Pension Risk News & Analysis : Pension Governance, LLC : Pension Risk & Investment

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 CNN.com 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.  

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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.

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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.

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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 Forbes.com, 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.

• Halloween is a top 10 "candy buying day" according to The Nielson Company.
• U.S. and UK consumers think that food companies should be doing more to make healthier goodies.
• Sixty-five percent of Americans who consume chocolate prefer the milk variety. See www.candyusa.org.
• January 3 is National Chocolate-Covered Cherry Day, April 12 is National Licorice Day, May 23 is National Taffy Day and August 30 is National Toasted Marshmallow Day. See www.candyblog.org.
• "The first patent for chewing gum was issued in 1869 to William F. Semple, a dentist from Mount Vernon, OH" as reported by the International Chewing Gum Association.
• Bubble gum is pink because the inventor had no other colors left. See http://www.betteroralhealth.info/orbit_us/about-wrigley/fun-facts/index.htm.  

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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 www.securitiesmosaic.com and the family of related websites. It's well worth your time. 

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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. >>

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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).

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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.

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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.

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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.

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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).

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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!

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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 www.fi360.com. For more information about pension best practices, visit www.pensiongovernance.com.

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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."

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Hear Susan Mangiero, PhD, AIFA, AVA, CFA, FRM speak about pension governance pitfalls. Part of the Second Annual Ohio Forum on Public Retirement: The Conference for the Public Retirement Systems of Ohio, Dr. Mangiero joins fellow pension consultant Mary Willett on a panel entitled "Fiduciary Responsibility - Is Your staff and Board on the Right Track?" Lisa Morris, Deputy Executive Director, School Employees Retirement System of Ohio, moderates. In a second presentation, she leads a case study discussion about San Diego and Amaranth Advisors.

To schedule Dr. Mangiero for your event, call BigSpeak! agent Mr. Barrett Cordero at 805-965-1400 or send an email to barrettc@bigspeak.com.

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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.)

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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.

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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.

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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.

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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

Instructor:
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...

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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?

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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.

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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 Toolbox^SM, we're nearly finished with the ebook equivalent. Email us if you want to be notified when it's ready.

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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.

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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.

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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.)

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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?"

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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