hedge funds found in government and industry publications. Referring to the President's Working Group on Financial Markets, Hedge Funds, Leverage and the Lessons of Long Term Capital Management (1999) he points out that “[t]he term is commonly used as a catch-all for ‘any pooled investment vehicle that is privately organised, administered by professional investment managers, and not widely available to the public.’”
Hedge funds are hard to pin down by definition but have some common characteristics:
The main vehicles/structures in which the investments are managed (funds) tend to be in a jurisdiction that is not the same as that of the investment manager – generally for tax, regulatory and disclosure reasons (although onshore hedge funds are getting more common in Europe and have always been common in the US, where the manager will often have an onshore and an offshore version of the funds).
The funds generally have a lighter form of regulatory overview and the investment managers are often subject to lighter regulatory regimes (although AIFMD has changed that in Europe as has the Dodd–Frank Act in the US).
The funds are able to use leverage which can be unlimited even though the manager may indicate the level of leverage they expect to employ in the prospectus.
There is little prescription on the form that the offering documents for the fund need to take, the types of disclosure required in them and the nature of reporting to investors.
There is minimal proscription on the types of investment activity and instruments that the manager can use or enter into on behalf of the fund unless restrictions are voluntarily adopted in the fund documents or rules that arise from a listing need to be complied with.
A number of the significant operational activities such as trade settlement, administration, transfer agency and custody are outsourced to third parties who may themselves be in another jurisdiction.
These funds are not generally available to the investing public and there are generally qualification requirements in respect of nationality and types of investors including investor sophistication and knowledge (ironically, often measured by the amount of wealth the investor has).
There is an assumption of caveat emptor when investing in these funds as it is assumed that the investor has done its homework prior to investing and these investments are for institutional and very wealthy investors who generally hold non-voting preferential interests in the fund.
The focus of the investment manager of the fund is normally to preserve capital and to try to achieve absolute returns for their investors rather than returns relative to an index.
The manager is usually remunerated for its efforts by a fixed fee with reference to the assets being managed and a variable fee with reference to the returns it is able to generate.
The governance of the fund is generally determined and controlled for all practical purposes by the investment manager to the fund, e.g. through the use of management shares which retain the voting rights in the fund for most things other than adverse changes to the investor's rights.
The risks of investing in these funds – apart from the investment risks themselves – are driven primarily by the structure of the fund, its service providers and the contracts with these third parties for services, the manner and extent of control over investments, the independence of governance and the nature of the instruments and the manner in which they are used. Fraud can also be an issue, but the chances of detecting fraud (as opposed to its indicators) are, in my view, low in any due diligence review. In relation to fraud the best one can expect to do is identify those environments in which fraud is possible and seek to avoid or control them. But for the investor, in the absence of fraud, the main impact hedge fund risks have on the safety of their investment can be summed up simply into:
Operational risk in a hedge fund context has been evolving as a concept and different people have different views on what it means. Even looking at the books currently available on the subject, the approaches differ, emphasising the backgrounds of the authors – whether it be a quantitative modelling approach or one that emphasises background research. For the purposes of this book, operational risk covers all those risks that are not investment risks and this defines the scope of the due diligence requirements discussed in this work. Some risks arguably are both operational and investment risks – leverage, liquidity, concentration risk and counterparty risk are some examples – but the focus of the investment professional is different to that of the operational risk professional, even in these areas of overlap, and therefore in my view merits discussion. In any event operational due diligence cannot be done in isolation of the investment due diligence. The two should be done in tandem if they are to be effective.
These characteristics make operational risk and the operational due diligence process an essential element of investing in alternative investment funds.
Although this book focuses on hedge funds, its application to other alternative investment funds is not significantly different because the principles do not differ, except perhaps in minor detail and regulatory focus.
1.1 THE ROLE OF A HEDGE FUND IN AN INVESTMENT PORTFOLIO
A lot of empirical research appears to suggest that active investment management rarely beats the market. So why bother? I am no expert in this area, but sophisticated investors consider hedge funds for the following reasons:
Alternative investment funds tend to operate on a tax-neutral basis, which makes them attractive to investors to maximise tax planning opportunities.
A lot of investment talent in the industry has moved to the world of alternative fund investment and this is one of the ways to tap into that talent.
These investments provide a degree of diversification.
Research suggests that although the main driver of returns is asset allocation strategy; investors who understand this and can identify the right alternative investment funds for their time horizons can benefit from such investments.
Alternative investment funds focus on capital preservation and absolute returns – theoretically this means that a manager can go to cash if they are not comfortable with the investment environment.
Although leverage can magnify the risks of loss, such investments give the opportunity to get leveraged exposure, thereby increasing the return (and of course loss) potential.
It is argued that the manager and investor's interests are more greatly aligned through the fee structure and level of investment by the manager in the fund.
It therefore seems clear that there is a place for hedge funds and alternative investments in the market and that as these products evolve, due diligence processes need to evolve to enable investors to take sensible decisions in the light of the risks that they identify and assess. This makes understanding some of the structural and operational issues of previous due diligence exercises important.
