Hedge Funds: How to Spot the Warning Signs of Failure
Hedge funds are, and will continue to be, one of the major asset recovery battle grounds. The warring parties comprise those running the funds (the investment managers), investors and regulators.
There is no doubt whatsoever that collective investment vehicles, such as hedge funds, receive a massive amount of investor funds and will continue to do so. Hedge funds in the context of this article refer loosely to a number of different types of investment structure that are generally set up, domiciled and administered in offshore jurisdictions but which are typically run by investment managers in countries such as the US. These funds may not be the subject of direct regulation, but regulation usually applies to the service providers (which act as a registered office and provide director or administration services) and increasingly to those acting as investment managers.
Investors range from large corporations, pension funds and investment banks to high net worth individuals. There are estimates that the value of assets invested in hedge funds globally exceeds US$1trillion and is growing.
A typical hedge fund will be a corporate entity incorporated in an offshore jurisdiction. The Cayman Islands is a good example and is the market leader for this type of structure. The company will be set up by the prospective investment manager who is likely to be working for a small investment management company or working alone. The investment manager will have determined what their investment strategy is going to be and will have potential investors interested in investing. The investment manager will have to find auditors for the fund, an administrator, attorneys and independent directors. A detailed offering document will be prepared outlining the basis upon which the fund will operate, and investors will be permitted to subscribe for shares and subsequently redeem them.
The trading strategy has to be clearly explained and may involve a combination of, for example, long or short selling and trading in derivatives, such as calls, options or futures. Once the structure is established, investor subscriptions will be received by the administrator, shares will be issued to the shareholders and the subscription monies will be placed under the control of the investment manager. The funds will then be invested in accordance with the predetermined trading strategy. The administrator will have to prepare regular net asset valuations of the fund’s assets (NAV). This will take into account the market value of its investments and positions, and take account of the fees due to the investment manager (which is generally calculated on the basis of the profits made by the fund over a pre-determined period), the fees of the administrator, auditors and attorneys and then calculate the value of the interest of each shareholder. Depending on the type of fund and its investments, the NAV may be calculated monthly or on a more regular basis.
In order to calculate the NAV, the administrator requires information about the value of the fund’s investments. If the investments are in securities or other instruments that can be traded on recognized markets then this information will usually be obtained electronically directly from the fund’s prime broker. This verifies (or should verify) the existence of the fund’s assets. Many administrators will then double check the value of the investments using sources such as Bloomberg, to verify market prices. As investments become more esoteric, they become harder to value. Some funds invest in private equity or investments that are not publicly traded and are highly illiquid. This makes pricing them very difficult and often, until the investment is realized, its current value can only be based on its acquisition cost.
Provided that the investment manager has followed the trading strategy disclosed in the offering memorandum, then investors will have been fully informed about the nature of the proposed investments and the difficulties that there may be in pricing and realizing them. This is the risk they take for potentially very high returns.
More complicated structures are often used which involve master and feeder funds, fund of funds, limited partnerships and segregated portfolio companies.
The success of hedge funds and other similar types of investment structure depends heavily on the skills and trading strategy of their investment managers. Some are conservative, others are very high risk. Clearly a poor strategy or an unexpected movement in markets can lead to a number of problems for a hedge fund. What is interesting is that, generally, hedge funds will not become insolvent, i.e. they will not get into a position in which they own more than the value of their assets. The fund may, however, lose sufficient value to simply cease to become viable going forward. Adverse movements in markets can also cause concern among investors and assuming that investors have a right to redeem, there can be a ‘run’ on the fund with large numbers of redemption requests. If there are problems with the markets in which the fund trades or its positions have become illiquid it may be impossible to generate sufficient liquidity to meet the requests. In turn, this can force the fund into seeking protection from the bankruptcy courts. These are some of the causes of market failure.
The more difficult cases involve either market failure and then an attempt to conceal that on the part of the investment manager or simple theft of investor funds by the investment manager.
