CLE Webinar About ERISA and Hedge Funds and Private Equity Funds

I am pleased to announce that I will be speaking as part of an upcoming Strafford live webinar, "Alternative Investments in ERISA Retirement Plans: Mitigating Liability Risks for Hedge and Private Equity Funds and Pension Plan Fiduciaries" scheduled for Wednesday, May 24, 1:00pm-2:30pm EDT. I am given ten (10) guest passes. If you are interested, please let me know.

Once the ten guest passes are gone, you can still attend the webinar. By referencing my name, you can receive a fifty percent discount. As long as you use the link shown below, the offer will be reflected automatically in your cart.

Our panel will provide ERISA and asset management counsel with a review of effective due diligence practices for institutional investors from both a legal and economic perspective. The panel will offer risk mitigation best practices at a time of increased government scrutiny and lawsuits by plan participants.

After our presentations, we will engage in a live question and answer session with participants so we can answer your questions about these important issues directly.

I hope you'll join us.

For more information or to register >

Or call 1-800-926-7926 ext. 10
Ask for Alternative Investments in ERISA Retirement Plans on 5/24/2017
Mention code: ZDFCT


Dr. Susan Mangiero, Managing Director
Fiduciary Leadership, LLC
Trumbull, Connecticut

Pensions and Politics

Since I started this blog a decade ago, I've repeatedly lamented the unfortunate situations when investment decisions are determined by politics rather than based on prudent process. As I read "Teachers Union and Hedge Funds War Over Pension Billions" by Brody Mullins (Wall Street Journal, June 28, 2016), I can't help wonder if pensions are once again being used as political ping pong balls.

Mind you, I am not advocating a particular strategy or asset class for any of the teacher funds mentioned in the article. One would have to examine relevant facts and circumstances, investment goals and risk tolerance, at a minimum. However, as a taxpayer and fiduciary expert, I am disturbed by the possibility that asset managers are being lopped off an approval list (or added as the case may be) on the basis of whether they disagree (or agree) with the views of the American Federation of Teachers ("AFT").

In 2015, multiple organizations (including the AFT) published "All That Glitters Is Not Gold," a thirty-nine page analysis of eleven U.S. public pension plans that invested in hedge funds. Authors of the study urge decision-makers to:

  • Carry out "an asset allocation review to examine less costly and more effective diversification approaches" and
  • Mandate "full and public fee disclosure from hedge fund managers and consultants" to include information about performance.

These recommendations seem to make sense and should be applied to all asset classes with two qualifiers. First, cost is not necessarily the sole determinant. Selection and monitoring should consider numerous factors such as how an asset manager mitigates risks, safeguards against rogue traders and ensures operational excellence. Second, performance numbers should be consistently measured across asset managers, go beyond historical numbers, be adjusted for risk-taking and much more.

My prediction is that we'll have lots more news about politics and pensions. This could be a good thing if actions by lawmakers and public pension trustees evidence improved oversight and good governance. Otherwise, questions asked about dubious practices may get answers too late to effect meaningful change.

Note: In terms of full disclosure, I was part of the team that reviewed New York City Employee Retirement System ("NYCERS") operations. I was not involved with any discussions about changing asset allocations.

Hard to Value Assets, Hedge Funds and Investment Fiduciaries

As I have pointed out on multiple occasions, valuation is an integral part of investment risk management for several reasons. First, fees paid to asset managers are frequently linked to performance and performance calculations depend on reported values. If values are artificially inflated, returns are likely to be inflated as well. Second, imprecise values can skew asset allocation decisions, lead to hedges being too big (or too small) and possibly cause an investor to breach trading limits that are part of an Investment Policy Statement. It's no surprise then that valuation process questions about who does what, when and how continue to surface.

According to a May 9 Wall Street Journal article, the U.S. Securities and Exchange Commission ("SEC") is investigating "the way hedge funds value their thinly traded holdings and how they respond when investors ask for their money back." The SEC has been vocal about its concerns regarding asset valuations for awhile. In December 2012, Bruce Karpati, then Chief of the Asset Management Unit of the SEC Enforcement Division (and now in private industry), talked about a focus "on detecting fraudulent or weak valuation practices - including lax valuation committees and the use of side pockets to conceal losing illiquid positions - and the failure to follow a fund's stated valuation procedures." Click to read "Enforcement Priorities in the Alternative Space." (As an aside, some hedge funds buy and sell actively traded securities for which there is a ready market and full price transparency.)

The U.S. Department of Labor ("DOL") regularly broadcasts its concerns about "hard to value" assets, including financially engineered products that show up in certain defined benefit and defined contribution retirement plans. In September of 2008, I spoke before the ERISA Advisory Council, by invitation, to address valuation issues from the perspective of a trained appraiser and fiduciary best practices expert. Click to read "Testimonial Remarks Presented by Dr. Susan Mangiero." I talked at length about valuation questions to ask of service providers and procedural prudence considerations for institutional investors.

A few weeks ago, senior attorney Fred Reish addressed monitoring and uncertainty in his April 19, 2016 newsletter. He directed readers to Fiduciary Rule preamble text that urges an advisor and his financial institution to install an adequate monitoring process before recommending "investments that possess unusual complexity and risk, and that are likely to require further guidance to protect the investor's interests." Click to read "Interesting Angles on the DOL's Fiduciary Rule #1." It doesn't take a rocket scientist to conclude that a "complex" and "risky" investment could be hard to value and not particularly liquid. (I have purposely not defined the terms in quotes herein as they are often related to facts and circumstances for a particular investor.)

Expect to read more about this important topic of valuation, especially as applied to those investors in search of higher returns. In a "no free lunch" world, risk and return go hand in hand. It's not necessarily a bad thing to take on greater risk as long as there is an understanding at the outset as to what gives rise to uncertainty and how risks are being mitigated.

Pension Risk Governance Blog Still Going Strong After Nine Years

Nine years today marked the debut of Since then, I am proud to say that traffic has steadily grown, with continued feedback and suggestions about all sorts of topics. I am deeply grateful to visitors to this independent website for their time and encouragement. While the specific feedback tends to vary by issue or job function, a central theme is clear. Ongoing education about topics such as due diligence, fees, risk management, asset allocation, hedge funds, liquidity and valuation is both needed and desired. In 2015, this award-winning blog will continue its focus on providing objective and helpful information about important subjects that challenge investment stewards and their advisors, attorneys and regulators who oversee the management of more than $30 trillion.

As I point out in "Financial Expert Susan Mangiero Celebrates Ninth Year as Lead Contributor to Pension Risk Governance Blog" (Business Wire, March 25, 2015), "There is never a shortage of subjects to discuss, thanks to ongoing suggestions and contributions from readers and the significant realities of changing demographics, market volatility and new accounting rules."

To date, there are over 900 published analyses, research updates and guest interviews that can be readily accessed by category and keyword. Simply click on the Archives section of For a complimentary subscription to this blog, as posts are published, click here to sign up. Click here to read our Privacy Policy. If you are interested in contributing an educational essay or letting us know about a relevant news item or rule change, please email

Until the next blog post, thank you for your interest!

Alternatives and Retail Retirement Account Owners

The prospect of being part of millions of retail retirement plans has some financial advisors and hedge fund managers giddy with excitement. The 401(k) market alone is huge. According to the Investment Company Institute, as of Q3-2012, these defined contribution plans held an estimated $3.5 trillion in assets. In 2011, over fifty million U.S. workers were "active 401(k) participants." This compares favorably to an approximate $2.66 trillion hedge fund market size in 2013, up from $2.3 trillion one year earlier. Private equity, real estate and infrastructure comprise the rest of the alternatives investment sector according to a press release issued by Preqin, a financial research company. See "Alternative Assets Industry Hits $6tn in AUM for First Time" (January 21, 2014).

CNBC contributor Shelly K. Schwartz explains that alternative investment strategies are appearing in the form of 400 plus mutual funds and exchange-traded funds ("ETFs") that employ "complex trading strategies" such as managed futures, long/short trading in stocks and multiple currency exposures. Allocating to leveraged loans, start-up ventures and global real estate are other ways that these relatively new funds seem to be mimicking the approach taken by hedge funds and private equity funds that traditionally have catered to institutional investors and high net worth individuals. Notwithstanding regulatory differences relating to diversification, percentage of "illiquid" investments, redemption, daily pricing and how much debt can be used to lever a portfolio, statistics suggest a growing interest on the part of smaller investors to get in on the action. See "Seeking safe havens? Analysts, advisors point to liquid alternative funds" (November 24, 2013). Also check out "Goldman pushes hedge funds for your 401(k)" (Fortune, May 22, 2013) in which reporter Stephen Gandel describes new funds being offered by various financial institutions, some of which invest in mutual funds that mimic hedge fund investing strategies and others that invest in hedge funds directly.

Not everyone is an ardent fan. In "FINRA warns investors on alternative mutual funds," Reuters reporter Trevor Hunnicutt (June 11, 2013) describes regulators' concerns that "not all advisers and investors understand the risks involved," especially with respect to whether a retail-oriented fund is truly liquid. In its "Alternative Funds Are Not Your Typical Mutual Fund" publication, the Financial Industry Regulatory Authority ("FINRA") cautions investors to assess investment structure, strategy risk, investment objectives, operating expenses, the background of a particular fund manager and performance history.

Given the ongoing search for the next big thing, we are likely to see a lot more activity in the alternative investments marketplace - for both institutional and high net worth clients as well as for individuals with modest wealth levels. will return to this topic in future posts. There is much to write about with respect to fiduciary implications, risk management and valuation.

In the meantime, I want to thank ERISA attorney David C. Olstein with Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates for apprising me of a 2012 U.S. Department of Labor grant of individual exemption for Renaissance Technologies, LLC ("Renaissance").  Described as a "private hedge fund investment company based in New York with over $15 billion under management" by (September 26, 2013), Renaissance holds a large number of equity positions in stocks issued by household name companies. Click to see a recent list of their transactions. The "Grant of Individual Exemption Involving Renaissance Technologies, LLC," published in the Federal Register on April 20, 2012 makes for interesting reading for several reasons. First, it describes policies relating to important topics such as valuation, redemption and disclosures for "privately offered collective investment vehicles managed by Renaissance, comprised almost exclusively of proprietary funds" and the impact on retirement accounts in the name of Renaissance employees, some of its owners and spouses of both employees and owners. Second, as far as I know, there are not a lot of publicly available documents about proprietary investment products that find their way into the retirement portfolios of asset management firm employees and shareholders. Third, as earlier described, there is evidence of a growing interest on the part of the financial community in bringing hedge funds or hedge fund "look alike" products to the retirement "masses."

Hollywood and Hedge Funds

Some pension funds invest in hedge funds. Some hedge funds invest in movie companies. That's why pension fund fiduciaries may be interested in the recent comments made by Hollywood insider George Clooney. According to "George Clooney To Hedge Fund Honcho Daniel Loeb: Stop Spreading Fear At Sony" by Mike Fleming Jr. (Deadline, August 2, 2013), the actor and sometimes director and producer criticized activist hedge fund investor and head of Third Point LLC, Daniel Loeb, for what can be politely described as undue interference. The catalyst seems to be a May 14, 2013 letter written to the president and CEO of Sony, Kazuo Hirai, by Third Point's CEO in which several recommendations are made, including the public sale of a minority stake in Sony Entertainment. Although Sony rejected the IPO, documenting the importance of the entertainment business as "fundamental to Sony's success" in an August 6, 2013 letter to Third Point LLC, the conversations about company ownership and ways to enhance value are instructive.

Some of the numerous comments left on various publication websites refute the notion that a material investor has a right to make suggestions. This sentiment defies logic. For one thing, an investor (large or small) may have legitimate questions and suggestions that can potentially enhance the value of all shareholders. Second, an asset manager has a responsibility to its investors. Remaining silent about concerns could put the activist at risk for fiduciary breach. Third, an activist investor by definition has typically amassed "enough" money to transact. Unless we are talking about a jumbo lottery winner who wants a seat at the table, resources had to have come from somewhere, usually from other parties such as endowments, family offices, pensions and individuals who believe in the activist's strategy. That's not to say that an activist investor is always right or wrong but certainly deserves a hearing without impunity. For those companies that want to avoid short-term actions that they deem unattractive and antithetical to long-term performance, going private is one way to keep naysayers away from the door.

However, there are those who believe that squeaky wheels improve corporate governance and boost stock price. In "Activist investors find allies in mutual, pension funds" (Reuters, April 9, 2013), journalists Jessica Toonkel and Soyoung Kim attribute FactSet for statistics that show an increase in activist campaigns, from 187 in 2009 to 241 in 2012. They quote Hedge Fund Research as asserting that "Over the past three years, activist hedge funds have outperformed more traditional hedge funds." According to "Let's do it my way" (The Economist, May 25, 2013), activists were once given short shrift but that is no longer the case. "Indeed, some American pension funds have even placed money with activists to keep companies on their toes."

An added twist exists when activist investors gain exposure indirectly versus buying shares for cash. In "CSX Battles Hedge Funds - A Cautionary Tale for Pensions?" by Susan Mangiero (July 5, 2008), I wrote about a legal challenge to The Children's Investment Management (UK) LLP by CSX Corporation over the hedge fund's then prevailing cash-settled swap position as a way to gain equity exposure and a path to control. (The court ultimately decided not to opine on whether a total return swap holder is a beneficial owner. Click to access the July 18, 2011 CSX Corp. v. The Children's Inv. Fund Mgmt. opinion issued by the United States Court of Appeals For the Second Circuit.") According to "Sony Holdings Blurred by Third Point Swaps, Goldman Bonds" (Bloomberg, June 11, 2013), Mariko Yasu and Takako Taniguchi suggest that Third Point's direct equity stake could be less than five percent since it "doesn't show up in regulatory filings" and "[s]hareholdings of more than 5 percent of a company have to be reported to Japan's Ministry of Finance." Its "exposure" to an estimated 64 million Sony shares could be "clouded" due to its "use of cash-settled swaps and convertible bonds." A key question for investors in Third Point LLC and other activist hedge funds that use equity swaps is whether voting rights will be enhanced or impeded when derivatives are used.

Whatever you think about George Clooney or Daniel Loeb, the role of activists and the way they finance their positions is critically important to understand.

ERISA Assets: QPAM and INHAM Audit Legal Requirements and Best Practices

I am happy to announce that I will be joined by esteemed colleagues Howard Pianko, Esquire (Seyfarth Shaw) and Virginia Bartlett (Bartlett O'Neill Consulting) on September 10, 2013 from 1:00 to 2:30 pm EST to talk about QPAM and INHAM compliance audits. See below for more information. Click to register for this forthcoming educational event about ERISA requirements. (Note: I am given a few complimentary guest passes. Contact me if you are interested and they are still available.)

This CLE webinar will prepare counsel to advise asset manager clients regarding Qualified Professional Asset Manager (QPAM) and in-house asset manager (INHAM) audits as required by the Department of Labor. The panel will review the new exemption rules, who can conduct an audit, what the process entails, and how to showcase good practices with existing and prospective plan sponsors.

Continue Reading...

Hedge Fund and Private Equity Fund Due Diligence for Pension Funds

If you missed the Strafford CLE event on June 5, 2013 entitled "ERISA Pension Plans in 2013: Due Diligence for Hedge and Private Equity Funds: Avoiding the Pitfalls with Alternative Investments for Institutional Investors and Fund Managers," there is still an opportunity to purchase the recording. Click here for more information.

In the meantime, click to access the due diligence slides that were used by Dr. Susan Mangiero (Fiduciary Leadership, LLC), private fund attorney Rosemary Fanelli (CounselWorks) and ERISA attorney Tiffany Santos (Trucker Huss).

While we ran out of time with so much left to discuss beyond our assigned 90 minute slot, the two attorneys who spoke with me talked a lot about their perception of a changed environment. Their message was that institutional investors seem to be under a lot more pressure now to demonstrate that comprehensive due diligence activities have taken place. One attorney listener in the audience echoed this sentiment presented by the two legal speakers. He offered his opinion that an investment consultant or financial advisor should work closely with both an ERISA counsel as well as a fund attorney as part of the due diligence process.

Dr. Susan Mangiero Speaks at Fiduciary Conference About Due Diligence for Alternative Investments

I am delighted to have been invited to join the faculty of the Master’s Track at the annual fi360 investment fiduciary conference, held this year in Scottsdale, Arizona. Speakers include: (1) ERISA attorney Charles Humphrey (2) Edward Lynch, AIFA, RF, GFS with Fiduciary Plan Governance, LLC (3) Dr. Susan Mangiero, AIFA, CFA, FRM with Fiduciary Leadership, LLC and (4) pension auditor Michelle Sullivan, CPA with Freed Maxick CPAs

The fi360 Master’s Track offerings are created especially for those with a knowledge of fiduciary standards and how that standard applies to the topics being presented.

Our session is entitled "Due Diligence for Alternative Investments." Our panel will focus both on the legal issues and the internal control compliance issues that cannot be ignored by anyone with a fiduciary responsibility to prudently select and monitor. This session will describe the impact of Dodd-Frank on investing in alternatives, various court cases and regulatory enforcement actions as well as the DOL/IRS regulatory guidance on alternative investment allocations. Click to read more about this session and the other sessions to be presented at this conference of investment fiduciary professionals from April 17 to April 19.

Pension Risk Governance Blog Celebrates Seventh Birthday

I am delighted to announce our seventh year as an educational resource for the $30+ trillion global retirement plan industry. With over a million visitors to, I appreciate the ongoing feedback and encouragement from financial and legal readers. This blog began as a labor of love and continues to be personally rewarding as a way to help guide the discussions about pension risk, governance and fiduciary duties.

Here is a link to the March 25, 2013 Business Wire press release about, an educational pension risk governance blog for ERISA, public and non-U.S. pension plan trustees and their advisors.

As always, your input is important. Click to send an email with your comments and suggestions.

Thank you!

ERISA Pension Plans: Due Diligence for Hedge Funds and Private Equity Funds


Join me on May 1, 2012 for a timely and interesting program about alternative investment fund due diligence and other considerations for ERISA plan sponsors, their counsel and consultants. Click here for more information.

This CLE webinar will provide ERISA and asset management counsel with a review of effective due diligence practices by institutional investors. Best practices will be offered to mitigate government scrutiny and suits by plan participants.


With the DOL's and SEC's new disclosure rules and heightened concerns about compliance and valuation, corporate pension plans that invest in alternatives must focus on properly vetting asset managers more than ever before or risk being sued for poor governance and excessive risk-taking.

The urgencies are real. The use of private funds by asset managers is crucial for 401(k) and defined benefit plan decision makers. Understanding the obligations of private funds is essential to any retirement funds with limited partnership interests.

In addition, suits and enforcement actions against asset managers make it incumbent on counsel to hedge fund and private equity fund managers to fully grasp and advise on full compliance with the duties of ERISA fiduciaries to plan participants.

Listen as our ERISA-experienced panel provides a guide to the legal and investment landmines that can destroy portfolio values and expose institutional investors and fund managers to liability risks. The panel will outline best practices for implementing effective due diligence procedures.


  • ERISA fiduciary duties for institutional investors
    1. Hedge funds and private equity funds compared to traditional investments
  • Regulatory developments
    1. Disclosure
    2. Compliance
    3. Valuation
  • Developments in private litigation involving pension plan fiduciaries and alternative fund managers
  • Best practices for developing due diligence plans



The panel will review these and other key questions:

Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.

  • Regulatory developments
    1. Disclosure
    2. Compliance
    3. Valuation
  • Developments in private litigation involving pension plan fiduciaries and alternative fund managers
  • Best practices for developing due diligence plans
  • What are the regulatory concerns for ERISA pension plans that allocate assets to hedge funds and private equity funds?
  • What are the potential consequences for service providers that fail to comply with new fee, valuation and service provider due diligence regulations?
  • What can counsel to pension plans and asset managers learn from recent private fund suits relating to collateral, risk-taking, pricing, insider trading and much more?
  • How should ERISA plans and asset managers prepare to comply with expanded fiduciary standards?


Following the speaker presentations, you'll have an opportunity to get answers to your specific questions during the interactive Q&A.


Susan Mangiero, Managing Director
FTI Consulting, New York

She has provided testimony before the ERISA Advisory Council, the OECD and the International Organization of Pension Supervisors as well as offered expert testimony and behind-the-scenes forensic analysis, calculation of damages and rebuttal report commentary for various investment governance, investment performance, fiduciary breach, prudence, risk and valuation matters.

Alexandra Poe, Partner
Reed Smith, New York

She has over 25 years of experience in investment management practice counseling managers of hedge funds, private equity funds, institutional accounts, mutual funds and broker-dealer advised programs. She counsels hedge and private equity fund advisers in all stages of their business and due diligence matters.



Louisiana Pension Funds and Hedge Fund Redemption Concerns

As I've written many times herein, understanding transferability restrictions is a "must do" for institutional investors who allocate monies to asset managers. While a pension, endowment, foundation or family office may decide to invest part of its portfolio in illiquid securities for strategic reasons, it is still necessary to understand how to exit if necessary. In "Hedge Fund Lock Ups and Pension Inflows" (July 4, 2011), the point is made that investors who want to redeem but are barred from doing so may seek redress in a court of law. Regulators are paying close attention too.

According to recent news accounts, several Louisiana pension funds that sought to withdraw some of their money from a New York hedge fund were given promissory notes with assurances that it could get cash in several years. Moreover, it may be that the hedge fund in question has counted assets under management more than once due to a feeder fund organizational structure that boasts over a dozen smaller vehicles which cross trade with one another.

In a joint statement dated July 11, 2011, the Firefighters' Retirement System ("FRS"), New Orleans Firefighters' Retirement System and the Municipal Employees' Retirement System ("MERS") describe how attempts by FRS and MERS "to capture some of the profits that had been earned in an investment known as the FIA Leveraged Fund" initially met with resistance on the part of the fund manager to provide cash right away. Instead, the two requesting institutions were told to expect paper IOUs while certain assets were to be liquidated in an orderly manner over a period of up to two years. The statement goes on to say that the pension plans had each been promised a return of at least 12 percent per annum and that if the "collateral supporting the preferred return declines to a level that is 20% above the systems' collective account values, there is a trigger mechanism requiring a mandatory redemption of the systems' investment" with the 20% cushion" designed to protect the systems' accounts against any loss in value."

Getting a promissory note has not made for happy campers who now worry about the liquidity of the FIA fund and "the accuracy of the financial statements issued by the two renowned independent auditors." The statement goes on to say that the hedge fund manager has been apprised that the pension plans intend to "closely examine" performance records by putting together a team that consists of their board members, internal auditors and investment consultant. A forensic economist may be added to the team.

Click to read the July 11, 2011 joint statement from these Louisiana pension plans about hedge fund liquidity concerns for this particular manager.

Having just checked the SEC website, this blogger does not yet see the formal inquiry statement. Speaking from experience, complexity is never a good thing. Someone somewhere has to understand what risks might give rise to material problems. Moreover, proper due diligence of funds that invest in "hard to value" instruments has to take into account how they are modeled and who is vetting the integrity of the model numbers. Regarding organizational structures that encompass multiple money pools, it is imperative to understand who exactly has a claim to assets in a worst case situation of forced liquidation.

A few years ago, I refused to continue with a valuation engagement of a hedge fund because neither the general partner nor the master fund's attorney could adequately answer my questions about priority of claims for a complex offshore-onshore ownership structure. In several recent matters where I have served as expert witness, concerns about restrictions of transferability and collateral monitoring have taken center stage. Be reminded that in distress, book values often fall seriously short of fire sale or even orderly liquidation (auction) values.

Let's hope that questions can be cleared up in a timely fashion.

Readers may want to check out these articles:

  • "S.E.C. and Pension Systems to Examine Fletcher Fund" by Peter Lattman, New York Times, July 12, 2011; and
  • "Pensions Want Look Into Fund's Records" by Josh Barbanel, Steve Eder and Jean Eaglesham, Wall Street Journal, July 13, 2011.

Hedge Fund Lock Ups and Pension Inflows

Various sources tout increasing inflows to hedge funds from public and corporate pension plans.

In "Strong start to hedge fund activity in 2011" (April 1, 2011), Pensions & Investments reporter Christine Williamson writes that "First-quarter institutional hedge fund activity, including net inflows and pending searches, totaled $18 billion - the highest since the intense investment pace of the first quarter 2007, which saw $25 billion in activity." James Armstrong of Traders Magazine describes the billions of dollars going to hedge funds in recent months as a catalyst to "increased trading volumes for the equities trading business." See "Hedge Funds Could Juice Volume" (June 2011). Imogen Rose-Smith of Institutional Investor gives readers a detailed look at the love affair with hedge funds in "Timeline 2000-2011: Public Pensions Invest in Hedge Funds" (June 20, 2011).

Fortune writer Katie Benner says "wait a minute" to what seems to be an upward trajectory in retirement plan allocations to hedge funds with a 51% increase since 2007 and a doubling of the mean allocation to 6.6% (according to a study by Preqin). In "Hedge fund returns won't save public pensions" (March 30, 2011), she cites willful underfunding and a "mish-mash of accounting tricks" as fundamental problems that will not be corrected with more money in alternatives.

In her May 16, 2011 article for Pensions & Investments and entitled "Promises, promises: $100 billion still locked up," Christine Williamson writes that assurances made to institutional investors in 2008 and 2009 about redemptions are not being met by some hedge fund managers. At that time, jittery pension funds, endowments and foundations that wanted out were asked to be patient rather than force hedge funds to unwind hard to value positions at sub-par prices. Quoting Geoff Varga, a senior executive with Kinetic Partners US LLP, a consultancy for asset management firms, there is an estimated $100 billion in "exotic" or non-standard investments that were stuffed into "emergency side pockets." He adds that it is hard to come up with an exact number, especially since managers' valuations of these illiquid positions are not always realistic.

Certainly the issue of side pockets is unlikely to go away any time soon. On October 19, 2010, Emily Chasan reported that the U.S. Securities and Exchange Commission ("SEC") had filed a civil complaint against several hedge fund managers for overvaluing illiquid assets. See "SEC charges hedge fund of inflating 'side pockets'" (Reuters). Click here to read the SEC complaint and October 19, 2010 press release from the SEC. On March 1, 2011, Azam Ahmed with the New York Times Deal Dook described another case in "Manager Accused of Putting $12 Million in Side Pockets."

This blogger, Dr. Susan Mangiero, has written extensively on the topic of hard to value investments and liquidity and served as expert witness on cases involving due diligence allegations. Acknowledging that not all hedge funds invest in hard to value instruments, the following items may be of interest to readers:

Hedge Funds, Private Equity Funds and ERISA Pension Plans

Alternative fund managers and regulators will convene in Washington, D.C. from July 19 through 21, 2011 to talk about pension investing in hedge funds and private equity funds. Over several days, those who present before the ERISA Advisory Council will be asked to address questions such as those listed below:

  • What differentiates a hedge fund from other types of investments?
  • What differentiates a private equity fund from other types of investments?
  • How are hedge funds and private equity funds, respectively, correlated with the returns of traditional equity and fixed income investments?
  • How can defined benefit and defined contribution plan sponsors mitigate "the lack of liquidity that is characteristic of these investments?"
  • How can fee transparency be enhanced?
  • "Are there any unique diversification benefits offered by hedge funds and private equity investments as opposed to a fund of funds?"
  • What is the view of target date fund managers with respect to including hedge funds and/or private equity strategies within their funds?

