Friday, February 28, 2014

A Grand Hedge Fund Conspiracy: Fletcher Asset Management and Citco – Part II

A Grand Hedge Fund Conspiracy: Fletcher Asset Management and Citco – Part II

Yesterday I described the ill-fated investment made by Massachusetts Bay Transit Authority (MBTA) and three Louisiana public pension plans into hedge funds managed by Alphonse Fletcher.  I also outlined the master-feeder fund structure that governed these investments.

Everything that can go wrong in an investment went wrong immediately after the pensions invested with Fletcher.  First, the values of existing securities in the master fund were vastly overvalued.  Second, the investments were subject to far more leverage than the investors bargained for.  Some of the leverage was applied in the master fund (margin loans), some was buried in the feeder funds, and yet more leverage was contained in special purpose vehicles (SPVs).   

SPVs are subsidiary legal entities set up to house specific assets and liabilities in order to protect lenders from bankruptcy.  These entities afford lenders greater protection from bankruptcy than if they lent directly to a fund or corporation.  They also can be used to hide liabilities.  You may recall that Enron made heavy use of SPVs in the 1990s, and many Wall Street banks used these entities to house mortgage exposure before the credit crisis.    Fletcher and Citgo hid a great deal from its investors using SPVs.

Finally, the proceeds from MBTA’s and Louisiana’s capital contributions almost immediately flowed out of the funds in order to enrich Citco, a senior executive at Citco, Mr. Fletcher, and several of his associates.  In other words, very little of MBTA’s or Louisiana’s money went into the investment strategies marketed by Fletcher.

Citco is a well-known administrator of hedge funds.  As the administrator, they were supposed to set the value of the fund after receiving reports from the manager.  Investors in Fletcher’s funds thought Citco was involved in the process based on the offering memorandum.  However, in its agreement with Fletcher, Citco limited its involvement to administrative matters. Fletcher valued the fund; a clear conflict of interest.  Quantal, a risk management consultant, assisted Fletcher even though it had no experience in valuing the illiquid securities held in the Fletcher Funds.   In addition, Quantal’s president became a director of one of Fletcher’s improperly acquired businesses, Richfield Financial (see below).

In order to get the Louisiana pensions to invest, Citco and Fletcher created an SPV called Corsair.  Corsair was supposed to absorb losses if the fund didn’t earn the 12% preferred return and enjoy the gains above 18%.  Most of Corsair’s assets were in the form of a loan from RBS. When the credit crisis hit, RBS called the loan, resulting in a crisis for Fletcher.  Instead of notifying Louisiana as required by its legal documents, Fletcher covered up the problem, arranged to repay RBS, and created $160 million in fictitious notes.
Malaysia (1999)
The story gets even stranger.  Mr. Fletcher acquired Citco’s hedge fund of fund business, using his investors’ capital to finance the transaction.  The company, Richfield Financial, was falling apart just as it was being acquired.  Again, the pension clients had no idea that their capital was going toward the acquisition of a business for Citco’s and Fletcher’s benefit.  In addition, the founder of Richfield, who was also a senior manager of Citco, was allowed to make an investment in one of the Fletcher funds at a valuation that allowed him to draw millions of dollars out of the fund. 

It’s bad enough that a money manager violated his fiduciary duty to his clients.  Having the fund administrator in on the impropriety is even worse, especially as Citco continues to hold itself out as global leader in fund administration and valuation.[1]  Moreover, the accountants and lawyers who created and blessed this byzantine structure and the banks who financed it, gladly took their fees and either participated in the deception or conveniently averted their eyes as Fletcher and Citco went about defrauding their investors.

There is much more to this story, as Fletcher and Citco created many other SPVs and made investments that were not part of Fletcher’s stated investment strategy.  The dollars involved in this fraud are small in comparison to the Madoff or Stanford scandals.  However, the scope is breathtaking.

After reading Warren Buffet's investment letter on Saturday, my friends in the investment business might want to read the trustees report on Sunday.[2]


Thursday, February 27, 2014

A Grand Hedge Fund Conspiracy: Fletcher Asset Management and Citco – Part I

A Grand Hedge Fund Conspiracy: Fletcher Asset Management and Citco – Part I

A hedge fund manager named Alphonse Fletcher convinced the Massachusetts Bay Transit Authority (MBTA) and three Louisiana public pension plans to invest in a series of funds that turned out to be grossly overvalued and became a source for enriching almost everyone except the investors.  The investment by the public pensions followed the usual pattern.  The pension trustees were lured by returns that were too good to be true.  However, the roles of the administrator, auditors, valuation service, and lawyers are far more interesting to me.  This tale is laid out in a four hundred-page report issued by a bankruptcy trustee.[1]  In order to understand how all these experts helped to perpetrate the fraud, I’m going to need to spend some time explaining the role of administrators, auditors, and the other experts who set up and monitor hedge funds.  Before I dive into these details, I’ll try to summarize how the pensions were hoodwinked.
Sharing Overhead II (1998)
Here’s the proposition that lured the Louisiana pensions.  They were promised a 12% preferred return with further participation in any gains up to 18% return.  The other investors in the fund would own any return above 18%.  Fletcher Asset Management showed prospective investors a track record that was almost completely devoid of monthly losses.  Fletcher said that these returns were derived from investing in PIPEs (private investment in public equity).  In other words, Fletcher made private placements in troubled public companies that couldn’t access the public markets.  Curiously, FAM’s historic returns were 8.13% per annum.  This leaves the question why the other investors would be willing to guarantee Louisiana a 12% return.  The pensions should have also questioned how anyone could post such consistent returns investing in PIPEs.

