Pension Risk Matters : Pension Risk News & Analysis : Investment Governance, Inc. : Pension Risk & Investment

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.

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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.

CNNMoney.com 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.

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