(June 1, 2003 ) The “Alternative” Investment Quagmire |
While pensions generally are aware that “alternative” investments such as hedge funds and venture capital funds are not regulated by the SEC or state securities regulators, few pensions fully appreciate the complexities involved in reviewing and monitoring investments in these funds. When these investments turn sour, pensions may suddenly discover they are completely unprepared to investigate what went wrong, identify an appropriate exit strategy and recover losses. Due to diminishing performance among traditional asset managers, pensions are pouring money into “alternatives” at a time when knowledge of the myriad problems related to these investments is limited. Throwing lots of money into unregulated, highly risky, poorly understood investments sounds like a prescription for disaster. We believe pensions need to develop greater familiarity with the problems related to investing in “alternatives” before they plow further ahead into uncharted waters.
The “Belt and Suspenders” Approach
Some pensions may utilize a consultant that specializes in “alternative” investments or adopt a fund-of-funds approach where an upstream manager is retained (and paid) to select and monitor managers who will be actually managing fund assets. Indeed, some funds adopt a "belt-and-suspenders” approach employing the skills of a consultant specialist to recommend a fund-of-funds manager who will, in turn, manage the managers. However, in our experience, consultants that specialize in “alternative” investments are few and far between and often lack the skills necessary to ferret out troubling practices. Some of the larger consulting firms simply designate a given individual within the firm to handle “alternative” investments. This individual, who may have no real talent in such matters, by default, assumes responsibility for a diverse range of unregulated products. Fund-of-fund managers, on the other hand, typically have greater expertise but add significantly to the cost of investing in “alternatives.” We have also seen cases where the fund-of-fund manager itself has engaged in some of the very same abuses that are common among managers of “alternative” assets. In fact, we recently were made aware of a consultant specialist who recommended an unproven fund-of-funds manager who later hired her, shortly after the manager was hired by her pension client. So even the “belt-and-suspenders” approach may not be adequate to safeguard pension assets.
Different Risks for Different Types of “Alternative” Funds
While both hedge funds and venture funds are lumped together under the asset class of “alternatives,” these are very different types of funds involving some similar, but also other entirely different, risks. Hedge funds primarily invest in publicly traded securities with readily ascertainable market values. Venture funds, on the other hand, typically invest in the securities of private companies that are subjectively valued by the general partner managing the fund. Valuation issues may arise in connection with securities held in the portfolio of either type of fund. With respect to venture funds, we believe that most pensions are still over-valuing their investments in such funds, as a result of inflated subjective valuations provided by fund managers. While venture managers may have reduced valuations as a result of the Bubble bursting and the market for initial public offering drying up, valuations still appear overly optimistic. Below is a list of some of the other common problems we encounter when investigating “alternative” investment managers.
Lack of registration and regulation enables these firms to misrepresent virtually every facet of their identity. We have found cases where members of the general partner of a fund have wildly overstated their educational and professional experience. For example, individuals formerly employed by investment firms but having no investment experience or duties whatsoever may creatively draft their biographical profiles to indicate tremendous investment prowess.
While conventional wisdom may be that the most talented are attracted to unregulated environments permitting greater creativity, the unscrupulous are also drawn to such niches. Furthermore, it is common to find the same unscrupulous individual involved in multiple unregulated enterprises. His biographical profile may easily be modified as needed from private placement memorandum (“PPM”) to PPM to simultaneously lure investors into the different funds he promotes.
In addition, an alternative manager may misrepresent the amount of time he is dedicating to managing a given fund. Or, worst still, he may disclose that he is not committed to spend any particular amount of time to manage the fund and, in fact, operates multiple other investment funds. Questions may arise regarding whether the manager is devoting adequate time to managing the fund’s assets, as well as regarding his investment qualifications.
“Alternative” PPMs are typically drafted heavily in favor of the manager of the fund. Unlike regulated products where the law may require that the investor be treated fairly with respect to certain matters, anything goes here. Thus, drafting a PPM becomes an exercise in limiting the rights of investors and protecting the manager from any possible outcome. Any pension that simply accepts an “alternative” investment proposal without modification is almost certainly walking into a deal unfairly skewed in the manager’s favor.
