Hedge Fund Lock Ups and Pension Inflows

Posted on July 4, 2011 by Susan Mangiero

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:

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Financial Model Mistakes Can Cost Millions of Dollars

Posted on June 7, 2011 by Susan Mangiero

 

It's been awhile since I've blogged. Work has been busy and then I took off ten days to visit Paris. The City of Lights is amazing indeed. Now that I'm back, I will try to blog more frequently. There is certainly no shortage of topics about risk, governance, litigation, valuation and so on.

For those who don't know, I created a sister blog a few months ago. See GoodRiskGovernancePays.com. Nearly all of the time, the posts on each blog are different. However, I decided to reprint a post from GoodRiskGovernancePays.com here since the topic is hugely important. After all, for those defined benefit and defined contribution plans that are exposed to "hard-to-value" investments, leverage and perhaps higher than expected volatility, model risk could be the hidden alligator that bites if left unchecked. As always, I welcome your comments at contact@fiduciaryleadership.com.

Here is the post that was originally posted on June 2, 2011 by Dr. Susan Mangiero.

In a recently published article about financial models entitled "Financial Model Mistakes Can Cost Millions of Dollars" (American Bar Association, Section of Litigation, Expert Witnesses, May 31, 2011), Dr. Susan Mangiero defines model risk and explains why it is so important. Referencing the recent $242 million enforcement action by the U.S. Securities and Exchange Commission as a result of model mistakes made by a well-known asset management firm, this financial expert cites the heightened regulatory and litigation imperatives with respect to risk and valuation models. She concludes the article by listing some of the ways to mitigate risk. These include, but are not limited to the following:

  • Hire knowledgeable programmers with capital market experience;
  • Create and follow a set of policies and procedures that govern how and who will validate financial models over time and what will trigger revisions in a model(s);
  • Avoid conflicts of interest that would reward managers for ignoring problems and would potentially preclude an independent and objective assessment of problems and related corrective action(s);
  • Test assumptions for validity in stable markets as well as extreme circumstances;
  • Stress a model using a sufficient number of economic scenarios to gauge its predictive power and whether results can be relied upon in both good or bad times;
  • Educate personnel about how a particular model is supposed to work;
  • Establish a response strategy should a problem occur and investors need to be informed before things get out hand;
  • Scrap models that are overly complex and expensive to replicate;
  • Don't be afraid to ask questions about inputs, data quality, results, and concerns; and
  • Invite informed outsiders to offer an independent and regular critique on a confidential basis.

 

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Model Risk Costs One Asset Manager $242 Million

Posted on February 3, 2011 by Susan Mangiero

According to a February 3, 2011 document released by the U.S. Securities and Exchange Commission ("SEC"), AXA Rosenberg Group ("AXA") and various related entities have settled a matter relating to model risk for $242 million in economic damages and penalties. In a company letter dated April 15, 2010, several AXA executives describe an error with an investment model as having been "discovered in late June 2009" and "corrected between September and mid-November." While there are issues about the disclosure of said problems, the official message to investors at that time was a continued commitment to risk management.

Investor fallout has occurred nevertheless with various press accounts reporting the withdrawal of monies from AXA by pension plans such as the School Employees' Retirement System of Ohio, Los Angeles Fire and Police Pensions, the City of Fresno Retirement System, Florida State Board of Administration, the Marin County Employees' Retirement Association and the Montana Board of Investments. 

As I've written before, valuation (and by extension, model risk assessment) is a key element of the due diligence of asset managers. For a list of some of the "must ask" questions about model reviews, click to read "Asset Valuation: Not a Trivial Pursuit" by Susan Mangiero, PhD, CFA, FRM (FSA Times, The Institute of Internal Auditors, Q1-2004).

Email contact@fiduciaryleadership.com if you want to further discuss model review best practices.

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U.S. Department of Labor and Definition of Fiduciary

Posted on January 25, 2011 by Susan Mangiero

As the U.S. Department of Labor ("DOL") prepares to expand the definition of fiduciary, at the same time that the U.S. Securities and Exchange Commission is doing likewise, the financial industry is girding for some potentialy massive changes.