According to U.S. Department of Labor documents, the aim is to create best practices guidance in areas such as leverage, liquidity, transparency. valuation, operational due diligence, client and asset concentration and offering documents. Click to download "2011 ERISA Advisory Council: Hedge Funds and Private Equity Investments." Click to read the June 22, 2011 U.S. Department of Labor news release about the forthcoming meetings to address hedge funds and private equity investments by ERISA plans.

Interested readers may want to check out the following of many items that are available for further research:

Help With Form 5500 Reporting

For those in need of help, click to access the "Troubleshooter's Guide to Filing the ERISA Annual Report" (U.S. Department of Labor, October 2010). This 70-page publication includes a handy reference chart that relates to the Form 5500 and Form 5500-SF (for small firms), along with related attachments. Another helpful resource is "FAQs About The 2009 Form 5500 Schedule C."

School's still out regarding the extent to which plan sponsors will be able to comply with new rules. So far, Schedule C seems to be a sticking point with numerous questions being asked about how to properly report "indirect" versus "direct" compensation to service providers.

As more pension plans allocate monies to mutual funds, hedge funds, private equity funds and funds of funds, they will need to report details about fees paid to these organizations as they too are now deemed service providers.

Valuing Positions in Alternatives - New DOL Scrutiny

According to "DOL rule could raise pension funds' costs: Proposed fiduciary requirement would hit appraisers of alternative investments" by Doug Halonen (Pensions & Investments, November 15, 2010), those who provide independent valuations could soon be declared fiduciaries. Remembering that there is no free lunch and that every new rule has unintended consequences, third party pricing experts are already running for cover. Some say they may exit the appraisal business at the same time that ERISA plans are enlarging their positions in alternatives and also being called upon to provide more information in their Form 5500 filings.

In case you missed it, click to access my comments on this topic, entitled "September 11, 2008 Testimony Presented by Dr. Susan Mangiero before the ERISA Advisory Council Working Group on Hard to Value ("HTV") Assets."

I had the pleasure of presenting on the same topic of risk management and valuation to the OECD and International Organization of Pension Supervisors in Paris in June 2010.

Clearly, pension plan decision-makers and their advisors, attorneys and consultants are going to be challenged to find the right balance between return and risk (with valuation questions being one type of risk). Not every alternative investment is "hard to value." Indeed, some mutual funds and other "traditional" choices have their own challenges in terms of pricing and liquidity.

Click to read "Hedge Fund Valuation: What Pension Fiduciaries Need to Know" by Susan Mangiero, Journal of Compensation and Benefits, July/August 2006.

Hedge Fund Valuation and Performance Reporting

According to "Offshore hedge fund is trouble for Seattle's pension fund" by Rami Grunbaum (Seattle Times, April 11, 2010), the Seattle City Employees' Retirement System ("SCERS") got a nasty surprise when they asked again for overdue financial information about a hedge fund in which it had invested. According to various records, the U.S. Securities and Exchange Commission has similar questions about "true" value versus reported performance numbers. Contacted by deputy news editor Grunbaum for a general comment about hedge fund valuation and performance reporting, I stated that "Pension trustees shouldn't allow hedge funds to hide behind a veil of secrecy" and that "If a hedge-fund manager is unwilling to explain their valuation process - and related procedures and internal controls - run, do not walk for the nearest door."

If you missed some of my earlier writings on the important topic of valuation, I've included several items below:

Email if you would like more information about hedge fund risk management and valuation productivity tools from an institutional investor perspective.

U.S. SEC Significantly Steps Up Enforcement

In case you missed it, the U.S. Securities and Exchange Commission announced significant enforcement initiatives on January 13, 2010. These include a focus on due diligence and valuation issues with a particular emphasis on due diligence, investment advisors, investment companies, performance and valuation.

Read "SEC Names New Specialized Unit Chiefs and Head of New Office of Market Intelligence" (U.S. Securities and Exchange Commission, January 13, 2010).

This follows on the heels of our January 7, 2009 blog post wherein we reported that the FBI is hiring over 2,000 professionals with backgrounds in accounting and finance. See "FBI Hiring Spree - More Financial Fraud Expected?" and "Wanted by the FBI: Talented Professionals to Serve the Nation."

Leverage - I Love You, I Need You - Don't Hurt Me


If institutional investors thought of leverage as a bouquet of daisies, they'd be playing "(S)he loves me, (S)he loves me not" and hoping to still be respected in the morning. Now that the worst economic recession of modern times might be abating somewhat, more than a few buy side executives are looking for a sweetheart to help them replenish diminished portfolio values. Let's just hope that the love affair is not fickle, causing more hurt than help.

In "Wall Street's New Flight to Risk" (February 15, 2010), Bloomberg BusinessWeek reporters Shanon D. Harrington, Pierre Paulden and Jody Shenn write that investors are on the prowl for yield. With over $150 billion allocated to U.S. bond funds, returns are low and the only way to add some excitement is with exotics such as "payment-in-kind" bonds that encourage the issuance of more debt than a borrower's operating cash flow would ordinarily support. Derivatives are another Valentine, with banks "again pushing" collateralized debt obligations ("CDO's) that can increase in value (depending on the trade) as defaults increase. 

On January 27, 2010, Wall Street Journal reporter Craig Karmin writes that public pension funds are borrowing money to enhance returns rather than allocating to alternatives such as hedge funds and private equity pools. According to "Public Pensions Look at Leverage Strategy," funds can turn in a good performance with the use of leverage without having to resort to "volatile stocks" or illiquid assets. Others quoted in this recent piece suggest that risks exist and must be acknowledged.

Heartbreak hotel - here we come.

Call me crazy but a move towards leverage (possibly excessive) seems scary UNLESS and UNTIL asset managers and institutional investors alike can demonstrate that they know how to properly measure and manage. For every person who is asked to define investment leverage, the answer is seldom the same. AIMA Canada makes a good effort to add clarity to this important topic. See "An Overview of Leverage" (Strategy Paper Series Companion Document, October 2006, Number 4).

L'amour with leverage - how sweet it is, until it isn't. Then what?

Hail to the Chief - Risk Officer That Is


In "Risk Redux" by Kristin Fox, founder of Fox Inspires, LLC (Private Wealth, January 7, 2010), I am quoted extensively on the topic of risk management. I'm happy to note that others interviewed for the article reiterate many of the points I made.

Given the changed landscape, post Madoff and so on, the life of a Chief Risk Officer ("CRO") is even more harried than ever before. He or she is often expected to save the ship without impeding the traders' ability to turn a profit. Applied to hedge funds, the task is arduous indeed as the threat of global regulation looms closer and investors clamor for heightened transparency about fees, concentration of positions and overall risk-taking.

Since so many pensions, endowments and foundations are adding to their hedge fund allocations, the article is worth a read. Some of my talking points are listed below:

  • Risk management is an integral part of a firm’s culture and one of the keys to its success. “Instead of looking at risk management as a roadblock, it should be promoted as part of your culture and viewed as the best way to ensure the firm’s longevity.”
  • There is no one size fits all approach to hedge fund risk management. It depends on the size of the organization, strategy, type of clients, risk tolerance, to name a few items.
  • A CRO must ask tough questions about the risk "cost" of every expected dollar in return.
  • Compensation must support the notion of a risk culture or any other efforts to mitigate risk are doomed to fail.
  • Kick the tires on models. Ask if underlying assumptions prevail.
  • Make sure that everyone understands the nature of leverage, from the back office clerk to the front room trader.
  • Acknowledge that risks seldom live in isolation. One of the unpleasant surprises of 2008 and 2009 had to do with the convergence of risks. The traditional reliance on correlations had no place in the volatility maelstrom that created heartburn for a lot of investment professionals. "For example, with structured products, liquidity risk was arguably greater than anticipated because the quality and quantity of supporting collateral was sometimes wanting. For any financial institution that had hedged part of its structured product portfolio, it may have found itself with another risk in the form of counterparty defaults. The risks are often not additive, and a good CRO needs to truly understand the interrelationships among financial, operational and legal risks, to name a few."
  • Figure out a way to overcome the resistance of those who are already burdened with their own work but who are nonetheless critical to the risk management process. A good CRO must make friends and motivate accounting, legal, systems and trading to hold hands and come together to properly manage the R word.

Though written in 2003, my article entitled "Life in Financial Risk Management: Shrinking Violets Need Not Apply" is still relevant. I describe the building block concepts as well as the skill set required for an effective CRO.

Return, Liquidity and Valuation


More than a few of our recent conversations with pension, endowment and foundation decision-makers focus on hard-to-value investing. At a time when 2010 beckons with the hope of a buoyant market, institutions seek returns from alternatives such as hedge funds, private equity and venture capital. According to "The Endowment & Foundation Market 2009," put out by the Spectrem Group, about six out of ten organizations seek to rebuild by emphasizing non-traditional asset allocations. Other recent studies confirm the same sentiment with the caveat that liqudity is key.

Therein lies the rub.

  • Can you invest in "hard to value" assets and satisfy a need for ready cash at the same time?
  • Who should monitor valuation of "hard to value" assets?
  • What areas of concern are most acute from the investment decision-maker perspective?
  • What elements are "must have" with respect to effective policies and procedures?

In my September 11, 2008 testimony before the ERISA Advisory Council on the topic of hard to value investing, I emphasized the need to subsume pricing as part of pension risk management (though the concept transcends retirement plans, with full applicability to endowments, foundations, college plans, sovereign wealth funds and other types of buy side executives).

Click to access the United States Department of Labor Advisory Council report on hard to value investing. 

Participate in a short survey entitled "Hard to Value Investing Policies and Procedures." The questionnaire consists of twelve multiple choice queries. For those interested in receiving survey results, be sure to include your name and email address before you hit the "Submit" button.

Are Pensions the New Power Players In Hedge Fund Land?

According to "Hedge Fund Power Shift Could Be A Good Thing," Securities Industry News reporter Carol Curtis (May 18, 2009) posits that hedge funds will benefit from a recent push to lower fees. Say what? Yes indeed. The thinking goes like this. As pensions push for lower fees and improved transparency from hedge fund and private equity fund managers alike, their win may thwart U.S. and global attempts to regulate alternatives. This in turn will put smiles on the faces of non-traditional fund managers, making for interesting bedfellows all the way round.

Speaking of full disclosures, I was interviewed for this article by Carol Curtis. I pointed out the nature of recent demands for concessions, adding that pensions, endowments and foundations should ask about the make up of both administrative and performance fees rather than relying on gross percentages.

Suppose an institutional investor is comparing Hedge Fund A against Hedge Fund B. The latter may spend more on operations because it licenses a sophisticated risk management system which in turn helps that fund monitor its holdings on a regular basis. Is the "cheaper" fund the better choice? It depends on a variety of issues. The point is that total fees charged may not tell the full story. Institutional investors will want to understand the nature of spending and the basis on which performance numbers are calculated, at a minimum.

Click to read this opinion piece. You may need a password to access the full article.

Hegemony in Alternatives Land - Are Pensions Getting the Upper Hand?

According to "Investors warn private equity over cash calls" (March 26, 2009), Reuters reporter Simon Meads writes that private equity firms are facing "intense pressure" from limited partners (pensions, endowments and foundations). Cash strapped themselves, institutional investors are telling asset managers not to come knocking on cash infusion doors any time soon.

Does this phenomenon present a fiduciary conundrum? For one thing, might a limited partner be sued for a contractual breach if they refuse to pony up additional monies? Second, could a dearth of new cash making its way to private equity fund managers end up creating more financial pain for the limited partners? After all, if a private equity and/or venture capital fund finds itself short of the almighty dollar (or other currency), it may be unable to invest in new companies deemed to be high growth and/or be hamstrung from keeping current portfolio companies afloat. On the other hand, limited partners may be reeling from their own pain (whether Madoff induced, stemming from equity losses or something else) and figure that the cost of incremental disbursements outweighs the expense of abstaining.

One thing seems clear.

Institutional investors are demanding more for less. In "Calpers Tells Hedge Funds to Fix Terms -- or Else" (March 28, 2009), Wall Street Journal reporters Jenny Strasburg and Craig Karmin write that this large California giant is "demanding better terms from hedge funds, including lower prices and 'clawbacks' of fees if performance weakens." Said to have been sent to 26 hedge and 9 funds of funds, a March 11, 2009 memo outlines terms, with a proviso that counter terms will be considered.

In a March 6, 2009 article by the same two writers, the deputy chief investment officer for the Utah Retirement System echoes similar sentiments. In his "Summary of Preferred Hedge Fund Terms," Larry Powell calls for lower fees, adding that "management fees should be used to cover operating expenses only, and are not appropriate funding sources for staff bonuses, business reinvestment, strategy expansion, or wealth accumulation by partners." The 4-page letter urges a share structure that transfers "liquidity risk evenly among commingled investors" that could result in how gates, lock-ups and redemption terms apply to short and long-term investors, respectively. Regarding disclosures, Powell describes a minimum laundry list to include items such as:

  • Annual audited financial statements
  • Quarterly information about fees, operational costs, concentration of clients and soft dollar activity
  • Monthly Net Asset Values, return attribution by strategy, geography and/or sector, largest long/short positions, leverage at the fund and strategy level
  • Weekly return attributions and month-to-date estimates of return.

We've heard numerous institutional investors put a stake in the ground for what they perceive to be a more level playing field (their words). Just a few months ago, I led a workshop on risk management and "hard to value" investing red flags to a group of large public plan auditors. Many of the audience members described a "disclose" or "we'll walk" policy now in force with respect to alternative funds. (Hopefully it goes without saying that not every alternative fund is a "hard to value" fund.)

Several things come to mind. Could demands from institutional investors be potent enough, if met, to stave off new regulatory mandates, some of which are outlined in "Does More Financial Regulation Make Us Safer?" (March 29, 2009)? Second, might we see a flurry of alternative fund manager fee-related lawsuits, similar to 401(k) "excessive" allegations that are making their way through the court system?

The match is on - investor versus manager. Who will get the biggest slice of the pie going forward with respect to economic rights?

Does More Financial Regulation Make Us Safer?


According to its March 26, 2009 press release, the U.S. Department of Treasury advocates what they call "comprehensive reform" to modernize the U.S. financial system and seek to avoid major meltdowns. Key components include:

  • Addressing systematic risk rather than focusing on "potential insolvency of individual institutions" alone
  • "Strengthen enforcement and improve transparency for all investors" as a way to safeguard consumers and investors
  • Create a "substantive system of regulation that meets the needs of the American people," avoid turf wars and "assign clear authority, resources, and accountability" to those in charge of enforcement
  • Outreach to non-U.S. regulators in order to "address prudential supervision, tax havens, and money laundering issues in weakly-regulated jurisdictions."

For those who think this is all bark and no bite, consider that U.S. Treasury Department Secretary Geithner is calling for (a) registration of hedge fund advisers above a certain size, not to mention additional reporting requirement for said alternatives (b) "comprehensive framework of oversight, protection and disclosure for the OTC derivatives markets" (c) more stringent capital requirements for organizations deemed to be major financial market participants and (d) a single independent regulator to oversee "important" entities. Click to read "Treasury Outlines Framework for Regulatory Reform" (March 26, 2009).

Not everyone thinks that more regulation is smart regulation. During a recent interview with First Business, hedge fund consultant Kristin Fox voiced two problems with a regulatory power grab. Enhanced disclosure may lull people into false security, discouraging them from probing further. Additionally, regulators may struggle to understand the economics of "complex" instruments. Click to view "Financial System Overhaul," written by Beejal Patel (March 26, 2009).

Let me ask what may seem like simple questions.

The point is that we've had more than a trivial amount of regulation in place for years yet we've still had problems. How are new mandates going to trump existing rules?

You Can't Regulate Honor

As famed playwright George Bernard Shaw once said, "The most tragic thing in the world is a man of genius who is not a man of honor." I've been thinking about the "H" word a lot lately, especially given what seems like to be a never-ending onslaught of news items about fraud or outright bad practices. The current brouhaha in the Empire State is one example. 

In "Criminal Case Ensnares Aides to Ex-New York Comptroller" (March 19, 2009), Wall Street Journal reporters Craig Karmin and Peter Lattman describe a "pay to play" scheme that has the makings of a Hollywood thriller. Attempting to outgreed Gordon Gekko, several aides to a former New York State comptroller have been charged by the U.S. Securities and Exchange Commission with over 100 counts, including money laundering and bribery. According to the regulator's website (Litigation Release No. 20963), private equity and hedge fund managers were encouraged to pay many millions of dollars "in the form of sham 'finder' or 'placement agent' fees," expecting to secure asset allocation commitments from the New York State Common Retirement Fund.

Were this an isolated event (and to be fair to the defendants, these are only allegations at this point), people may be willing to look askance. Alas, we have Madoff, Sir Stanford, AIG bonus lunacy and so much more.

Not being a psychologist, I'm unclear as to why people conduct themselves in a questionable fashion. Some say that bad players rationalize their acts as short-term (not to be repeated) or legitimate entitlements ("I'm owed'). Even if one accepts fraud or sub-par practices as okay (and hopefully few do), it is not smart business. Ultimately, people get caught, even if it means mental anguish in the form of time spent, worrying about being found out, remorse or both. How sad too that innocent spouses, family members and children get a place in the "hall of shame," next to the responsible party.

I've made no secret that I'm an advocate of free markets. In response to several colleagues who demand even more mandates, my question to them is whether they think honor can be regulated. Pour moi, I think not. Force does not equate to walking a straight line.

If there is a silver lining to financial mishaps of late, perhaps it is this. More and more individuals (business persons or otherwise) are having lively debates about ethics, best practices and fiduciary standards. It's a great start, don't you think? 

One attempt at getting the message out is the recently published "Principles of Financial Regulation Reform: A Model for Change." Developed by CalPERS and other large public pension plans, the March 2009 document urges greater transparency and freedom to invest, "consistent with fiduciary responsibilities," without limitation "on the universe of available investments." Somewhat ironically, the New York State Common Retirement Fund is a signatory to this call for reform. (Could some of the newly minted principles have possibly forestalled or prevented the alleged fraud now being investigated by regulators?)

Connecticut State Legislators Target Hedge Funds


 Following up on "Hedge Fund Haven Gets Double Whammy from Pension Plan and New Regulations" (March 2, 2009), here are links to the three regulations being considered by the State of Connecticut General Assembly:

Here are a few interesting questions.

  • If the Nutmeg State implements and enforces new hedge fund laws, anticipating that investors are now protected, how will they explain any future losses?
  • How will legislators seek to protect investors in the case of hedge fund look alikes? Federal Reserve Chairman Ben Bernanke referred to AIG as an "irresponsible" hedge fund. (See "AIG An 'Irresponsible' Hedge Fund, Regulators Say," FINalternatives, March 4, 2009.) A quick read of the aforementioned state proposals would suggest that these proposed laws will not apply to this insurance giant or other non hedge fund "hedge fund."
  • In the event that the U.S. Congress and non-U.S. regulators each create their own set of rules and they conflict with one another, which ones trump?

Hedge Fund Haven Gets Double Whammy from Pension Plan and New Regulations

According to "Taxpayers may pay for pension shortfall" by Neil Vigdor (Greenwich Time - March 1, 2009), prosperity for this lovely Connecticut may soon be a distant memory. A recent meeting of town officials revealed that "the town's pension fund has lost nearly 24 percent, more than $100 million, since last year. Continued deterioration in the equity markets could lead to a $16+ million contribution in short order. Layoffs of public workers have already begun with more likely to come. Though some employees are being directed to 401(k) plans in lieu of the traditional defined benefit plan, municipal woes are a huge headache.

Making matters worse, Greenwich - the home of more than a few major hedge funds - may soon be slapped with onerous compliance costs if Nutmeg state legislators have their way. Hartford Business Journal reporter Greg Bordonaro writes that three bills could potentially roil an already challenged industry. One bill would prohibit investments in hedge funds for individuals (institutions) with less than $2.5 ($5.0) million in assets. Another proposed rule would force additional transparency for any hedge fund that take pension assets. Only time will tell if lawmakers get their way. Earlier attempts at state mandates were rebuffed, fearing that the state would lose tax revenue from wealthy hedge fund managers. However, choppy markets make alternatives a ripe target for attack. Should compliance costs soar, Greenwich town leaders will have more to worry about than pension deficits. As hedge fund attorney John Brunjes says, "It's a highly competitive business, so it would take very little in terms of regulation for hedge fund managers to consider doing business elsewhere." Click to read "Lawmakers Propose Stiff Hedge Fund Oversight.

What's interesting is that equity-related losses are tempting plan sponsors to accelerate their allocation to strategies that lure with the potential of higher returns. Whether doubling up makes sense is a topic for another day. However, alpha-seeking institutions may have nowhere to go if new rules depress expected returns by increasing costs. The counter argument is that regulations are long overdue. No doubt it will be an interesting year for hedgies.

France Pushes for Hedge Fund Regulation

Financial Times reporters Ben Hall and James Mackintosh report that France is calling for stricter regulation on hedge funds. Possible changes include: (a) higher capital requirements imposed on banks that lend to hedge funds and otherwise provide services as prime brokers (b) more transparency and (c) mandatory registration of hedge funds with regulators "in the country where they are sold." (See "France to call for hedge fund crackdown," February 12, 2009.)

France's finance minister, Christine LaGarde, has been calling for additional hedge fund rules for months, urging other countries to band together in this effort. Just a few months ago, LaGarde told Daily Telegraph readers that "the health of hedge funds had long been her prime concern. She cited the adverse impact of leverage for many alternative fund managers, some of whom were forced to sell assets quickly in order to stay afloat. See "Hedge Funds could be next to be hit, says French finance minister Christine Lagarde" by Henry Samuel and Harry Wallop (October 17,2008).

With heightened public scrutiny, the inevitable increased costs of regulation can't be welcome news to industry participants. Investors will have to weigh the perceived benefits of new rules against the potential economic impact on performance. Picking sides may not be possible for too much longer.

C'est la guerre! 

Vive Le Free Markets - Oh Never Mind!

French economist Frédéric Bastiat must be rolling over in his grave as more and more headlines decry capitalism in favor of stringent regulation. In "Policy Makers Weigh Fed Oversight of Derivatives" (February 2, 2009) Wall Street Journal reporter Deborah Solomon writes that Washington movers and shakers are all a twitter about whether to regulate over-the-counter derivative instruments. (One could argue that some regulation currently applies since federally regulated banks dominate this space but that's a discussion for another post.) House Financial Services Chairman Barney Frank (Democrat, Massachusetts) is quoted as saying that "It's not a brand-new regulation but an expansion of the authority of the Federal Reserve."

According to his official website, Senator Chuck Grassley (Republican, Iowa) - along with Senator Carl Levin (Democrat - Michigan) - have introduced legislation to "close a loophole in securities law that allows hedge funds to operate under a cloak of secrecy." In "Grassley and Levin introduce hedge fund transparency bill" (January 29, 2009), this new legislation, if passed, would empower the U.S. Securities and Exchange Commission ("SEC") to force hedge funds to register, thereby putting them under the auspices of the Investment Company Act of 1940. 

In his January 29, 2009 statement, Senator Levin described three basic elements of The Hedge Fund Transparency Act, besides registration. These include the filing of an annual statement that would be available to the public, the maintenance of books and records as required by the SEC and the cooperation with the SEC as relates to examination or information requests.

Levin adds that "The information to be made available to the public must include, at a minimum, the names of the companies and natural individuals who are the beneficial owners of the hedge fund and an explanation of the ownership structure; the names of any financial institutions with which the hedge fund is affiliated; the minimum investment commitment required from an investor; the total number of investors in the fund; the name of the fund's primary accountant and broker; and the current value of the fund's assets and assets under management. This information is similar to what was required in the disclosure form under the SEC's 2004 regulatory effort. The bill also authorizes the SEC to require additional information it deems appropriate."

About two weeks earlier, the President's Working Group on Financial Markets ("PWG") released its best practices for hedge funds, encouraging market participants to adopt comprehensive policies and procedures to (hopefully) thwart problems. The institutional version, entitled "Principles and Best Practices for Hedge Fund Investors: Report of the Investors' Committee to the President's Working Group on Financial Markets" (January 15, 2009), includes an entire section devoted to fiduciary issues. Some of the text is overly broad but it is a good start in terms of getting people to think hard about subjects such as suitability and oversight.

The industry version, entitled "Best Practices for the Hedge Fund Industry: Report of the Asset Managers' Committee to the President's Working Group on Financial Markets" (January 15, 2009), has a noteworthy section about valuation (a topic near and dear to my heart). I am particularly interested in tracking which hedge funds decide to set up a valuation committee, if one does not currently exist. If hedge fund managers follow the report's recommendations, they will likely be spending lots of money on independent pricing services.

Two key questions loom. Will industry attempts at best practices slow down or possibly ward off increased regulation? If not, will regulation and enforcement parallel or conflict with suggested best practices?

This blogger gal goes on the record as favoring industry self-regulation. Sadly, when too few participants fail to recognize the benefits of taking responsibility to preserve open and fair markets, the strong arm of government is inevitable. Consider what Bastiat wrote in the 1800's, still relevant today:

  • "Everyone wants to live at the expense of the state. They forget that the state wants to live at the expense of everyone."
  • "Taxes must, in the end, fall upon the consumer."
  • "The worst thing that can happen to a good cause is, not to be skillfully attacked, but to be ineptly defended."

Whether we end up talking about "smart" or "better" regulation, financial market participants STILL have a chance to eat, live and breathe best practices, for themselves and for their investors.

Capital Calls Are Tough for Institutions and General Partners Alike

According to PE Week Wire (January 15, 2009), the Los Angeles City Employees' Retirement System ("LACERS") has rescinded its authorization to invest in Cityfront Capital Partners, L.P. ("Cityfront") since said fund has yet to raise a "minimum of $50 million in committed capital, which was to include LACERS' commitment." Part of this California pension fund's allocation to "Specialized, Non-Traditional Alternative Investment Programs," an agreement was reached on August 14, 2007 to invest $5 million in this "small and middle market buyout fund of funds investment vehicle." According to a January 13, 2009 "Report to Board of Administration," LACERS' Chief Investment Officer explains that the buyout fund has "only been able to raise $7 million in 'hard commitments' with no near-term expectations of achieving the $50 million minimum level."

Cityfront is not alone in feeling the pinch. According to "VCs Feeling the Pain of Newly Poor LPs" (January 16, 2009), PEHUB writer Connie Loizos writes that some institutional investor limited partners are strapped for cash, having lost money in the market of late. For those for which the problems are dire, they are simply failing to meet a capital call(s) when the venture capital or private equity  fund comes calling for more money.

On January 17, 2009, Wall Street Journal reporter Pui-Wing Tam wrote that, not surprisingly, venture capital investment has "dropped 30% in the fourth quarter to its lowest level since 2005." Traditional exit strategies such as issuing equity via an IPO (initial public offering) or being merged or acquired are currently seen as unlikely options for many VC-backed companies. See "Venture Funding Falls 30%." (A subscription may be required to read this article.) A few weeks earlier, fellow Wall Street Journal reporter Craig Karmin wrote that pension funds are rethinking how much money should remain in private equity, hedge funds "and other nontraditional investments." Karmin describes a capital call "crunch" with private equity funds demanding cash but pension funds expecting to "offset the payments with returns from other private-equity investments." Elusive gains create a double whammy for both limited and general partners alike. See "Once Burned, Twice Shy: Pension Funds" (January 3, 2009).

Business Week Executive Editor John Byrne and writer Steve Hamm tackle the topic of increasing risk aversion on the part of venture capitalists in a December 30, 2008 video entitled "Is Silicon Valley Losing Its Magic?" Citing Andy Grove, author of Only the Paranoid Survive, Hamm avers that the ability for young companies to innovate is being curtailed as venture capitalists and private equity bankers scale back. Institutional investors that do not make capital calls and/or step up to the plate to allocate fresh monies may prevent venture capital and private equity funds from generating robust returns. On the other hand, institutions which are not enjoying attractive, risk-adjusted returns from venture capital and private equity funds could be reluctant to make capital calls.

