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.
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. 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.