The neverending staircase
You may have seen various versions of the optical illusion of the neverending staircase - a stairway under which, no matter how far you walk, you don't get any higher. One of the most famous versions is the drawing by M.C. Escher, "Ascending and Descending" (see wiki article)
Why this analogy? Well, we thought that we would open 2010 with another comment on the issue of responsibility for valuation of hedge fund portfolio securities. Based on the various prospectuses that have recently come across our desks, "up to date" offering documents seem to be converging around a standard set of disclosures. Unfortunately, the cumulative effect, for the investor at least, is pretty much the same as the neverending staircase.
The starting point in most PPM's (Private Placement Memorandum) is usually to state that the board of directors is responsible for managing the business of the fund, which would include, inter alia, valuation and calculation of the NAV. Indeed, to this point, many best practice guidance papers (AIMA, IOSCO etc.) all state that the "governing body", i.e. the Board, is the entity "responsible" for valuation.
However, not so fast.
This structure creates multiple problems. The first is obvious - corporate secretaries in the Cayman Islands, serving on the board of hundreds and hundreds of hedge funds, clearly have no capability whatsoever to value complex financial instruments. Directors get round this minor hiccup in two ways: (i) to specify that they may rely upon information furnished to them by the Investment Manager and (ii) to delegate the calculation of the NAV to the Administrator, as we will discuss in a moment.
While we are not lawyers ourselves, we can give a layman's view as to the degree of liability and responsibility Cayman law places on a fund director - in simple terms, not much. We stand to be corrected by more informed legal minds, but, in our understanding, Cayman directors have a fiduciary duty to the fund (not to the shareholders) simply to act honestly and in good faith. The problem with this logic is that, unless a director is presented with direct evidence of fraud, every director will always be of the view that their reliance on the investment manager's security prices, for example, is undertaken honestly and in good faith.
(As an aside, as we discussed recently, one of the latest innovations from Cayman counsel is simply to put in the PPM that the Directors are not responsible for valuation at all. Not helpful for investors, but at least one of the Cayman directorship shops tells it like it is).
So let's turn to the admin. Usually, the prospectus starts with reassuring language that the board has delegated the calculation of the NAV to the administrator. However, the offering document will then state that the administrator is obligated to follow the procedures outlined in the PPM related to "calculation of the net asset value".
Here the fun really starts, as this section of the PPM will usually state that it is the Investment Manager, not the administrator, who will determine the prices for any hard to value securities (such as those not listed on an exchange). While the PPM may say that the Manager must act in "good faith", the phrase "in the sole discretion of the Investment Manager" will likely be repeated on multiple occasions. As we have often noted, it goes without saying that if investors are to lose money due to valuation fraud, it is unlikely to be as a result of deliberate mismarking of IBM common stock - the culprits will be hard to value, Level 2 and 3 positions.
Moreover, the final paragraph of the PPM's net asset section usually ends with something along the lines of "the Board of Directors, in consultant with the Investment Manager, may permit any other method of valuation to be used which is considered to better represent fair value". As above, the directors can, of course, accept any recommendation from the manager provided that, in doing so, they act honestly and in good faith.
Just in case this framework was not clear enough, the administrator usually inserts a PPM disclosure stating that they are entitled to rely upon (and shall not be responsible for the accuracy of) financial data provided to them by prime broker, third party pricing services or the investment manager. Moreover, the administrator will state that if the Board or the Investment Manager is involved in the pricing of any of the Fund's securities, the Administrator may accept such prices without any further liability.
So we come to the neverending staircase - investors hoping for independent pricing look to the board, then to the administrator...and find themselves back just where they started, with pricing responsibility - at least for anything where prices could be more easily manipulated - back with the manager.
As we look towards 2010 and the renewed growth of our industry, this issue is, in our view at least, the achilles heel of hedge fund investing. It is nearly a decade since Lipper, Lancer and Beacon Hill, yet the core issue in these cases - managers pricing their own books without effective administrator oversight - remains unresolved. Indeed, as we have illustrated above, the biggest change since 2002 is for fund offering documents to be far more explicit to disclose and disclaim responsibility. This is the exact opposite of working to close this control loophole.
There are many possible solutions, starting, of course, with careful due diligence. Looking forward, we see potential for a redefinition of service provider roles and responsibilities, realignment of fee structures with a focus on vesting and deferral, emergence of new valuation specialists in addition to traditional administrators and wider use of managed accounts. These are just a handful of suggestions among a much longer list of tools which could be deployed. We encourage both investors and managers to challenge the legal status quo and look for better solutions - being proactive is clearly preferable to waiting for Lipper 2.0.
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