It is a veritable catch-22.

Editor's Note: 

Funds of Funds - What Comes Next?

According to John Gapper, funds of funds ("FOFs") are significant players, accounting for nearly one-half of all hedge fund assets. This Financial Times chief business commentator connects growing institutional interest to a rise in demand for intermediaries who offer due diligence services. Post-Madoff, he paints a grim picture for the industry unless good players are able to differentiate themselves from those who are now being scrutinized.

Whether certain organizations could have detected fraud is unknown at this time though Grabber suggests that "funds of funds need to work harder and show that they actually contribute something valuable." I am quoted as saying “It is not as if this stuff is really complicated. A lot of the risk of fraud can be mitigated by measures that are low-cost and not very time-intensive.”

I certainly agree with Gapper that there is a "role for the good funds of funds." I'd go further to say that it is unfortunate indeed for those funds of funds that exercised care and discipline in researching  financial and operational risks on behalf of pensions, foundations and endowments. They are unfairly being painted with a dirty brush.

For institutional investors, a key question remain. Will pensions, endowments and foundations continue to reach out to funds of funds or decide instead to hire in-house experts? If they have already hired one of the funds of funds that turns out to be tied to large Madoff-related losses, to what extent might investment fiduciaries be asked to explain their FOF choice and subsequent oversight of said FOF? These are important questions, yet to be answered.

Click to read "Funds of funds have to work harder," Financial Times, January 7, 2009. (Access may be limited to subscribers only.)

Editor's Note: Click to read "Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds," published by the U.S. Securities and Exchange Commission. Click to read "Report on Funds of Hedge Funds," published by the International Organization of Securities Commissions, June 2008.

Congress and Hedge Fund Regulation

Many financial market participants seem resigned to an onslaught of new regulations. For them, it is no longer a question of "if" but "when," with the unknown being the form of eventual rule-making. One area that is likely to receive more than a passing glance is the role of the service provider to pensions, endowments and foundations. Always important, the Madoff scandal has pushed the issue front and center as institutional investors, reeling from reported losses, ask their advisors for clarity about their exposure to the now defunct Bernard L. Madoff Investment Securities LLC. According to "Crackdown on hedge funds after Madoff affair" (December 29, 2008), Financial Times reporters Deborah Brewster and Joanna Chung suggest that funds of funds may be especially feeling the pinch, with an anticipated change in how due diligence is conducted.

Next week's Congressional hearing should be telling. Convened by U.S. Congressman Paul Kanjorski (Democrat - Pennsylvania), this investigative meeting may be "standing room only" as members of the Financial Services Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises seek to understand what went awry before being able to "craft a strong, effective, modern regulatory system for the financial services industry." 

Though best left to legal experts, one wonders if a likely inquiry will center on the allocation of fiduciary duties across investors and advisors. Under what circumstances might an advisor or consultant be seen as encouraging an "unsuitable" investment? This of course begs the question as to what is deemed "appropriate" for a particular buyer and on what basis should an investment be assessed for a particular pension, endowment or foundation? We've heard that some financial professionals are responding to l'affaire Madoff by imposing more stringent, and arguably prudent, literacy requirements BEFORE accepting client money.

Hedge Fund Valuation - Dead or Alive?

A key element of any valuation engagement is an assessment of "premise of value." Said another way, an appraiser must determine whether an economic entity is likely to remain in business (and therefore should be treated as an ongoing concern) or instead be put in the "not going to make it" bucket. If operations are thought to soon cease, imminent liquidation is almost sure to follow, (wherein the business sells assets and tries to make good on outstanding obligations, to the extent that proceeds are available.) According to a recent article, the "alive or dead" litmus test may be needed now, more than ever before. reporter Ben Rooney cites a recent Hedge Fund Research study that documents 344 liquidations or "more than three times the 105 liquidations in the third quarter of 2007" or "77 more than the previous record of 267 liquidations in the fourth quarter of 2006." On an annual basis, failed hedge funds may reach nearly 1,000 for the full year or more than "the previous record of 848 of 2005." (See "Hedge fund graveyard: 693 and counting," December 18, 2008.)

Redemptions, wild market swings and idle cash, sitting on the sidelines, are a few likely culprits with respect to which hedge funds survive or fail. What this means to institutional investors is profound. Due diligence must address whether and for how long a particular hedge fund might be expected to be a viable commercial enterprise (and so much more). Without stating the obvious, who wants to plunk down good monies for a fund that has a low probability of being around for the foreseeable future?

In a related article, Financial Times reporter James Mackintosh reports that Switzerland's Union Bancaire Privée has told "managers of the $56bn it has allocated to hedge funds to put in immediate redemptions for any fund that does not have independent administrators and custodians." The article goes on to say that some hedge fund notables are on the redeem list while others have decided to appoint independent third parties. (See "Investor demands fund checks," December 23, 2008.)

Anecdotally, I've heard that institutional investors (either through the audit or compliance functions or both) are requiring more documentation (read "transparency") from their hedge fund managers. To date, they say they have had little push-back. One wonders if there is a balance of power shift underway, favoring institutional investors. After all, how many of us have heard some asset managers decline (sometimes vehemently so) to implement what they deem to be expensive and time-consuming procedures UNLESS pensions, endowments and foundations demand such?

Editor's Note: Valuation of a hedge fund as a business is not the same thing as assessing the worth of instruments inside the hedge fund's portfolio. Consider a particular hedge fund that successfully invests in distressed securities.

Financial Domino Effect: Pensions and Alternatives

As this blogger has said for many months, pension risk management trumps a return-only focus. Few care about the risks associated with the upside. It's the extreme tail of a price distribution that gets people's attention. When low frequency (read DIRE) values occur, watch out. The dominoes crash into other, the structure crumbles and someone is left picking up the pieces. Is that happening now? You betcha! Any problems with investments, heretofore put into neat asset buckets, spill over into other parts of the portfolio, forcing major decisions about asset allocation, liquidity and cash requirements.

A November 16, 2008 New York Times article makes my point. (See "From the Valley Comes a Warning.") Writers Jeff Segal, Lauren Silva Laughlin and Rob Cox explain that the California Public Employees' Retirement System (Calpers) has to now decide whether and how to rethink its strategic asset allocation to alternative investments. Originally meant to be about 10 pecent of its overall portfolio, equity sector losses have apparently pushed the giant public plan's relative exposure to hedge funds, venture capital, private equity beyond its limit, to about 14 percent of its asset holdings. Worse yet (from a strategic asset allocation orientation) is that a market downturn may now accelerate calls for capital from the private equity and venture capital funds in which Calpers is invested, forcing an even higher allocation. (The idea is that some portfolio companies need more money now because their respective revenue projections cannot be met as corporate spending contracts. Private equity and venture capital fund managers - and their investors - can either lose everything they have invested in the portfolio companies or try to help them stay afloat, by giving them a cash lifeline sooner than anticipated. Hence, the need to accelerate capital calls.)

Calpers is not alone. We've heard from plenty of plan sponsors that the "stay the course" or bid adieu to alternatives (some or all) is at the top of their decision list. The problem is that exiting a particular private fund may be costly, so much so that the plan sponsor is made worse off in the short- and intermediate-term. Additionally, plan sponsors seldom have the legal right to turn down a request for additional capital from private equity fund X or venture capital fund Y. According to private investment fund attorney John Brunjes, a partner with Bracewell & Giuliani, "in a private equity or venture capital fund is a contractual relationship. Except for fraud or duress, pensions are on the hook to write a check when the alternative fund manager comes calling."

If true, that some plan sponsors are "stuck" for the foreseeable future (i.e. must meet their capital commitments to alternative fund managers) AND their losses continue in traditional equity land, participants may take it on the chin in the form of reduced benefits. Taxpayers and/or shareholders may be asked to make up the difference. From the mail and calls we get at Pension Governance, Inc., there are a lot of individuals who are beyond unhappy about what they see as their diminished future due to rescinded benefits, disappearing plans, sponsor insolvencies and so on. (While our company focus is on plan sponsors and their service providers, our web presence encourages communication from plan participants.)

With respect to investment fiduciary duty, will members of the investment committee be held liable for not having properly assessed correlation patterns over extreme data ranges? When things go south and investor flee to quality, "contagion" is not uncommon. This means that bad news impacts the performance of multiple asset sectors, even those thought to move inversely or independent of each other. The "one world - one market" phenomenon translates into lower diversification benefits.

Will investment fiduciaries be held accountable for not better measuring liquidity or assessing transferability restrictions or the legal implications of capital calls? What is the role of consultants and fund of funds managers in evaluating risk factors beyond the numbers themselves? Are there some private funds deemed to have done enough to vet the suitability of alternatives for their institutional investor clients.

I'll be writing much more about the changing relationship between institutional investors and private funds. What do you want to know more about in these areas? Drop me a line.

Editor's Notes:

  • On January 4, 2007, I wrote: "Contagion itself is dangerous but when you consider what some describe as an inevitable convergence towards one global market, with trading that occurs 24/7, the potential for serious harm is real. Continued technological advances, international deregulation and investors' willingness to go offshore promote lightening speed information flow. When bad news hits, it's the shot heard 'round the world. Having worked on three trading desks during volatile times, I know firsthand how quickly things can change." (See "Pension Contagion - Should We Worry?")
  • The Calpers website reports that, as of September 30, 2008, its current allocation to alternatives is 12.2% versus a target of 10 percent. For more information, click here.
  • Here is the link to the slide show that has Silicon Alley shivering in their boots. Essentially famed venture capital firm Sequoia Capital told entrepreneurs to watch their cash and acknowledge that the funding party may be over, at least for awhile. See for yourself. Read "The Sequoia: 'RIP: Good Times' presentation: Here it is" by Eric Eldon, Venture Beat, October 10, 2008.

Successful Hedge Fund Manager Bids Adieu, Insults and All

In a somewhat scathing goodbye letter to his investors, hedge fund manager Andrew Lahde lambastes his investors. Calling them "low hanging fruit" and worse, click here to read for yourself.

My rationale for posting the letter is not to sensationalize but rather point out that people seem to be getting more vocal about the economic and political state of affairs. I think this angst is going to have a dramatic impact on the legislative landscape. Recently asked whether I think more regulation is on its way, I answered "without doubt."

Plan sponsors are likely to see a lot more politicians passing the retirement benefit plan "hot potato. The calculus is simple.

  • More pension plan woes + Social Security gaps (or international equivalents)
  • Blame game begins
  • Hold plan sponsors responsible for helping retirees make up for losses.

In response, plan sponsors that take pension governance seriously (and are demonstrated fiduciary leaders) are likely to have more influence on the outcome.

Pensions to Hedge Funds: Lock Me Up

As markets tumble, hedge fund investors are asking for longer lock-up provisions in order to preserve their investment.

Say what? 

The reasoning goes like this. If an investor can redeem, and does in fact ask to redeem, a hedge fund manager may be forced to sell assets to raise cash. More liquid assets are sold first, leaving behind less liquid assets that are arguably harder to value. Pre-mature sales, due to accelerated redemption requests, may even force a hedge fund to close and "give long-term investors their money back at a time when asset prices are low." By asking for longer lock-up periods, investors are seeking to forestall forced sales and thereby protect their original investment. See "Hedge investors ask for lock-ups to avoid closures" by Laurence Fletcher, Reuters UK, October 8, 2008.

We caught up with Mr. Edward Stavetski, Director of Investment Oversight, Wilmington Family Office, and asked him for his two cents. Here is what he has to say.

"This crush of cash outflows may be only one cause of fund closures at year end. Consider high water marks as we near the end of the calendar year. As news that some hedge funds are down 30 to 40 percent, it will become quite difficult for those fund managers to realize any earnings from their respective 20 percent performance clause. Most funds use management fees to keep the lights turned on but depend on the performance fee income to hire star traders or retain top talent. Without the near-term promise of a high performance payout, we could see a dramatic shift of key players in the hedge fund world. While people may rejoice that the 'nasty' hedge fund cult is finally getting its just desserts, the damage will reach far beyond the hedge fund community. The rush to buoy cash holdings will depress prices of stocks, bonds, mortgage-backed securities and other capital-raising mechanisms in the near-term. None of this is good news for investors, asset managers and/or consumers."

This blogger wonders if smart money will head towards or away from hedge funds. After all, if pensions and 401(k) plans are dumping stocks in record numbers, and U.S. treasuries (and international equivalents) return little, how else will plan sponsors and individuals "make up for losses?"

We'll watch and see.

Testimony of Dr. Susan Mangiero About "Hard to Value" Assets


At the invitation of the ERISA Advisory Council, I presented testimony about "Hard to Value Assets" on September 11, 2008 in Washington, D.C. Some of the questions I was asked to answer are listed below:

  • Should valuation issues play a role in the selection of plan investments, and in achieving proper asset allocation and diversification?
  • What, if any, modifications to plan investment policies and guidelines should plans consider when utilizing "hard to value assets?"
  • As fiduciaries, what do you deem to be or what do you expect to be "hard to value assets?"
  • Who can the fiduciary rely upon when ascertaining the value of "hard to value assets" when the fiduciary is incapable of valuing, in order to fulfill their fiduciary responsibility to plan participants?
  • What valuation policies and procedures should a fiduciary adopt when holding "hard to value" assets?
  • What disclosures and education measures are required or suggested for participants and fiduciaries with respect to plans which invest in "hard to value" assets?

Given the recent tumult in the global financial markets, it seems as if an eternity has passed since the September 11 hearing date. Valuation continues to be a hugely important topic. I hope that my comments are informative and helpful to readers. Let me know what you think. Click here to read "Testimonial Remarks Presented by Dr. Susan Mangiero." 

New Pension Report Just Released on Hedge Funds and Private Equity

Here is a link to a just-released report from the U.S. Accountability Office, entitled "Defined Benefit Plans: Guidance Needed to Better Inform Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity."

In terms of full disclosure, Pension Governance, LLC provided its authors with background information about risk management and valuation considerations. Having just received this now public document, I will read it more thoroughly at a later time and report back. It looks like a comprehensive analysis.

I am off to provide testimony as part of today's meeting about "Hard to Value Assets." The meeting is being held at the request of the ERISA Advisory Council. My submitted testimonial statement will be uploaded in the next few days.


Hedge Fund Valuation Survey

Business Valuation Resources and Pension Governance, LLC just completed a joint survey on business valuation firms that currently provide valuation services to hedge fund clients. It appears that relatively few hedge funds are reaching out to the business valuation profession, despite regulatory and legal pressures to improve valuation practices. Some highlights are summarized below:

  • Of the few survey respondents who currently provide services to hedge funds, appraisers say that 55% of their clients have a formal valuation process in place.
  • Appraisers who took the survey say that almost half of their hedge fund clients generate valuation numbers internally. A quarter of their clients rely on third party administrators. Relatively few used certified business appraisers.
  • Many reasons were given by appraisers as to why hedge funds procure a valuation. These include, but are not limited to: auditing (33% of respondents), asset allocation (27%) and performance reporting (24%), redemption (18%) and risk management (18%).
  • Eight out of 10 appraisers with hedge fund clients say they’ve never been called in to assist their hedge fund clients with the development of a valuation policy.
  • When asked about standards (guidelines), 48% of survey respondents claim their clients cite fair value accounting rules, 23% of respondents say their hedge fund clients use no standards and 23% of survey-takers cite the Private Equity Industry Group Guidelines (PEIGG) as a guide for their hedge fund clients.
  • For those survey respondents who choose not to pursue hedge fund valuation work, appraiser liability is cited as the primary deterrent (77% of respondents), followed by 54% of survey-takers who say they are unfamiliar with the hedge fund industry.

Editor's Note: Thirty-nine persons answered the survey. Additional research is underway.

Is 2 and 20 Soon to be Gone?

Wall Street Journal reporters describe a trend that some believe was once only urban legend, namely hedge fund managers cutting their fees. In "Hedge Funds' Capital Idea: Fee Cuts" (September 9, 2008), Jenny Strasburg and Craig Karmin describe a new balance of power in which investors are being courted to stay the course rather than pull out their money in search of greener pastures. Replete with examples, the article suggests that jittery institutions may get a big discount on fees if they agree to lock-up periods or give the fund managers ample time to recover losses or improve on sub-par performance.

This makes sense from the hedge fund managers' perspective, especially those who face unprecedented redemption requests. From the pension investors' vantage point, things are not so clear. Yes, it's great to be able to pay lower fees but if the price of doing so is the realization of a mediocre risk-adjusted return profile, plan sponsors may be better off rethinking their allocation to that fund. As with everything else, it's seldom so simple. Unwinding a position may be expensive in terms of transaction costs alone. Then there is the issue of what should replace the hedge fund, if jettisoned from the pension portfolio.

What will be interesting to watch is whether other hedge funds feel pressured to follow suit in terms of dropping fees.

New Jersey Gets Okay to Invest $9 Billion in Alternatives

Star-Ledger reporter, Dunstan McNichol, reports of a now-settled legal tussle between municipal worker unions and the State of New Jersey ("Court OK's Jersey plan to invest pension money in hedge funds," August 23, 2008). At the heart of the matter is The Garden State's desire to allocate 10+ percent of its $78 billion retirement system assets to hedge funds and other non-traditional investments as a way to avoid getting slammed when stock markets sour. (Unions have described alternatives as risky.) At the same time, "Court lets NJ invest pension money in hedge funds" (The Associated Press, August 23, 2008), reports a recent actuarial analysis that puts the shortfall as bigger than originally believed, due to a surge in police and firefighters who "are retiring with disabilities."

According to statistics published by the State of New Jersey, Department of the Treasury, Division of Investment, the alternatives portfolio (commodities, real estate, private equity and hedge funds is 11.7 percent (versus a target allocation of 10.3 percent) as of June 30, 2008. In its press release, dated July 15, 2008, the recent loss of 3.1 percent (at mid-year 2008) still leaves a five-year average return of 9.1 percent, higher than "the assumed actuarial investment return of 8.25 percent." Division Director William Clark credits alternatives for avoiding a loss of approximately $3 billion, had the pension's asset mix "not been diversified away from its historic concentration purely on equities and bonds."

New Jersey is not alone in seeking alternatives as a diversifier. Yet there remains a critical question as to when and why equities are deemed "riskier" than alternatives. Of course, one must be particularly careful with his or her answer. Market capitalization, strategy, relevant time period, restrictions on transferability and industry and economic fundamentals are a few of the many determinants of risk (financial and otherwise) that distinguish traditional equity holdings from alternatives.

Editor's Note: To learn more about official symbols, including the State Seal, visit the State of New Jersey website.

Public Pensions and Hedge Funds

In "States Double Down on Hedge Funds as Returns Slide," Bloomberg reporters Adam Cataldo and Michael McDonald (August 14, 2008) suggest that public pensions may get a double whammy if alternative investments go south. New York, New Jersey, South Carolina and Massachusetts are just a few of the large public plans now allocating monies to non-traditional investments such as hedge funds, real estate and private equity. This is not necessarily good or bad though one wonders about the timing. Will current market volatility help or hinder plans in search of higher returns? This blogger is quoted as follows:

"It doesn't come risk-free," said Susan Mangiero, president of Pension Governance, LLC, a research firm based in Trumbull, Connecticut. "You could end up having a worse performance and the chain of events is lower funding status and increased taxes."

Managing director Eileen Neill, with Wilshire Associates, states the need to "diversify some of the equity risk" and to attempt strategies that will help match the growth in liabilities. As I told the Bloomberg reporters (though not included in this article), how one measures diversification potential is key to understand. Correlation analysis only goes so far when markets are turbulent and bad news tends to adversely impact otherwise uncorrelated markets. Additionally, correlation assumes a linear relationship when comparing returns for a particular investment pair (hedge fund versus a large cap equity index for example). When the relationship is non-linear, correlation is less useful as a gauge of potential risk reduction.

Just as important, past is not prologue. Assessing historical returns can be misleading at best. Stan Rupnik, Chief Investment Officer at the Teachers' Retirement System of the State of Illinois, is quoted as saying that "Chasing performance, especially in a public fund, can be a dangerous thing." It is important for trustees to make sure that "what if" analysis is being done on a regular basis, taking into account relevant risk drivers. Consider private equity and venture capital. An accelerating credit crisis has made it extremely difficult for companies to go public or for potential suitors to finance their bid. As a result, returns suffer. No surprise that pension investors (and their plan participants) take a hit too.

Editor's Note:

Seal of Approval for Hedge Funds

In a recent interview, Mr. Stanley Goldstein announced the creation of an industry watchdog group, led by the New York Hedge Fund Roundtable. Its goal is to self-enforce otherwise voluntary and "weak" hedge fund practices. (As I wrote in "Doris Day, Scarlett O'Hara and Financial Market Tumult," July 19, 2008, a July 17, 2008 Financial Times editorial refers to such guidelines as cosmetic, meant to attract institutional investors and to keep regulators at bay.)

Goldstein, a CPA and founder of several hedge funds, explains that the aim is "not to start a separate organization but to use the existing one to compile and disseminate standards for hedge funds to follow," adding that "We do not see enforcement as practical or desirable but rather, hope that 'industry usage' will evolve along the lines which we, and others like us, deem appropriate."

Goldstein's support of the free market to act as the ultimate enforcer is laudable, especially at a time when global regulators are far from silent about the need for more stringent rules. Will Adam Smith's "invisible hand" really work? Let's hope so. As this blogger as written many times before, regulations no doubt change the way market participants behave, often leading to the "Law of Unintended Consequences."

Goldstein strongly believes in the power of collective self-policing. "By analogy, you will notice that more and more not-for-profit organizations are beginning to create audit committees on their boards and some have adopted "whistle blower" policies. There was no mandate nor promulgation forcing them to do this. What happened? Donors asked questions and boards had no choice but to make sure the right boxes could be checked off or risk losing contributions, the lifeblood of funding. These charities are run by smart people who are taking the hint. They want to be good players. With luck, time and some coordination, we can edge hedge funds in the same direction."

In the absence of a serious industry attempt to do better (for those funds who are not already at the top of their game), new accounting rules (FAS 157 or IAS 39 for example) and/or regulators' admonitions (such as the U.S. Department of Labor's recent letter to a plan sponsor, urging them to do their own valuation homework) could cause institutional investors to shy away from alternative investments such as hedge funds. If true that alternatives might help to diversify a portfolio, then a rejection due to a statutory artifice (versus an economic exigency) would be yet another example of the "Law of Unintended Consequences." (Read "Regulators Tell Pensions to Independently Value Positions," August 9, 2008, to access the aforementioned letter about valuation.)

This blogger says "bravo" and wishes the New York Hedge Fund Roundtable the best of luck. If Pension Governance, LLC can be of assistance, count us in. We agree that volitional "best practice" attempts are almost always far superior to a "one size fits all" authoritative mandate.

Editor's Notes:

  • According to economist Adam Smith in his Wealth of Nations, "Every individual...generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention." Click for more quotes by Adam Smith.
  • According to the Library of Economics and Liberty, the "Law of Unintended Consequences" states that "actions of people - and especially of government - always have effects that are unanticipated or 'unintended.'" The concept is related to Adam Smith's invisible hand theory wherein the famous economist wrote "It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own self interest."
  • In aftermath of mandates such as FAS 133 (U.S. derivatives accounting standard) or FRS 17 (UK retirement benefit plan accounting standard), experts documented a clear change in the way impacted parties went about their business.
  • Interested readers can download "The Failings of FRS 17 and the Impact of Pensions on the UK Stock Market" by SEI researchers and Laurence Copeland (Cardiff Business School). The assertion is that, several years after its  2001 implementation, "the majority of UK pension schemes have closed to new entrants." In an attempt to promote transparency about retirement plans, the unintended effect is a diminution of aggregate employee benefits.
  • Another interesting publication is "The Impact of FAS 133 on the Risk Management Practices of End Users of Derivatives, "Association of Financial Professionals, September 2002. Researchers conclude that reduced hedging activity is likely due in part to the implementation of what users describe as an "excessive burden" in order to comply.
  • Regulators have called for more rules to govern non-profit boards, leading some to suggest that improvements are part "stick" as well as "carrot." For example, the Pension Protection Act of 2006 mandates enhanced disclosures and distribution limits for non-profits. Read "The Pension Protection Act of 2006 and Nonprofit Reforms" by Eileen Morgan Johnson, Whiteford, Taylor & Preston, LLP, January 2006. Also click to read "Nonprofit Governance In the United States" by Francie Ostrower, The Urban Institute, 2007. Click to access the Appendices to this paper.

Pension Fund Governance in the Lonestar State

Hat tip to Robert Elder, journalist for American Statesman, who writes that a prominent Dallas financier has been jettisoned as chairman of the Texas Pension Review Board, "which oversees nearly 400 public pension systems that hold $200 billion in assets." In "Perry ousts head of pension board" (American Statesman, June 24, 2008), Elder describes Frederick Rowe as a vocal critic of alternative investment commitments by retirement plans that do not always fully consider risks.

According to its website, the Texas Pension Review Board has a variety of duties, including the oversight of "the actuarial analysis process" and making recommendations of "policies, practices, and legislation to public retirement systems and their sponsoring governments." If one clicks on "Tools," you can download the audio files of board meetings. The most recent one (dated April 10, 2008) is worth a listen as it centers on asset allocation and risk assessment with then Board Chairman Rowe criticizing a "backward-looking" approach to assessing investment performance and a reliance on investment consultants who advocate alternatives and "reduce what they call risk in patching together this crazy quilt of uncorrelated assets." (It's a large file and may take a few minutes to download.) 

In its "Written Investment Policies for Public Pension Systems," the section on risk is brief and focuses on the erosive impact of inflation and the possible gap between actuarial interest assumptions and realized performance. The statement that "to increase one's understanding, one can also look at the actual rates of return and volatility for the past 25 years" caught my eye. As most financial experts know, the risk-return tradeoff, along with correlation patterns (and much more), can change dramatically over time. To rely only on historical numbers without conducting a "what if" analysis (which may be a regular activity by various Texas plans) is ill-advised. Additionally, a decomposition of a period as long as 25 years into economic "regimes" goes a long way to avoid the artificial smoothing of risk measurements. Decisions based on metrics that lower risk may not always be the best ones, putting it mildly. However, to be fair, readers are urged to describe investment objectives in terms of return (absolute and relative) as well as the risk-adjusted rate of return. It would be nice to see this document beefed up to include extensive guidance on how various risks (economic, operational, default, etc) will be measured, monitored and managed.

In a separate article ("TRS switches key outside law firm," American Statesman, July 24, 2008), Elder writes about a recent change of fiduciary counsel that has apparently upset some trustees of the Teacher Retirement System of Texas. Elder describes the decision as "unusual" because of a close split vote and imminent plans to discuss "governance policies and ethics rules in September" (suggesting that some trustees favor continuity). One pension attorney with whom I recently spoke offers that a change of fiduciary counsel is not in and of itself a red flag.

In a lengthy comment, posted to Elder's blog, Public Capital, Mr. Jim Lee, Board Chairman of TRS writes that "8 trustees voted for or expressed support" for the hiring of a new outside legal expert and that trustees unanimously voted in favor of "diversification changes in April 2007." He adds that a variety of alternative investments "will make up potentially another 30 percent of the portfolio, up from approximately 4.5 percent" as part of a "very deliberate progression." Printed page 68 of the Comprehensive Annual Financial Report (for fiscal year ending on August 31, 2007) shows a private equity target allocation of 10% with a minimum range of 5% and a maximum range of 15%. The given target for hedge funds is 4% with a minimum range of 0% and a maximum range of 5%. The target for real estate is 10% with a minimum range of 5% and a maximum range of 15%.

