The quarter past: Hedge Funds Stagger Through First Quarter '08
Lipper HedgeWorld Staff, Chicago.
The last half of 2007 was a lousy one for hedge funds, thanks to the credit crunch. So far, 2008 hasn’t been much of a picnic, either.
Société Générale (SocGen), one of Europe’s largest financial groups with a worldwide staff of 120,000, revealed on 24 January that it uncovered a fraud that the firm said was ‘exceptional in its size and nature’. The fraud, which SocGen said would have a negative effect of €4.9 billion (US$7.18 billion) on pre-tax income for 2007, was perpetrated by a single Paris-based trader: 31-year-old Jérôme Kerviel, who was responsible for hedging plain-vanilla futures on European equities indexes.
It represented the biggest fraud ever committed by a rogue trader. According to a press release, Mr. Kerviel took ‘massive fraudulent directional positions in 2007 and 2008 beyond his limited authority’. He was able to conceal this fraud ‘through a scheme of elaborate fictitious transactions’ thanks to his knowledge of control procedures gleaned ‘from previous employment in the middle-office’, though it is not specified whether he held the position at SocGen. SocGen dismissed Mr. Kerviel and added that the trader’s managers would also leave the company.
Police later arrested another employee of Société Générale as part of its inquiry into the scandal. The Paris prosecutor’s office identified the person being held as a trader from a subsidiary of SocGen.
Following an internal review, Credit Suisse announced on 19 February it was reducing the value of some asset-backed positions by US$2.85 billion. The estimated hit on net income would be approximately US$1 billion, according to Credit Suisse. Market watchers had been perplexed by the apparent contrast in fortunes at rival banking institutions UBS AG and Credit Suisse over each bank’s mortgage-backed securities exposure. While UBS acknowledged large exposure and made equally large write-downs, Credit Suisse had emerged relatively unscathed. That led some market insiders to privately suggest that Credit Suisse had been less than forthcoming about its own mortgage-backed exposure.
That changed, at least in part, when Credit Suisse announced that ‘further to its commitment to provide transparency…’ it had ‘undertaken an internal review that has resulted in the re-pricing of certain asset-backed positions in its Structured Credit Trading business within Investment Banking.’ The reductions reflected ‘significant adverse first quarter 2008 market developments,’ the bank said.
Citigroup Inc. suspended investor withdrawals from a US$500 million credit hedge fund to give it a chance to ‘stabilise,’ a bank spokesman said on 15 February. The London-based fund, called CSO Partners (CSO), faced investor redemptions after a 10% loss in November, prompting its manager John Pickett to resign, according to Citigroup spokesman Jon Diat. The fund was up 27% since inception in August 2004 to 31 December 2007.
2008: The Year of the Activist Hedge Fund
Damien J. Park, Hedge Fund Solutions, Philadelphia.
For the past year, people have speculated activist-style investing would go the way of the Internet boom and bust witnessed earlier this decade. However, despite a weaker economic outlook, shaky credit markets, and a sub-prime turmoil upending financial markets worldwide, activist hedge funds continue to grow at remarkable rates in both number and in assets under management. Indeed, by all measures, activist investing is showing signs of credence even when other hedge fund strategies, such as quantitative investing, seem to be faltering. Much of their sustainability can be attributed to advantages in the way these funds are structured, while controversial methods of accumulating substantial ownership stakes, tag-team campaigns and new stock exchange rules should continue to foster their growth for years to come.
While many hedge funds have seen investors fleeing for the exits, on a whole, the activist fund has maintained a steady stream of capital inflows. One explanation for this can be ascribed to the fact that these investors have somewhat of a secret weapon: longer lock-up periods.
Unlike most hedge funds that allow investors to withdraw funds on a quarterly or semi-annual basis, activist-style investment vehicles typically require investors to commit to investing in the fund for a period of two to three years. In a poor economic environment, this can be the difference between a fund’s success and failure and has two real tangible benefits. First, activists are less concerned with monthly returns, ongoing redemptions and fund maintenance, which allows for a longer-term outlook on stock picking; and second, a weaker stock market often generates better investment opportunities in fundamentally sound businesses — the Rosetta Stone of an activists’ stratagem.
Armed with a greater number of militiamen and enlarged stockpiles of weaponry, activist investors are continuing to wreak havoc in boardrooms across America by being more vocal and by launching more campaigns against the establishment than ever before.
