Good Risk Governance Pays - Investment Best Practices | Risk Management | Valuation

My comments on April 3 about investment fraud and risk governance struck a chord. As a co-presenter for "Going Beyond the Essential Background Checks: Accessing Crucial Information About the Management Team, Board of Directors, the Economics for the Team and the Succession of the Investment Staff," 4th Annual Due Diligence & On-Going Monitoring of Alternative Investments Summit, Financial Research Associates, LLC, I talked about the numerous reasons why a typical background check is necessary but insufficient.

Send an email to Dr. Susan Mangiero if you would like more information about investment fraud thought leadership under way.

In the meantime, some hot button items that should be considered by institutional investors and asset managers that want to be green lighted by pensions, endowments, foundations, family offices and sovereign wealth funds include, but are not limited to, the following:

• Legal Ownership Structure - Ask for information about who owns what, who has voting rights and whether or when assets can be transferred across legal and tax jurisdictions. If an asset manager cannot or will not provide an organization chart and legal documentation that explains an often complex ownership structure, think twice about taking next steps. I resigned from an assigment to value a U.S. hedge fund limited liability partnership ("LLP") when the CEO and the company's attorney begrudgingly provided by-laws and an organization chart that illustrated firsthand a hard-to-understand web of cross-ownership (offshore and onshore). Should trouble occur, it is imperative to understand how economic rights are distributed and on what basis.
• Job Descriptions - A titular executive is not the same thing as having an experienced and knowledgeable person fill a critical function. As an expert witness, I wrote a report that pointed out, among other things, that the Chief Risk Officer was in name only. The actual person who bore that title was anything but a risk management professional.
• Internal Controls - Entire books have been written about the importance of vetting operational risks and internal controls. Suffice it to say, make sure that important tasks such as trading and approving wire transfers are each carried out by different individuals. Transactions should be verified on a regular basis by independent parties. Checks and balances should be in place to avoid breach for items such as surpassing trade size, making a material change to investment reports and/or modifying the approval process for moving money.
• Complexity and Model Risk - As I discussed in "Model Risk and A $242 Million Overlay" (February 3, 2011), models can be nested so that mistakes made at one level can be catastrophic if not caught early and corrected. That is exactly what happened in a matter relating to AXA Rosenberg, costing the firm nearly $250 million. Someone has to kick the tires on a regular basis. Model audits should be conducted by individuals who are not going to be compensated on the basis of a model's outcome(s).  When trading strategies are complex, it is sometimes tough to identify problem areas. I remember the words of one of my doctoral professors vividly because they still ring true today. "If you can't explain a trading strategy or make-up of a model, you don't know enough to make important decisions."
• Key Person Risk - Marquee name traders may be a draw for institutional and high net worth investors but proceed with caution. First of all, banking on a name trader does not guarantee that good processes are in place. Second, it is critical to know if key person insurance is in place to address the early exit of a trader or executive and the exact nature of the coverage. Also inquire about what happens if a key person gets a divorce and an ownership stake in the asset management firm becomes part of the settlement. Investigate whether the firm has a succession plan, a non-compete contract for departing executives and/or buy-sell agreement to guide how partners leave or join the firm.
• Intellectual Property - Ask about ownership of a patent, trademark, proprietary technology and/or marketing/sales collateral. In one situation, there was a real concern that the head of sales would have carte blanche to use the client list on behalf of a competitor. Depending on the costs to acquire each client, use of a list elsewhere could deal a crushing blow to a firm and by extension, destroy value for limited partners and/or investors in a particular fund or fund family.
• Governance and Committee Structure - A board of advisors can serve as a line of defense for investors in a fund as long as its members do their job well. I recall being interviewed to serve as an expert for a large hedge fund litigation. After having read the initial documents, I told the attorneys that the existence of a pricing committee and a risk management committee was impressive and asked to see the meeting minutes. The response was that neither committee had ever met. Of course a committee could meet on a regular basis but never address critical issues and thereby be ineffective, offering no safeguard for an investor(s).
• Vendor Contracts - Unless someone is doing a comprehensive review of service provider contracts, an investor is likely to encounter a coverage gap. In the matter of hard-to-value investing for example, many times an independent verification of prices is left undone when fund of funds managers, prime brokers, custodian banks and/or consultants accept numbers from hedge fund and private equity funds "as is" as part of their respective contracts.
  