As stated many times herein, alternative investments are not inherently "good" or "bad." However, as more U.S. and non-U.S. plans (public and corporate) invest in alternatives, it is extremely important to understand how decisions are made with respect to risk assessment, including valuation of "hard to value" assets. In the case of TRS, with a total fund value as of August 31, 2007 of $111.1 billion, the aforementioned annual filing cites the creation of a risk committee of the board to oversee "the overall risk of the portfolio" and establish "policies and practices to measure, manage and mitigate" exposures. A second initiative is the determination of "key risk parameters", derivative instrument limits and related counterparty credit ceilings, along with addressing liquidity, operational, settlement and legal uncertainties.

Editor's Note: The Teacher Retirement System of Texas was cited as "Public Pension Fund Investor of the Year" by Alternative Investment News, an Institutional Investor publication. Click to read the June 26, 2008 press release.

South Carolina Retirement System Forays Into Alternatives

Looking forward to "enhancing and diversifying" the $29 billion investment portfolio of the South Carolina Retirement System ("SCRS"), the South Carolina Retirement System Investment Commission awards a strategic mandate to the D.E. Shaw Group. According to the July 28, 2008 press release, capital will be allocated to an "array of absolute return, direct capital, private equity, real estate, long-only and 130/30 opportunities." (The SCRS website describes the Investment Commission as consisting of six "financial experts," having been created in 2005. A designated fiduciary for the SCRS, The Commission "is now responsible exclusively for investing and managing all assets of the SCRS.)

According to the "South Carolina Retirement System Investment Commission - Annual Investment Plan, Fiscal year 2007-2008" (last updated on July 19, 2007), an asset allocation has been approved that "is significantly different from the previous asset allocation." While equity cannot exceed 70 percent of the total investment portfolio at any time, alternatives are targeted to make up fifteen percent of assets, with five percent each in private equity, real estate and "Global Asset Allocation/Absolute Return" (GAA/AR). As shown in the table below, deviations might occur, in part perhaps because "it may take five years or longer before the total allocation to private equity is fully invested." (Private equity was just approved in November 2006, via a constitutional amendment, followed by a state referendum and ratification by the state legislature.)

Excerpt from the Annual Investment Plan: (%)
                          Sub-Asset Class   Target    Minimum     Maximum
                           GAA/AR      5           2           8
                         Private Equitiy      5           0         10
                          Real Estate      5           0         10

In reading further, investment managers are clearly held responsible for "compliance with all guidelines," using "then current market values" as a benchmark. Given that FAS 157 presents all sorts of mark-to-market (or mark- to-model) challenges for alternative fund managers, it will be informative to track how D.E. Shaw and others (a) satisfy SCRS guidelines while (b) helping this public plan giant embark on what might be construed by some as an "aggressive" foray into non-traditional strategies ("aggressive" in the sense that the minimum versus maximum totals could vary considerably, from 2  percent to 28 percent of total assets). Many questions arise, some of which are listed below.

  • Will the Investment Commission create and make public a separate risk management and valuation policy(ies) for alternative investments?
  • How will the use of derivative instruments for 130/30 strategies be tracked across managers in the context of asset allocation sub-sectors?
  • Why does the "Derivatives Review" exclude a statement about the monitoring of collateral by those fund managers who employ derivatives, direct and embedded? (The "March 31, 2008 Quarterly Report" does describe "continued development and refinement of risk control reports to monitor liquidity, leverage and counter-party risk.")
  • Will the cost of requiring "all managers" to "present book value and current market value for all securities held" on a quarterly basis turn out to be prohibitive and counterproductive? This assumes that "all securities" include those that, by their very nature, represent a bundle of "hard to value" economic rights. For example, will private equity managers be asked to get an independent, third-party appraisal of holdings every quarter? 
  • The aforementioned "March 31, 2008 Quarterly Report" states that "two private equity funds were approved totaling" 85 million Euros. Will these non-U.S. dollar investments be hedged? If so, how will fund managers be graded in terms of performance? Will fund managers be graded differently, depending on choice of hedging instrument and/or strategy?
  • How will an allocation to alternatives be determined in the context of variable funding ratios? (According to the "2007 Popular Annual Financial Report," actuarial assets as a percentage of actuarial accrued liabilities fell from 86 percent in July 2002 to 69.6 percent in July 2006. Noted is a 229.84 percent increase in cash and cash equivalents between 2006 and 2007 "until final allocations to the new asset classes could be implemented.")

Ideally, the Investment Commission will fully inform plan participants and other interested parties (state taxpayers for example) about their deep dive into alternative waters and related, but critical, issues such as valuation and risk management.

Dr. Susan Mangiero Will Give Hedge Fund Conference Keynote

Join me at the 6th Hedge Fund Accounting & Administration Forum 2008 on July 22, 2008 at the Harvard Club. I will be giving the second day keynote presentation entitled "Hedge Fund Risk Management and Valuation - No Time for Shrinking Violets."

More about this presentation is excerpted below.

"Explore key questions and challenges facing hedge fund professionals in these turbulent times. Join appraiser and risk manager, Susan Mangiero, for a topical discussion about the fast changing operating environment for buyers and sellers alike. Always important topics, portfolio valuation and operational controls are front and center as fund managers, and their service
providers, deal with new rules and regulations and the continuing fallout of credit-related problems. Dr. Mangiero will share her insights about:

  • Regulatory enforcement hot buttons
  •  Valuation and risk management litigation trends
  • Best practices for evaluating key risks and managing exposure
  • Institutional investor impact as pensions/endowments/foundations allocate more money to alternatives.

To learn more about this FRA, LLC sponsored two-day conference (July 21-22, 2008), download the flyer.

Dutch and US Lawmakers React to Hedge Fund Activists

Far from the halcyon image of a young boy admiring Dutch tulips, hedge fund activism has some lawmakers seeing red.

In response to our July 5, 2008 post about CSX ("CSX Battles Hedge Funds - A Cautionary Tale for Pensions"), Peter at writes the following:

<< TCI also played a major role in the take over of ABNAMRO and benefited with an incredible return on investment (almost 100 percent). In the Netherlands legislation is being prepared to reduce impact of these activist inveztors that immediately profit by simply sending a warning letter to the board of a company. >>

Credit to Peter for directing us to the Governance Focus blog post entitled "Dutch taskforce wants to tighten corporate governance" (June 7, 2008). According to the cited June 5,2008 Reuters article with the same title, Dutch lawmakers seek to equalize what they perceive as an unlevel playing field across shareholders. In "Dutch corporate governance review mulls over M&A 'put up or shut up' clause" (Thomson Financial News, June 4, 2008), the head of the Corporate Governance Code Monitoring Commission, Mr. Jean Frijins, posits the need for more transparency as relates to corporate takeover attempts.

Stateside, reports on US Senator Chuck Schumer's letter to SEC Chairman Cox, asking why the court failed to penalize either The Children's Investment Fund or 3G Capital, having concluded that the "group" violated securities laws by not disclosing their partnership, pursuant to Schedule 13D rules.  Jurists did however allow TCI and 3G to vote their shares (direct and indirect via equity swaps). See "Schumer may propose bill concerning CSX ruling" by Ron Orol, June 18, 2008. Oral is the author of Extreme Value Hedging: How Activist Hedge Fund Managers Are Taking on the World (John Wiley & Sons, 2007).

As I wrote yesterday, this case is noteworthy for numerous reasons, not the least of which is the fact that derivatives (equity swaps here) are clearly changing the corporate governance landscape. Significant questions remain about what constitutes "appropriate" transparency (already a hot button issue for pensions, endowments and foundations that invest in hedge funds, not all of which provide "enough" detail about their holdings). Just as important, what is the proper role of activist money managers? Are they doing existing shareholders a favor by shaking up things, urging existing managers to improve performance (however "performance" is defined) or creating chaos? While each situation differs, their clout is far from non-trivial.

This blogger does not have sufficient information to make a judgment about the CSX case. On a more general note, however, it would be enlightening to understand how pension plan fiduciaries (defined benefit or defined contribution) vet corporate governance risk before allocating monies to a particular stock, bond or hedge (private equity) fund. Unless the plan's corporate governance policies are made available (if they exist at all), we learn only from reading headlines and court filings, after the fact.

Wouldn't it better for investment fiduciaries to ex-ante publish how they monitor and manage "beneficial ownership" issues, especially in the event of a takeover?

Editor's Note: Click to read the "Final Judgment, CSX v. The Children's Investment Fund."

CSX Battles Hedge Funds - A Cautionary Tale for Pensions?

In case you missed it, possible trend-setting legal parries are commanding attention from New York jurists, institutional investors and proxy specialists. According to corporate governance expert Jay Brown, "The CSX case is the first decision to find that shareholders must sometimes disclose the shares acquired by investors as part of equity swap transactions. This holding makes it harder for activist shareholders - trying to acquire or influence control of a public company - to keep their holdings secret." Brown should know. As a securities law professor (University of Denver Sturm College of Law) and lead contributor to The Race to the Bottom (a widely read legal blog), he and colleagues have penned no fewer than 16 posts about the ongoing litigation between CSX Corporation ("CSX") and several CSX investors - 3G Capital Partners ("3G" or "3G Capital") and The Children's Investment Master Fund ("TCI").

By way of background (and this is a summary only), a letter was sent to CSX by TCI on February 7, 2008, stating its intentions to acquire effective control. In response, CSX filed a lawsuit against the two funds. The Q1-2008 quarterly SEC filing for CSX states:

<< On March 17, 2008, the Company filed a lawsuit against The Children’s Investment Master Fund (together with certain of its affiliates, “TCI”), 3G Capital Partners Ltd. (together with certain of its affiliates, “3G”) and certain of their affiliates (collectively, the “TCI Group”) in the United States District Court for the Southern District of New York alleging violations of federal securities laws, including violations of Sections 13(d) and 14(a) of the Securities Exchange Act of 1934. The lawsuit alleges, among other things, that TCI and 3G have undisclosed plans with respect of CSX. The lawsuit further alleges that TCI and 3G have employed swap agreements in order to evade the filing requirements of Section 13(d) and that their Section 14(a) and Section 13(d) filings concerning their collective 12.3 percent swap position in CSX shares are materially misleading. The lawsuit further alleges that TCI’s and 3G’s disclosures in their Section 14(a) and Section 13(d) filings concerning their formation of a Section 13(d) group are false and misleading. >>

Click to access the CSX 10-Q, filed on 4/16/08. Click to read the complaint for "CSX Corporation v. The Children's Investment Management (UK) LLP et al," filed with the U.S. District Court, Southern District of New York.

Following various motions (in limine, opposition and so on), the two funds (owning about 20 percent in direct form and via equity derivative contracts) sent a letter to other CSX shareholders on June 20, 2008 in which they explain why five nominees should be elected to the CSX board. Citing support for their slate from RiskMetrics Group - ISS Governance Services, they write:

<< If you believe CSX cannot afford to rest on its laurels in favorable pricing and market environments, if you believe that CSX should strive to achieve its full operating potential, if you believe that CSX can and should be the best railroad in America and, finally, if you believe the board of CSX will benefit from the railroad experience of our nominees, along with the perspectives of large shareholders who are engaged because they have made a significant investment in CSX stock using their own money, we urge you to join with us in electing our five nominees to the board of directors of CSX by voting on the BLUE TCI/3G proxy card today. >>

On June 20, 2008, Judges Hall, Livingston and McMahon opine that TCI and 3G Capital Partners can vote their shares, additionally setting up a briefing schedule to include a July 25, 2008 date by which reply briefs in each appeal must be filed. Click to read the ruling.

The "TCI and 3G Comment on Circuit Court Ruling" (dated June 20, 2008) is short and sweet, expressing confidence in the then future June 25, 2008 vote to elect "five highly qualified director nominees." Following that vote, CSX declares the June 25, 2008 board vote "too close to call." In its June 25, 2008 press release, CSX states that the "annual meeting will reconvene at 10 am ET on Friday, July 25, 2008.

Courtesy of Knowledge Mosaic, we know that many large pension funds likewise invest in CSX (at least as of the end of Q1-2008). Regardless of the election results, the corporate governance impact is real. A partial list of funds is included below.


Not being an attorney, this case caught my eye because of the numerous and complex investment and governance implications, including the concept of"beneficial ownership" and use of financial derivative instruments. Several things come to mind.

  • When a defined benefit invests in a particular stock (or selects such stock for its defined contribution plan participants), are plan fiduciaries doing sufficient homework with respect to identifying "large" ownership stakes and assessing possible corporate governance implications?
  • For those defined benefit plans allocating monies to activist hedge funds, are investment fiduciaries taking into account a potential diversification "offset" that could occur if the plan invests directly in the same stock that represents a concentrated hedge fund position? (This is predicated on the notion that many pensions invest in alternatives for portfolio diversification reasons.)
  • Are pensions (endowments and foundations too) asking enough questions about their external money managers' use of derivatives? Always a critical exercise, this case illustrates that equity exposure can be material through both direct buys and indirect trades, i.e. equity swaps. Though not germane to this case, equity futures or options facilitate exposure to an individual stock and/or a particular sector of the equity markets. Will their use connote "beneficial ownership" and is the exposure deemed significant? (Note that in their June 2, 2008 amici curiae brief, the International Swaps and Derivatives Association, Inc. and Securities Industry and Financial Markets Association argue against the notion that equity swaps evidence "beneficial ownership," adding that to conclude otherwise would disrupt derivative market activity.  In an unrelated case, "Securities and Exchange Commission v. Larry P. Langford et al" (filed with the U.S. District Court for the Northern District of Alabama, Southern Division, on April 30, 2008), the issue as to whether swaps (interest rate) are securities appears again. See "SEC Plan for Swaps 'Securities' Gets Alabama Rebuff" by Bloomberg reporter Joe Mysak (July 3, 2008).
  • In the event that a fund manager is known to use equity derivatives (because the pension fund or consultant inquires), should plan fiduciaries be carefully tracking whether the derivatives represent a hedge, a cross-hedge or an anticipatory price/volatility trade? In the case of a hedge, yet another question goes to how best to measure effectiveness.

The CSX case is sure to be the beginning of a lively debate among financial market participants and corporate issuers.

Editor's Note: Go to for a great collection of corporate governance sites. Directors and Boards is another valuable resource.

Hedge Fund Liquidity - Maybe...

According to "Hedge Funds Gird for Withdrawals As Redemption Requests Roll In, Principals Scramble to Soothe Anxieties" (June 12, 2008), Wall Street Journal reporter Jenny Strasburg describes June 30 as a date to watch. Anticipating a flurry of requests, she writes that hedge funds are bracing for a slew of redemption requests, reaching unprecedented levels. Unfortunately for investors, requests to withdraw partially or fully from a fund may not necessarily equate to cash in hand.

As reporter Grace Wong wrote last summer ("Hedge-fund redemption shock
Investors looking to cash out this fall may be met with an unpleasant surprise
"), a liquidity event may be wishful thinking in some situations. For one thing, myriad hedge funds have long "lock-up" periods during which no withdrawals are permitted. Second, some require that advance notice of 45 to 90 days be given. When markets are volatile, even a day may seem like an eternity. Third, hedge funds may slow withdrawals or ignore them altogether, urging investors to be patient. In certain cases, the goal is to forestall a collapse that could occur if a manager has too little cash on hand. Fourth, even when redemptions are permitted, they don't always take the form of cash.

For pension funds, problems with redemptions might potentially cascade, wreaking serious havoc in other areas. For example, suppose a plan sponsor has combined an interest rate swap with an investment in a hedge fund (perhaps as part of a Liability-Driven Investing strategy). If the portable alpha generator falls short and the retirement plan wants out, the all-in performance likely suffers, for everyone. What then?

  • Does the plan sponsor move away from LDI?
  • Does the plan sponsor lick its wounds with the first hedge fund and find a substitute?
  • How does the plan sponsor take transaction costs into account?
  • Do fiduciaries switch to a different, more redemption-friendly asset allocation mix?

Other questions abound. If a hedge fund cannot easily redeem shares because its portfolio consists of "hard to value" assets, do pension investors make matters worse by pulling out? What are the fiduciary implications related to liquidity risk? (Hint: Fiduciaries don't get a free pass. Most legal experts will confirm that decision-makers MUST ask hedge fund managers lots of questions about the redemption process and worst case liquidity scenarios.)

Liquidity risk is real. To pretend otherwise, makes no sense. The ability to unwind a stake in a hedge fund is very much a function of negotiating favorable terms at the outset. Equally important, fiduciaries are urged to pay attention to hedge fund liquidity risk drivers along the way. What you see on paper may not be what you get later on.  

Dr. Susan Mangiero Speaks About Hedge Fund Valuation

Dr. Susan Mangiero, AIFA, Accredited Valuation Analyst, CFA and FRM addresses an audience of valuation practitioners on June 10, 2008 as part of the 15th annual conference sponsored by the National Association of Certified Valuation Analysts.

Part of its 15th annual conference, this mini workshop is a unique offering that combines information about hedge fund industry structure with core valuation concepts. The course will examine the overall structure of a hedge fund, including standard partnership terms, revenue structure, liquidity restrictions, and impact of hedge fund strategy on the value of hedge fund business itself. Special issues such as side pockets and high water marks will be discussed, along with a description of regulatory and accounting initiatives with respect to hedge fund valuation.

Editor's Note: A later posts will cover changes in regulations that directly impact the valuation process, including appraisal penalties now part of the Pension Protection Act of 2006.

Can You Spell "Bad Valuation Practices?"

Kudos to Sameer Mishra for winning the Scripps National Spelling Bee 2008 after a momentary setback. Initially confusing numnut ("one of little intelligence or thought") with numnah ("a pad that goes under the saddle to keep the saddle clean and to cushion the horse's or pony's back"), this smart 13-year old recovered with aplomb. Click to view his funny response.

Proper spelling remains a passion of mine. I won a dictionary in a national writing contest while in high school, passed AP English with flair and continue to find delight in the written and spoken word. By the way, for those who rely on your computer's spell check function, take note of Janet Minor's homage lesson in poetry. "Bad spellers, untie."

"I have a spelling checker
It came with my PC;
It plainly marks four my revue
Mistakes I cannot sea.
I've run this poem threw it,
I'm sure your pleased too no,
Its letter perfect in it's weigh,
My checker tolled me sew."

Making innocent mistakes occurs. Hey, we're all human. What about errors of judgement when one should allegedly know better? According to New York Times reporter Gretchen Morgenson ("First Comes the Swap. Then It's the Knives," June 1, 2008), UBS and Paramax Capital are duking it out in court over credit default swaps, now a $62 trillion market (based on statistics provided by the International Swaps and Derivatives Association). At the heart of UBS AG v. Paramax Capital Intl., No. 07604233 (NY Supreme Court, NY County, filed Dec. 26, 2007) is whether this large Swiss bank had the right to demand additional collateral from a Fairfield County, Connecticut hedge fund as market conditions moved.

According to Morgenson, "UBS would pay Paramax 0.155 percent of the $1.31 billion in notes annually for its insurance and Paramax would deposit collateral to back the swap, increasing it if the value of the underlying notes declined." What's astonishing is not that the value of the notes declined (credit crisis anyone?) but that the hedge fund (with "just $200 million in capital") found itself facing a shortfall far in excess of the original $4.6 million it used to capitalize the swap. 

Our team is trying to get the complaint filed by UBS and the counterclaim filed by Paramax so we can verify who supposedly said what. One assertion (according to the June 1 New York Times article) has a bank executive citing a policy of setting "its marks on the basis of 'subjective' evaluations that permitted it to keep market fluctuations from impacting its marks." Does this mean that positions were artificially valued, regardless of changes in risk drivers? If true, such a policy would be mind boggling at best.

In researching this case, I came across a January 23, 2004 press release in which Paramax Capital Group (presumably the same entity as cited in the lawsuit) announces the launch of a "new multi-seller asset-backed commercial paper program." Part of an effort to satisfy a "need and demand for thirdy party conduits in this new structured finance paradigm," the then Chief Investment Officer for Paramax adds "we think we can provide a high value service and funding to our institutional client base as a complement to their structured finance and funding efforts." One wonders if institutional investors (assuming there were some), allocating monies to Paramax, asked any or all of the following questions:

  • How did the hedge fund represent its process of valuing complex instruments?
  • Did either the bank or hedge fund employ an independent third party pricing service?
  • Did the hedge fund have an appropriate capital risk budget in place?
  • How did the bank measure its credit exposure to the hedge fund and to the swap class?
  • Who established internal controls (at the hedge fund and bank) to avoid undue leverage?
  • How did the hedge fund (bank) measure leverage?
  • How did the hedge fund (bank) monitor collateral exposure?

Ultimately, only the trier of fact can and will determine fault (if any) and related damages. "Numnut" was the wrong word for our young spelling champion but it may end up being an apt description for someone, in what sounds like an ugly mess.

Glitz and Glam or "Stodgy" Fundamental Investing?

When I was a young MBA pup (New York University), an investment professor asked students to purchase "Security Analysis" by Benjamin Graham and David Dodd. Not an unusual choice until one noticed the 1940 copyright. My reaction at the time was to think that this scholar needs to retire soon if he can't find a more modern text. Alas, the marvels of youthful ignorance, heh?

This flashback came to mind in reading the flurry of newspaper articles about the intended $23 billion purchase of Wm. Wrigley Jr. & Co. by private candy giant Mars Inc. Helping to finance things is no other than Warren Buffett who negotiated an approximate 10 percent of the deal for Berkshire Hathaway. With a stake in Sees Candy and the Coca-Cola Company, this uber value investor is familiar with beverages, salty snacks and sweets. (Note that Thomson Financial News, via, reports that Moody's Investors Service has put some of the Chicago gum giant's debt ratings under review as a result of the proposed structure.)

According to "Mars to Buy Wrigley’s for $23 Billion" by New York Times reporter Andrew Ross Sorkin (April 28, 2008), Wrigley's sales revenue just topped $5 billion. The National Confectioners Association reports that "gum sales continue to surge growing 9.3% over the latest fifty-two weeks" with the "key growth engine" being "seasonal confectionary products."

This news item is interesting but even more so after reading "Inside Citi, a Hedge-Fund Push Blows Up" wherein Wall Street Journal reporter David Enrich describes sales enthusiasm gone amuck. Having sold interests in "safe" fixed income hedge funds Falcon and ASTA/MAT to retail clients, global wealth management staffers are wrestling with a lawsuit, unhappy brokers and disgruntled investors. The article continues that Citi sold "only to clients with large, diversified portfolios." As litigation ensues (assuming it does), more will be known about sales practices and representations made to clients, existing and prospective.

Will an ordinary stick of gum pave the way for riches and leave certain "exotic" alternatives in the dust? One wonders - shades of the tortoise versus the hare? What are the lessons for retirement plans as billions of dollars are making their way into non-traditional securities?

Editor's Note: Here are a few fun facts about the confectionary industry.

Valuation - Getting on Track

As an Accredited Valuation Analyst and long-time advocate of the notion that effective risk management and valuation go hand in hand, the release of two reports that emphasize good process in these areas is welcome news. See "Principles and Best Practices for Hedge Fund Investors" and "Best Practices for the Hedge Fund Industry." Click to read "PWG Private-Sector Committees Release Best Practicies for Hedge Fund Participants" (April 15, 2008) where "PWG" stands for the President's Working Group.

While I agree with Peter Schwartz that self-regulation and market discipline is ideal, I'd like to think that calls for reform are positive reactions to problems rather than "desperate" pre-emptive strikes against statutory mandates. Is that naive? Perhaps but hope springs eternal. (Read "Valuation is the Heart of the Matter," reprinted in "Money House of Cards or Disciplined Approach?" - April 17, 2008)

Where I part company with my colleague is that I believe one can (absent a once in a lifetime event) value complex securities if they are equipped with an analytical toolbox. If we peek inside, "hammers and nails" would include: (a) reasonable assumptions (b) appropriate and tested models (c) understandable and available data (d) identification of relevant risk factors that drive value (e) methodology that can be explained to others and reflects relevant economic considerations (f) disciplined, systematic process and (g) common sense.

Ultimately, value equals price when a willing (and hopefully informed) buyer and seller agree on terms. Until then, should we surrender to what some deem as villainous fair value accounting rules or roll up our shirt sleeves and get to work, acknowledging that a calculated "value" may differ from an eventual price?

I opt for the latter because I believe action beats passivity (though some may say nein to investing in the first place). Indeed there are numerous occasions that require an opinion of value for "official" reasons (tax reporting, account redemption, fund creation, determination of hedge size and so on.) What worries me is when alternative fund managers adopt an arbitrary stance or embrace a philosophy that discourages attempts to apply reason, discipline and care.

  • Example One - Two or more appraisers may reasonably disagree on an exact identical DLOM ("discount for lack of marketability") for a particular economic interest. Yet a careful analysis of what contributes to a possible liquidity event is far superior to the X% times number of years formula in use by some alternative fund managers. 
  • Example Two - Appraisers cost a fund (or its investors, depending on which party pays) because they charge a fee to render independent, objective third party assessments.  Are pensions, endowments and foundations better off by blithely relying on marks provided by traders, knowing that they are often compensated based on reported performance (inducing an inherent conflict of interest as a result)?
  • Example Three - Should we accept that some instruments truly cannot be valued or instead identify economic and non-economic factors that impact the ability of an owner to eventually sell? Should we ignore emerging mechanisms that create markets in all sorts of "hard to value" business interests such as someone's client list or their employee stock options? 

Mr. Schwartz is certainly right to warn that some situations are challenging at best. As this blog has emphasized (perhaps ad nauseum), suitability assessment is a critical first step. It makes no sense to invest other people's money (plan participants) or encourage direct allocation (as with 401(k) plans) unless decision-makers truly understand risk drivers (qualitative, quantitative, economic, non-economic).

This blog will continue to address valuation issues. Your feedback is welcome. Drop us a line.

Editor's Note: Check out and the family of related websites. It's well worth your time. 

Money House of Cards or Disciplined Approach?

Courtesy of fellow blogger and technology entrepreneur, I am reprinting "Valuation is the Heart of the Matter" by Peter Schwartz  (founder and president of Knowledge Mosaic).

<< Business and financial regulation in the United States builds upon two worthy traditions - self-regulation and self-disclosure. By design, these traditions preempt and represent lightweight alternatives to more heavy-handed and prescriptive direct regulation by government agencies. When the SEC deputizes private organizations such as the NYSE to police its members, it is adhering to the time-honored tradition of deputizing private citizens to maintain public order. When the SEC requires electronic disclosure, it respects the dependence upon, and responsiveness of, financial markets to the flow of information - to the idea that, indeed, markets are little more than the flow of information.

However, when industries themselves call for more self-regulation and more self-disclosure, it is always an act of desperation, not merely because they want to avoid direct government oversight, but because they are acknowledging that they can no longer survive without some measure of public accountability and public trust. They are acknowledging that the open markets to which they pay fealty now threaten to consume them.

In that spirit of desperation, today we are privileged to experience the much-anticipated release to the President's Working Group on Financial Markets of two private sector reports on hedge fund best practices - one from the hedge fund industry and one from institutional hedge fund investors (primarily pension funds, endowments, and foundations). These reports represent responses to the meltdown in the financial services industry that has led to the evaporation of more than $245 billion in asset write-downs and credit losses since the beginning of 2007, and to market instability that the hedge fund industry no longer trusts it can manage.