Explosion of activist investing
Early this year, Carl Icahn, one of the world’s most notable activist investors, casually remarked in an interview, ‘In today’s environment, there are a great number of companies that can use activism… I think we’re going to be very active this year.’
Based on the number of activist situations since the beginning of January, it’s safe to say Icahn isn’t the only one keeping busy. More than 80 activist campaigns have been launched at US companies across practically every industry during the first seven weeks of 2008. And while many of the insurgent names are familiar from proxy ballots a year ago (Nelson Peltz’s Trian Fund, Warren Lichtenstein’s Steel Partners, Dan Loeb’s Third Point, and Barry Rosentein’s Jana Partners), plenty of newcomers are establishing themselves on IR watch lists as ‘investors of interest,’ adding to new levels of uneasiness in weekly management meetings and regularly scheduled board meetings.
Servicing the Investment Industry with Excellence: A Personal Perspective
Edith G. Conyers, ISIS Fund Services, Bermuda.
There is no single formula for successfully matching the right fund with the right administrator, but there are a number of components that must be considered when an investment manager chooses an administrator for their fund products. This can be a difficult and time consuming process if done properly, as the needs of a manager and his products can vary greatly and must be carefully looked at against the functionality and capabilities of the potential administrator. A prerequisite to getting this right is that both sides have a good understanding of each other’s businesses. Too many managers ‘follow the herd’ and opt for an administrator they’ve heard of, and assume they can do the job — and do it well — because ‘everyone else uses them’. This is often not the case, and a large number of investment managers and their investors end up unhappy with their choices. The unfortunate thing about this is that, to some extent, they are trapped as they become suspicious of all administrators and certainly don’t want to go through the time and effort and expense of switching to a new administrator without some assurance that the experience will be that much better. To compound this, it often doesn’t reflect well on the fund or the manager when switching service providers, and may cause the investors to lose confidence in the manager’s abilities to get things right the first time.
In the 20 plus years I have been in this business, I have always found that as an administrator, the business is yours to lose because it takes a lot for funds/managers to make a move. They have to be really unhappy and fed up with the status quo. The downside for us, in our experience, is that these situations are reflected in the books and records of the companies we take on, as they are often in bad shape (be it corporate governance records, shareholder records or accounting records) and we’re the ones that get to put everything back into good order. This is no easy task and causes a great drain on resources trying to fix things.
A manager’s experience with a fund administrator should be a positive one, where the administrator is adding value to the process in each functional area. The most basic form of fund administration includes fund accounting and shareholder services. This may or may not include portfolio valuation services or comprehensive anti-money laundering services (AML), depending on your administrator and where they are based. To me, the core functionality should cover portfolio valuation (most administrators have developed particular expertise in certain areas over others), general ledger accounting, net asset value (NAV) calculations, performance and management fee calculations, equalisation and series accounting, registrar and transfer agency services including extensive AML and know your customer (KYC), accounts payable and cash administration, and last but not least, corporate secretarial services promoting good corporate governance.
Life Settlements: And Now For Something Completely Different
Allan Meyer, Wickham Investment Counsel Inc. Hamilton, Bermuda.
Introduction
I was first introduced to the idea of life settlements in 2006. I was initially drawn to the high returns and safety of this new asset class. With the volatility of the stock and bond markets over the last 12 months, the uncorrelated nature of this investment has grown in attraction. The growth and maturing of this asset class has confirmed for me that this will be an asset of special interest for many more years. I applaud the professionalism that institutional investors are bringing to this area and feel confident that more clarity is being brought to the whole investment process, to the betterment of investors and sellers.
Description
Life settlements can be described as the secondary market for life insurance policies issued primarily in the United States. In the life settlement transaction, a policyholder sells a life insurance policy, due to changing circumstances, for an immediate cash payment or ‘settlement’ to an investor. The investor pays the subsequent premiums and is entitled to receive the policy’s proceeds at the death (or ‘maturity’) of the insured. The proceeds from the sale of the life insurance policy may make a valuable contribution towards the insured individual’s search for additional liquid assets and the reduction of existing payment obligations, the premiums. Consideration paid for a life settlement is negotiated in an open market by the purchaser or agent and the vendor and is based upon various factors, including the financial strength of the insurance company that issued the policy, the nature of the policy, the estimated life expectancy of the insured named in the policy, the estimated premiums payable in respect of the policy over the expected life of insured, and the history and condition of the insured.
