By Michelle Celarier
Former Deutsche Bank derivatives trader Boaz Weinstein was one of the brightest stars to open a hedge fund following the global financial crisis, with his Saba Capital Management’s assets peaking at $5.78 billion in June 2012.
But years of losses dimmed Weinstein’s star, and the biggest investor in his hedge fund wanted out. Canada’s Public Sector Pension Investment Board asked to redeem its entire $500 million position in New York–based Saba as of March 31, 2015.
Then it cried foul. It turns out that Saba’s returns plummeted in March, leading the $112 billion Canadian pension fund — which runs the retirement account of the Royal Canadian Mounted Police, among other public employees — to sue Saba in September.
The Canadian pension, known as PSP, claims Saba defrauded it by abruptly changing the way the illiquid securities in its hedge fund were valued, causing them to sink just long enough to cut the pension’s payout. After returning PSP’s money, Saba reverted to its old way of valuing its portfolio of corporate bonds, and they suddenly rose in value, contends the lawsuit, filed in New York State Supreme Court. Last year Saba had its first annual gain in four years, rising 3.36 percent, according to a weekly rundown of hedge fund performance by HSBC Holdings.
Weinstein, whose fund assets have dwindled to $1.6 billion, has denied the fraud allegations and is fighting PSP in court. The manager, also a chess grand master, told the judge in the case that the pension fund “recklessly and maliciously attacked” his firm, which did “absolutely nothing wrong.” (PSP and Saba both declined to elaborate on the court documents.)
There’s good reason for Weinstein to push back. According to consultants, investors are now citing valuation methodology as a top issue in their due diligence of hedge funds that invest in illiquid securities. The Securities and Exchange Commission, which requires all registered funds to have a valuation policy, has likewise homed in on this over the years.
“Valuation risk is the No. 1 risk of the alternative-investment world,” says Sam Lieberman, a partner in the securities litigation group at law firm Sadis & Goldberg in New York.
As the bull market soared in recent years, investors began to worry that the hard lessons of 2008 might have been forgotten: In recent years a growing number of hedge funds eked out extra returns by venturing into illiquid corners of the markets, from junk bonds to so-called unicorns — pre-IPO tech start-ups valued at more than $1 billion. With markets now falling, investors fear that managers will be more tempted to game the numbers. That means managers could collect performance fees on returns that aren’t what they’re cracked up to be. What’s more, industry experts say some hedge fund firms employ valuation models that afford managers a lot of flexibility around how they price these hard-to-value assets, giving them leeway to mark their books in a way that’s advantageous to them.
This time around, however, investors have a little more leverage because they and their consultants pushed for more transparency on valuation after the suspended redemptions, gates and side pockets of 2008. Many hedge funds, through their administrators, are now providing their clients with quarterly reports that disclose how much of a fund’s assets are illiquid, how much of the book is marked independently by the administrator, and the biggest red flag: how often the manager made those valuations. What the report doesn’t show is whether the manager overrode the independent valuations.
“It’s a monitoring tool, not a solution,” says Jeff Lisle, who formerly headed North American operational due diligence for hedge fund consulting firm Albourne Partners and now has his own consulting firm, Fortifinancial, in Tiburon, California.
Lisle, who has helped promote such reporting, warns that “in every major market downturn, there is a risk that private valuations may not go down in line with public valuations.” This time around, he began to see worrisome signs at the end of 2014, when some hedge funds weren’t writing down their portfolios of loans to energy companies because they thought the price of oil would quickly rebound. One fund’s net asset value and performance fees had to be restated because the auditor wouldn’t sign off on the loan values, he recalls.
The problem for hedge funds is that valuation problems could turn into a PR nightmare for them just when investors need their ability to weather market downturns. Things could get ugly, some attorneys say. “When everyone is making money, even if someone is ripping you off a little bit, you don’t care,” notes Michael Bowe, a New York partner specializing in securities fraud at law firm Kasowitz Benson Torres & Friedman. Referring to the suit against Saba, he adds, “When you have markets getting tight and there’s not enough pie to go around, you’re going to see more and more of these fights.”
Improper valuation of hedge fund assets and misstated returns have been at the heart of almost every hedge fund scandal. One of the most infamous of these entangled former New York City deputy mayor Kenneth Lipper, whose Lipper Convertibles hedge fund was found in 2002 to have inflated its $4.9 billion portfolio by $250 million. Lipper himself was never charged — the fraud was perpetuated by portfolio manager Edward Strafaci — but it took him nearly a decade to clear his name.
Just this January the SEC settled with Equinox Fund Management, a small, Denver-based managed-futures firm that agreed to repay investors $5.4 million in excessive fees after misleading them over how it valued some assets. The SEC’s investigation found that the firm was supposed to charge fees based on the net asset value of its holdings but actually used the notional value, which included leverage.
