Hedge Fund Good Risk Governance Pays Susan Mangiero Certified Financial Risk Manager Risk

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SEC Reports Strong Enforcement Year Due to New Analytical Tools

Posted by Susan Mangiero on October 19, 2014

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According to an October 16, 2014 press release, the U.S. Securities and Exchange Commission (SEC) reports a record 755 enforcement actions covering a wide range of misconduct, and obtained orders totaling $4.16 billion in disgorgement and penalties. for the fiscal year-end ending in September 2014. One reason given for this increase from prior years is the enhanced use of data and quantitative analysis.

From what I have read, these technology-focused tools include proprietary risk analytics to evaluate hedge fund returns, part of the SEC’s Aberrational Performany Inquiry initiative. The idea is that reported returns should comport with the underlying investment strategy and selection of benchmark. If returns appear inflated, inquiries are likely to follow. Asset managers that are legitimately managing money in accordance with their stated approch may want to check the extent to which their calculations are transparent and effectively communicated to investors.

The Accounting Quality Model (AQM) is another technique that is described by the Association of Certified Fraud Examiners as having real potential to be a game-changer. In SEC Announces Enforcement Initiatives to Combat Financial Reporting and Microcap Fraud and Enhance Risk Analysis (July 2, 2013), the Financial Reporting and Audit Task Force is said to expand and strengthen its focus on fraud detection and poor auditing procedures. Stated areas of emphasis include financial statement revisions, how a company performs relative to industry peers and whether proper disclosures are being made to investors.

Attorney Andrew J. Morris with Morvillo LLP gives readers some helpful insights about the AQM in his article entitled A Look Inside The SEC’s Accounting Quality Model (Law360, January 6, 2014). Using its vast library of company data, the SEC wants to systematically identify financial reports that suggest inferior earnings quality, caused by inappropriate accounting judgments. Since filings must now be formatted using eXtensible Business Reporting Language (XBRL ), the SEC can take advantage of the uniformity of data fields to automatically parse what its algorithm determines as an outlier. As Mr. Morris points out, company management has a certain amount of accounting latitude. A regulatory model may generate what he calls a false positive because it does not consider that flexibility. Should that situation occur, a company will have to expend time and money to justify its accounting policies. His recommendation is to thoroughly document these judgement calls ahead of time. Examining how other companies in an industry determine important metrics is another good thing to do. Auditors play a vital role by conducting thorough analytical reviews that resolve all anomalies and then reconciling any problem areas that arise as a result of that ex ante assessment.

As BakerHostetler partner John Carney and associate Francesca Harker point out, the SEC has a powerful agent in its corner now. As the SEC computer trawls continuously uploaded financial data, it will generate a risk score to determine whether a filing is given a quick, unsuspecting review, or whether it is thoroughly dissected by an SEC exam team, possibly leading to an expensive audit. Besides benchmarking financial reporting against industry norms, Mr. Carney and Ms. Harker urge companies to check their work since RoboCop cannot distinguish between honest errors and oddities. They further opine that the use of off-balance sheet transactions should be deemed reasonable and that discretionary accruals should be conservative. See Corporate Filers Beware: New ‘RoboCop’ Is On Patrol (Forbes. August 9, 2013).

My firsthand knowledge of financial statement analysis is that one must understand the different ways that numbers can be assembled and what the end results truly represent. It is necessary to be a financial detective. I have taught multiple financial statement analysis courses. I have worked with external and internal company auditors. I have rendered opinions of value and reviewed appraisal reports done by others. I have served as a forensic economist on multiple dispute matters that entailed taking a deep dive into how specific metrics are computed. The work is far from trivial and can be quite complex. A company that provides specificity about its policy choices is typically in a far better position than when an objective third party is forced to second guess why one approach was selected over another. It is a lot easier to give a company the benefit of the doubt when ample policy breadcrumbs exist. Good documentation is less disruptive when employees leave and others are asked to assume their responsibilities.

I could write volumes about earnings quality and ratio techniques. There is so much to say. For now, let me suggest that companies and their attorneys may want to likewise perform a Dupont analysis on a regular basis. It is a technique that, if applied correctly, enables a financial statement user to better understand different aspects of how a company is run and to ask appropriate questions. Email contact@fiduciaryleadership.com if you want a copy of Why the DuPont Model is Important by Dr. Susan Mangiero (Valuation Strategies. January/February 2004).

Plato said that A good decision is based on knowledge and not on numbers. That makes sense but does not change the fact that regulators are watching the numbers.

