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. 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.
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.