What strikes me in reading these reports, and observing the conversation about the recent financial crisis from a distance, is the centrality of the problem of valuation. Both reports combine reference to valuation with other key aspects of hedge fund management and investment - disclosure, risk management, taxation, accounting, liquidity, trading, and compliance. But there is a palpable sense that the other practices and conditions are secondary - that all would be well if we only knew how to value structured securities and derivatives.

The bottom line is that we don't. The credit rating agencies don't. The banks don't. The hedge funds don't. Institutional investors don't. And in the absence of robust valuation data, methods, and models, there is no floor to the risk that financial institutions face when they toy with structured securities and derivatives.

Both reports carve out special sections for the discussion of valuation challenges. The institutional hedge fund investors' report - which starts by affirming that "valuation is ultimately at the core of any investment" - is more discursive on this subject than the hedge fund industry report. This may be indicative of general differences in stylistic approaches to the subject matter. Or it may suggest an entirely different perspective on the depth of the issue, with anxiety about valuation reflecting investor concerns more than the concerns of asset managers.

While both reports focus on the need for better valuation methods, valuation policies, valuation committees, and valuation governance, neither really grapples with the core reality - which is that huge dollar volumes of assets simply cannot be valued. There is insufficient liquidity and inadequate data, and in their absence, values depend upon someone simply assigning a value that has no relation to anything except the interest in making a market out of vapor. Until the hedge fund industry, and government regulators and policymakers, acknowledge this deep emptiness at the heart of the financial industry, all the reports in the world will amount to nothing more than a rearrangement of the deck chairs on the Titanic. >>

Co-Founder of Defunct Hedge Fund Gets 20 Year Sentence

Bayou Group leader, Samuel Israel III, age 48, receives a sentence of 20 years for his part in handing a $400 million loss to investors. (He pled guilty to conspiracy and fraud in late 2005.) A shorter than 30 year sentence reflects his co-operation with the authorities. U.S. Districut Judge Colleen McMahon is quoted as rejecting leniency and instead chastising this hedge fund "mastermind" as a "career criminal" who "ruined lives." In what appears to be a sea change in sentiment towards financial fraudsters, Reuters cites Judge McMahon's upset, referring to white-collar crimes as "every bit as heinous as every other type of crime."

Click to read "Bayou co-founder sentenced to 20 years in prison" (Reuters - April 14, 2008).

Hedge Funds - Boardroom Friends or Foe?

As hedge funds around the world take a seat in the boardroom, new rules of engagement apply. In response, the Conference Board Governance Center Research Working Group on Hedge Fund Activism issues draft guidelines for companies under attack from alternative capital pools.

According to its March 18, 2008 press release, the Conference Board prioritizes five areas, as excerpted below.

  • What corporations can do to better monitor securities holdings and learn about those accumulations of stock or extraordinary trading patterns that may reveal a hedge fund's activism tactic.
  • What measures corporations can adopt to avoid becoming a target.
  • How boards and senior executives can react to an activism campaign and how they should respond to requests for change made by hedge funds.
  • How companies and large institutional investors can ensure integrity of the voting process in those situations where hedge funds borrow shares for the sole purpose of influencing a shareholders' vote.
  • What considerations institutional investors should be mindful of when allocating some of their assets to hedge funds pursuing activism strategies.

Pension plan fiduciaries are urged to "pursue their beneficiaries' long-term interest" when allocating monies to hedge funds that are likely to buy shares in public companies. Does this imply that hedge fund activists may be motivated by short-term gains only? The authors provoke with an intriguing question. What are institutional investors obliged to do so as not to reduce "shareholder value for companies that may be held elsewhere in their portfolio?" This is a valid query for several reasons. First, a pension plan may be working against itself if it invests in both an activist hedge fund and a particular company, each with divergent interests. Second, a plan sponsor may think it is getting diversification when in fact it is doubling up (or more) on a particular equity issuer. The economic consequences could be profound.

Members of the public are invited to comment before April 30, 2008. A final report is planned for June 2008. Click to download "Report of the Conference Board Research Working Group on Hedge Fund Activism: Findings and Recommendations for Corporations and Investors."

Adopting a similar stance that hedge fund activism is a "must know" topic, the National Association of Corporate Directors hosts an afternoon program in New York City on April 17. Entitled "Activist Hedge Funds: What Public Company Directors Need to Know," the esteemed speakers will address the reality that "hedge funds now account for as much as 30% of total U.S. equity trading." Click here to register.

Risks with Financial Counterparties

As discussed herein many times, counterparty risk is an important consideration before entering into any transaction or relationship. (Monitoring default probabilities and the economic fallout if non-performance occurs is likewise a worthy exercise and should be done on a regular basis.)

A recent alert ("The Risks Associated with Financial Counterparties") by Schulte Roth & Zabel LLP attorneys looks at what could happen if a prime broker falls on hard times. Citing the U.S. Bankruptcy Code and the Securities Investor Protection Act of 1970, Jessica Fainman and Lawrence Gelber remind that there is always some risk, even when the law seeks to protect "customer property." The article also includes an explanation of collateral possession under various scenarios, describes the impact of contract netting and lists prophylactic measures to avoid loss.

We concur with the general theme. Investors must be "vigilant in monitoring the financial condition of its brokers." This extends to pension plan fiduciaries who are ill-advised to allocate funds without having a solid understanding of operational and legal risks (in addition to feeling comfortable with a host of other uncertainties, including market and model issues).

Given billion dollar "lemons," making lemonade in the form of mitigating operational risk (including assessment of vendor controls) is a big step in the right direction. This blog's author adds another preventative item to the list. Ask prime brokers and related parties for a copy of their SAS 70 report. Gauge whether (a) good controls are in place (including the monitoring and safeguarding of collateral) and (b) how often controls are validated for effectiveness.

Hedge Fund Investing: Change is Good, You Go First

Thanks to Scott Adams and his popular Dilbert for continued wisdom in the work place.  I own a few Dilbert tee shirts, including one that says it all - "Change is Good, You Go First." It's rather apt when you consider the flurry of news about hedge fund investing by pension funds. As we reported on February 29, the U.S. GAO study takes a serious look at billions of dollars flowing into hedge fund coffers. (See "Hedge Funds: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention Is Needed.)" In the UK, the Hedge Fund Working Group published "Hedge Fund Standards: Final Report" in January 2008. With over 130 pages of suggested guidelines about risk management, valuation and investment policy, it reminds institutions, consultants and managers that due diligence is a weighty endeavor.

A read of these and other attempts to shed light on the growing hedge fund industry begs several central questions, ones that arose many times during the February 28 master class I led on hedge fund risk management and valuation.

  • Who is responsible for writing the checks to hire an independent third party who can review valuation policies and procedures - the investor or the fund manager or both?
  • Should a pension/endowment/foundation hire a consultant or fund of funds manager or both?
  • What if neither the consultant or fund of funds manager is willing to vet mark to model numbers for complex securities? (As we've discussed before, more than a few organizations are declining to review valuation numbers and instead accepting marks from traders who are seldom impartial since their compensation is tied to reported performance.)
  • Who properly bears the liability of poor decision-making with respect to hedge fund risk management and valuation? In "Illiquid Assets Expose Fund Directors to Legal Risk," Hedgeworld reporter Bill McIntosh cites Baronsmead Insurance Brokers as saying that fund directors "may be taking on personal liability for the fair valuation of highly illiquid assets." What about pension fiduciaries who delegate oversight? What is the extent to which they are liable?

If Dilbert is correct, change is impossible unless someone makes the first move. With respect to hedge fund investing, identifying who pays for what and when is a big deal.

U.S. GAO Issues New Report About Hedge Funds

In its "hot off the press" report about pension fund investments in hedge funds, the U.S. Government Accountability Office encourages additional focus on risk management. (We agree and in fact said as much when we were invited to provide background information for this report.) We will write more about this official study as we reflect on its content. In the meantime, click to read "Hedge Funds: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention Is Needed" (January 24, 2008).

Hedge Fund Valuation Goes Global

Just as US banks and hedge funds are coming to grips with a maze of pricing rules in the form of FAS 157, other countries are joining the fray. It's no surprise that institutional investors and their regulators favor more disclosure and evidence of tighter policies and procedures (if they don't already exist at a particular firm). Private and government plan sponsors from around the world will be convening in Sydney next week to discuss alternatives, strategic asset allocation, valuation, global regulation and pension risk management techniques.

This blog's author looks forward to participating in the Asset Allocation Summit. (Pension Governance, LLC is a conference media sponsor.) I will be leading the master class entitled "Global best practices in hedge fund valuation and risk management" and another workshop on 130/30 strategies. Click here to learn more. If you need to find a speaker or want to provide investment risk/valuation training for your team, we'd love to hear from you. Drop us a line.

Until then, look for news from Down Under this coming week!

Susan Mangiero Moderates Pension - Hedge Fund Mock Deposition

At a time when pensions, endowments and foundations are investing billions of dollars in alternatives such as hedge funds, responsible decision-makers must understand financial and legal risks. If they fail to dig deep or negotiate their interests properly (even when they use a consultant or fund of funds manager), fiduciary breach lawsuits could result. Join Dr. Susan Mangiero, AIFA, AVA, CFA, FRM (President of Pension Governance, LLC); ERISA attorney Noah Weissman (Bryan Cave LLP); and hedge fund attorney Nir Yarden (Bryan Cave LLP) for a mock deposition involving a pension fund’s investment in hedge funds, gone awry. Part of the Fiduciary 360 National Conference, audience members can see what happens during this discovery phase of litigation, watch and hear firsthand what someone in the “hot seat” is likely to experience and learn lessons about proper investment fiduciary process. According to Mangiero, author of "Risk Management for Pensions, Endowments and Foundations" and countless articles about investment risk and valuation, "The challenge is particularly acute when hedge funds invest in 'hard to value' assets or employ complex derivative instrument strategies. Identifying hidden risks can save institutional investors money, reduce stress and avoid harm to reputation."

For more information about this May 7 - 9, 2008 conference, go to For more information about pension best practices, visit

Investing in Hedge Funds? Check Out Valuation Process

Featured in the January 2008 issue of Emerging Manager Focus ("People to Know"), this blog's author reiterates the need for investors to verify how a hedge fund marks its positions to market (or model). An excerpt is provided below. To read more, download the pdf file by clicking here.

"Mangiero admonishes institutional investors to steer clear of any fund that provides their own marks for infrequently traded instruments. “Traders are encouraged to inflate asset values if their bonus emphasizes return and ignores the risk side of the equation. Those responsible for due diligence cannot look the other way. Independent third party providers must be involved in the valuation process. Surprisingly, this message is only beginning to resonate because it’s not always clear who is doing what. A pension fund may hire a consultant or fund of funds manager, thinking that they are investigating how numbers for ‘hard to value’ assets are determined, only to discover that neither they nor the administrator, custodian or prime broker do anything more than accept inputs from the traders.” Other elements of good valuation process are addressed in her newly developed course on hedge fund valuation for the National Association of Certified Valuation Analysts, including an overview of the part of the Pension Protection Act of 2006 that addresses valuation."

Missing Collateral = More Risk for Hedge Funds and Pension Plans

Some investors may be getting coal for Christmas. According to a December 20, 2007 Financial Times article ("Hedge funds assess exposure to banks"), reporter Saskia Scholtes describes a role reversal with respect to risk. Whereas banks worried about hedge fund losses in the aftermath of the 1998 collapse of Long Term Capital Management, hedge funds now tally their exposure to credit-challenged banks. Noteworthy is an observation by attorney Lauren Tiegland-Hunt that one-way derivatives-related collateral agreements expose hedge funds to risk of bank failure. She adds that, even if an agreement was bilateral, banks sometimes amended terms to "prevent hedge funds from calling for collateral before a bank’s losses on the trade reached a certain threshold, with the bank’s threshold marked as 'infinity'."

Kudos to this managing  partner of law firm Tiegland-Hunt for calling attention to an important risk factor. As this blog has pointed out several times, the posting of fungible assets such as U.S. treasury bills is one way to mitigate counterparty risk. A thorough assessment of the credit worthiness of the counterparty, consideration of the expected risk associated with a particular derivative instrument and/or strategy and analysis of overall exposure to a given name are similarly important.

For those pension funds sending money to hedge fund land, make collateral assessment part of your due diligence. Derivative instruments, used properly, can sometimes offer a bevy of advantages over investing in the underlying "cash" asset. However, as Nobel prize-winning economist Milton Friedman oft-declared, "there is no free lunch." Once a derivative instrument is created, its fair value (zero at inception) changes. Unfortunately, gains can only be realized by the winner in this zero sum game if the loser does not default.

Editor's Note: To learn more about collateral issues as relates to derivative trading, check out the 2005 ISDA Collateral Guidelines. (ISDA stands for International Swaps and Derivatives Association, Inc.)

Pension Litigation - Investment Link

In "Pension Fund Litigation Could Slow Investments," New York Sun journalist Liz Peek quotes yours truly on the surge in pension lawsuits, notably those alleging breach of fiduciary duty. Attorney Stephen Rosenberg, and creator of a popular ERISA law blog, is likewise quoted as citing the Herculean challenge faced by plan sponsors. Charged with a bevy of everyday tasks, now added to the list is the need to familiarize themselves with increasingly complex instruments and investment strategies. The article suggests that "increased accountability could dampen institutional enthusiasm for alternative investments."

In contrast, a survey just released by Russell Investments finds a worldwide trend on the part of endowments, foundations and pensions towards continued allocation of monies to alternatives such as hedge funds and private equity funds. With increases expected by 2009 in most countries, the twin issues of risk management and valuation will become arguably even more important (though they have never been unimportant).

The next several years promise to be interesting ones, to say the least.

FAS 157 and FAS 159 - Day of Reckoning for Pension Investors?

In case you missed it a few weeks ago, the Financial Accounting Standards Board voted 4-3 in favor of implementing FAS 157 on time. Ignoring early adopters, FAS 157 takes effect as of November 15, 2007. A company reporting at year-end (or any time after mid November) will be obliged to consider FAS 157. Its companion, FAS 159, allows organizations to "choose to measure many financial instruments and certain other items at fair value."

While "employers’ and plans’ obligations (or assets representing net overfunded positions) for pension benefits, other postretirement benefits (including health care and life insurance benefits)" are excluded from the list of eligible items that can be measured at fair value, plan sponsors are nevertheless impacted by both FAS 157 and FAS 159. 

  • If an employer issues stocks or bonds or transacts in other eligible assets and liabilities, FAS 157 and 159 will apply and could, at the enterprise level, indirectly impact pension plan economics.
  • If a plan invests in a wide variety of stocks and bonds issued by other reporting entities, fiduciaries will need to fully understand the gap between economic risk and the accounting representation.
  • In selecting external money managers, defined benefit and defined contribution plan fiduciaries alike will need to add FAS 157 and FAS 159 questions to their RFPs. Focus on  valuation model selection and testing, choice of inputs and appropriate "level" of three possible categories are a few of the many items to vet.

How FAS 157 relates to existing standards is not known with certainty at this time though FAS 133 accounting for derivative instruments is one affected area. While FAS 133 does not directly apply to a pension plan that trades derivative instruments, as investor, that plan must be savvy enough to access how issuer risk is impacted by new rules.  Consider a hypothetical scenario.

A defined benefit pension plan (Pension Plan Y) hires Bank X as a value-oriented equity portfolio manager. Bank X is a significant user of derivatives and has existing derivative instrument contracts with five different counterparties such a Bank Z, Corporation A and so on. Under FAS 157, Bank X must reflect counterparty risk in assessing fair value. Conceivably, this could result in a FAS 157 fair value for any or all of the five positions held by Bank X that is different enough from the fair value of the "hedged item." The result would be a nullification of favorable hedge accounting treatment for Bank X and reported post FAS 157 earnings that are more volatile. How does Pension Plan Y respond? Do they stop doing work with Bank X because their financial statements make them a higher risk? 

Reporting entities and investors alike are going to have to roll up their shirt sleeves and get to work. It doesn't take a rocket scientist to see the obvious. An incomplete understanding of FAS 157 and 159 lends itself to bad decision-making on the part of plan sponsors. 

Here we go...

Editor's Note: There are many ways to determine FAS 133 hedge effectiveness. If you want copies of selected articles on the topic, click here to send an email. Please include your name and company.) Click here to visit the FASB website to learn more about FAS 157 and 159.

Are 130/30 Programs Appropriate for Pension Funds?

After recently speaking to a group of public pension funds, I sat down to listen to other speakers, one of whom gave an eloquent talk about "130/30" strategies. Somewhat new on the investment scene, the goal of these "enhanced equity" strategies is to relax portfolio weight constraints that otherwise preclude a portfolio manager from expresssing a serious "thumbs down" for a particular stock. In addition, fund professionals are given latitude to emphasize favored stocks.

The mechanics are relatively straightforward. A 130/30 portfolio manager invests $1.00 in Stock X and sells $0.30 in Stock Y.  Proceeds from the short sale are used to purchase an additional $0.30 of Stock X.

Advocates assert that 130/30 funds (or variations thereof) are transparent, can be classified as equity, can be easily benchmarked and offer a possible way to increase returns. Critics counter that higher fees, frequent trading (and related costs) and relatively short track records give one pause. In addition, many of the funds employ quantitative models to drive investment decisions. In the last few months, amidst a credit crisis, more than a few quants found themselves selling off long positions while buying other stock to cover short positions. A tumble in returns and increased volatility was the unhappy result.

After the speaker concluded, I asked him how a plan sponsor is able to justify investing in 130/30 funds if its Investment Policy Statement specifically precludes short-selling, whether by design or, in the case of some public plans, short-selling is expressly prohibited. His response that pension plans are modifying their Investment Policy Statements to accommodate did not sit well with me. If trustees or other types of fiduciaries have made a conscientious decision to avoid short-selling, why change mid-stream? Mind you, this blogger is not saying that 130/30 strategies are bad or good but simply pointing out that prudent process would suggest the need for a thorough vetting of the attendant risks associated with this type of short-selling.

I asked ERISA attorney Stephen Rosenberg for his thoughts. With permission, comments from this McCormack Firm, LLC partner and fellow blogger are shown below. (Click here to read his fine blog.)

<< The fiduciary exposure - or at least the potential exposure - for the plans really runs to the rationale and due diligence, or lack thereof, in changing the pre-existing policy to allow the plan to instead invest using this strategy. The fiduciary’s obligation is one of prudence, and presumably there was a rational, intelligent reason for precluding such investment strategies for the plan’s investments. If the plan switches its policy to allow for such investing, the plan needs to be able to show an equally rational and defensible reason for the change. Otherwise, the plan and its fiduciaries open themselves up to claims, in the event the investment declines in value, that the original policy forbidding such investments was correct and the change was neither prudent nor well though out, and thus represents a breach of fiduciary duty. It may or may not be the case that such investment strategies should be part of the pension plan’s investment mix, but what is necessary to ward off fiduciary duty claims, and to satisfy fiduciary obligations, is a well thought out investigation, prior to making the change, by knowledgeable parties, into whether changing the plan’s investment policies in this regard is appropriate. The best defense to claims that such a change violated fiduciary obligations is competent third party advice from someone with nothing to gain from the change, i.e. advice on this issue from someone other than the bank seeking the investment. >>

Notable is his emphasis on getting INDEPENDENT feedback about the efficacy of a 130/30 strategy. Moreover, his comments about process make perfect sense. Before committing millions of dollars to a 130/30 type strategy, a plan sponsor should be able to thoroughly explain a change of heart about its stance on short-selling. Hopefully, for those plans for which there is an outright regulatory restriction (by virtue of state law let's say), they understand the compliance implications.

As the "short enabled" market grows, it will be interesting to track which pension plans participate and why.

Pension Governance is a Proud Co-Sponsor of Workshop on Hedge Fund Valuation

Introduction to Hedge Fund Valuations
October 31, 2007 --- Loews Philadelphia Hotel, Philadelphia, PA

Program Focus:
At a time when the global hedge fund market exceeds $2 trillion and regulators are seeking ways to force more transparency, understanding valuation fundamentals is critical. This course is a unique offering that combines information about hedge fund industry structure with core valuation concepts. The course will examine the overall structure of a hedge fund, including standard partnership terms, revenue structure, liquidity restrictions, and impact of hedge fund strategy on value of hedge fund business itself. Special issues such as side pockets and high water marks will be discussed, along with a description of regulatory initiatives with respect to hedge fund operations.

What You Will Learn:
This four-hour course will enable attendees to:

Understand competing industry valuation standards and best practices

Understand basic structure of hedge funds and fund of funds

Differentiate between valuation of hedge fund and hedge fund portfolio

Understand basic regulation relating to hedge funds

Learn about various investment strategies and how they impact valuation
Understand impact of FAS 157 and AU 332 as relates to hedge funds

Who Should Attend:
Hedge fund general counsel, valuation practitioners, auditors, regulators, and institutional investors such as pension funds

Susan M. Mangiero, Ph.D., AIFA, AVA, CFA, FRM, president and CEO of Pension Governance, LLC, has over 20 years of experience in capital markets, global treasury, asset-liability management, portfolio management, financial risk control, and valuation. She has worked on three trading desks, in the areas of foreign exchange, fixed income, futures, and options. Dr. Mangiero is regularly invited to speak about valuation, risk, and governance with an emphasis on applications to pensions and hedge funds. She has addressed groups that include the U.S. Department of Labor, Chicago Board of Trade, New York State Department of Insurance, Merrill Lynch, Association of Public Pension Fund Auditors, Association of Forensic Economics, New England Public Employee Retirement Systems Forum, Global Association of Risk Professionals, American Society of Appraisers, the Wall Street Transcript, Strategy Institute, Connecticut State Department of Banking, Canadian Investment Review (keynote), Strategic Research Institute, Incisive Media (publisher of Hedge Funds Review) and the Connecticut Society of Certified Public Accountants. Her book, Risk Management for Pensions, Endowments, and Foundations (John Wiley & Sons, 2005), looks at risk management and valuation issues, with an emphasis on fiduciary responsibility and best practices.

Continue Reading...

Pension Risk and Hedge Fund Cherry Picking

An October 9, 2007 Wall Street Journal article describes new academic research that suggests foul play in hedge fund orchards everywhere. In "Pricing Tactics Of Hedge Funds Under Spotlight: Some Managers Select Favorable Valuations To Lift Performance," reporters David Reilly and Gregory Zuckerman cite empirical evidence that hedge fund managers may cherry pick prices of "hard to value" instruments as a way to pretty up performance.

The issue of valuing instruments for which no ready market exists is a challenge indeed. At a time when pension funds are allocating billions of dollars to hedge funds, private equity and venture capital pools, fiduciaries risk serious fallout if they fail to establish solid ground rules regarding valuation. There are any number of "must have" elements that comprise effective policies and procedures. Ignore them and plan sponsors lose a precious opportunity to detect possible trouble before things get out of hand.

Now is not the time to take shortcuts when it comes to valuing "hard to value" instruments or conducting proper oversight of portfolio managers who trade relatively illiquid stocks, bonds, derivatives and hybrids.

If you are interested in reading other posts about valuation, click on any of the links provided below. In addition, feel free to email us if you want to read some of our many articles on the topics of risk management and valuation.

Valuation Problems Are Going to Cost Plan Sponsors Big Time

Model Risk - Great Unknown for Pension Plans

Valuation Awakening - Does the Emperor Have Clothes?

Tulip Craze Redux and What Models Mean to Pensions

Survey Shows that Pensions Worry About Risk Management and Valuation

Pensions and Hedge Funds and Private Equity - Assessing Risks

Hedge Fund Toolbox - Webinars for Pension Fiduciaries

Side Pockets and Valuation

Courts Want Evidence of Valuation Expertise

Private Equity, Mutual Funds and Valuation

Do You Really Know the Value of Your Portfolio?

Pension Funds Still Embrace Alternatives

In reading "Alternative investments still hot with pension fund managers" (Andrew Osterland, Financial Week, September 27, 2007), several things caught this blogger's eye. Summarizing a recent Citigroup Investment Research Survey of U.S. and European funds, the article states that "almost 90% of pension fund managers allocate assets to private equity investments vs. 50% to hedge funds." It was somewhat surprising then to read that "over 80% of managers expressed concern over the lack of marking-to-market of hedge fund investments."

Does that mean that pension investors are less concerned about the valuation of private equity positions? That seems odd. While true that many hedge funds actively trade (and therefore tend to have a shorter holding period than private equity managers), we've fielded valuation calls from more than a few defined benefit plan auditors and investment committees. Concern about how to fair value any position for which no ready market exists - hedge fund or otherwise - ranks high on their "watch out" list.  

Though some believe that accounting rule changes are the primary reason for concern, the Private Equity Industry Guidelines Group reports the following:

FASB Statement No. 157 did not change GAAP, it includes "provisions which required subtle changes to the guidelines which could be deemed significant! Fair Value was required for PE investments prior to Statement 157. Statement No. 157 clarified the definition, usage and disclosures necessary when using Fair Value and in certain circumstances changes historic practice in the private equity industry as further outlined below." (Source: 2007 Updated Private Equity Valuation Guidelines Frequently Asked Questions)

With more than $1.0 trillion expected to flow into alternatives by 2010 (as per survey results), understanding hedge fund and private equity valuation is critical.

Some Pension Funds Say to Hedge Funds - Hold On There

Wall Street Journal reporter Craig Karmin reports that, post credit crunch, some public pension funds are having second thoughts about hedge fund and private equity investments. Cited as a "significant reversal in thinking," the article points out that pension funds have oft-cited alternatives as a way to diversify against shifts in market conditions. (See "Pension Managers Rethink Their Love of Hedge Funds," August 27, 2007.)

In an August 26 article entitled "Just How Contagious is That Hedge Fund," New York Times contributor and financial pundit, Mark Hulbert, debunks the notion that all hedge funds generate market-independent returns. He attributes asset class interconnections and similar strategies made by large hedge funds as culprits. A loss in one sector or fund is likely to appear elsewhere. Investing in "hard to value" positions is another challenge. (This blog's author, an accredited appraiser, is working with the National Association of Certified Valuation Analysts to develop a hedge fund valuation course for October 2007.)

The Pension Governance team has been playing the role of Cassandra for many months. Click here for our January 4, 2007 post about contagion, the notion that what occurs in one market or fund cascades throughout the system. Regarding valuation, we've described the issue ad nauseum. Click on the Hedge Funds and Valuation folders on the left side of this blog's home page for lots of posts about these two topics.

For those who missed our six webinar series entitled Hedge Fund ToolboxSM, we're nearly finished with the ebook equivalent. Email us if you want to be notified when it's ready.

Give Us Our Money Back - Pitfalls of Lock Ups

In today's "Investors Mull How to Get Out Of Hedge Funds: Market Turmoil Highlights Notoriously Tricky Rules For Redeeming Shares." Wall Street Journal reporters Jeff D. Opdyke and Eleanor Laise paint a grim picture for investors in search of an exit. Besides the fact that many funds only permit redemptions at the end of a month or quarter, written notice is often required, sometimes as much as sixty to ninety days in advance. Even then, punitive fees may be imposed. Additionally, not all investors are equal if side letters exist that favor some over others.

For hedge funds already in crisis mode, redemptions may not come in time to stem further problems nor will they shield an investor from already realized losses. Moreover, fund managers may freeze redemptions, arguing that to do otherwise would imperil their ability to stay in business.