Investment managers are generally paid in whole or in part, based on the performance of the fund. When profits dip or the fund starts to suffer trading losses the pressure on investment managers rises and in the context of fund failures, this is typically when there is the incentive to either conceal losses in the hope that the fund can trade out of them, or alternatively try and manipulate the date on, or period in which, losses are accounted for in order to smooth out peaks and troughs in monthly performance. As the industry grows and fund administrators become increasingly reliant on direct data feeds from prime brokers to price portfolios and calculate NAVs so the ability of an investment manager to falsify pricing information is decreased.
There are still, however, a regular flow of cases involving smaller funds where the investment manager is able to falsify information about position and values, thus concealing trading losses, failure to comply with investment restrictions as set out in the offering document or, the theft by them of the assets of the fund. There is a current case where it is alleged that an investment manager cross-margined the assets of a fund against trading losses in accounts opened in the name of the fund, the existence of which was concealed from the fund administrator.
There are also increasing concerns about the use of offshore hedge funds to manipulate stock prices and make use of price sensitive information. These are in addition to major investigations by the SEC into market timing and similar regulatory and trading offences, all of which can have a significant effect on investors in hedge funds and their ability to redeem their investment.
The onus is on investors when considering whether to invest in what is probably an unregulated hedge fund to do their due diligence on the investment manager, directors, administrator, legal advisers to the fund and auditors before investing. Assuming that the investor decides to proceed to invest, set out below are some ‘red flags’ that should either lead to further enquiries or at least warn investors that there may be issues of concern that warrant further investigation.
Where investment prices and trading information is provided by investment managers or where there is ambiguity as to who bears the responsibility for pricing there is clearly a risk of manipulation. The administrator (if there is one) should be receiving such information direct from the prime broker in a form that can be verified, both in terms of the existence of the portfolio and its pricing.
Investments that are not readily saleable, easily priced or are thinly traded or which are complex with the risk of significant price volatility are often a cause of concern. Investors in private equity funds or those investing in illiquid investments where there has been full disclosure in the offering document, must be prepared for deferred redemption rights and difficulty redeeming even when there may be a right to do so.
Non-disclosure of the investment portfolio to investors or changes in investment parameters should be an immediate red flag. The investment manager must be disclosing its investment strategy which in turn must indicate at least the general nature of the composition of the portfolio. Some investment managers are reluctant to disclose to investors the precise assets in which they have invested so as to protect their trading strategy. In such circumstances, it is important that the fund has a reputable administrator and auditor.
When reviewing the advisors to a fund, investors should consider whether the investment manager is responsible for multiple funds with similar objectives where there could be a risk of improper trading between the funds. Investors should also be concerned with a lack of independent directors, infrequent board meetings, different service providers retained for different but related funds, any delay, qualification, or unusual disclosures in audited financial statements and any sort of regulatory action or other sanction against the investment manager or director.
As mentioned above, investors should be aware of whether an investment manager is being rewarded based on its performance and the inherent conflict of interest that this can give rise to on the part of the investment manager.
If a fund does get into difficulties or does fail and have to suspend its NAV and therefore seek protection from bankruptcy courts, the immediate question will be what or who is the cause of the loss: is it the result of poor management, adverse markets or fraud? Tasks that will then have to be undertaken are the quantification of losses and restatement of investor entitlement to the assets of the fund. This can raise questions as to how far back such restatements must go and what restatement methodology to employ?
Complex issues will arise when considering attribution of responsibility for losses and the identification and assessment of causes of action for loss recovery the realization of any residual portfolio, the treatment of redeeming and redeemed investors and dealing with ‘inter fund’ transferring investors. One common problem is that investment managers, administrators and directors usually receive the benefit of indemnities from the fund. This both limits their liability for losses, unless caused by their own fraud or willful misconduct, and also provides an indemnity from the assets of the fund in relation to any losses and claims made against them (other than as a result of their fraud or willful misconduct), including the legal costs of defending any such claims. With the complexity of funds and the manner in which they invest and trade and the multi-jurisdictional nature of the fund structures, this gives rise to further challenges for investors and those advising them in the light of a fund failure.