In response to the DOL's request for comments about an expanded definition of fiduciary as relates to retirement schemes, I warned that the law of unintended consequences could push knowledgeable professionals out of the marketplace. If fears that the liability costs will outweigh the benefits of working with plan sponsors, perhaps materially so, it will be difficult to attract the talent that is so badly needed to assist with implementing pension governance policies and procedures. 

I further wrote that a hefty dose of transparency could do wonders for differentiating "good" fiduciaries from others. This problem is not new. In fact, I wrote in 2006 that trying to identify who serves as a member of a plan's investment committee is like searching for hidden treasure. Click to read my 2006 post about pension fiduciary disclosure.

Click to read my January 20, 2011 letter to the U.S. Department of Labor about their proposed expansion of who should serve as a fiduciary.

Click to read the other letters submitted to the U.S. Department of Labor about this important issue of who properly counts as a fiduciary. Letters I read suggest the need for a universal education standard. As is the case in other countries, the United States could well end up with a mandate for independent fiduciaries to serve on investment committees, after having been properly vetted, licensed or otherwise credentialed.

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Venture Capital Allocation and the IPO Drought

Posted on March 18, 2010 by Susan Mangiero

On March 1, 2010, Dr. Susan Mangiero, CEO of Investment Governance, Inc. sat down to talk to financial and strategy expert, Mr. Pascal Levensohn. In this ninth question of ten, read what this Investment Governance, Inc. Advisory Board member has to say about IPOs and whether institutional investors should allocate monies to venture capital ("VC") funds right now. Click here to read Mr. Levensohn's impressive bio.

SUSAN: Does an anemic initial public offering ("IPO") market will remain a deterrent to VC investing?

PASCAL: Yes I do. I believe that an entire generation of American innovation is at risk as a result of the lack of IPO’s. The statistics are overwhelming in support of my position, starting with the fact that over 90% of jobs created by VC-backed companies occur AFTER their IPO - and this has been the case for 40 years. What concerns me the most about the IPO vacuum is that it is systemic and is the result of a “one size fits all mentality” when it comes to regulation of the securities industry.  A relatively unknown emerging growth public company with a $500 million market cap has different needs for research and trading support to provide liquidity for investors than IBM. I remain surprised that this seems to be difficult for our policy makers to understand, but I am encouraged that the U.S. Securities and Exchange Commission ("SEC") has recently invited public comments for a 90 day period to address structural problems with the U.S. equity markets.

Specifically, the SEC wants to know if anyone from the public has thoughts on "whether the current market structure is fundamentally fair to investors and supports capital raising functions for companies of various sizes, and whether intermarket linkages are adequate to provide a cohesive national market system." The Commissioners expressed particular interest in receiving comments from a wide range of market participants. Comments on the Concept Release are due within 90 days after publication in the Federal Register.

Click to read "SEC Issues Concept Release Seeking Comment on Structure of Equity Markets" (January 13, 2010).

I believe that the U.S. equity capital markets must be structured with the goal of promoting the growth of publicly held small businesses in America. America had this structure in place prior to 1997. We should take a hard look at what has changed to render the small company IPO extinct. (Contrary to popular belief, it first became an endangered species before the technology bubble).

Compounding this problem is the fact that, with no IPO options, the consideration paid for companies in trade sales - acquisition by larger companies - has been declining.  Why should venture capitalists take the risks associated with starting up a new company, working through all of the difficulties with multiple financing rounds and executive changes over a six-to-eight or even ten-year period, only to get backed into a corner by a large multinational that dominates the sales channel and can wait them out?

The biggest problem the VC industry has today is that, absent access to public market capital, there are too few VC-backed companies that are self sustaining cashflow generators.  The biggest problem that the U.S. economy has today is unemployment. You would think that maybe the stewards of the U.S. economy, our legislators, could make some structural changes to our small company capital markets regulations to fuel the greatest job creation engine in America - the entrepreneur driving an emerging growth company. This problem goes way beyond venture capital. Consider that 47% of all IPO’s since 1991 were backed by neither VC’s or private equity firms. This is an American problem.

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