We have investigated cases where, contrary to representations by the manager, the manager has no assets under management, no track record and the pension client discovers he is the only investor in the fund. In order to deceive a pension in such a circumstance, it is imperative that the manager withhold information regarding total assets actually under management in his fund. Of course the independently audited financials would reveal such information. Managers provide various excuses for the lack of timely audited financials, including that an audit was not undertaken in order to save investors the cost of the audit. Alternatively, managers may seek to delay sending audited financials the first year or two of the fund’s life until additional investors have been drawn into the fund.
As suggested above, representations regarding past performance by unregulated “alternative” money managers are often more fiction than fact. Also, liberal “borrowing” of performance records is not unusual. It is common for venture managers to quote the past performance of other funds they manage, including funds that have very short but impressive initial performance (as subjectively computed by the manager), in promoting new funds. Projections regarding future performance may be more reflective of historic venture capital returns (which are themselves suspect) than likely future outcomes.
The fee structures of “alternative” investments are highly complex, often involving several pages of print to fully explain. Since there are no standards here, it is important to scrutinize fees carefully. Many of these fee structures, even if written clearly, are subject to interpretation. We have investigated funds of funds where the pension investor was told the fee was 1% but the audited financials indicate it is almost 2%.
There are often significant differences or inconsistencies between the selling document and the legal document governing the fund’s operations. What is summarized in the PPM may be very different from what is fully stated in the partnership agreement governing the fund.
Affiliated Transactions and Self-Dealing
Perhaps the most illusive and troubling aspect of “alternative” investments is the potential for affiliated transactions that inflict harm upon the investors in the funds. For example, a manager may “front-run” a fund he is managing by first investing in a private company at one price and later investing on behalf of the fund at another (usually higher) price. There may be justifications for the different prices paid, however, it is extremely difficult for investors to determine whether they have been treated fairly. With respect to regulated, registered investment managers, such “front-running” is generally prohibited. We have even seen cases where managers sell shares of companies they founded and own to the fund they manage. Self-dealing presents serious conflict of interest issues that are difficult, if not impossible, to overcome.
Misrepresentations regarding professional experience, management fees and performance fees, number of clients, assets under management and track record, as well as questionable transactions involving self-dealing and front-running, all of which are commonplace in the world of “alternative” investments, are difficult to research. Most funds do not have the internal resources to delve into such matters. Many pensions simply choose to turn a blind eye to any suspicions that may arise during the life of the fund and focus only on performance as calculated upon final liquidation.
Hedge funds and venture funds have important differences with respect to redemption or withdrawal rights. While investors generally may withdraw from hedge funds periodically during the year, venture funds do not permit withdrawal until termination of the fund—which may be ten or more years into the future. Thus investors in “alternative” funds who have concerns regarding management of the funds may face difficult choices. Do they simply allow the manager to continue managing their money? Do they voice their concerns and seek reassurances? Or must a pension, once notified of possible improprieties, take definitive, possibly legal, action? A failure to take meaningful action may be embarrassing and difficult to defend where there are subsequent adverse developments. On the other hand, there is no obvious immediate solution if the PPM indicates investors cannot withdraw their funds. Given this quagmire, it is not surprising that pensions, once committed to an “alternative” fund, may choose to adopt a “don’t ask, don’t tell” attitude regarding manager operations.
Create Your Own “Regulatory Oversight”
In our opinion, there are no simple solutions when it comes to resolving “alternative” investment problems, due to the lack of transparency and liquidity related to these investments. So the best course for pensions is to familiarize themselves with the difficult issues related to these investments and develop, prior to investing, a strategy for dealing with any problems that may arise. The odds are that pensions investing in multiple “alternative” funds will eventually encounter management and/or performance problems. The more knowledgeable investors are as to the shenanigans related to these investments the more likely troublesome issues will be identified by them. For pensions that are not prepared to fashion their own “regulatory oversight,” probably the best course would be to simply avoid “alternative” investments altogether.