Background
While life settlement transactions date back over 100 years, the life settlements market has had its history more recently linked to the viatical business. The viatical market developed during the 1980s as AIDS patients looked to unlocking their insurance money to pay for their care. The industry developed a bad reputation among the general public due to allegations of fraudulent dealings and, from an investment standpoint, it was a disaster as medical advances extended patients lives and decreased the returns on these investments. Life settlements originally grew out of the increasing needs of people over age 65 who no longer required life insurance coverage and they were offered a source of cash for their policies that might otherwise have been worthless.
With the development of an open market for life insurance policies came the realisation that the actuarial value of a life insurance policy is greater than the corresponding cash surrender value. The sale of a policy allows the beneficiary to forego the ongoing premium payments or liability, and realise the value of this policy. This market has grown very quickly due to the simple fact that investors can pay more than the cash surrender value of the policies and expect to get an above average return in an uncorrelated asset class. Over the last 10 years, the life settlement market has grown substantially, to the point where it is now attracting institutional interest.
Attractive returns
Purchase prices of insurance policies are determined by market conditions of supply and demand, individual circumstances and by various state regulations. Some fees and charges may be incurred by the investor for purchasing and managing the portfolio. We have noted more competition in the purchase of attractive policies over the last few years, and this has lowered the anticipated returns.
Fed's Role Questioned in Bear's Rescue
Emma Trincal, HedgeWorld.com Staff, New York.
The announcement by JP Morgan & Co. on 24 March that it had sweetened its bid for Bear Stearns to $10 per share from $2 per share signaled JP Morgan’s eagerness to close the acquisition. But to many it has been the US Federal Reserve and, more specifically, the New York Fed, behind what many call the Bear Stearns bailout. That, they say, sets a dangerous precedent that could lead to moral hazard.
‘Whether the price was $2 or $10, the Fed is effectively doing a bank bailout. If they need to, they’ll do it again,’ said Alex Allen, chief investment officer at London-based fund of funds Eddington Capital Management Ltd., in an interview. ‘If you have extreme greed, somewhere down the line, you should pay the penalty. And Bear was greedy in that they had a highly-leveraged balance sheet and invested in an extremely risky asset class. One or two banks should go bankrupt. It may create systemic risk short-term, but it would send the right message that you can’t conduct your business recklessly and expect the taxpayer to pay for it.’
In response to this moral hazard charge, US Treasury Secretary Henry Paulson, who worked closely with the Fed in brokering the first deal at $2 per share, so far has responded by pointing to the pain being felt by Bear Stearns' shareholders and asking how anyone can say the Fed is bailing out Bear Stearns.
This argument has lost some of its pertinence now that the deal has been sweetened five-fold to $10 a share. In midday trading on 25 March, Bear’s share price was $10.70, a sign that the market is starting to agree with the new offer. Perhaps to alleviate the anti-Fed argument, the amended deal proposes to let JP Morgan shoulder the first $1 billion of any losses associated with Bear’s problematic mortgage portfolio. The total size of that portfolio is $30 billion. Critics continue to say, though, that the Fed is bailing out the bank, whether it takes on $29 billion or $30 billion in risk exposure.
As a result, the renegotiated agreement seems to signal two things.
First, JP Morgan needed to make the deal happen. ‘The share price was trading above the $2 price for most of the past week and the likelihood of a counterbid from shareholders and employees was mounting,’ said David Hendler, analyst at fixed-income research firm CreditSights Inc. In the new version, JP Morgan will be able to buy 39.5% of newly issued Bear Stearns shares. This new provision leads many to believe that the purchase of Bear Stearns by JP Morgan is now a done deal.
But a cloud remains over the Fed. And the question of whether, by stepping in, the US central bank is avoiding a systemic meltdown or setting a dangerous precedent that will incite banks to continue poorly managing their balance sheets, remains unanswered.
An Examination of Fund Age and Size and Its Impact on Hedge Fund Performance
Meredith Jones, Pertrac Financial Solutions, New York.
Introduction
This article updates research originally published in the February 2007 issue of the investment journal Derivatives Use, Trading & Regulation (re-titled of as May 2007 to Journal of Derivatives & Hedge Funds). This article attempts to discover whether smaller, younger hedge funds offer stronger performance than larger, older hedge funds. Using indices created with six subsets of hedge fund data (small, medium, large, young, mid-age and older funds, as defined herein), and Monte Carlo simulations, we examine the performance, volatility and risk profiles of each fund group. With 2007 being a more difficult year for the markets and for many managers, we tested our original findings by updating our study to include performance through December 2007.
