Hedging liability bets is not a good idea for hedge funds

On any given day, hedge funds account for more than half of the daily volume on the New York Stock Exchange and have an equally large presence in every other financial market. This growing industry is currently comprised of an estimated $1 trillion in total assets under management and over 8,000 funds. Analysts currently predict that this space will expand to $2 trillion by the year 2009.

The explosive annual growth experienced by hedge funds since 1988 has been the result of two key elements: appreciation of assets and new money entering the industry. Since hedge funds first appeared as a highly profitable investment strategy (limited to only accredited investors), they have been essentially free from SEC requirements that apply to similar investment vehicles (mutual funds). However, new SEC regulations effective Feb. 1, 2006, require hedge funds to register as investment advisors under the Investment Advisors Act of 1940.

SEC investigations
The collapse of Long Term Capital Management in 1998 was one of the earliest events to raise the SEC’s awareness of hedge funds. The company had utilized complex mathematical analyses to take advantage of fixed arbitrage deals, usually with U.S., Japanese and European governmental bonds. Among LTCM’s principals were two Nobel Prize Winning economists and a group of Ph.D. certified arbitrageurs.

Unfortunately, when a highly leveraged gamble of more than $1 trillion with various forms of arbitrage was unsuccessful, LTCM lost $1.9 billion in one month. Fearful that there would be a chain reaction, The Federal Reserve stepped in and organized a bailout with a total estimated cost of approximately $4.6 billion.

LTCM’s massive investment failure demonstrated the influence of hedge funds in the economic market. As an influx of capital continues, coupled with massive investor losses, litigation has increased. The SEC documented more than 20 cases against hedge funds in 2005; there were only two in 2000. Litigation within the hedge fund arena has been predominantly fraud related, similar to the traditional exposure of directors and officers of public companies. Notable cases include: Granite, Manhattan, Lipper, Beacon Hill and Bayou.

Granite Partners, managed by David Askin, specialized in collateralized mortgage obligations. By 1999, Granite Partners had grown to $600 million in assets under management. When Granite’s performance began to decline, Askin reportedly manipulated information to demonstrate a smooth upward return trend. When Granite’s broker dealers chose to end their extension of margin to Askin, the firm’s distorted valuation method was revealed. Investors sued both the manager and the broker dealers.

In 1995, Michael Berger started Manhattan Investment Fund in New York and collected $575 million from investors through the end of 1999. Berger was accused of issuing inflated financial statements and altered documents to give the appearance that fund performance was much better than it actually was. Berger was sued by investors and later charged with fraud.

In the Lipper case, Edward J. Strafaci, the former manager of the Lipper convertible hedge funds, was charged with allegedly overstating fund values. The firm’s $4.9 billion portfolio had apparently been inflated by as much as 40 percent, according to the investors’ suit against the founder, Ken Lipper.

In 2002, the SEC alleged that Connecticut-based Beacon Hill Asset Management inflated its funds’ value to investors by more than 50 percent, cost investors $300 million. The SEC eventually settled with Beacon Hill for $4.4 million.

The SEC is also currently investigating Bayou Management LLC, a $440 million hedge fund based in Stamford, Conn. It has been suggested that Samuel Israel III, the founder, made improper trades and lost significant assets of the firm. Instead of disclosing the losses to investors, Israel allegedly tried to trade up to regain the losses. Investors have brought suit against Bayou, Bayou’s banker and the hedge fund consultants.

Areas of exposure
The SEC issued a final ruling in December 2004 requiring that certain hedge fund managers register with the SEC. It is doubtful that the registration will prevent fraud. However, oversight will increase the transparency of the industry as a whole and open hedge funds to new exposures, scrutiny and possible litigation, including in the following areas.

Valuation: All securities are hard to price to some degree. Even if a hedge fund seeks to value its portfolio correctly, there is a significant potential for unintentional errors. This ambiguity, coupled with other motives, can be a catalyst for disaster.

Compliance accountability: A firm must designate a chief compliance officer who cannot be involved with day-to-day management. This officer must implement policies and procedures, including a written code of ethics, that creates a higher standard of accountability for the firm and its directors and officers.

High fee structure: Typical hedge fund fee structures include a 1 percent to 2 percent management fee plus 20 percent of profits. Putting this into prospective, an average mutual fund charges 1 percent to 2 percent of assets. In a 2003 report, Bernstein Research reckoned the size of the hedge-fund industry was one-sixth that of the mutual fund industry yet already provided more revenues.

Institutional investors’ capital: Current investments in hedge funds by institutions account for approximately 1 percent of the assets of U.S. institutions, or about $70 billion. By comparison, the assets of non-U.S. pensions, endowment foundations and high net investors represent approximately $39 trillion. Even a nominal increase in the contributions to alternative investments would represent a huge influx of capital to hedge funds. As institutional dollars in hedge funds increase, there will be a concomitant expansion of regulatory scrutiny and potential for litigation.

Majority shareholders: As majority shareholders in many companies, some hedge funds have abandoned their historical passive involvement for a more active role. Recent examples of company activism include: forcing consideration of a sale, pushing companies to bankruptcy, pressuring share buybacks or dividends and scrutinizing executive pay packages. With this new position comes potential conflict from both minority shareholders and existing company management.

Katie Verry is an assistant vice president in the San Francisco office of Tri-City Brokerage, a division of insurance wholesale broker, BISYS Commercial Insurance Services. She can be reached at KVerry@tricityins.com.

Topics Lawsuits