Perhaps MBTA and Louisiana drew comfort from the fact that the fund administrator was Citco, the accountant was Grant Thorton, the outside counsel was Scadden, and the outside valuation expert was Quantal International.  Moreover, the offering memoranda and side letters afforded the pensions all sorts of rights and protections, which turned out to be as worthless as the investment.

Fletcher Asset Management set up a master-feeder arrangement, which is fairly common for hedge funds.  Typically the master fund controls the assets, while the feeder funds hold the investor’s capital, which in turn, is invested in the master fund.  This structure enables investors to invest in a fund tailored to their specific requirements.  For example, some investors prefer an offshore fund in order to shield themselves from taxes.  Other investors might be interested in applying more leverage. Another group of investors might insist on different economic terms (e.g., lower fees, but a longer lock up), and still others might insist on having their own account.  Each of these different funds can be set up to collect the investors’ contributions and pass them along to the master fund, where the manager can invest the contributions on a consolidated basis.  As the master fund achieves gains or losses, these results are passed back to the appropriate feeder fund on a pro rata basis.

A fund is a legal entity, so each feeder and master fund has to have directors or trustees and an administrator to keep track of investors and their contributions and distributions as well as the value of their investment.  Each fund will also have to be audited and have legal representation.  As you can imagine, there are numerous opportunities for a variety of experts to earn fees for setting up and administering the master-feeder fund structure.  The governance of these structures is usually pretty weak.  While each fund has a set of directors, many of these people sit on dozens and dozens of fund boards and have little expertise in the underlying strategies used by the money managers.  The directors simply follow scripts prepared by legal counsel.

Valuation is one of the critical factors in operating a collection of funds.  If the master fund is invested in conventional stocks or bonds that trade frequently, the valuation process is pretty straightforward, much like a mutual fund.  However, as a fund becomes involved in illiquid or esoteric securities, the valuation process becomes much more complicated.  Moreover, the manager has a built-in conflict of interest because higher valuations produce higher fees and inventive payments.  As a result, managers are required to follow strict procedures, which are supposed to be overseen by the fund administrator.  In addition, auditors are supposed to test and challenge the valuations.

As we’ll see tomorrow, Mr. Fletcher exploited the master-feeder fund structure for his own benefit, and for the benefit of the experts who were supposed to be overseeing his activities.


Tuesday, February 25, 2014

Warren Buffet on Index Funds

Warren Buffet on Index Funds

Many investors think that Warren Buffet’s investment record at Berkshire Hathaway is proof that active managers can beat the stock market.  When it comes to Mr. Buffet’s estate, he begs to differ.  In his annual letter to Berkshire shareholders, Mr. Buffet tells readers:

My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I've laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife's benefit. (I have to use cash for individual bequests, because all of my Berkshire Hathaway (BRKA) shares will be fully distributed to certain philanthropic organizations over the 10 years following the closing of my estate.) My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's. (VFINX)) I believe the trust's long-term results from this policy will be superior to those attained by most investors -- whether pension funds, institutions, or individuals -- who employ high-fee managers.[1]

I have nothing to add.  The full letter will be available on March 1.  I urge you to spend some time on Saturday reading it.

Investment Meeting (19995)


Monday, February 24, 2014

Unnecessarily Stirring the Pot: Rhode Island

Unnecessarily Stirring the Pot:  Rhode Island

If there’s one thing that investing has taught me, it is how to make mistakes.  Apparently my talents as a blogger are as fraught with miscues as my career in money management.  Last fall, I lauded the efforts of Ted Siedle in exposing Rhode Island’s foray into alternative investments.  After Mr. Siedle posted his critique on his website, he was hired by American Federation of State, County & Municipal Employees (AFSCME) to conduct an investigation of Rhode Island’s pension practices.    The report, “Rhode Island Public Pension Reform: Wall Street’s License to Steal”[1] is misguided, as I have discussed in previous posts.[2]  I should not have praised Mr. Siedle’s efforts in the first place.