Expert Networks and Fiduciary Duties

Posted by Susan Mangiero on September 08, 2014

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I was recently asked by an attorney I know for my governance opinion about the use of expert networks. He has a pension fund client that is pondering whether to allocate money to a hedge fund that is a frequent user of expert network services. As is typically the case, I answered It depends. Is the expert network sponsored by an organization that self-polices as to who shares information and on what basis? Does that organization ask its experts to take training as to what constitutes material non-public information? Is compliance with existing rules and regulations about material non-public information disclosure regularly monitored? Are the experts providing their general opinion about industry trends or tipping close to the edge of spilling the beans about proprietary company actions?

Certainy an individual with a fiduciary duty to trust beneficiaries (such as a pension plan investment committee member) should be asking the hedge fund about how it uses expert networks. One might even assert that it would be bad business to avoid experts if the compliance and governance boxes have been checked off and there is a robust instrastructure in place about appropriate knowledge-sharing.

Speaking from personal experience, I have turned down nearly all of the requests made of me by the one expert network with which I am registered. They seem to have a thorough compliance program in place and I am regularly asked to take training anew about the use of material non-public information. That is not the concern although admittedly, it has been over a year since I updated my profile with them. My discomfort stems from the kinds of facts and observations I am asked to share. If I have worked for or with a particular firm, I am not prepared to talk about strategy which I gleaned while in that unique position.

In my research, I did not find many articles or white papers on this specific topic of pension fund allocation to hedge funds that use expert networks. According to Insider Probe Impact Felt by Pension Fund (January 24, 2011), Wall Street Journal writer Steve Eder described the difficult position that fiduciaries found themselves in when some of their asset managers were questioned by U.S. officials about trading decisions tied to expert network interactions.

In general, pension plan fiduciaries have a critical job to do in vetting their asset managers. They need to get their questions answered or possibly consider diverting monies to another manager. There is no free lunch. Even liquidating a position with one hedge fund to go elsewhere could be costly due to early withdrawal penalties.

As with anything else, caveat emptor rings true when it comes to the use of expert networks by asset managers and, by extension, putting dollars with said asset managers by institutional fiduciaries.

Muni Bonds, Pension Liabilities and Investment Due Diligence

Posted by Susan Mangiero on August 06, 2014

Hot off the press and courtesy of the American Bankruptcy Institute, Muni Bonds, Pension Liabilities and Investment Due Diligence by Dr. Susan Mangiero, Dr. Israel Shaked and Mr. Brad Orelowitz, CPA covers a litany of headline-ripping issues. The quality of financial disclosures, legal uncertainty about the treatment of pension benefit contracts with state and city employees, regulatory mandates and the presence of hedge funds as buyers of deep discount bonds are a few subjects covered by the authors in this educational piece.

They emphasize that decisions rendered by the courts could assist future investors. One positive aspect is that the legal, economic and political skirmishes associated with municipal bond distress now being played out are helping to set the stage for future clarity. For example, if prospective investors are comfortable in their belief that large unfunded post-employment obligations can be compromised as part of a distressed-debt workout because they see that tact as succeeding now, they might be willing to nevertheless allocate monies to pension-plagued cities and states, albeit at a higher yield. In turn, that fresh capital can be a lifeline for a municipality that has fallen on hard times, even if it comes with a higher service cost.

Another section of this July 2014 article looks at recent litigation activity, with a prediction of further lawsuits being filed against bank underwriters, rating agencies, financial advisory firms and asset managers with deep pockets. One reason for this has to do with a spotlight on public financing that is unlikely to dim any time soon. Questions about the scope of due diligence carried out on potential and existing issuers are currently being asked by the U.S. Securities and Exchange Commission (SEC). Earlier this year, LeeAnn Ghazil Gaunt, SEC head of the enforcement division unit that covers municipal securities and public pensions talked about the importance of ongoing disclosures as a critical source of information for investors. See SEC Launches Enforcement Cooperation Initiative for Municipal Issuers and Underwriters (March 10, 2014). In September of this year, the Government Accounting Standards Board (GASB) will hold public hearings about its rules for reporting Other Post-Employment Retirement Benefits (OPEB). Click here to learn more.

In case you missed it, the U.S. Treasury has created a new office to examine public pension issues. Its Director of the State and Local Finance Office, Mr. Kent Hiteshew, recently told those who attended a meeting of the Council of State Governments that Q1-2014 liabilities of $5.03 trillion are the largest ever since 1945 and the collective funding gap has widened since the 2007-2009 recession. See U.S. Treasury to put public pensions under scrutiny (Business Insurance. August 5, 2014) and Treasury Creating Office of State and Local Finance by Kyle Glazier and Naomi Jagoda (The Bond Buyer. April 17, 2014).