Performance by size of fund
We created three size-based hedge fund indices by first combining the hedge fund performance records from the Hedge Fund Research, HedgeFund.net, Morningstar’s Altvest and Barclays Global HedgeSource databases into a single ‘master’ database. Duplicate hedge fund records, as well as records for funds of funds, were removed. Reports were then run to find the monthly return and monthly fund size for each fund from January 1996 through December 2007. All funds were recatagorised each month based on its then-current fund size and divided into three classes: funds with less than, or equal to, $100 million under management; funds with over $100 million up to $500 million under management; and funds with over $500 million. A simple mean of all monthly returns in each of the three categories was calculated for each month. If a fund did not have a reported fund size in a given month, it was not included in any of the size-based indices for that month. Funds denominated in a non-US currency with a very different value from the US dollar (eg, JPY, NOK, SEK), were also excluded from the size-based indices if it was not clear whether the monthly fund sizes reported for such funds were denominated in USD or the native currency, making accurate size categorisation problematic. The sample of funds included in each of the three indices varied from month-to-month. The small-size index contained, on average, 2,763 funds per month. The medium-size index contained, on average, 653 funds per month and the large-size index contained, on average, 201 funds per month. In all three cases, earlier monthly samples contained fewer funds than later samples. The three size-based indices that were created using this information are shown for the full period below in Figure 1, and in 2007 alone in Figure 2.
Legislative Changes in Bermuda
Anthony Whaley, Conyers, Dill & Pearman,
Upcoming legislative changes in Bermuda
Bermuda’s regulatory framework has long been one of its key selling points — hedge fund managers consider Bermuda to be one of the best regulated jurisdictions available, with a long track record in the industry. The new Investments Funds Act 2006 (the Act), which came into force on 7 March 2007, introduced a number of changes, although the regulatory framework for Bermuda’s hedge fund industry remains largely intact. The new Act brings more clarity and certainty about the process for hedge fund authorisation and continues to allow a high degree of flexibility. A number of other legislative changes are afoot in Bermuda.
Forfeiture clauses
There are now ongoing discussions between the Ministry of Finance and the Bermuda International Business Association (BIBA) Legislative Change Committee regarding further modernising our partnership legislation. The incorporation process for companies has been streamlined over the years so that only the Bermuda Monetary Authority’s (BMA) consent will be required in most cases, and it is proposed to dispense with the requirement for partnerships to obtain ministerial consent in the same way that it is not required in the case of companies who do not carry on restricted business activities. At the same time, it is intended to improve the existing procedures for the regulation of partnership in Bermuda, in large part by removing the requirements for the Minister of Finance’s consent to change the name, change its business, change the resident representative and deal with other routine matters.
The BIBA Legislative Change Committee are also currently considering possible amendments to our partnership legislation to clarify the position as to whether or not clauses in partnership agreements which forfeit partnership interests are enforceable under Bermuda law.
The particular kind of forfeiture clause referred to is one providing for the forfeiture of a partnership interest in the event of the relevant partner’s failure to pay (additional) capital into the partnership when called upon to do so by the general partner, in accordance with the terms of the partnership agreement. A primary purpose of such a clause is to give an incentive to each partner to comply with its contractual obligations to provide (additional) partnership capital.
We understand that such clauses are enforceable under Delaware law. After close examination of this issue from a Bermuda law perspective, our view (supported by UK Queen’s Counsel) is that although there is nothing objectionable per se in the inclusion of such a clause in a partnership agreement (which may be enforceable), the question is whether or not the Bermuda courts would have jurisdiction to grant relief from an enforcement of such forfeiture clause where such a forfeiture clause has been implemented. This is not so much a question of whether or not a forfeiture clause would be deemed to be a penalty clause or a clause for liquidated damages, as the case law shows that an innocent party is in a better position when seeking to enforce a forfeiture clause than when seeking to enforce a penalty clause in a contract.
In our opinion, the Bermuda courts would have jurisdiction to relieve a defaulting party against the implementation of a forfeiture clause. It is important to note that the jurisdiction is discretionary, and the Bermuda courts would be unlikely to grant relief where the failure to provide additional capital was wilful. The fact remains that the jurisdiction to grant relief exists and, consequently, the possibility that the implementation of such a forfeiture clause may lead to litigation.