by John Ward, Managing Director at Duff & Phelps, LLC
Once again, another Hedge Fund Fraud Indictment has reared its head leaving a stain on the industry. One has to ask, where was institutional ODD?
Clearly, according to the Indictment, the defendants acted fraudulently and with intent to abuse their investors. There are, however, so many red flags that one must wonder how were they all missed?
- How a fund's portfolio is valued is a critical ODD requirement. According to the indictment the defendants were mismarking numerous fund positions. Did investor's ODD members communicate with the fund's Administrator to understand how the fund was being valued? Were the positions listed as manager marked or broker quoted? What was the firm's and the Administrator's policy on price challenges? Were broker quotes being sent directly to the Administrator or first to the manager? Did ODD review broker quotes while onsite? Were Valuation Committee minutes reviewed onsite? Did ODD understand how involved the fund's traders were in the portfolio valuation?
- According to the indictment on SEC.gov, the fund's Valuation Policy was: "Premium Point will query the pricing sources (both securities dealers and pricing vendors) directly and determine the price as follows: if five or more prices are received, the average of the prices (excluding the highest and lowest) price will be used as the fair market value for that security. If four, three, or two prices are received, the average of the prices will be used as the fair market value for that security. If one price is received, this price will be used as the fair market value for that security." The SEC also noted: "Premium Point’s month-end valuation practice from at least January 2012 to March 2016 was to value the Funds’ securities at the midpoint between the bid price and the ask price." The policy and the practice do not align and a thorough ODD review of the fund's Valuation Committee minutes, or a review of the fund's marks should have identified the variance.
- Was the fund's Administrator appropriate and capable? Were they able to appropriately value the portfolio's securities or were they fully reliant on the fund's manager for valuing the portfolio? Did the Admin disclose in the fund's ITR that many of the positions were manager marked or were they listed as broker quoted? Who was calculating the bid/ask mean used for pricing, the manager or the Admin? According to a version of the indictment on Justice.Gov: "11. At all times relevant to this Indictment, the Firm [Premium Point] calculated the net asset value ("NAV") for the Hedge Fund and the New Issue Fund at the end of each month and sent the respective NAVs to its investors".
- More subtle is the implication of the fund's Valuation practice: the practice indicates the use of the bid/ask mean for valuing RMBS securities and loans. Most RMBS focused managers are generally long RMBS securities and use derivatives or futures for hedging strategies. By using the mean and not the bid to value the long RMBS exposure, the manager is consistently over-valuing their positions. If the fund was long/short with low net exposure, the overpricing of long positions would be generally offset by the underpricing of short positions leading to an acceptable average price. However when the portfolio is significantly long credit securities, the use of mid or mean pricing leads to an inflated valuation. Further, the wider the bid ask spread, the greater the markup of long securities. During periods of market stress or volatility, using bid/offer spread pricing for funds that are generally long credit, fund performance is enhanced even more.
There is a real value for conducting institutional quality ODD meetings with fund managers. Check-the-Box processes and cursory ODD reviews are unlikely to discover deep, intentional frauds being perpetrated by unscrupulous fund managers.
This article was written by John Ward, Managing Director at Duff & Phelps, LLC. John is one of our lead instructors at the IMDDA.
If the above article was relevant to you, you may be interested to register for one of his classes. Click the links below for more information on the Operational Due Diligence Masters Level Courses:
- Reporting, Risk Assessment, Ongoing Process and Exams, Masters Level – May 22 - May 23, New York
- Preparing for a Private Equity Fund Operational Due Diligence Onsite Meeting, Masters Level – June 12 - June 13, New York
- Preparing for a Hedge Fund Operational Due Diligence Onsite Meeting, Masters Level – July 17 - July 18, New York