In the last week, Rhode Island reached a settlement between the State’s public employees and government officials concerning pension reforms enacted in 2012.  The reforms, championed by Treasurer Gina Raimondo, are designed to reduce the pension’s deficit over the next several decades.  The settlement rolls back some of the reforms, while preserving most of the long-term savings.[3]

In the wake of the settlement, Mr. Siedle renewed his attack on the pension plan and Treasurer Raimondo.  His assertions are designed to undermine the confidence of state employees and retirees in the management of the pension plan.  These comments highlight why I was wrong to laud his earlier analysis.  Mr. Siedle now claims:

Workers will have no way of assessing whether the risks related to future benefit payments are acceptable; the most fundamental investment information will be withheld from them. That’s an outrageous oversight, in my opinion, and a benefit to Wall Street that many (but not all) parties to the pension negotiations probably never intended.[4]

This statement is completely wrong.  While not perfect (what report is?), the monthly reports[5] issued by the Treasurer’s office for the State Investment Commission provide a great deal of information about the performance and risks of the pension plan.  I didn’t study these reports closely when I first looked at Rhode Island. In going back to take a closer look, I found that the reports show exactly how much current and future exposure the pension has to individual real estate and private equity managers.[6]  It also details the investment performance of its hedge fund managers.[7]  The fees of prospective managers are revealed[8], and the risks of the portfolio are well documented.[9]   

In the Treasurer’s Annual Report[10] the performance of all the pension’s managers are revealed[11], and the fees for each asset class, including performance fees, are shown in detail.[12]  The fees for all the hedge fund managers are also displayed.  The annual report isn’t nearly as current as the monthly reports, but the overall level of disclosure is greater than the vast majority of pension plans in the United States. 

Mr. Siedle also attacks the State Treasurer’s investment credentials.[13]  While I’m in no position to judge Treasurer Raimondo’s previous experience as a venture capitalist, Mr. Siedle’s comments are off the mark.  Virtually no one who assumes oversight of a public pension plan has had previous experience managing at such a large scale.  Neither Mr. Siedle nor I should be second-guessing the voters of Rhode Island, especially since Treasurer Raimondo is not a sole fiduciary.  The investments are approved by the State Investment Commission, which includes a number of experienced investment professionals.[14]  Rhode Island also has a very experienced Chief Investment Officer, Anne Marie Fink.[15]  While the Treasurer wields a great deal of authority as Chairman of the SIC, Rhode Island has a great deal more relevant experience weighing in on investment decisions than the average pension plan.

In my view, the investment issues in Rhode Island are two-fold.  First, there’s the efficacy of alternative investments in driving performance and managing risk in pension plans.  As most of my readers know, I am a major skeptic.   When one large investor after another pursues the same basic strategy, the strategy seldom works.  Moreover, since alternative investments have high and asymmetric performance fees, the odds simply do not favor Rhode Island or any other pension investor.  Money managers will do very well at the likely expense of the pension plan.  However, Mr. Siedle is incorrect when he asserts that there’s something nefarious buried in the bowels of Rhode Islands relationships with Wall Street money managers.  What’s going on in Rhode Island is readily apparent.  They’ve made an expensive investment bet.

Second, pension plans become more difficult to manage when incumbent officials run for re-election or higher office.  Treasurer Raimondo is running for Governor, and inevitably critics and opponents will see politics behind every investment decision.  For example, the SIC recently terminated the pension’s relationship with Third Point, a hedge fund managed by Daniel Loeb.[16]  Mr. Loeb is an advocate of charter schools, so critics suspect that Third Point was fired in order to shore up the Treasurer’s political support.  As expected, the Treasurer’s spokesperson denies that politics came into play.  I don’t know how the decision was made, but it’s easy to see how this decision looks through a political lens. 

It always amazes me that people are shocked that politics come into play.  Everyone injects politics into the investment process.  Unions, retiree groups, legislators, money managers, and public officials try to insert politics into the investment process.  In fact, I have never seen a pension plan or endowment that didn’t involve some level of politics.    The combination of elections, money, and influence inevitably brings politics into the equation.  We should be shocked if politics didn’t make an appearance.  The goal of any investment organization is to try to keep the politics to a minimum.  Politics are bubbling around Rhode Island public pension plan, and Mr. Siedle’s report and commentary are helping to raise the political temperature to a boil.

[2] See, “Looking for Fire Where There’s No Smoke: SEANC Commissions a Pension Study,” January 17, 2014
[6] See, Monthly Report, January 2014 at 19-20, 22.
[7] Ibid, page 34.
[8] Ibid, page 3.
[9] Ibid, pages 24-27.
[11] Annual Report, page 39-42
[12] Ibid, page 37-38
[13] Siedle Blog, page 2.
[14] For example, J. Michael Costello is a senior professional with Endurance Wealth Management and has previous experience with Fleet Investment Advisors and Provident Group; Thomas P. Fay is a regional president of BNY Mellon and was CIO at Private Bank and Trust; Robert Giudici is a CPA, Paula McNamara is with the Murray Family Foundation and worked at Fidelity; and Andrew Reilly is a senior executive at Accretive Capital.
[15] Ms. Fink was managing director and portfolio manager at JPM Morgan Private Bank before becoming Rhode Island’s CIO.  Her response to Mr. Siedle’s report (see, is far more reasoned and informed than the original report.