“Fund managers can’t tell investors one thing and do another when assessing fees and valuing assets,” Marshall Sprung, co-chief of the SEC Enforcement Division’s asset management unit, said in announcing the settlement. “Equinox’s misleading disclosures gave investors a distorted picture of how the firm determined compensation and valued significant fund holdings.”
Most hedge funds still invest in plain-vanilla exchange-traded equities. In that case, there is no wiggle room when it comes to valuing the asset unless a reorganization occurs that leaves investors with warrants or other derivatives. But those who have forayed into the murkier world of, say, distressed bonds have more difficulty — or flexibility — in ascertaining their value.
Complex securities, like the convertible preferreds that ensnared investors in Buddy Fletcher’s now-bankrupt Fletcher Asset Management, are notoriously ripe for abuse. In that case, New York–based Fletcher’s bankruptcy trustee alleged that the fraud was like a Ponzi scheme, carried out in part by “the extensive use of wildly inflated valuations.” By using a theoretical model for convertible notes, for example, the firm reported valuations almost double what could realistically be achieved, according to trustee Richard Davis.
The liquidity features, combined with the private equity nature of many of Fletcher’s investments and the model-based approach, increased the risk that the fund wouldn’t be able to meet redemptions, Davis said in his 2013 report. It was a redemption request, from three Louisiana pension funds that had poured more than $100 million into Fletcher’s fund, that triggered the bankruptcy. The investors are still trying to get their money back from Fletcher.
During 2008’s bear market the valuation of all types of credit, including mortgage-backed securities, was turned on its head, as there was simply no bid on the most toxic stuff. That led many managers to either throw up gates to keep investors from bolting or push the illiquid holdings into side pockets, where some of them remain to this day. Now market participants say the lack of liquidity is more acute than before 2008: The Dodd-Frank Wall Street Reform and Consumer Protection Act means Street proprietary trading desks are no longer there to take the other side of a trade, potentially depressing prices further.
Already, there’s been some fallout — namely, the shuttering of a mutual fund run by Marty Whitman’s Third Avenue Management, which halted massive redemptions in its junk bond mutual fund in December after prices fell abruptly. Third Avenue is slowly liquidating the fund.
Even some of the stellar managers who have helped finance the pre-IPO tech unicorns to boost their returns may find it harder to justify the sky-high valuations given that the tech-heavy Nasdaq Composite index in January experienced one of its biggest monthly downturns since October 2008. The next shoe to drop could be these unicorns, which by their very nature are illiquid and hard to value. Unlike hedge funds, private equity and venture capital funds have more leeway on valuation because managers take no incentive fees until the funds mature.
Because hedge fund managers take performance fees every year, the going-private trend worries investors. “Valuation in less liquid markets has always been of concern, and the increasing movement into true private equity by hedge funds adds to the concern,” says Michael Hennessy, co-founder of Chapel Hill, North Carolina–based fund-of-funds firm Morgan Creek Capital Management. “It’s not just related to valuations but also liquidity, general overall risk management and accurate accounting for performance-based fees.”
The issue is so important that a group of top hedge fund investors, including major pensions and endowments, known as the Alignment of Interests Association, which grew out of the problems of 2008, has come up with specific guidance on valuation for hedge funds. The group asserts that “investment by independent third parties using industry best practices should be used whenever possible.” Funds should also have a policy for designating hard-to-value assets, known as Level 2 and Level 3 assets, that’s clearly disclosed to investors, the organization says, and “any material changes in valuation policies or methodologies should be clearly communicated to investors when they occur.”
If the illiquids become material, consultant Lisle says, at the very least, “get the hedge fund to side pocket it” — and make sure it doesn’t take fees on the side pocket until the gains are realized.
If any hedge fund handles private investments right, investors say, it’s Chase Coleman’s Tiger Global Management, whose privates are typically late-stage investments and limited to 15 percent of its $6.5 billion hedge fund, with a two-year lock-up and a three-year redemption cycle. The longer cycle would help Tiger Global in the event of a prolonged downturn, but in recent years that has not been a concern. The firm has repeatedly offered to return capital to investors. Last year only 7 to 8 percent of the fund was in privates — far below the contractual limit.
Tiger Global declined to comment, but investors say it has a big team of valuation experts looking at discounted cash flows, comparables and recent transactions. Last year its hedge fund gained 6.6 percent, compared with only 1.4 percent for the S&P 500 index. But tech stocks are getting hammered, and the fund lost 14 percent in January, investors say. The firm won’t say whether its hedge fund avoided the type of write-downs that some mutual funds have been undertaking on their unicorn holdings.