If that isn't gloomy enough, consider that investors who successfully withdraw money from a struggling hedge fund may have to give back. "If a hedge fund fails, in some cases a bankruptcy trustee or other investors may sue investors who have already redeemed money and try to force them to pay that money back into the fund, say Nixon Peabody's Mr. Mungovan and his co-chair of the firm's alternative investments litigation practice, Jonathan Sablone. The trustee could argue that the hedge fund didn't value its assets correctly and that investors withdrew more money than they were entitled to."

Valuation alarm bells are nothing new to this blog. We've been touting the need to assess a manager's valuation policies and procedures for months. As stated countless times before, we've asserted that valuation critically drives reported performance. Reported performance determines fees and fees drive risk management and asset allocation decisions. Now we see firsthand that valuation likewise drives the ability to liquidate.

Being locked up is no fun. For pension funds in desperate need of cash, the current state of affairs is agonizing.

Man or Machine - Do Pension Trustees Know?

The war between man and machine is no longer science fiction. As market turmoil continues, some experts suggest that "quant" funds may be making things worse. In "Blind to Trend, 'Quant' Funds Pay Heavy Price" (August 9, 2007), Wall Street Journal reporters Henny Sender and Kate Kelly describe the inadequacy of statistical models to accurately estimate "how risky the market environment had become." Losses by more than a few hedge funds are one result of automated trading.

In today's paper, New York Times reporter Landon Thomas Jr. adds that banks are starting to feel the pain as well and not just because of questionable credit issues in the sub-prime market. "Strategies employed tend to be not only duplicable but broadly followed — the result being a packlike tendency that has helped increase market volatility."

Investors seeking to withdraw funds has exacerbated liquidity concerns. Leverage is another stated worry. By definition, borrowing money allows a trader to take a bigger position than would otherwise be possible. Short selling and derivatives are oft-cited as other leverage-inducing techniques. When times are good, leverage can magnify positive returns. The flip side is that leverage results in bigger losses when things deteriorate.

Leverage is not per se "good" or "bad." However, investors must understand the extent to which a fund levers its trading and therein lies the rub. There are multiple ways to measure leverage and its impact on reported performance is not  well understood. (There is no universal consensus about how returns should reflect the "L" word.) Click here to see some examples recently added to the CFA Institute's site about Global Investment Performance Standards. (Choose Leverage/Derivatives from the pull-down menu.)

This blog's author adds "There is so much more work to be done in the area of disclosure and transparency. The amount of information that outsiders are missing is staggering. Even insiders may not have the full picture unless they know what questions to ask." Email us if you want a copy of "Deciphering Risk Management Disclosures" by Dr. Susan M. Mangiero, AIFA, AVA, CFA, FRM.

If pension fiduciaries thought that interviewing traders and portfolio managers was tough, try asking questions of R2D2.

Down by the Bayou (Hedge Fund), Judge Says Too Bad

Alleging breach of fiduciary duty, plaintiff South Cherry Street, LLC cited failure of consulting firm Hennessee Group to do proper due diligence of the now defunct hedge fund, Bayou Group. In response, federal judge Colleen McMahon "granted a defense motion to dismiss the case, finding that Hennessee wasn't alone in being duped by Bayou." (Click here to read the August 3, 2007 Reuters article.)

As several related cases make their way through the courts, pay attention to how the judge rules. Some experts suggest that institutions could be asked to assume more responsibility for the investments they make, even after hiring a consultant.

If true, things are likely to change. After all, why hire someone else if ultimate responsibility stays with the plan sponsor? The import is considerable. Trustees and other internal fiduciaries who now look to outside experts will have to become more expert themselves. (We've long advocated for better fiduciary training and selection standards, whether an outside firm is employed or not. Click here to read a recent blog post on the topic.)

Long, Hot Summer for Pension Investors Exposed to Credit Woes

Summertime and the livin' may be easy for Porgy and Bess. If you're an investor caught in the middle of a scorching hot credit meltdown, things are far from tranquil. Besides the fact that many deals are being put on hold (thereby reducing the universe of available stocks and bonds), more than a few asset managers are reporting giant write-downs. If you haven't seen it, the Wall Street Journal's list of affected deals and organizations is sobering. Click here to read "Scorecard: Debt Dilemmas - How Credit-Market Tremors Have Affected Junk Bonds, LBOs and Hedge Funds."

Jittery traders are starting to wonder how quickly sub-prime loan problems will spread to other market sectors, ultimately impacting the ability of corporations and individuals to borrow and spend. In "Strategies correlate after credit market crunch hits," Financial Times reporters Peter Garnham and Paul J. Davies describe changing patterns across markets and strategies. What does this mean for institutional investors? Quite simply, a lot.

Hedge funds and private equity managers who tout absolute return (based on uncorrelated return patterns) are going to have a tough challenge ahead if convergence occurs. Defined benefit plan sponsors are going to have no less a difficult time.

Strategic asset allocations are going to be directly (and arguably materially) impacted by the notion that "the investment world is getting smaller." To read an earlier post about contagion, click here to access "Pension Contagion - Should We Worry?"

Are Fiduciaries Paying Enough Attention to Default Risk?

According to Wall Street Journal  reporters Kate Kelly, Liam Pleven and James R. Hagerty, at least ten funds struggle with sub-prime loan woes in the form of diminished portfolio values. As if that isn't bad enough, some institutional investors are being given the unhappy news that withdrawals are suspended. For pension funds in search of liquidity, look elsewhere. (See "Wall Street, Bear Stearns Hit Again By Investors Fleeing Mortgage Sector," Wall Street Journal, August 1, 2007.)

As the fallout continues, with no end in sight, it is worth repeating that fiduciaries are on the hook for creating, and then following, a prudent process with respect to investment selection. ERISA itself mandates that employee benefit plan fiduciaries must carry out their duties in the sole interest of the plan's participants and with the "care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims."

These few words speak volumes about the many things a plan sponsor must consider before committing money to a particular instrument, strategy or asset manager. Questions naturally arise. A few of them are shown below.

1. Have plan sponsors sufficiently queried asset managers about how they measure default risk ?

2. How are structured financial transactions collateralized?

3. Who is responsible for collateral management?

4. What safeguards exist to enforce collateral quality and amount?

5. Do asset managers make their policies and procedures available to plan sponsors who want to know more about valuation, operational controls, collateral issues and trading limits?

6. Are positions being marked to model?

7. Who reviews the integrity of the model and related data inputs?

8. What could cause estimated default risk to rise for "questionable" borrowers and how are asset managers tracking identified risk drivers?

9. What are the investors' rights to withdraw funds?

10. Does an asset manager reserve any capital against its expected risk exposure, voluntarily or otherwise?

Several observations are in order. First, investment problems are not unique to small funds. To the contrary, some large mortgage-related funds (in terms of assets) are currently in crisis mode. Second, recent market drops and rising credit spreads are forcing companies to delay IPOs or incur higher costs of capital. This means that all investors are invariably impacted. Third, the fallout is global, with several prominent non-U.S. funds announcing big hits.

This may be the beginning of the end for easy credit and the start of a "brave new world" for plan sponsors who cannot afford a "see no evil, hear no evil, speak no evil" approach.

Public Pension Plans and Hedge Funds

Washington Post reporter Tomoeh Murakami Tse writes about the growing number of public pensions with current monies allocated to hedge funds or thinking about making an investment. She quotes Larry Swartz, executive director of the Fairfax County pension funds' board of directors as focused on many factors. "It's about developing a smoother return stream and managing the level of volatility in the retirement system year to year."

In stark contrast, Masachusetts Secretary of State William F. Galvin counters that "There's an inconsistency between the concept behind hedge funds, which is high-risk, high-return, and the concept behind pension funds, which is little risk, guaranteed return."

So who is right? Do hedge funds offer a way to reduce risk or do they instead add risk to a portfolio?

Without knowing more about a particular hedge fund's strategy and quality of  risk controls, it would be hard for anyone to make a blanket statement, one way or the other. What is important is process. Yours truly, Susan M. Mangiero, President of Pension Governance, an independent research and training company, is quoted as saying that survey results suggest that pension funds are too easy on hedge fund managers. "A pension fund manager really needs to ask some tough questions about how the hedge fund is valuing these assets." Importantly, it's not just valuation but a host of other factors that fall into the "must know" category before monies should be committed. See "Public Pension Systems Betting on Hedge Funds" by Tomoeh Murakami Tse , Washington Post, July 24, 2007.)

Two Hedge Funds Report Assets Are Nearly Gone


Wall Street Journal journalists Kate Kelly, Serena Ng and Michael Hudson report that two once-large hedge funds are barely worth the paper that documents their existence. According to a letter to investors, parent Bear Stearns has already committed $1.6 billion in a "collateralized repo line to the High-Grade Fund" but cautions that prices are dropping fast. At the heart of the matter is the challenge to "place values on assets tied to subprime home loans" that are not actively bought and sold. (See "Subprime Uncertainty Fans Out - Bear's Hedge Funds Are Basically Worthless; More Bond Fire Sales," Wall Street Journal, July 18, 2007.) 

As an accredited appraiser, I'm here to say that there is an entire industry of valuation professionals who eat, live and breathe process, standards and methodologies. In fact, following the U.S. savings and loan debacle in the early 1980's and the 1989 enactment of the Financial Institutions Reform, Recovery and Enforcement Act ("FIRREA"), Congress essentially sanctioned the work of several entities - Appraiser Qualifications Board and the Appraisal Standards Board. For more information about the Appraisal Foundation and its history, click here.

So the hullabaloo about valuation problems (likely the tip of the iceberg) is extremely important but ignores a critical point.

In general (and not necessarily germane to this particular pair of hedge funds), a failure of institutional investors to oversee who renders value numbers, how, and on what basis, opens the door to "anything goes." Independent assessments of models and processes are arguably more important than ever before. If plan sponsors feel uncomfortable with the rigors of valuation and risk management, hire experts to help. Make sure that they know what they are doing. Ask whether they have specialized credentials and experience.

Why is valuation so important? Numbers drive nearly EVERYTHING financial,  from performance reporting to risk management to determination of fees and asset allocation decisions. GIGO - Garbage in, garbage out - could be very hard to explain as an acceptable basis for good decision-making.

If you are interested in reading a June 4, 2007 interview I gave to Securities Industry News about hedge fund valuation, click here.

Hedge Fund Returns - Illusion or Fact?


Financial News reporter William Hutchings writes that more than a few hedge funds trading in "illiquid" securities engage in smoothing of returns. Citing research conducted by his firm, RiskData CEO Olivier Le Marois says that "instead of following a mark-to-market process to price securities based on what the market is giving for the securities, they are implementing a subjective process of evaluation." While an independent third party could objectively provide an opinion of value or vet the process in place, smoothing empowers the portfolio manager to decide "the value of the securities he is trading." As an aside, for those who invest in hedge funds, consider how many Private Placement Memorandums give a manager full discretion over what and how often positions are valued. (Click here to read "A third of funds hide their true volatility" by William Hutchings, Financial News, July 12, 2007.) 

RiskData earlier announced that they would market something called the Bias Ratio. Developed by one of their fund of hedge fund clients, Protege Partners, this approach examines "month-to-month changes in net asset value" against various statistical return patterns, by asset class. (See "Risk Manager Markets Method To Monitor Hedge Fund Results" by Michael A. Pollock, Smart Money, July 3, 2007.)

On June 27, we wrote that the SEC intends to query hedge funds about their approach to valuing "hard-to-value" assets. Given recent headlines about billion dollar value mistakes, can pension fiduciaries afford not to ask tough questions about process? We repeat what we said then. "In the event of an asset write-down, fiduciaries are going to be grilled about the extent to which they vetted the valuation policies and procedures of hedge funds in which they invested. Absent any documentation to explain the (hopefully thorough) due diligence process they employed, pension decision-makers will squirm. A pretty picture - NOT!" (Click here to read "SEC Announces Investigation of Hedge Funds' Valuation Methodologies.") 

In the event that a pension fund hires a consultant or fund of funds manager, are they digging deep into valuation issues? Can they? (As an accredited appraiser, I can vouch for the rigor of training and experiential requirements as regards valuation.) If they don't "own" the valuation oversight duty, who does? At a recent hedge fund valuation workshop I co-led, a colleague read from a fund administrator's client contract, highlighting the section that disclaims responsibility to vet valuation numbers provided by the hedge fund. You often find similar disclaimers from prime brokers and custodians, forcing pension funds to ask - "Who is paying attention?"

If true that valuation numbers from hedge funds are passed through the hands of multiple parties and no one is asking rigorous questions about their quality, aren't pension fiduciaries greatly exposed to liability? The issue is made more complex when various service providers such as consultants play the role of fiduciary.

Answers to questions about valuation should be more than an optical illusion.

Pension Governance, LLC Offers Webinars for Pension Fiduciaries about Hedge Fund Risk Management

Hedge funds are increasingly being used as part of a pension’s liability-driven investing (“LDI”) strategy or to potentially diversify a portfolio. At the same time, several recent hedge fund blow-ups, along with their prominent presence in corporate boardrooms via activist investing, has regulators and institutional investors more than a little concerned. Pension fiduciaries must demonstrate a rigorous due diligence in their selection process or risk breach of duty allegations. 

In an effort to assist plan sponsors, Pension Governance, LLC continues its Hedge Fund ToolboxSM series with two more online events this week. Join pension decision-makers for an engaging and timely discussion about the use of leverage, derivatives and financial risk controls (July 10, 2007) and operational risk (July 12, 2007).

According to series creator, Dr. Susan M. Mangiero, CFA, Accredited Valuation Analyst, Financial Risk Manager and Accredited Investment Fiduciary Analyst, "There is a sea change underway with respect to the use of hedge funds by pension plans. While increased monies to alternative fund managers may make perfect sense in some situations, a lack of understanding about financial and trading risks could spell disaster for retirement plans. We help plan sponsors interview a hedge fund’s risk manager as a more complete gauge of potential problems. If that function does not exist, that could be a red flag. However, the existence of a risk management function in and of itself does not mean that it is an effective safeguard against runaway losses. Personal and professional fiduciary liability exposure, duty to oversee and an increasingly complex investment landscape makes this a particularly challenging time for plan sponsors.” President of Pension Governance, LLC, Mangiero adds that "Our goal is to help fiduciaries with research, process checks and training to thwart trouble and help to promote best practices."

For more information, click here. Recordings of all six webinars are available for a modest fee to non-subscribers. To order past webinars, click here.

Pension Governance, LLC is registered with CFA Institute as an Approved Provider of professional development programs. Each program qualifies for 1.5 PD credits.

About Pension Governance, LLC:
Pension Governance, LLC ( is an independent research, analysis, training and publishing company, emphasizing investment fiduciary risk management. Covered topics include fee structure, liability-driven investing, controls, valuation, alternatives and fiduciary best practices for board members, CFOs, treasurers and their attorneys, consultants and banks.

Media Sponsors:
Pension Governance, LLC is proud to have Albourne Village,, Lipper Hedge World, and the National Association of Certified Valuation Analysts as media sponsors.

SEC Announces Investigation of Hedge Funds' Valuation Methodologies reporters, Karey Wutkowski and John Poirier, relay the SEC's intention to review valuation methods used by hedge funds.  Testifying before the House Financial Services Committee on June 26, Chairman Christopher Cox said that "We are going to further review, using the SEC staff, the valuation and other issues that managers for these funds have." Apparently, his message to the press, after the hearing, was serious, citing "concern that hedge funds and the investment banks that manage them are not marking assets to their proper value," something that "is of interest to the SEC's examinations and enforcement departments." Click here to read more.

So what does this portend for the plan sponsors knee deep in "hard-to-value" hedge funds? In the event of an asset write-down, fiduciaries are going to be grilled about the extent to which they vetted the valuation policies and procedures of hedge funds in which they invested. Absent any documentation to explain the (hopefully thorough) due diligence process they employed, pension decision-makers will squirm. A pretty picture - NOT!

In some circumstances, the use of an external consultant may provide little refuge, especially if a plan sponsor is unable to demonstrate that the consultant has a good command of valuation principles as applied to hedge funds. Having just co-led a workshop about hedge fund valuation, I was appalled to hear a colleague describe the "not my job" mentality of some service providers who act as pass-throughs for valuation numbers. That begs the question - If the consultant, administrator, prime broker or custodian are accepting traders' marks with no review (however formal), who exactly is overseeing the valuation activity at a particular hedge fund or fund of funds? Moreover, how independent are numbers that are generated by traders whose bonus is almost always tied to reported performance? (We'll talk about valuation standards and best practices in later posts.)

Stormy days ahead?

If you'd like our insight or want to learn more about the work we do in this area (before the fact, during the investment process or after trouble begins), email us. All inquiries are kept confidential. Also note that we'll be devoting seventy-five (75) minutes to the topic of hedge fund valuation from noon to 1:15 p.m. EST on June 28. Click here for more information.

Pension Fiduciaries and Hedge Fund Clones, Fees and Fiduciary Duty

In a June 22 article, Lipper HedgeWorld reporter Emma Trincal writes about the imminent debut of a hedge fund replication index product, courtesy of Barclays Capital. According to Managing Director and Head of Equity Derivatives, Hassan Houari cites research that "up to 80% of the performance of hedge fund indexes" can be explained by changes in the market. Houari further adds that Barclays seeks to offer a "cheaper, more liquid and more transparent alternative." Click here to read the article entitled "Barclays to Debut Hedge Fund Clone." (Registration is required.)

Clones are a popular topic these days. Last week, during Part Two of the Hedge Fund ToolboxSM, sponsored by Pension Governance, LLC, Dr. Susan Mangiero, CFA and Accredited Valuation Analyst talked about increasing pressure for fiduciaries to justify fees. "Amid a flurry of 401(k) lawsuits alleging 'excessive' fees, it doesn't take a rocket scientist to know that hedge fund fees are next. If a plan sponsor can synthesize a signicant portion of expected returns for a particular hedge fund strategy, how can they justify paying for active management?"

Not everyone concurs that replication is possible. During the June 19 online event, co-founder of Bulldog Investors and the David who conquered Goliath SEC in the battle over regulation of hedge funds, Philip Goldstein challenged the notion that investors would be better off with a passive approach. "An Elvis impersonator is not Elvis." Ed Stavetski, CFA and Chief Investment Strategist for CMG Investment Advisors, LLC added that "Many hedge fund professionals work hard to identify value on behalf of their investors."

Emphasizing fiduciary duty, Ed Lynch, Senior Vice President and Investment Officer with Dietz & Lynch Financial Strategies Group of Wachovia Securities, LLC, reminded listeners that ERISA is clear on fiduciary duties that mandate a rigorous analysis of fees. Echoing the urgent need for discipline in the form of a systematic process to assess alternatives (in fact, any type of investment), Mangiero elaborated. "Fees drive performance and performance drives strategic asset allocation and re-balancing decisions. Plan sponsors need to get it right. Every trade costs money."

Click here to purchase the broadcast and slides for a nominal fee. (Past webinars are listed in chronological order.) Pension Governance subscribers enjoy webinar access for no additional charge. Click here to subscribe.

Pension Fiduciaries - Time to Wake Up and Smell the Coffee, Part Three

In his pension blog, ERISA litigator Stephen Rosenberg recently wrote about the forthcoming legal battle between the San Diego County Employees Retirement Association ("SDCERA") and Amaranth Advisors, LLC. In response to an original complaint against the once mighty energy hedge fund, its high-power attorneys countered with a motion to dismiss. Claiming caveat emptor, defendants assert that the plan sponsor understood the risks and went ahead anyhow. Click here to read the original complaint and here to read the motion to dismiss.

How this case will be adjudicated is anyone's guess. Nevertheless, the outcome will be closely watched as it goes to the very heart of investment disputes by asking who bears responsibility.

In our kick-off of the Hedge Fund ToolboxSM webinar series on June 14, 2007, we heard from former FBI agent Mr. Ken Springer (now president of Corporate Resolutions) and senior attorney and former regulator, Rick Slavin (now partner of law firm Cohen and Wolf P.C.). Both gentlemen vigorously urged pension investors to undertake a background investigation of key principals, check documents and never shy away from asking tough questions. Springer added that "material non-disclosure of critical events in one's career" represents a major concern, along with the need to do additional follow-up to explain discrepancies. Late payment of credit card bills or a faillure to pay child support suggest carelessness with other people's money.

In his overview of case precedent and enforcement actions, Slavin offered that sloppy, obtuse or incomplete paperwork is usually the beginning of trouble. He reiterated that the use of outside parties does not absolve plan sponsors of their fiduciary duties. Oversight obligations remain.

Springer told listeners that Bayou's problems, pre-meltdown, were evident had investors carefully reviewed available facts. "Blatant conflicts of interest, overstating of employees' accomplishments, suits by former employees, suits filed by investors and even suits filed by hedge fund managers" should have caught investors' attention before money changed hands. Slavin suggests that we're in for a bumpy ride. "There is every indication that more litigation and enforcement is on its way."

Rosenberg agrees. "We are currently watching the rise of a pension/401(k) investment plaintiffs bar, clearly modeled after the securities litigation class action bar, ready and waiting to sue pension advisors and anyone else in the line of fire for excessive fees, poor investment choices, and anything else that affects returns in the plans." He adds that, "If the hedge fund’s lawyers are right, then aren’t the plan’s fiduciaries and other advisors potentially liable for breaching their own obligations to the plan and its participants to properly select and monitor plan investments? And if so, then their best defense should the newly forming class action bar come after them for this mess would be that, contrary to what the hedge fund’s lawyers say, they actually did full and complete due diligence, and therefore lived up to their obligations and cannot themselves be liable for the fact that the investment went south."

Wise words to remind us of the importance of good process!

If you are interested in purchasing the recordings of any webinars that have already taken place, click here. (Webinars are listed in chronological order.) Click here to register for any or all of the forthcoming webinars in this exciting new series. Speakers will address the roles of financial advisor and consultant on June 26. Valuation is the topic of the June 28 event.

Pension Fiduciaries - Time to Wake Up and Smell the Coffee, Part Two

In "A Conversation with a Fiduciary" (published by Morningstar), independent pension fiduciary Matthew D. Hutcheson provides a thought-provoking assessment of ERISA Section 404 and passive versus active investment choices for 401(k) plan participants. Click here to read the article and here to read Hutcheson's March 6,2007 testimony about 401(k) fees before the U.S. House of Representatives.

On the other side of the fence, Financial Times writer John Authers extolls the virtues of Dave Swenson's "uninstitutional portfolio" approach in his June 9, 2007 article about the Capital Asset Pricing Model and market efficiency. With more than two-thirds of the endowment fund for Yale University in alternative assets "which are not readily marketable," the contrast is telling. While the evidence seems to strongly support Swenson's approach for Yale, issues abound with respect to alternatives investments and command attention. "See "Yale puts academic theory of investment into practice.")

I co-led a workshop on the valuation of "hard to value" assets on June 12, 2007 and came away with a renewed appreciation of the fact that more than a few institutions may truly be in the dark with respect to risk factors. Worth mentioning again is that risk itself is not bad. However, risk that is ignored cannot be measured and, by extension, can certainly not be managed. For most investors, limited resources make it difficult to replicate the Connecticut Ivy's success. Addressing a recent gathering of alumni, Swenson said that "Yale is set up to make high-quality active management decisions" with a staff of twenty and a long time horizon.

The debate continues with respect to style because it is a crucial (nay impossible to ignore) element of investment management. Strategic asset allocation and tactical implementation are likewise integral determinants of fiduciary liability for a given organization. To the extent that Hutcheson reminds us to focus on the "F" word and move the conversation to process that supports duty, plan beneficiaries applaud.

Tell us what you think. Should fiduciaries do a better job of justifying when active strategies make sense? We will talk more about these issues because there is a lot to say.

Click here to email your comments. Please indicate if you would like the comments kept private.

Pension Fiduciaries - Time to Wake Up and Smell the Coffee, Part One

Today's post and the next few that follow focus on pension governance (the name of our new website and a term that is often used to describe fiduciary duties and best practices). For a discussion of what pension governance means, click here to read interviews with market leaders. It's such an important topic yet often overlooked. In fact, the U.S. Department of Labor created an educational program ("Getting It Right") in order to help individuals understand their duties. (The results of countless audits apparently left examiners nervous about the folks who did not properly self-identify as fiduciaries.)

"Hot off the press" is a set of standards devoted to the topic of pension governance. Newly published by the Stanford Law School, the so-called Clapman report urges pension funds, endowments and charitable funds to adopt principles that reflect prudence, ethics and transparency. Citing some big dollar "no-no's" on the part of institutional decision-makers, chief architect of the report, Peter Clapman,and others rightly point out that giant institutions must walk the walk if they admonish corporations to do the same. CEO of Governance for Owners USA and former chief investment counsel of TIAA-CREF, Clapman adds that “Bad governance also weakens funds by eroding public support for them." One element of the report calls for funds to provide clear (and make public) information about governance rules.

Yippee Yahoo!

A few of us sometimes feel as if we've been screaming in the wind about the urgent need to know who is in charge and how they are running the show. (I'm sure Clapman and others would agree.) To read how bad things are in terms of NOT being able to easily identify where the buck stops, check out "In Search of Hidden Treasure." More than a year ago, I wrote "that a systematic identification of who does what and why with respect to employee benefits is simply not a reality as things stand today. This makes it difficult (perhaps impossible) to effect change."

The Clapman Report suggests that funds hire "trustees who are competent in financial and accounting matters." Read "Practice What You Preach" for our list of basic questions about pension fiduciary selection, training and performance evaluation. Anecdotally, I've often queried trustees and  other types of fiduciaries - "How do you become and stay a fiduciary? Do you take a quiz? Do you possess a certain amount of relevant experience? Do you get paid what you're worth in terms of liability exposure and hours spent on plan-related tasks?"

Scary to say, selection is frequently a function of who is seen as having a few hours of free time. Unfortunately, being a plan fiduciary is arguably a full-time job. Moreover, with so many complex decisions to make, someone with a limited background in topics such as investing may truly struggle to understand basics, let alone nuances of evaluating risk-adjusted return expectations. Even when an external consultant is used, a fiduciary still retains oversight responsibilities (a topic deserving of its own separate post).

Another proffered recommendation from the Clapman Report is to "establish clear reporting authority between trustees and staff" and to "define appropriate responsibilities and delegation of duties among fund trustees, staff, and outside consultants." We couldn't agree more. Check out our earlier discussion about the importance of incentives in "Paper Clip Theory of Pension Governance."

One thing is clear. Pension governance is starting to attract attention. That's great news for the many fiduciaries already doing things the right way. (You deserve recognition.) For those who need to improve, perhaps the spotlight on practices, good and bad, will encourage change. That would be a huge plus for plan beneficiaries, taxpayers and shareholders.

Here are a few resources for interested readers.

1. Committee on Fund Governance: Best Practice Principles -"Clapman Report" (Stanford University)

2. Prudent Practices for Investment Stewards (Fiduciary 360, AICPA, Reish Luftman Reicher & Cohen)

3. Asset Manager Code of Professional Conduct (CFA institute)

4. Standards of Membership and Affiliation (The National Association of Personal Financial Advisors)

5. CFP Certification Standards (Financial Planning Standards Board)

6. Regular Member Code of Ethics (National Investor Relations Institute)

7. Code of Professional Responsibility (Society of Financial Service Professionals)

8. Also check the site for the Financial Planning Association. I understand that they are soon to release a new set of standards for financial advisors.

Large Endowment Loses Auditor Over Valuation Issues

According to the Daily Texan, the University of Texas Investment Management Company will soon have to rely on its internal audit staff. Chairman of the University System's Audit, Compliance and Management Review Committee, Regent Robert Estrada "reported to the board that Ernst & Young was uncomfortable with pricing the investment company's private equity and hedge fund investments. Regent Robert Rowling added that the firm also had issues with the time gap between UTIMCO's quarterly reports." Click here to read the article.

