What's an Honest Hedge Fund Manager to do if Aberrational Performance" is to be Investigated, not Celebrated?
By Cynthia Harrington, CFA, CFE, Cynthia Harrington & Associates, LLC
The SEC’s new Aberrational Performance Inquiry (API) ups the compliance ante once again. Even though we understand that the purpose of questioning outperformance is to catch the next Bernie, seeming to penalize outperformance of hedge funds invokes the feeling of being in an insane asylum. After all, isn’t “aberrational performance” the sector’s outstanding value proposition?
How then do funds manage to achieve this Goldilocks alpha, which is just enough, but not too much, and still win investors’ commitments? Some answers may be found in an analysis of the early cases filed under API, as well as recent research into behavioral finance.
What is the SEC Looking For?
Promising to “canvas all hedge funds” the Asset Management Unit of the SEC’s Enforcement Division announced its own version of a “black box” strategy. The Commission reportedly started construction on a proprietary data analysis system in 2009. Details of its functions are still opaque, except for the claim that it will use “proprietary risk analytics to evaluate hedge fund returns,” and inputs will be monthly numbers.
Even the precise measure of “aberrational” is still in question. Like many of the new regulations, it’s both undefined and a moving target. In the first announcement of the API to Congress last March, Robert Khuzami, the Director of the Division of Enforcement for the SEC specifically stated that all funds outperforming “market indexes by 3% and [are] doing it on a steady basis” would flag further notice. The comparison, while still not clearly defined, has morphed into something more realistic. The queries will now focus on funds with “performance that appears inconsistent with a fund’s investment strategy or other benchmarks.”
We expect that both the benchmark and degree of outperformance will become known as time wears on and cases are filed. But in the early months, all superior performing funds may be swept up for initial review. The potential for increased scrutiny lands first on desks of the compliance officer and operations head. An upgrade to record keeping, especially in the documentation of investment decisions, valuation of assets and trading policies is in order.
What are the Odds?
The Commission claims that it is reviewing thousands of funds for performance that exceeds targets. This might seem like the SEC holds all the cards and can call other players at will. The four cases described below yield clues as to what second order factors would prompt investigators to see if a fund is bluffing.
The first four cases announced on December 1 allege pretty familiar misdeeds. The list includes fraudulent valuation of portfolio holdings, misuse of fund assets and misrepresentations of performance, type of assets held, degree of liquidity, specific investment strategy, valuation procedures, and key personnel conflicts of interest. Each was flagged by the outperformance indicator and took various levels of additional investigation to uncover the problems. These second levels of investigation lend clues to key areas of focus for funds’ internal upgrades.
One, ThinkStrategy Capital Management LLC was the manager and advisor of two hedge funds, ThinkStrategy Capital Fund (TS Capital Fund) and TS Multi-Strategy Fund (TS Multi-Strategy Fund). At its peak in 2008, ThinkStrategy managed approximately $520 million in assets. The SEC’s complaint alleges that ThinkStrategy and its sole managing director, Chetan Kapur, who made all investment and trading decisions and acted as compliance officer, grossly inflated the performance and assets of the TS Capital Fund, giving investors the false impression that the fund’s returns were consistently positive and minimally volatile. The complaint also alleges that ThinkStrategy misrepresented the size and credentials of ThinkStrategy’s management team. The fund did not use outside administrators, custodians or auditors, except for one year, in 2003, when financial statements were audited. However, these audited financial statements were never provided to investors because Thinkstrategy and Kapur didn’t like the results. Instead, returns boasting a positive year end performance were reported on marketing materials, investor letters and hedge fund web sites.
|Table 1: Captial Fund-A, Reported v. Actual Returns (Annual)|
Source: United States District Court Southern District: Securities Exchange Commission v. Chetan Kapur; Lilaboc LLC d/b/a ThinkStrategy Capital Management, LLC.
Additionally, the extent and scope of due diligence procedures on the TS Multi Strategy Fund of hedge funds were misstated. Despite stating in investor presentations that Kapur selected managers who used only reputable outside service providers, the assets landed at some high profile fraudulent funds, including Bayou Superfund, Valhalla Victory Funds and Finvest Primer Fund. The “second moment” investigative factors in this case were probably the absence of reputable service providers and the number of fraudulent funds chosen, despite supposed disciplined reviews.
The case against Millennium Global Emerging Credit Fund would have necessitated a deeper review. Unlike the previous case, Millennium’s books were audited by a “Big 4” firm and they also worked with a top administrator. The SEC’s claim sets out an elaborate scheme to overvalue the investments and net assets of the fund. The portfolio manager conspired with brokers to provide phony mark-to-market quotes for two of the fund’s portfolio investments, which were illiquid and sizable sovereign debt instruments in emerging countries. Both the administrator and independent auditor were fooled by the phony pricing, as well as the fund’s investors.
Illiquid and micro cap securities may have been additional red flags in the complaints filed against LeadDog Capital LP and Solaris Management LLC. The owners of LeadDog’s adviser invested almost all their assets in illiquid penny-stocks or other micro cap and private companies. On further investigation, it became known that the owners of LeadDog were also controlling shareholders of the microcap companies, most of which had a consistent history of net losses and received “going concern” opinions from their independent auditors. Misstating the reality to investors, LeadDog’s advisers stated that at least half the fund’s assets were invested in liquid positions for which the valuations were marked to market each day and that other assets would be valued according to GAAP. When an investor looked to redeem, the advisor refused, citing that there was insufficient liquidity.