One of those companies is photo-messaging service Snapchat, which has gained a lofty $16 billion valuation even before hitting the public markets. In November mutual fund giant Fidelity Investments, which invested in late-round financing for Snapchat, said it had sliced the company’s value by 25 percent. The write-down happened at about the same time that the Wall Street Journal reported that the SEC is looking into how mutual funds, with their daily liquidity, are valuing the private tech companies in which they’ve invested.
Can hedge fund firms escape the SEC’s radar? Snapchat’s most prominent backer is Coatue Management, which made a $50 million early-stage investment in the company; the tech-oriented firm run by Philippe Laffont also launched a $450 million hybrid private equity–hedge fund vehicle. Coatue declined to comment, but such funds typically assess annual incentive fees. Snapchat has been popular among others in the hedge fund crowd, garnering investments from Glade Brook Capital Partners and York Capital Management in its latest financing round.
Until now the private holdings have bolstered returns, and investors are sanguine about the future. “But even if, on average, they get it right, the securities are illiquid, so nobody really knows what the value is,” warns Peter Hecht, senior investment strategist at Evanston, Illinois–based Evanston Capital Management, which invests in hedge funds.
One of privates’ biggest selling points is that they lower the volatility of the fund’s returns. But that can be illusory, Hecht points out. “Even if your manager is honest, even if he’s as white as snow, you have this issue with privates,” he says. “If you look at reported return streams, you are going to underestimate the risk.” Because privates’ values tend to lag the instantaneous prices in public markets, their returns tend to get smoothed out over time, Hecht says. As a result, it is likely that “you’re going to underestimate the beta and overestimate alpha,” he says. “It can be huge.”
In another asset class, last year’s SEC case against Lynn Tilton and her New York–based private equity firm, Patriarch Partners, is an example of what can go terribly wrong in the world of privates. The agency accused Tilton — known as the diva of distressed investing for her flamboyant wardrobe of miniskirts and stilettos and her penchant for private helicopter travel — of defrauding investors by hiding the true value of her private equity funds’ investments and charging $200 million in undeserved fees.
Tilton had bundled loans of companies she controlled and placed them in three collateralized loan obligation funds called Zohar I, II and III, raising $2.5 billion. Tilton was often the CEO of those companies and managed the collateral for the loans as well. She refused to write down the loans even when the companies quit paying interest, the SEC said. Meanwhile, she continued to take incentive fees on the funds. Zohar I finally filed for bankruptcy in November, when the loans matured, and the fund had no cash to pay investors.
“Tilton violated her fiduciary duty to her clients when she exercised subjective discretion over valuation levels, creating a major conflict of interest that was never disclosed to them,” SEC enforcement director Andrew Ceresney said when the agency charged her last March. Tilton, who declined to comment, has denied the SEC’s accusations and tried unsuccessfully to move the case from the agency’s in-house administrative court to federal court.
One investor who told Alpha he turned down the Zohar investments has a good piece of advice for others: Read the documents carefully. That might have helped Canada’s PSP with its Saba investment. Saba’s offering documents talk about using “external pricing sources” to value illiquid securities. But in the end the asset’s value seems to depend on the “opinion” of Saba.
In court papers PSP claims that Saba regularly priced the value of illiquid bonds of newspaper publisher McClatchy Co. using the required external pricing sources. But PSP claims that when it wanted its money back, Saba “changed course” and went to a “bids wanted in competition” methodology, searching for lowball bids even though it never sold the McClatchy bonds. As soon as PSP redeemed, Saba marked the bonds back up using the previous method, the pension plan claims.
Before last March, Duff & Phelps and Reuters were the typical external pricing sources used by Saba, its lawyer acknowledged at a court hearing on December 10. But during the month PSP redeemed, actual broker bids were offered by Goldman Sachs Group and used to mark the bonds, he added.
In the end, the methodology may not matter. “If the investment manager determines that the valuation of the securities . . . does not fairly represent fair value, the investment manager will value such securities as it reasonably determines,” the Saba offering document reads. The values determined by the investment manager “will be final and conclusive.”
Saba’s documents do appear to give it leeway, but the pension fund may have a case if it can show that the firm deviated from normal practice, securities lawyers say. “If you can show Saba did it in bad faith for the purpose of minimizing the redemption, that’s problematic,” says Kasowitz’s Bowe.
Saba insists that it did nothing wrong and so far has been unwilling to settle. But the reputational damage likely has been done. Even if Weinstein wins the case, investors say it may be tough for him to persuade new investors to sign on.
The lesson in all these valuation examples is that it pays to be wary. “Protect yourself,” cautions Evanston’s Hecht. “You should go into every meeting thinking markets are close to efficient, but there are a lot of good salespeople out there. Approach everything with skepticism.”
That’s a wise philosophy in good or bad times.