In a related piece, this blogger was interviewed about the topic of hedge fund valuation in Securities Industry News. Part of a June 4, 2007 special report entitled "Critical Issues for Hedge Funds," the topic of how, why and when hedge funds get valuation help (or don't as the case may be) arose. As an accredited appraiser, I know from firsthand experience that many people in hedge fund land do not acknowledge the presence of the traditional business valuation community. That's not necessarily good since the latter group has long ago acknowledged the regulatory prohibition against a formulaic approach and the need for specialized valuation training. Judges are none too happy and are tossing expert opinions out of their courtroom if they fail to reflect established valuation concepts and practices.

When asked why valuation is so important in this industry, I said the following:

<<  Valuation numbers drive nearly every financial decision. Hedge fund managers need to know how to rebalance their portfolios, adjust risk management positions and report numbers to investors upon which they earn their fees. Valuation becomes especially important in the case of illiquid investments like private equity, distressed securities, emerging-market securities and complex derivatives. It is also an issue as more hedge funds go public. How else will you come up with a net asset value for the initial public offering, without a formal assessment? Additionally, institutional investors are on the hook to understand how hedge funds value their holdings. The last thing pension fund, foundation or endowment fiduciaries want is a blowup that could have been prevented with a thorough vetting of the managers' valuation process. That includes assurance from the hedge fund managers that numbers are being provided by an independent third party. >> (To read "The State of Valuation", go to A subscription is required but you can register for a trial.)

If you would like a copy of some of the articles I've written about hedge fund, derivative instrument and asset valuation, click here to send an email.

Survey Shows That Pensions Worry About Risk Management and Valuation

In his May 16 testimony to Congress, Mr. Douglas Lowenstein, head of the Private Equity Council, extolled the virtues of non-public investments. With over $110 billion invested in private equity by twenty large public pension funds, Lowenstein cites relatively higher historical returns that have helped plan sponsors pay the bills. Click here to read his testimony.

A few months earlier, a survey conducted by the State Street Bank describes escalating interest in hedge funds. At the same time, half of respondents expressed "a need for additional reporting and analysis on the part of hedge fund managers and more rigorous due diligence practices," adding that "they find it difficult to gain a portfolio-wide view of risk, and that aggregating risk statistics provided by all hedge funds in their portfolio was problematic. The same number also agreed that obtaining an accurate valuation of hedge fund holdings can be problematic." Click here to read the executive summary of the survey.

As with any investment, there is no "perfect" choice. Selection depends on a wide variety of factors.( A discussion about optimal asset allocation and security/fund selection is outside the scope of this blog post.) However, a few points are in order.

1. Risk management and valuation concerns are not created equal. They vary across type of asset and fund. Private equity funds tend to trade less frequently than hedge funds. Even within an asset class (assuming you agree that hedge funds constitute a separate asset class), the risk-return tradeoff varies by strategy, management and much more. For example, the use of derivatives by a market neutral hedge fund can differ dramatically from that of a macro oriented fund.

2. The use of a side pocket may reduce the need for frequent valuations. However, institutional investors need to understand if a side pocket is to be used, what will go inside the side pocket and the impact on reported performance as a result of its use.

3. Knowing that a manager employs derivatives is not enough. Understanding instrument and strategy choice is likewise important (though still not sufficient).

4. Valuation numbers provided by traders or anyone else who stands to benefit by reporting high numbers should be discarded and replaced with those provided by an independent party.

If you are interested in knowing about other red flags, email us in confidence.

Pensions and Hedge Funds and Private Equity - Assessing Risks

In case you missed it, here is the link to a video of my appearance on CNBC's Morning Call.  While I concede that it's impossible to have an in-depth conversation in only a few minutes, several things are worth mentioning as a result of the May 17 chat with host Mr. Mark Haines.

1. Not all institutional investors have a large staff to vet different investment ideas. Moreover, large does not always mean better. Witness Fannie Mae and Amaranth Advisors. "Thorough" is the watch word.

2. If considering a hedge fund, ask if the fund has a functional risk manager who monitors, tests and reviews policies for financial and operational trouble spots. Does that person have independence and authority to effect meaningful change?

3. I believe the other speaker in this segment said that private equity avoids having to deal with the daily volatility of being invested in public equities. Caution - The absence of a ready trading market does not necessarily mean that there is less risk. Some could easily assert the opposite. Private equity deals, because they are private, entail valuation challenges, difficulty in liquidating ownership interests and so on.

4. The use of correlation (a measure of linear association) to gauge diversification benefits depends on having good data for all relevant time periods. If using an inappropriately long calendar period (example: last ten years), output may reflect a smoothing out effect which therefore underestimates "true" volatility.

5. There is much more to say on the topics of risk management and valuation!

Hedge Fund Toolbox - Webinars for Pension Fiduciaries

At a time when pension funds explore new ways to buoy funding, billions of dollars are being allocated to hedge funds and fund of funds. Either direct or part of a portable alpha strategy, alternative investments offer potential benefits but often bring new challenges in the form of multi-tiered fees, valuation, leverage, transparency, short-selling, illiquidity and operational risk. Add to the mix the mandates of the Pension Protection Act of 2006 and one thing is clear. Pension fiduciaries are on the hook to demonstrate a solid understanding of the structural and financial characteristics of hedge funds and fund of funds and what could potentially cause problems if left unchecked.

To help pension decision-makers better understand this important area, Pension Governance, LLC has created the Hedge Fund ToolboxSM – a series of six webinars that focus on hedge fund economics, operations and legal considerations. Webinars are scheduled as follows:

•Hedge Fund Fees, Performance and Transparency (June 14, 2007)
•Hedge Fund Documentation, Background Checks, Enforcement and Litigation (June 19, 2007)
•Role of Consultants and Financial Advisors in Selecting Hedge Funds (June 26, 2007)
•Hedge Fund Valuation, Use of Side Pockets and New Accounting Rules (June 28, 2007)
•Hedge Fund Leverage, Use of Derivatives and Risk Management (July 10, 2007)
•Hedge Fund Operational Risk (July 12, 2007)

Register to attend the entire series or individual webinars. If you miss an event, recordings will be available for a modest fee for non-subscribers. Webinars are free to all Pension Governance subscribers. For more information, go to

About Pension Governance, LLC:
Pension Governance, LLC ( is an independent research and analysis company that focuses on benefit plan related investment risk, corporate strategy, valuation and accounting issues, with the fiduciary perspective in mind. Pension Governance, LLC is registered with CFA Institute as an Approved Provider of professional development programs.

Media Sponsors:
Pension Governance, LLC is proud to have Albourne Village (, ( and the National Association of Certified Valuation Analysts ( as media sponsors.

Pension Governance, LLC
Susan M. Mangiero, 203-261-5519

Hedge Fund Settlements with SEC - Lessons for Pension Plans

Hedge fund Amaranth Advisors, LLC has settled an SEC complaint regarding violation of Rule 105 of Regulation M  which makes it "unlawful for any person to cover a short sale with offered securities purchased from an underwriter or broker or dealer participating in an offering, if such short sale occurred during the . . . period beginning five business days before the pricing of the offered securities and ending with such pricing.” Click here to read the SEC-Amaranth document.

Zurich Capital Markets Inc. has settled with the SEC on an issue relating to hedge fund trading. According to the order, "ZCM, an entity that provided financing, aided and abetted four hedge funds that were carrying out schemes to defraud mutual funds that prohibited market timing. Specifically, ZCM provided financing to four market-timing hedge funds that employed various deceptive tactics to invest in mutual funds. ZCM and these hedge funds knew that many mutual funds in which they invested imposed restrictions on market timing activity. In order to buy, exchange and redeem shares in these mutual funds, these hedge funds employed deceptive techniques designed to avoid detection by these mutual funds. ZCM came to learn that the hedge funds were utilizing deceptive practices to market time mutual funds, and nonetheless ZCM provided financing to them and took administrative steps that substantially assisted them. By providing assistance to the hedge funds, ZCM aided and abetted the hedge funds’ violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder." Click here to read the SEC-ZCM document.

One takeaway for pension fund investors is that a review of the manager absolutely must include a thorough assessment of trading practices.  Some of the many questions in search of answers include the following:
  • What trading controls, by category, exist?
  • Who oversees compliance?
  • How are violations detected?
  • What is the penalty for internal policy breach?
A second takeaway is to ask serious questions about the entire chain of command related to trade processing, reporting and who gets paid to do what.

Look for news next week about our hedge fund webinar series for pension fiduciaries. The Hedge Fund ToolboxSM will cover many important topics such as valuation, risk management, fee structure, disclosure and ERISA considerations.

Risk Center TV - Hedge Fund Risk and Plan Sponsors

For those who don't know, has recently started broadcasting interviews with risk management professionals. I had the pleasure of being interviewed a week ago about a few of the many steps that pension funds can take to assess hedge fund risk. Clearly, in just a few minutes, it's impossible to provide more than a few soundbites. However, allow me to reiterate one point.

Before plunking down monies to invest in a hedge fund or fund of funds, ask to meet with the risk manager and request a copy of their risk management policy. If the fund has no official risk manager, ask to meet the person who assumes functional duties (if not the title). If the fund tells you that their risk management policy is proprietary, ask for a general description of risk controls and the system of oversight. If you still get push back, think about your comfort level if something goes awry and you are asked why you invested anyhow, even though your request for information was rejected. (Even if information is provided to you, you may want to assess whether the information is "enough.")

Some may assert that the Private Placement Memorandum (PPM) is sufficient. See for yourself. In my view, the PPM often addresses risk in overly broad and vague terms, certainly not enough to give a pension investor any meaningful amount of information about the risk management process.

If you would like to see the short interview, go to and click on the relevant video. If you would like more information about hedge fund risk and valuation issues, contact us at We will be uploading information next week to about a forthcoming series of webinars we call the Hedge Fund ToolboxSM. Our series of webinars known as the Private Equity ToolboxSM is already in the works. We have a spectacular line-up of speakers.

P.S. These comments do not reflect investment, legal or governance advice. Readers still need to meet with their counsel about their fiduciary responsibilities as regards hedge fund investing.

Consulting Firm Pays $2.75 Million for Hedge Fund Recommendation

According to money management letter (April 9, 2007 issue), Rocaton Investment Advisors paid $2.75 million to the San Diego County Employees Retirement Association "for recommending Amaranth Advisors." The article also goes on to say that no information is forthcoming about whether Rocaton did anything wrong and whether this money is covered by professional liability insurance.

The reason for citing this article is not to put any one particular firm in the spotlight but rather to suggest that pension fiduciaries check with their appropriate counsel and do sufficient homework internally to make sure that everything that should be done is being done. This includes, but is not limited to, seeking answers to the following questions:

1. How much experience does a particular consultant and/or financial advisor under consideration have with respect to examining hedge funds or fund of funds?

2. Does the consultant and/or financial advisor have an adequate understanding of the hedge fund or fund of funds' use of leverage through short-selling and/or use of derivatives, if relevant? What is their systematic process for examination of leverage? How do they define leverage and does that comport with industry norms?

3. Has the consultant and/or financial advisor identified (and explained to plan sponsors) possible risk factors associated with a given hedge fund or fund of funds? Sector concentration, management style, specific ownership structure of the limited liability company or partnership, availability of risk analytics, stop loss triggers, primary and secondary plans for liquidation, valuation policy, redemption restrictions and use of side pockets are JUST the beginning.

We'll talk much more about the issue of investment risk review in coming days. Why? Plan sponsors are still on the hook for monitoring their monitors. It's simply not as easy as passing along a hot potato regarding due diligence to someone else.

P.S. There is a rumor that another pension consultant has offered recompense in conjunction with this hedge fund case. If true, could this be a trend in going after consultants and/or financial advisors in the event of losses?





The F Word for Pensions

Before I realized the importance of being a fiduciary, work was fun. I have a fondness for the good old days when I had more financial freedom. That was before the failure of our high risk portfolio. What folly! Now the lawyers tell me our strategy is not a good fit, our process is feeble and breach may be a felony with personal liability not far behind. I wish I could flee! >>

Perhaps a bit too gimmicky, my goal was to get the audience to think about the ultimate F word - FIDUCIARY - and the related consequences associated with a job poorly done. My contention? We're all risk managers now.

Think about what's happened in the last few days. Volatility is up. Assets that typically move inversely with one another are moving in the same direction - down, more than a few investors are liquidating positions to meet margin calls, credit problems are rearing their ugly head in the form of sub-prime loan losses and there is overall nervousness about how risk is priced.

Is this the tipping point that compels pension fiduciaries to examine their risk management policies and procedures - and those of their appointed money managers - or do they instead shrug off bad times as short-term and likely to reverse? If not market turbulence, what will get fiduciaries to focus on risk-adjusted return in a more meaningful way?

Can Pension Funds Forgive Hedge Fund Failures?

According to David Hammerstein of Yanni Partners, ("Fewer Second Chances For Failed Fundies" - Hedge Fund Daily, February 27, 2007), "There is an extra standard of caution and care that has to be demonstrated among institutional investors" when it comes to giving failed hedge funds another chance. Noting the significant amount of pension dollars going into alternatives, Hammerstein emphasizes the need to assess risk controls.

He's not alone. Next week, I will join other speakers at the 23rd Annual Risk Management Conference to wax and wane about all sorts of investment-related risks. Hosted by the Chicago Board Options Exchange, Chicago Board of Trade, Chicago Mercantile Exchange and OneChicago LLC, the conference brings together a variety of researchers, investors and consultants.

My presentation is entitled "What Every Institutional Investor Fiduciary Must Know About Derivatives" and will cover investment fiduciary practices related to risk control. (Click here to view the agenda.

Can the risk lion be tamed?

Absolutely - but only if one is willing to open the cage door and acknowledge its presence!

Pensions, Hedge Funds and Risk

On February 22, 2007, the President's Working Group on Financial Markets (PWG) released a set of principles and guidelines concerning "private pools of capital, including hedge funds." In concert with various U.S. agencies, the PWG report urges investors, creditors, counterparties, pool managers and supervisors to identify and understand fund-specific risks or walk away.

For fiduciaries, the guidelines (some of which are excerpted below) are clear. Individuals who are unable to demonstrate that a rigorous investigation of risk has taken place, BEFORE investing, put themselves in the line of fire with respect to personal and professional liability.

<< 1. Fiduciaries should consider the suitability of an investment in a private pool within the context of the overall portfolio and in light of the investment objectives and risk tolerances.

2. Fiduciary evaluation should include the investment objectives, strategies, risks, fees, liquidity, performance history, and other relevant characteristics of a private pool.

3. Fiduciaries should evaluate the pool’s manager and personnel, including background, experience, and disciplinary history. Fiduciaries also should assess the pool’s service providers and evaluate their independence from the pool’s managers.

4. Fiduciaries should consider the private pool’s manager’s conflicts-of-interest and whether the manager has appropriate controls in place to manage those conflicts.

5. Fiduciaries should conduct the appropriate due diligence regarding valuation methodology and performance calculation processes and business and operational risk management systems employed by a private pool, including the extent of independent audit evaluation of such processes and systems. >>

It will be interesting to watch what happens. Will some pension decision-makers forego investing in alternatives because the risks are considered too difficult to understand, let alone accept? Who will embrace the challenge and recognize the reality that risk management is an integral part of investment management? You simply cannot select funds without understanding how managers address financial and operational risk. When a fund invests in less liquid and/or complex instruments, the plot thickens.

Click here to read Agreement Among PWG and U.S. Agency Principals on Principles and Guidelines Regarding Private Pools of Capital.

Nutmeg State Seeks Pension Disclosure from Hedge Funds

According to reporter and financial professional Julie Fishman-Lapin, Connecticut could soon become less hedge-fund friendly if state legislators have their way.
In " State readies for a debate on regulation..." (Greenwich Times, February 9, 2007), Fishman-Lapin describes an initiative by Fairfield County Republican John E. Stripp that, if passed, would "require Connecticut-based hedge funds that receive more than $10 million from a pension fund to report the investment to the state banking commissioner within 30 days. The disclosure would include the name of the pension fund, the beneficiary organization and the address of the fund manager." Click here to read Proposed H.B. No. 5102, Session Year 2007 - An Act Concerning Hedge Fund Activity With Respect To Pension Funds.

Democratic state senator Bob Duff cites hedge fund disclosure requirements as part of his overall intent to focus on consumer protection. He will soon introduce a bill that likewise emphasizes disclosure. Click here to read his January 25, 2007 press release.

On December 5, 2006, addressing the U.S. Senate Committee on the Judiciary, CT Attorney General Richard Blumenthal urged federal regulators to increase penalties for fraud, raise the amount of money to qualify investors and adopt federal standards before states take matters into their own hands. Click here to read his remarks. Blumenthal is walking the walk, having formed the Hedge Fund Task Force last fall. The goal? To improve things and hopefully avoid an expensive Amaranth-type meltdown. (See "Hedge hunting season in Connecticut - In the wake of the Amaranth disaster, Connecticut Attorney General Richard Blumenthal seeks to reform the hedge fund industry" by Ellen Florian Kratz, Fortune, October 4, 2006.)

There is so much to write about the hedge fund - pension fund nexus. We will continue to focus on this important topic area. Until then, and in case you missed them, here are a few links to prior blog posts about hedge funds, along with links to some articles about hedge fund risk management and valuation.

Hedge Fund Notables for Pension Investors (December 29, 2006)

Hedge Fund Disclosure - Round Three (November 12, 2006)

Will Private Equity Stay Private? U.S. Dept. of Justice Makes Inquiries (November 5, 2006)

Pensions, Hedge Funds and Disclosure (October 27, 2006)

Legislative Matchmaker: Hedge Funds and ERISA (August 1, 2006)

Survey Shows That Institutional Investors Are Worried (July 28, 2006)

Will Hedge Funds Displace Pension Plans in Court? (July 9, 2006)

Hedge Fund Valuation: What Pension Fiduciaries Need to Know (Journal of Compensation and Benefits - July/August 2006)

Do You Know the True Cost of Your Retirement Plan? (May 14, 2006)

Hedge Fund Basics: Risk, Return and Reality (Family Foundation Advisor - January/February 2005)

Hedge Fund Imperatives (Hedge Fund Manager - December 2004)

Hedge Fund Notables for Pension Investors

Given the flood of money making its way from pension land to alternatives, fiduciaries may be interested in today's New York Times article entitled "The Private Lives of Hedge Funds." Reporter Jenny Anderson celebrates the panache of more than a few hedgies with a colorful description of the Houdini award, the Better-Than-Barings Blow-Up award, and the Debutantes award, to name a few.

Mr. Phillip Goldstein gets the Braveheart award for playing David to the SEC Goliath when he questioned their authority to have hedge funds register. After winning his case, he has since taken to the airwaves, campaigning to be exempted from disclosing details about his fund's holdings.

I have written about Mr. Goldstein on three occasions as part of a continuing commentary about transparency versus the protection of proprietary (and arguably valuable) information. While this issue remains unsettled as of today, it's noteworthy that over 1,200 hedge fund professionals showed up at a recent industry event to hear about topics such as the impact of newly released AICPA document, "Alternative Investments Audit Considerations: A Practice Aid for Auditors". For those who have yet to read this beauty, auditors must have sufficient data to support fund valuation numbers, including position detail.

Here are the links to the three aforementioned posts.

1. "Pensions, Hedge Funds and Disclosure" (October 27, 2006)

2. "Will Private Equity Stay Private? U.S. Dept. of Justice Makes Inquiries" (November 5, 2006)

3. "Hedge Fund Disclosure-Round Three" (November 12, 2006)

Is this the start of a new trend?

Leverage: Friend or Foe to Pension Investors?

In today's New York Times, reporter Jenny Anderson talks about lackluster returns for some hedge funds. In "Hedging '06: Year to Read the Caveats," she quotes Christy Wood, CALPERS senior investment officer, as saying that this year marks the third year that "the global equity markets and long-only managers outperformed hedge funds" and that "If you threw all these in an index fund net of fees, you would have done better than if you put it in the hedge fund industry."

The article continues that CALPERS has another $3.5 billion to invest, beyond the existing $4 billion in hedge fund investments. Their appeal, says Ms. Wood, is equitylike performance with bondlike risk.

The numbers are compelling. Courtesy of data from Hedge Fund Research, the article describes inflows in excess of $110 billion through Q3-2006, compared with $47 billion last year.

What caught my eye is the quote about leverage and the notion that markets have all but ignored situations like Amaranth and its reported $6 billion loss.

Excerpted from this piece, investment advisor Stewart R. Massey, founding partner of Massey, Quick & Company, is quoted as saying that "If there's a lesson in 2006 - and no one talks about it anymore - it's that leverage is a very dangerous thing" and "there's too much out there."

On the face of it, leverage is not necessarily bad (nor is it necessarily good). However, in bad times, levered investments can cause significant harm to a pension fund portfolio. Let's hope that fiduciaries are asking good questions about leverage and not forgetting that things can sour quickly. Far from an exhaustive list, here are a few basic queries for hedge fund managers.

1. How does your fund measure leverage?

2. What is the fund's average leverage measurement?

3. Are there particular market conditions and/or investment positions that worsen leverage?

4. What is the fund's stop-loss policy as a way to curtail trouble before it's too late?

5. How does the fund value its "hard-to-value" positions and what is the likely impact on reported leverage?

6. Does the fund's leverage vary over time or has it been relatively stable?

7. How does the fund's leverage metric compare with similar strategy hedge funds?

8. How does the fund' return compare with similarly leveraged peers?

9. Does the fund's risk management policy address leverage?

10. Does the fund plan to do anything different going forward that would materially impact leverage? If so, why and what policy changes will occur as a result?

Hedge Funds, SEC and Sunshine

In compliance with the provisions of the Government in the Sunshine Act, the SEC will hold a meeting today to discuss a variety of things, including the proposal of new rules to determine whether to (1.) "revise the criteria for natural persons to be considered 'accredited investors' for purposes of investing in certain privately offered investment vehicles" and (2.) "prohibit advisers from making false or misleading statements to investors in certain pooled investment vehicles they manage, including hedge funds."

Click here for the meeting announcement and here to access the webcast.

While both items merit discussion, the issue of accredited investor qualifications got people talking over lunch a few days ago. The current definition, pursuant to the General Rules and Regulations promulgated under the Securities Act of 1933, Rule 501, Definitions and Terms Used in Regulation D, applies various criteria including whether someone's individual net worth, "or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000."

In the event that the SEC applies more rigor to the definition of accredited investor, how will they proceed? Will they increase the minimum net worth number and if so, why? Is the implication that wealthier investors are smarter or just that their losses don't count as much in proportionate terms? While accredited investors are excluded for purposes of calculating the number of purchasers under relevant securities rules, why is a "non-contributory employee benefit plan within the meaning of Title I of the Employee Retirement Income Security Act of 1974" counted as one purchaser when the "trustee makes all investment decisions for the plan?"

Hopefully a detailed explanation will accompany any decisions made in the aftermath of this meeting. Better understanding what responsibilities regulators want each hedge fund investor to shoulder by virtue of changing the rules can only be a good thing.

Hedge Fund Disclosure - Round Three

On November 8, 2006, I spoke again about the issue of hedge fund transparency and disclosure as relates to ERISA fiduciaries. Part of a three-person panel focused on hedge fund risk management (co-sponsored by BVA, LLC, ING Investment Management and law firm Alston Bird LLP), my comments were directed to an audience of about ninety people, representing hedge funds and service providers.

Since my remarks were picked up by several publications, and because this issue has now become a cause celebre of sorts, I'd like to clarify a few things. (Click here to read "The Law Giveth, The Law Can Taketh Away", 11/10/06, Institutional and here to read "Amaranth, New Law Puts Onus on Pension Trustees" by Chidem Kurdas, New York Bureau Chief, 11/08/06, Registration may be required.)

In case you missed my earlier two posts on the topic of information and economic value, click here and here. No investment is "good" or "bad" on its face. An investor must carry out a careful analysis of characteristics that are thought to contribute to the expected risk-return tradeoff. Moreover, an investor must consider its objectives and constraints.

2. Current law requires ERISA fiduciaries to make informed decisions. (Other criteria apply and fiduciaries are urged to seek legal counsel to better understand their responsibilities.)

3. Notwithstanding current law, common sense mandates a modicum of information and analysis before plunking down money. Why would someone invest in something resembling a black box, especially when they are acting as stewards of other people's money?

4. Some fund managers can choose to provide limited information to potential investors, to the extent permitted by prevailing law. ERISA fiduciaries may be subsequently forced to look at other funds that provide whatever information is deemed necessary to discharge their duties. The Pension Protection Act of 2006 sheds arguably more light on what a fiduciary must do with respect to proper investment decision-making. However, it is not a standalone document and references opinions that will ultimately have to come from the U.S. Department of Labor and elsewhere.

6. The point about due diligence was emphasized by attorney Nir Yarden with Bryan Cave LLP as part of a recent Financial Research Associates conference about liability-driven investing. Yarden urged fiduciaries, including consultants and money managers, to thoroughly consider their exposure under ERISA, adding that "it won't take another blow-up to get people in trouble. Fiduciaries do not have the luxury of walking away from their statutory responsibilities. ERISA may apply even in the event of sub-performance."

7. Having a healthy debate about information requirements is a good thing. Please send or post comments. (If you have any difficulty posting to the blog, please email us.

Will Private Equity Stay Private? U.S. Dept. of Justice Makes Inquiries

In "U.S. Department of Justice Comes Knocking, Raising Specter of Private Equity Antitrust Concerns," law firm Goodwin Procter, LLP writes that "the DOJ has sent out requests to some of the industry's largest and most well-known firms, asking that these firms provide information and documents relating to company auctions since 2003."

Reported earlier by the Wall Street Journal ("Private-Equity Firms Face Anticompetitive Probe" by Dennis K. Berman and Henny Sender - October 10, 2006) and Red, the DOJ is interested in knowing how firms transact and the extent to which competition in bidding occurs.

At the same time, Investment Dealers' Digest reports on the imminent launch of a new trade association, the Private Equity Council ("PE Trade Group Nearing Launch Amid Intensifying Scrutiny" by Ken MacFadyen - October 30, 2006). Slated as its new head, Mr. Harry Clark "insists that the group's genesis was in no way a response to the Justice Department's inquiry and he notes its role will not be in reacting to such events."

At a time when pension funds are increasingly looking at alternative investments such as hedge funds and private equity opportunities, an issue that resurfaces time and time again is transparency. In August 2005, the State of Illinois enacted legislation to protect "the commercially sensitive information of companies that receive private equity funding from public pension funds." One of five other states at the time, the then-cited goal was to "provide transparency in public investments in private equity without damaging portfolio companies' ability to compete."

You may recall an earlier post about hedge fund competitiveness and transparency. (Click here to read "Pensions, Hedge Funds and Disclosure" about Mr. Phillip Goldstein's letter to the U.S. SEC in which he requests exemption from the filing of Form 13F. In that post, I talked about the relationship between information and fiduciary responsibility.

No doubt the issues of transparency and market structure will continue to grab headlines. It's far from trivial.

Editor's Note:
Mr. Goldstein sent a copy of the letter to share with readers. Click below.

Upcoming Hedge Fund Events

A new study by the Bank of New York and Casey, Quirk & Associates predicts a trend upwards in hedge fund investments by pension funds. Entitled "Institutional Demand for Hedge Funds 2: A Global Perspective," the authors predict that hedge funds are here to stay.

What does this imply for pension fiduciaries? Quite simply, a lot. Understanding how a hedge fund (or fund of funds) manages its risk and values its holdings is paramount.