Further focus on municipal benefit arrangements is no surprise. As I’ve long maintained, government-sponsored retirement plan funding problems can lead to higher taxes and may lose votes for incumbents. Lawmakers no doubt want to avoid any kind of costly bailout, especially given the recent warning that Neither Medicare nor Social Security can sustain projected long-run program costs in full under currently scheduled financing, and legislative changes are necessary to avoid disruptive consequences for beneficiaries and taxpayers. Click here to read more from the Social Security and Medicare Boards of Trustees.

Institutional Investors Uniting Over Limited Partner Terms

Posted by Susan Mangiero on May 29, 2014

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During a recent trip to London, I had a fascinating discussion with a UK attorney who advises institutional investors on contract terms. One of her admonitions to clients is to negotiate hard with a general partner and embrace the power of the purse rather than accept less favorable terms with respect to fees, transparency and other rights. I have been hearing the same message in the United States get louder as time marches on. Indeed, some institutional investors have told me that they are prepared to go elsewhere if their demands are not met, particularly if a failure to get adequate information and protection imperils the ability to carry out their individual and collective fiduciary duties. This important supply-demand push-pull dynamic, coupled with real liability exposure for trustees and other types of investment stewards, is critical for asset managers to acknowledge and embrace in an increasingly competitive marketplace. I have been told by institutional investors that a sympathetic ear counts for a lot.

In a recent article entitled Hedge Fund Investors Rejecting Firms Over Transparency (FINalternatives. May 28, 2014), the point is made that 89% of polled institutions, family offices and high net worth individuals have declined to put money with at least one hedge fund due to transparency concerns. For private-equity and real-estate funds, the number is 71%. While survey respondents admit to improvement in how much information they are receiving, they want additional data about factors such as exposures and leverage. Frequency is another preference with quarterly reports being classified as too late to be helpful.

FORTUNE Magazine private equity guru Dan Primack decries the veil of secrecy that public pension plans maintain with respect to their private equity investments. In What public pensions should (and shouldn’t) disclose about their private equity investments (May 6, 2014), he suggests federal regulations to force detailed reports if states and municipalities choose not to disclose on a voluntary basis. He adds that pensioners and taxpayers have a right to know about things such as how much a retirement plan investment committee has allocated to a particular asset manager. In addition, he writes that performance should be published but with adjustments to reflect the reality of the J-curve effect wherein returns for a new asset management vehicle could be negative for the first few years. The amount of base fees that are paid by a public pension fund investor each year, along with the percentage of carried interest — plus the percentage of ancillary fees that accrue to limited partners should likewise be disclosed. Finally, the use of a placement agent should be made known as well as the terms associated with that party.

Where I part company with Mr. Primack is in the area of private-equity fund and venture capital fund compensation. He writes that Personal compensation is a touchy thing for many people, and disclosing it in this case likely would cause certain VC and PE firms to stop taking public pension commitments. My experience, based on work as a forensic economist who is hired as part of a regulatory enforcement or civil litigation or arbitration dispute, suggests that inherent conflicts of interest can arise and will remain unchecked until too late, if monetary incentives are a mystery. Consider the problems that arise should a private-equity or venture capital fund self-report valuations. These same valuations drive the performance numbers that are shared with institutional investors. They likewise determine the level of fees paid by those same pensions, endowments, foundations and so on. General partners will arguably receive higher bonuses and other types of compensation if fee revenue goes up. This chain of events that reflects a conflict of interest and possible excess fees paid by limited partners is a slippery slope and hard to avoid unless more about the reward system is known.

Board governance is yet another issue that is proving troublesome at best for institutional investor limited partners. Some asset managers have admitted to me that they were not greenlighted by a pension plan or other type of investor with large amounts of capital to deploy because they had no independent board representatives, no outside advisory board and/or there was a dearth of committees to address serious topics such as pricing and risk management.

Fees, as mentioned earlier, can be another stumbling block. As highlighted in her May 24, 2014 piece about private equity funds, New York Times journalist Gretchen Morgenson described annual monitoring fees that would still have to be paid by limited partners, even if a portfolio company has an exit via acquisition. Refer to The Deal’s Done. But Not the Fees. She goes on to say that some expenses such as monies paid to engage industry experts are not always reimbursed to investors and that, post Dodd-Frank, the U.S. Securities and Exchange Commission (SEC) can and is taking a hard look at the fees charged by firmst that comprise the $3.5 trillion private equity market.