• Investment Reports - Financial statements, audited or otherwise, do not always provide the same information on investment reports. The topic of performance reporting is left for another post as it is both broad and complicated. Suffice it to say however, all investors should be treated equally in terms of information access. With side letters and side pocket arrangements, disclosure may be limited and provided on a selective basis. As an expert on a regulatory enforcement case, I explained what industry standards exist for reporting true economic risks and returns versus statements that may be misleading at best. The hedge fund being investigated had topped off losses for some investors but not others and used some creative ways to report results.
• Borrowing Capacity - In 2008 and 2009, numerous investors were taken by surprise when asset managers were unable to honor redemptions (if allowed in the first place). One indicator (and there were many) of a liquidity crisis was the inability for some asset managers to borrow enough cash to keep going. Even worse, some prime brokers pulled back existing credit lines and/or charged considerably more which in turn depressed potential upside for investors. Ask about the current costs of borrowing and the capacity and sources for an asset manager to borrow more if needed. Depending on the leverage inherent in an asset manager's trading strategy, it may be necessary to ask for a copy of borrowing agreements and to understand what could trigger a margin call(s).

The list of problem areas is long and worthy of close scrutiny, ideally by an independent third party who can work with the internal auditor, external auditor and/or board of directors (assuming that all of these parties are focused on best practices and not contributing to a fund's downfall). Institutional and high-net worth investors alike should monitor these and other risk factors before writing a check.

Background checks are invaluable tools for investors who want to conduct proper due diligence. Importantly however, a background check is simply not going to provide the kind of information described above that can make a difference between investment success and failure.

Insider trading, anti-money laundering, investment fraud techniques and much more are left for future blog posts...

Gold has received a thumbs up from J.P. Morgan as a form of collateral for repurchase and securities lending transactions. This means that someone will need to assign a value for each unit of physical bullion and then store the amount that relates to estimated counterparty risk. According to "J.P. Morgan Will Accept Gold as Type of Collateral" by Carolyn Cui and Rhiannon Hoyle (Wall Street Journal, February 8, 2011), illiquidity fears have discouraged financial institutions from accepting gold as collateral in the past. The World Gold Council website reports that trading is a 24-hour operation, rendering the global gold market as "deep and liquid."

In contrast, a few days later, it was reported that a 300 million euro pension fund, the Stichting Pensioenfonds Vereenigde Glasfabrieken ("SPVG"), was directed to reduce its gold holdings from 13% of its assets to between 1% and 3%. The reported concern on the part of the Dutch pension regulatory body, the Nederlandsche Bank ("DNB") is price risk. Although gold has risen from $600 per ounce to in excess of $1,000 per ounce since 2008, when the Dutch glassmaking company's retirement scheme purchased bullion, a drop in value could lower the solvency ratio.

Several issues come to mind about the use of gold for financial purposes. For one thing, if I am investing in the stock of a bank that accepts gold as collateral for a large amount of transactions, I'd like to know if the bank is hedging the metal and, if so, to what extent. I'd also like to understand how they price commodities like gold and the frequency with which they reassess counterparty risk. For an institutional investor like a pension fund that holds gold as an investment, it would be helpful to understand: (a) whether they own physical quantities or stock in a company that mines the metal (b) how value is assessed and on what basis (c) whether gold holdings are hedged and, if so, to what extent (d) what role gold plays (i.e. diversification, safety, etc). An economic analysis of the risk-return for gold, like anything else, is paramount and must consider multiple factors, some of which are listed here.

According to "Insider Probe Impact Felt by Pension Funds" by Steve Eder (Wall Street Journal, January 24, 2011), those hedge funds that are being investigated by the FBI may find themselves confronted with even more challenges. If they are forced to sell positions that are deemed "bad" because they resulted from the use of material, non-public information, they could realize an economic loss on top of incurring transaction fees not originally anticipated, including the disgorgement of specified profits. Additionally, if any worried institutional investors want out early, hedge funds being probed may find themselves facing unplanned redemptions. Unless their prime broker (assuming they have one) provides offsetting capital in the form of a cost-effective credit line, a liquidity squeeze could occur.

Although some institutions such as pensions, endowments and foundations invest in hedge funds to diversify their respective portfolios over the long-term, uncertainty about a manager's ability to remain in business can trigger a run which in itself has the potential to hasten its demise. In some cases, a fund manager may offer reduced fees to its investors as a way to buy time and try to get back on the road to recovery.

In the event that a lawsuit is filed, there are numerous liquidity risk factors that must be taken into account. For one thing, it is necessary to know if lockups were accepted by investors. If so, on what terms? If redemption rights existed but a hedge fund chooses not to allow redemptions (which has occurred as an unwelcome surprise to investors), economic damages would have to take into account what (if any) provisions the hedge fund management team had made in order to satisfy withdrawal requests before trouble began. In addition, an analysis would have to take into account whether and on what terms (cost) a hedge fund could sell off part of its holdings to raise cash and whether (and why) credit facilities could be rescinded. The ability to raise cash from new and/or existing investors is another issue, along with whether a hedge fund is overly dependent on just a handful of investors.

The foregoing is not an exhaustive list. Every situation relies on relevant facts and circumstances but one thing is certain. There is no free lunch. There is a cost associated with illiquidity risk.