Solaris’ misdeeds formed a similar pattern. Contrary to Solaris’ stated claim that they “followed a non-directional” strategy (i.e. using long, short, and neutral positions to hedge risk, generate income, and maintain equity growth over the long term) to trade in equity, options, and futures, fund adviser Patrick Rooney invested significant client assets in the financially troubled and illiquid microcap company, Positron Corp., of which Rooney served as chairman. The SEC alleges that Rooney and Solaris Management concentrated Solaris’ investor funds in the single position, and through a series of private transactions and market purchases, Solaris built a position of 1.1 billion shares in Positron, which represented over 60% of the outstanding ownership interest in the company. The complaint alleges that Rooney and Solaris Management hid the Positron investments and Rooney’s relationship with the company from the Solaris Fund’s investors for over four years.
From these initial cases multiple allegations were filed against each fund. Using outperformance as a filter, other common themes of owning illiquid and thus hard to value securities and the eventual appearance of fund adviser conflicts of interest follow through these cases. The absence of a reputable service provider in three of these cases suggests that might be a prominent screening factor as well.
Under the new SEC Initiative, fund owners and advisers find themselves in a strange balancing act between needing to outperform to meet investor expectations but not by too much to stay within the SEC’s performance guardrails. Avoiding regulatory risk means maintaining adequate support that the returns are generated honestly, which for most funds means spending significant time, effort and resources on compliance. This calls for greater attention to record keeping and being cognizant of strategies that are likely to attract attention. For instance, opportunistic funds that may employ strategies that are difficult to value, like unlisted securities and less liquid investments, should pay particularly close attention to following and documenting their investment selection and pricing policy, internal controls, and potential conflicts of interest.
The SEC’s first cases also were against the owners and advisers of funds managing less than $1 billion. As the Initiative progresses the investigations might reach into larger funds that then are at risk of the SEC finding misdeeds of errant employees before fund management does. Establishing stronger internal controls and managing them effectively are actions that reduce this risk. A review of common controls should cover whether a fund has processes in place to:
- Monitor that trades are being made in accordance with the fund’s investment strategy as documented in offering memorandums and operating agreements
- Document valuation techniques and inputs to valuation for all hard to value and illiquid securities for each reporting period
- Work with an independent committee or board to review and sign off on these valuations
- Review third party relationships for conflicts of interests
- Require mandatory vacations and have other employees perform the responsibilities
- Require supporting documentation for approval of all fund disbursements
- Safeguard assets by segregating the following three responsibilities: check signing/ wire transfer authorization; bank/broker reconciliation; and maintenance of the books and records (general ledger)
- Have a party independent from the parties listed above review bank reconciliations and scan bank/broker statements each month for reasonableness/ unusual transactions
Heightened awareness of the human propensity for errant behaviors is another risk management technique. The field of behavioral finance provides evidence for human foibles that can be managed to decrease risk while increasing productivity. Two findings discussed below have particular relevance for managers charged with maximizing performance and minimizing regulatory risk.
We all exhibit restraint bias it seems. In study after study, subjects overestimate their ability to resist temptation. And, counter intuitively, we overestimate more when times are good. When bellies are full and we’re feeling abundant about life, we are even more likely to think that we can resist temptation than when we’re hungry and times are bad.
Like the universality of overestimating restraint, it has been found that subjects will cheat to the limit of their personal integrity. To compound matters for fund managers needing their investment staff to be creative in their ideas and strategies, creative people are also more likely to cheat. This fact comes to us by way of the Harvard psychologist who wrote Predictably Irrational. In five studies Daniel Ariely and colleagues showed that subjects with creative personalities tend to cheat more than their unimaginative brethren. Additionally, a creative disposition is a better predictor of unethical behavior than is intelligence.
According to these findings, employees at outperforming funds are most likely to overestimate their ability to restrain from temptations to keep performance high at any cost. As the coffers fill, the incidence of fraud is likely to increase, not decrease. It is at these times that managers should scrutinize documentation more carefully.
Additionally, funds want to hire creative people who can adapt more quickly to changing environments and ferret opportunities more aggressively. The advice then is to be even more creative. When controls are in place and set, creative people don’t have to work very hard to get around them. Additional informal measures might include rotating controls of particular focus, watching for unusual relationships among staff, noting lifestyle upgrades not matched to compensation, and being aware of changes in behavior in individuals when under stress.
Superior performing funds are going to be under increased scrutiny under API. The burden will be significantly easier to carry by focusing on high risk areas, ensuring there is consistency between actions and public statements of actions, and maintaining thorough documentation behind investments in positions with less objective pricing mechanisms. Retaining talented managers and analysts that outperform the market is still the number one priority and will be the deciding factor behind funds that endure, despite the new regulatory onslaught.
Cynthia Harrington, CFA, CFE, is founder and principal of Cynthia Harrington & Associates LLC, which provides asset managers with innovative programs to manage 21st century human capital. Cynthia can be contacted at email@example.com.