Ms. Morgenson references a recent speech by SEC executive Andrew Bowden, as expressing concern about recent exam results. Specifically, in his comments before the Private Fund Compliance Forum 2014, this director of the Office of Compliance Inspections and Examinations (OCIE) raised eyebrows when he said that By far, the most common observation our examiners have made when examining private equity firms has to do with the advisers collection of fees and allocation of expenses. When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time. Refer to Spreading Sunshine in Private Equity (May 6, 2014).

I am currently conducting extensive research in the area of private fund contracts and will publish the analysis when it is complete. Suffice it to say that the conversations about who gets what, when and how at the private fund bargaining table are sometimes heated.

Due Diligence & Regulatory Hot Buttons: What Advisors Need to Know About Liquid Alts

Posted by Susan Mangiero on May 02, 2014

I am delighted to join a top-notch panel of financial speakers to talk about the explosive growth in the liquid alternatives (alts) market. Courtesy of the Center for Due Diligence. our session will take place on October 15, 2014 in San Antonio, Texas and will be part of what is expected to be a lively and informative conference about due diligence, compliance and investment governance.

To identify the red flags that should make advisors nervous about recommending a particular manager and/or product, join our distinguished panel for a lively discussion about the fiduciary implications applicable to advisors who are considering Liquid Alts for small and mid-market retirement plan clients.

Hedge Fund and Private Equity Fund General Counsel Workshop

Posted by Susan Mangiero on April 17, 2014

I am pleased to announce that I will be presenting on April 23 as part of an educational and timely convening for hedge fund and private equity fund General Counsel, legal staff and compliance professionals. Presented by Dechert ‘s Financial Services and White Collar and Securities Litigation Groups, this workshop will include sessions as described below.

SEC and Investor Areas of Focus in the Private Fund Industry

Priorities in SEC exams;
Discussion of operational and risk management issues around the use of models; and
Concerns voiced by institutional investors with respect to private funds.

Marketing in Europe

Marketing approaches in Europe what can (and cant) you say and do;
National private placement regimes the consequences for US managers; and
The impact of disclosure and transparency requirements on US managers and their service providers.

New York Attorney General’s Recent Focus on So-Called Insider Trading 2.0

An overview of New Yorks Martin Act;
NYAGs agreements relating to private funds use of consumer confidence surveys, research analyst surveys and wire services;
The NYAGs investigation of exchange co-location agreements; and
Issues raised by the new Michael Lewis book on high-frequency trading: Flash Boys.

This event will run from 8:30 am to 10:00 am EST in New York City. Breakfast will be served. Attendees may be eligible for continuing legal education credits.

This event is by invitation only. If you are interested in attending, send a request via email to kara.hardie@dechert.com or call Ms. Kara Hardie at 202-261-3493. Please mention that you learned of the event by reading this blog post, authored by Dr. Susan Mangiero, when making an inquiry.

ERISA Pension Plan Investing in Hedge Funds and Private Equity Funds

Posted by Susan Mangiero on March 25, 2014

ERISA Pension Plans: Mitigating Liability Risks for Hedge and Private Equity Fund Alternative Investments

Posted by Susan Mangiero on March 17, 2014

I have the pleasure of being part of an April 17, 2014 program for Strafford’s continuing legal education offerings for and about ERISA plans. As a courtesy, I can invite up to ten (10) professionals as my guest. If you are interested, send an email to contact@fiduciaryleadership.com with your name, email address, title and company affiliation. See below for further information about this exciting program or click here to learn more.

This CLE webinar will provide ERISA and asset management counsel with a review of effective due diligence practices for institutional investors. The panel will offer best practices to mitigate government scrutiny and suits by plan participants.

Description

The DOL’s and SEC’s new disclosure rules and heightened attention on compliance and valuation mean corporate pension plans are subject to new scrutiny. Plans that invest in alternatives must focus on properly vetting asset managers more than everor risk claims of poor governance and excessive risk-taking.

Advisors to hedge funds and other private funds have been impacted by new regulations in the past few years. Understanding asset managers’ obligations is essential to any retirement funds with limited partnership interests.

In addition, suits and enforcement actions against asset managers are on the rise. Counsel to hedge fund and private equity fund managers must fully grasp and guide clients on full compliance with the duties of ERISA fiduciaries to plan participants.

Listen as our ERISA-experienced panel of benefits counsel and professionals provides a guide to the legal and investment landmines that can destroy portfolio values and expose institutional investors and fund managers to liability risks. The panel will review new ERISA considerations for 2014 following recent regulatory changes and outline best practices for implementing effective due diligence procedures.