If you are interested in learning more, these events may be of interest.

1. Risk Management for Hedge Funds: Best Practices in a Changing Environment - November 8, 2006
(This complimentary NYC breakfast meeting is near capacity. If you cannot attend because of space, click here to request that materials be sent to you.)

2. Hedge Fund Valuation Toolbox - November 21, 2006 - first of four webinars (There is a charge.)

3. Hedge Fund Valuation and Red Flags - December 1, 2006 workshop (There is a charge.)

Pension Consultants and Hedge Funds

In "Retirement funds fear untested consultants" (HFM Week, August 17-30, 2006), Jefferson Wells engagement manager Aileen Doherty describes a need for independent hedge fund valuations and a concern that pension consultants may not be doing as much as possible to vet valuation issues. Attorney Doherty adds that "There is going to be more pressure on pension funds to make sure the managers they hire are doing what they are supposed to be doing", especially at a time when "Pressure from the SEC and individual states is growing."

In the same article, Wilmer Hale partner Alexandra Poe asserts the need for "trustworthy third party valuations", adding that pension fund trustees "may feel they have hired consultants to get to the bottom of it, and they may feel underserved."

Any pension consultant who wishes to comment has an open invitation from this blog to offer your perspective. The same invitation extends to investors. Please be reminded that we do not endorse any particular firm for any type of product or service. We would simply be acting as a communication conduit.

As I've written before, valuation is a cornerstone of a hedge fund's activities, including, but not limited to, asset allocation, trading, risk management, performance reporting, compliance and auditing.

A point which CANNOT be emphasized enough is the need for independence and objectivity. Regulatory bodies such as the IRS and various courts continue to emphasize specialized valuation training and designations. This applies regardless of purpose - rendering an opinion of value of a particular position or portfolio, assessment of the economic interest of a hedge fund partner or the business itself (such as when a new person exits or enters, key person insurance, divorce) and/or a review of the process employed by organizations providing valuation numbers.

As an Accredited Valuation Analyst, I have written extensively about valuation issues. Please email if you want a copy of any or all of these items:

1. Chart that describes various valuation designations
2. Aforementioned article
3. Hedge fund valuation panel transcript from earlier this year

In case you missed these items, these links may be of interest.

"Hedge Fund Valuation is a Big Deal for Pension Fiduciaries"

"Do You Really Know the Value of Your Portfolio?"

"Hedge Fund Valuation: What Pension Fiduciaries Need to Know" (Source: Journal of Compensation and Benefits, July/August 2006)

Pensions, Hedge Funds and Disclosure

According to Bloomberg reporter Jenny Strasburg ("Goldstein Asks SEC for Hedge-Fund Filing Exemption", October 24, 2006), Phillip Goldstein, "the investment manager who successfully blocked the U.S. Securities and Exchange Commission from requiring hedge funds to register, asked the agency to exempt him from stock disclosure rules." Ms. Strasburg reports his claim that mandated disclosure of holdings on Form 13-F would create economic harm as they constitute "valuable trade secrets." (It does not appear that his letter to the SEC has yet to be published. I will keep searching and post, if and once it is available.)

At the same time, Institutional Investor reports Paul Myners, chairman of the Ermitrage Group, as telling UK conference attendees that hedge funds provide protection against otherwise low returns. "Myners is pressing pension plans to pump up their allocation to 10 times the current level, to 30%."

Stateside, a new study by the Bank of New York and Casey, Quirk & Associates predicts a trend upwards in hedge fund investments by pension funds. Entitled "Institutional Demand for Hedge Funds 2: A Global Perspective," the authors predict that retirement plans around the world will triple their current hedge fund holdings to over one trillion dollars.

If Mr. Goldstein is successful in preserving confidentiality on behalf of his investors, more power to him. However, as a pension fiduciary, prudence would be difficult to justify in the absence of "sufficient and necessary" disclosure. (U.S. Code Title 29, Chapter 18 mandates "the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.")

While reasonable people can disagree about what constitutes "necessary and sufficient" information, certain questions come to mind with respect to hedge fund disclosure. (This is far from an exhaustive list.)

1. Is the hedge fund deviating from the stated strategy? If so, how does that affect asset allocation decisions for the pension fund investor?

2. How do holdings of the hedge fund change over time? What is the impact on transaction costs and, by extension, reported performance?

3. Do hedge fund holdings pose any problem for a pension fund with respect to liquidity?

4. Are the hedge fund's particular holdings difficult to value?

5. In the case of Form 13F, reported information reflects holdings of at least $100,000, a non-trivial amount by most accounts. If a hedge fund holds a large stake in a particular company, how is that likely to affect company policies and, by extension, how shares perform? (See the September 2006 issue of Chief Executive for an interesting article entitled "Do Hedge Fund Activists Have You in Their Sights?")

The list is long but the takeaway is simple. If investors plunk down millions of dollars, they should know enough to make an informed decision.

Hedge Fund Regulation Redux

In the aftermath of losses incurred by several Connecticut-based hedge funds and a recent court case that no longer requires hedge funds to register with the U.S. SEC, Attorney General Richard Blumenthal has convened a state-level Hedge Fund Task Force. Fortune writer Ellen Florian Kratz quotes Blumenthal as saying: "The facts about mammoth losses by Amaranth offer additional powerful and compelling evidence about the need to reform disclosure and oversight requirements [for hedge funds]."

According to a Reuters release on September 27, 2006, the U.S. House of Representatives has now passed a bill that mandates a federal study of hedge funds. "The bill, written by Delaware Republican Rep. Michael Castle, would require a wide-ranging study of hedge funds, their risks and regulation by the President's Working Group on Financial Markets, a multi-agency committee."

These two regulatory initiatives come around the same time that a new study augurs favorably for significant growth in the hedge fund industry. Just released by the Bank of New York and consulting firm Casey, Quirk & Associates LLC, the study concludes that "by 2010 institutions investing in hedge funds will increase to nearly 25% of all institutions, up from 15% today, representing a more than 60% increase. Retirement plans globally will account for the vast majority of asset flows, with corporate and public pension plans in the United States accounting for the largest percentage increase overall."

As with any investment, procedural prudence is paramount before committing funds. In the case of those hedge funds that purchase and sell complex securities that trade in thin markets, decision-makers absolutely must ask tough questions about risk management and valuation. Moreover, they need to feel comfortable with answers provided and understand how the oversight process changes over time and why.

If you are in the neighborhood, join us for a complimentary breakfast meeting on November 7 in midtown Manhattan from 8:30 to 9:30. Co-sponsored by valuation and risk company BVA, LLC, law firm Alston Bird LLP and ING Investment Management, we'll talk about hedge fund risk management and valuation issues that simply cannot be ignored by pension fiduciaries. Click here to have an invitation sent to you and/or to receive information about other upcoming events.

Amaranth, Hedge Fund Risk Management and Pensions

Yes, amaranth is a grain but it's the CT based hedge fund by the same name that is making headlines. If you haven't read by now, Amaranth Advisors L.L.C. has reportedly lost $4 billion by taking long natural gas trades in anticipation of rising prices. (See "Amaranth's Risky Business" by Matthew Goldstein,, September 18, 2006.)

Notwithstanding some obvious questions about oversight, the issue of risk management is unavoidable.

What was the organization doing to identify, measure and manage risk?

With about an hour of web sleuthing, I found a handful of job postings for Amaranth, all focused on analysis, modeling, risk and valuation. For example, an August 6 post describes the need for a technology analytics developer whose responsibilities would include the "development of real time systems supporting valuation and risk analytics".

Top name schools list (or listed) Amaranth as a recruiter of risk and computational graduates. More than a few Amaranth alums list their experience there as involving hedging, model building and/or risk analysis.

Amaranth is listed as a client by a UK risk management technology company.

In May 2006, the Chief Financial Officer was part of a panel entitled "Leading multi-strategy & single strategy funds explain the controls they use to maintain independence of the pricing function and the role of their administrators in fund valuation for different categories of illiquids and thinly traded securities".

On the face of things, it seems there was some focus on risk. Perhaps a lot. It's impossible to say from the outside looking in. It will be enlightening to all of us as we learn more about the firm's internal controls and risk trading systems.

Then, there are the investors.

What responsibility do they have to ask questions about a particular fund manager's risk management policies and procedures? New York Times reporter Mary Walsh writes that the County of San Diego had $160 million invested with Amaranth. No doubt we'll learn about other institutional investors as time goes by. (See "Pension Fund Tallies Losses and Rethinks Its Strategy" by Mary Williams Walsh, New York Times, September 20, 2006.)

What discussions took place between pension fund investors and Amaranth and/or the referring consulting firms? Was there a thorough drill down before writing a check? Can interested members of the public obtain the due diligence meeting notes?

What was the role of regulators?

In its September 15, 2004 letter rejecting the notion of SEC registration, the General Counsel for Amaranth at the time wrote that "Amaranth does not 'operate in the shadows' outside of regulatory scrutiny. Amaranth is registered as a commodity pool operator with the Commodity Futures Trading Commission, is a member of the National Futures Association and counts among its affiliates two SEC-registered broker-dealers who are members of the National Association of Securities Dealers and one investment counsel and portfolio manager registered with the Ontario Securities Commission. As a result, Amaranth already devotes significant resources to regulatory compliance and is subject to many compliance obligations that are duplicative of those that would be required by the Proposed Rule."

Could any or all of the regulators have identified problem areas before now?

Only insiders know what transpired and it is virtually impossible to do anything more at this point than conjecture about good or bad practices.

However, there are real lessons to be learned here, not the least of which is the urgent need for a rigorous and independent assessment of a fund's risk management and valuation practices, policies and controls (if it is not already being done).

Let's be very clear. This notion is not specific to any particular fund but rather a prescription for investment decision-making in general. Is it true that some investments are considered ex ante riskier than others and thereby demand more scrutiny? Yes. Is it true that pension fiduciaries have ultimate oversight authority? Not speaking as an attorney (and urging readers to check with counsel), oversight is a critical task. Is there a possibility that real people could lose real money? Yes. Is revisiting the money manager selection and review process - emphasizing risk management and valuation issues - time well spent? Yes. Is there any reason not to get started right away? No.

Pension Treasure-Seeking in Portable Alpha

The topic of portable alpha pops up in conversation a lot these days as defined benefit plan managers contemplate ways to enhance return.

What is portable alpha?

According to, portable alpha is the strategy of "portfolio managers separating alpha from beta by investing in securities that differ from the market index from which their beta is derived."

Alpha itself is usually defined as a measure of excess return above expected return, adjusted for market risk. If alpha is positive, a money manager is thought to have done a good job.

Like any other investment, risk and expected return considerations are paramount. However, unlike more traditional choices, portable alpha strategies may employ additional leverage and/or investing in securities for which there is not always a ready market.

Learn more by attending the "4th Annual Portable Alpha Conference" on September 18 in New York City. Dr. Susan M. Mangiero, CFA will moderate a 2:00 p.m. panel entitled "The Trustee Perspective: Taking Us Into the Boardroom - Crucial Trustee Issues Associated With Portable Alpha." Panelists include:

Mr. Carlos Resendez, Plan Trustee
San Antonio Fire & Police Pension Fund

Mr. Bradley Imamura, Former Trustee
San Jose Federated City Employees Retirement System

Attorney Anthony Abboud, Of Counsel
Greenberg Traurig, LLP
Former Trustee, Illinois Teachers Retirement System

According to the brochure for the 4th Annual Portable Alpha Conference: Critical Issues During a Period of Change, "This conference is geared to institutional investors and investment professionals and examines three key themes associated with portable alpha that investors face: First the challenges and opportunities portable alpha presents to plan sponsor trustees and institutional investment professionals as seen through their eyes. Second, the emerging intersection between 'liability-driven investment strategies' and portable alpha. Third, key implementation challenges and risk management issues associated with portable alpha usage. We will examine each of these areas through a series of informative panel discussions and lectures."

Legislative Matchmaker: Hedge Funds and ERISA

A provision in the pension bill just passed by the U.S. House of Representatives could permit hedge funds to increase Employee Retirement Income Security Act ("ERISA") holdings before having to wear the fiduciary hat (for those that don't voluntarily assume the role now). The current limit is twenty-five percent of a hedge fund's total assets. The precise way ERISA assets are calculated is likewise expected to change.

According to Greenberg Traurig hedge fund attorney Nir Yarden, "an ERISA fiduciary is tasked with many responsibilities not otherwise required, some of which could significantly impact hedge fund strategy, investment mix, fees and reporting."

As one can imagine, advocates and critics are plenty. A healthy debate is good. After all, a particular hedge fund may be perfect for one defined benefit plan but wholly inappropriate for another. (To date, hedge funds are typically not offered as a 401K investment choice.)

What is important is that hedge fund (or fund of funds) managers who become ERISA fiduciaries truly understand what that means.

For example, with respect to the use of derivatives, a U.S. Department of Labor guidance letter is pretty clear.

As with any investment made by a plan, plan fiduciaries with the authority for investing in derivatives are responsible for securing sufficient information to understand the investment prior to making the investment. For example, plan fiduciaries should secure from dealers and other sellers of derivatives, among other things, sufficient information to allow an independent analysis of the credit risk and market risk being undertaken by the plan in making the investment in the particular derivative. The market risks presented by the derivatives purchased by the plan should be understood and evaluated in terms of the effects that they will have on the relevant segments of the plan's portfolio as well as the portfolio's overall risk.

Plan fiduciaries have a duty to determine the appropriate methodology used to evaluate market risk and the information which must be collected to do so. Among other things, this would include, where appropriate, stress simulation models showing the projected performance of the derivatives and of the plan's portfolio under various market conditions. Stress simulations are particularly important because assumptions which may be valid for normal markets may not be valid in abnormal markets, resulting in significant losses. To the extent that there may be little pricing information available with respect to some derivatives, reliable price comparisons may be necessary. After entering into an investment, a plan fiduciary should be able to obtain timely information from the derivatives dealer regarding the plan's credit exposure and the current market value of its derivatives positions, and, where appropriate, should obtain such information from third parties to determine the current market value of the plan's derivatives positions, with a frequency that is appropriate to the nature and extent of these positions.

Valuation is another touchstone. Fiduciary duties require a thorough assessment of everything related to plan investments. In "Hedge Fund Valuation: What Pension Fiduciaries Need to Know", this author emphasized the need for an independent assessment of valuation and/or valuation processes, including, but not limited to a check of price data collection, accuracy of pricing models and existence of controls that are meant to separate the trading and payment functions. The central role that valuation plays is becoming all too apparent as regulators and auditors ask tough questions.

Valuation drives nearly every investment activity. It is impossible for hedge fund managers to make meaningful decisions about asset allocation, portfolio re-balancing, risk management, fee assessments and performance evaluation in the absence of good valuation numbers. It is equally difficult for the pension fund investor to evaluate managers, decide whether to redeem or subscribe, verify calculated incentive fees charged by the typical hedge fund and otherwise carry out their mandated fiduciary duties. (Click here for a copy of the article.)

Any hedge fund or fund of funds manager, seeking additional ERISA money, should think about creating a laundry list of MUST DO items required by law and reflecting best practices. This would necessarily include a process check of risk management and valuation policies, procedures, along with reporting methodology. (A sign of the times, we've been fielding a lot of inquiries of late on these topics.)

Fees are another issue altogether and deserving of an additional post or two. (Read what we wrote in May 2006.)

So Congress plays matchmaker. Whether hedge funds and ERISA plans will represent a marriage made in heaven or a relationship destined for divorce court critically depends on prudent process.

Two little words that mean oh so much!

Will Hedge Funds Displace Pension Plans in Court?

There is no doubt that hedge funds are here to stay, especially with respect to their increasing clout in the boardroom. According to editor and associate publisher of Directors & Boards, Jim Kristie, "Corporate America is owned by hedge funds". He points out that institutions, including hedge funds, own more than sixty percent of equity issued by top U.S. corporations. Moreover, he cites research that "the average institutional holding period is about 12 months" and possibly even shorter.

In the same issue, William G. McBride warns that activist hedge fund investors "rely on negative media to keep the pressure on boards of directors", highlighting bad practices, sluggish earnings and/or vague communication about strategy.

For some institutional investors, seeking redress by going to court as lead plaintiff is another type of activism. (See the recent post about this topic.) Given their significant ownership stake, is it possible therefore that hedge funds could displace pension funds as key players in litigation against company boards?

In a recent speech, U.S. SEC Commissioner Paul Atkins cites a concern about "complicity between short sellers, namely hedge funds, and plaintiff's lawyers". He adds: "As the story goes -- and I have personally seen instances of this before I came to the Commission -- the two groups can act in concert to systematically drive down the price of a company's stock, to their mutual gain and the company's and its shareholders' loss."

Institutional investors that use the legal system to ferret out wrong-doing serve society well. Their actions arguably help to promote capital market transparency and thereby facilitate economic growth.

Regarding activist hedge funds and their role in litigation as plaintiff, lead or otherwise, it is impossible to generalize anything from a few anecdotes. Moreover, the selection of lead plaintiff depends on many factors.

We welcome hearing about research that directly examines the role of hedge funds as lead plaintiffs and will keep you posted as our investigation ensues.

Hedge Fund Valuation is a Big Deal for Pension Fiduciaries

As earlier stated, asset valuation is the cornerstone of investing. (See "Do You Really Know the Value of Your Portfolio?")

The absence of good valuation numbers makes it virtually impossible to execute vital tasks:

1. Asset allocation

2. Risk management

3. Performance evaluation

4. Selection and comparison of managers ...

(The discussion of what constitutes "good" numbers is left for another posting.)

Regulators and politicos are hardly alone in urging more prudence with respect to the valuation of certain positions. Industry groups have jumped into the fray, and some assert, it's none too soon. The Private Equity Industry Guidelines Group posted valuation guidelines a few years ago. Its mission: "To promote increased reporting consistency and transparency while at the same time improving operating efficiency in the transfer of information among market participants by establishing a set of standard guidelines for the content, formatting and delivery of information." The "MFA's 2005 Sound Practices for Hedge Fund Managers" has a lot to say about valuation policies and procedures and is well worth a read.

So why is this important to pension fiduciaries? For one thing, countless fiduciaries are allocating monies to hedge funds. Second, a recent article offers that hedge funds could have as much as fifty percent of their money tied up in relatively illiquid assets, in part (some argue) to avoid having to register their managers.

According to U.S. SEC Commissioner Roel C. Campos, "To avoid dilution and unfairness, valuation numbers must be accurate and unbiased. A key element of monitoring the risk of hedge funds is to understand the valuation used by said funds and counterparties to the funds."

Hiring an independent appraiser can go a long way to aiding this process, especially when accreditation itself entails satisfying rigorous education and experiential requirements. In fact, courts and regulatory bodies are increasingly turning away experts on valuation matters unless their credentials include specialized valuation training. (Note: As an Accredited Valuation Analyst and someone who has completed course and exam requirements for two other specialized valuation designations, I can attest to the rigor.)

With so much at stake, pension fiduciaries should be asking tough questions of their hedge fund managers (and/or consultants who recommend hedge fund managers).

1. Does the hedge fund rely on independent appraisers to provide assessments of fair market value?

2. Has a hedge fund established a proper valuation process?

3. How often are the valuations updated? *

4. Is each opinion of value well documented?

5. Are all terms and conditions of a particular economic interest specified and analyzed accordingly?

6. Does the hedge fund manager acknowledge how much of its portfolio is not valued on a regular basis, thereby affecting reported portfolio performance?

The list is long. One thing is certain. Hedge fund valuation is the topic "du jour". Can a pension fiduciary afford to invest in a hedge fund, fund of funds, private equity fund, venture capital fund, commodity pool, derivatives fund and so on, without understanding whether, and to what extent, managers have considered various valuation issues?

* Not discussed here, there are those that assert that some positions should not be valued and that doing so would jeopardize the asset allocation decision that led to investing in relatively illiquid holdings in the first place. I welcome your comments regarding this point.

Welcome Albourne Village, Hedge Fund Manager and RiskCenter Readers

We're up to 6300 visitors since late March 2006 and look forward to making even more new friends.

Today we welcome readers from Albourne Village , Hedge Fund Manager and RiskCenter, respectively.

Albourne Village "is a free and unique internet-based knowledge economy for the Alternative Investment community. The site has been designed as an ideal environment for evolving hedge-fund news, intellectual property, content and debates on current issues, as well as a valuable source of commercial contacts."

"HFM Week and are produced exclusively for the international hedge fund community. Hedge Fund Manager was launched in September 2002, and is now published weekly. It is now read by over 5,500 alternative fund managers - predominantly CFO's and managing partners - and their key advisors across the globe."

Risk Center "is the first Web-based syndicated news service devoted exclusively to providing financial risk professionals with the inside scoop on breaking economic, political and financial stories, as well as the risk strategies required to measure and manage these risks. Acting as the eyes and ears for risk professionals, RiskCenter provides an information filter so that viewers do not have to search through a myriad of sources to find the key news that has been researched and written from the point of view of a risk manager."

Let us know what you think. We'd love to hear from you.

Do You Know the True Cost of Your Retirement Plan?

That a relationship between investment performance and fees exists is hardly news. Fees matter. However, it's not quite as simple as it may seem. Fees vary by amount, timing and form. A two percent fee, charged upfront, hurts more than a two percent fee that is levied on the back end. A no-load fund that charges higher annual expenses might cost an investor more than a fund with an upfront charge but lower annual expenses. For mutual funds and exchange-traded funds, the U.S. Securities and Exchange Commission provides a handy calculator with the qualifier that "the results should be compared for several funds or different classes of a single fund".

Importantly, lower may not necessarily mean better. Consider performance fees such as those charged by numerous hedge funds. If an investor understands and willingly acknowledges likely risks, a performance fee may be an acceptable price to pay for participating in returns that exceed a pre-specified benchmark.

However, good decision-making cannot take place in the dark. As described below and in a GAO report about mutual fund disclosure, transparency is not always easy to come by.

1. Database vendors typically provide returns on a gross basis because that is how they are reported by participating money managers. Evaluating a large number of funds requires manual adjustments to facilitate an "apples to apples" basis. This is time consuming to say the least and sometimes difficult to do.

2. Fees vary by type of fund, strategy and timing. Care must be exercised to take into account relevant factors.

3. Fees change over time. Past fees may not be a bellwether of future fees.

4. Reported performance may not reflect all elements of a portfolio as would be the case with side pockets or similar mechanisms. Refer to Barry Schachter's hedge fund blog for comments about side pockets.

5. Mutual fund expenses may not be reflected in published performance reports, forcing one to review the Statement of Additional Information.

6. Institutions and retail clients do not bear the same costs so fee analysis must incorporate any differences.

According to, New York Attorney General Eliot Spitzer announced plans to "examine how 401(k) investments are allocated and whether fund managers are exacting higher fees than participants believe they are paying".

What this portends is anyone's guess. Investigations have the potential to shed light on the important topic of investment fees. Of course, institutional investors should be asking lots of tough questions before they commit dollar one to any particular manager. In fact, it's their duty to behave prudently and proper inquiries, during the RFP process and in-person interviews, are a perfect time to dig deep.

Derivatives: The $270 Trillion Gorilla

The just released pension fund asset management guidelines, courtesy of OECD (Organisation for Economic Co-operation and Development), state that "legal provisions should address the use of derivatives and other similar commitments, taking into account both their utility and the risks of their inappropriate use".

I will devote considerable time to the topic of derivatives and pensions in this blog. For now, I will make a few introductory comments to hopefully whet your appetite.

1. Derivatives can be used in a variety of ways to manage assets and/or liabilities and for both defined contribution and defined benefit plans (though there are significant differences with respect to strategy, risk assessment, accounting treatment and so on). I have written a lot about this topic, including a book and countless articles, and there is still much more to say. Identifying, measuring and managing risk is a cornerstone of being a good investment fiduciary.

2. The derivatives market is huge. According to the Bank for International Settlements, outstanding over-the-counter derivatives contracts (in terms of notional amounts) exceeded $270 trillion when estimated in June 2005. Think about it. In comparision, the U.S. national debt tally is approximately $8.36 trillion. Estimated 2005 gross world product is $59.38 trillion. The global derivatives market is the proverbial 200 pound gorilla of the financial world. It is worthwhile understanding why this market continues to grow. (Stay tuned!)

3. Derivatives are contracts that "derive" their value from the value of an underlying security, commodity, index or other type of instrument. For example, the value of a gold derivatives contract depends on the price of cash gold. (Derivatives valuation is a broad topic and will be addressed in other postings.)

4. The term "financial risk management" typically refers to the use of derivatives in some fashion (though this is not always the case).

5. Pension fiduciaries who ignore derivatives, especially if the Investment Policy Statement restricts their use, may want to rethink their stance. They should know that financial performance is impacted by the price behavior of derivative instruments if they have allocated monies to: (a) hedge funds or mutual funds that employ derivatives (b) asset-backed securities such as mortgage-backed bonds or collateral default obligations (c) convertible bonds (d) callable bonds (e) currency sharing agreements (f) private equity with warrant arrangements (g) contingencies of any type and the list goes on.

6. Derivatives, used improperly, can wreak havoc. Much more will be said about the identification and measurement of risk, how to determine appropriate use and a host of other critical MUST KNOW elements of the decision-making process.

7. The issue of a fiduciary duty to hedge is an ongoing and interesting legal question.

8. Financial engineering opens the door wide to a variety of new investment opportunities for pension funds. Fiduciaries must know (or learn) how to evaluate each opportunity. Outsourcing does not eliminate the fiduciary's duty to monitor.

9. Using derivatives is seldom a one-time event but instead requires a commitment to evaluate economic efficacy on an ongoing basis.

10. Creating a risk management process is just the beginning. I will address the Five C Approach(SM) as a way to assist fiduciaries.

Hedge Fund-Pension Nexus

The growth in the hedge fund industry has been nothing short of meteoric with assets now exceeding one trillion dollars. At the same time, the winds of change are blowing hard. Hedge funds and fund of funds are arguably facing tougher competition, increased regulatory pressures and, in some experts' opinion, a capacity constraint. (These points are discussed in greater detail in my article for entitled "Promise or Peril".)

Of particular importance is a trend in institutional investor interest in hedge funds and other alternatives. According to "Institutional Demand for Hedge Funds: New Opportunities and New Standards" (a joint 2004 study by Casey, Quirk & Associates and the Bank of New York), defined benefit plans represent the fastest growing source of capital. This trend is already having a dramatic impact on hedge fund practices and will likely accelerate if pending Congressional pension reform liberalizes the amount of ERISA money a hedge fund can manage before having to declare itself a fiduciary.

As plan sponsors are being asked to better justify their investment decisions, they will look to hedge fund and fund of fund managers for more and improved information. Valuation of relatively illiquid securities is another concern. On March 23, 2006, the Financial Services Authority in the UK described asset valuation as a central part of its supervisory focus, adding that "hedge fund managers may be exposed to conflicts of interest as their remuneration is based on performance and assets under management". Elsewhere, the U.S. Securities and Exchange Commission has commented that "the broad discretion that these advisers have to value assets and the lack of any independent review over that activity gives rise to questions about whether some hedge funds' portfolio holdings are accurately valued". I will spend considerably more time on this topic in future postings.

On a related note, experts consider what will happen if 401(k) plan participants are given the choice of investing in hedge funds or fund of funds. Suitability, liquidity, transparency and potential returns are just a few of the issues that will be discussed at a free panel in New York City on April 4, sponsored by the North American Securities Administrators Association, Inc.

With billions of dollars at stake, the hedge fund-pension nexus is attracting a lot of attention and for good reason. Stay tuned!