Fiduciary Magazine

Archive for June, 2009

By Andre Peschong

Looking at the fallout on Wall Street, there has been great change in the financial industry and, in turn, some unintended consequences. The hedge funds that once numbered over 7,000 (my unofficial estimate as I couldn’t find a substantiated number) are now pared down to around 3,000. Venture Capital has retreated to higher ground by doing larger deals and more 2nd, 3rd and 4th rounds into existing portfolio companies. Private equity houses have largely been untouched, but they are suffering from the lack of exits. Three of the largest investment banking firms have gone under or been absorbed by larger traditional banks.

What are the unintended consequences of this current market upheaval for the financial sector? The most glaring one follows the first law of thermodynamics (and I paraphrase) which portends that nothing is ever created or destroyed but merely shifts forms. The shift I am alluding to is the movement of talent and deals at these former large tier investment banking firms to new firms, or to more aggressive mid tier boutique investment banks or specialty M&A houses.

This shift takes time, which is probably a contributing reason for the lack of IPO’s, PIPE transactions or any other type of liquidity events for the private equity/VC market.

Need proof? According to Price Waterhouse Coopers (PWC) the VC activity for the first quarter is down to levels not seen since 1997. VC and private equity funds have to consider the types of deals and companies they are willing to invest in based primarily on the extended holding time. The only current exit for a privately backed company is through an M&A transaction and those deals will be done at increasingly smaller multiples as this is a buyers’ market. The events of the past 12 months have really made professional investors and funds alike re-examine their investment model, pricing and exit strategies. The unintended consequence of these events are a boon to M&A boutiques that concentrate on buyside representation or that have top tier clients looking for bolt on acquisitions.

The market needs time to readjust to the new landscape in the capital markets. Deals will be under much heavier scrutiny from all sides, the accountants, VC’s, private equity groups, valuation firms, investment banks etc. This shift in due diligence on transactions will be significant. There will be a natural growth of service providers bringing additional transparency to the “deal” business. A true and needed unintended consequence.

Morningstar ran a report about how you can get Buffett-like returns by blending two funds…hmmm?

Buffett has been the luckiest investor the world has ever known. You cannot invest like Buffett. He gets calls, dealflow, that you’ll never get. He gets terms that you’ll never be offered. He’s also 78 and has invested through the largest and longest bull market the world has know.

What you see here, is an issue of Causation: Buffett is the richest man, therefore he has made nothing but prescient decisions during his life. This is of course a logical fallacy. I felt so strongly about this, and feel that the investing public is misled about how to trade and make money from investing, that I recorded a web tv episode on Buffett.

If you want to get returns like Buffett, buy the Berkshire Class A’s or B’s. That’s the ONLY way you’ll get Buffett-like returns – because he’s the only one getting them.

I interviewed Barry Ritholtz yesterday. Here is a link to the podast

By Aleksey Matiychenko and Gregory Dyra — April and May have been tremendous months for global financial markets. MSCI World Index rose 11.49% and 9.52% respectively. While the index is currently down 83 basis points in June, it is up 7.46% for the year. The world as a whole seemed to perform better than did U.S. While S&P rose 15.2% from March 31, 2009 through May 29, 2009, by June 22 the index was only up 2% for the year. Emerging markets, on the other hand, are now up more than 32% year to date.

It seems that hedge funds have been able to ride the up market well. The Barclay Hedge Fund Index is now up more than 10% through the end of May with all hedge fund strategies posting positive performance. Perhaps proving the existence of mean reversion, the biggest losers of 2008 posted the best performance in 2009 so far. Convertible Arbitrage Strategy that lost 27.66% in 2008 is up 19.18% through end of May. While the Emerging markets strategy lost 39.57% in 2008, it is now up 21.29% year to date.

While the hedge fund industry has shown signs of recovery, there has not been a tremendous increase in the launching of new funds. Based on the Barclays database we estimate that about 40 funds have been launched so far this year. This figure is even exaggerated since it includes multiple share classes of some of the funds. In comparison more than 1,900 funds were launched in the first five months of 2008. As of June 6, 2009 about 300 funds have not reported performance for April 2009.

While some reports suggest that the outflow of capital from the hedge fund industry has slowed, the industry remains in a transitional or rather transformational stage. In the post Madoff world, the days of happy, trusting Goldilocks approach to picking hedge fund managers are over. The Madoff case served as a catalyst to shift investors’ views on how to select, evaluate and invest in hedge fund managers. The initial kneejerk reaction promoted conversations of investing only in fully transparent and liquid hedge funds via Managed Account structure. While it’s unlikely that hedge fund industry will shift entirely into Managed Account structure, it’s clear that hedge funds that want to survive in the new world will need to adjust to tougher demands from their investors.

The three most popular demands that are likely to be imposed on surviving funds are lower fees, better liquidity and better (full) transparency.

In this column, we briefly touch on the first two and discuss the last one in more detail.

Fees

Hedge fund managers typically make money from a combination of the management and performance fees. Most funds have High Water Mark provisions that imply that the funds cannot charge performance fees after suffering losses until those losses are recouped by the investor. After suffering the worst year in 2008, most hedge funds are not likely to collect performance fees in 2009. It’s likely that the standard “2 & 20” model will change in the future, though, it’s unlikely that the fees will fall significantly as they will become even more essential for covering funds’ operating expenses.

Liquidity

Liquidity, or rather lack of it, can be blamed for many problems related to the current crisis. Anecdotally we have seen the trend in launches of more liquid fund of funds products. Managed accounts with weekly or daily liquidity seem to be in fashion for now. The liquid/managed account structure has certain advantages since it provides investors with transparency, liquidity and control of their portfolios. Not all hedge fund strategies, however, lend themselves to such structure. It seems unlikely that the hedge fund industry will shrink down to just Equity Long/Short, Equity Market Neutral and CTA strategies (the strategies that are most suitable for the managed account structure).

Transparency

Perhaps one of the biggest complaints about hedge funds is the lack of transparency. The press and the media describe hedge funds as opaque investment vehicles striving on secrecy and open only to the rich. Many investors blame that alleged opaqueness for many of the financial problems that we are experiencing right now. Some demand full transparency.

While some of the criticism is valid, it would not be fair to just say that all hedge funds are secretive and opaque. In this article we touch on three main topics related to transparency: the current state of hedge fund transparency, pros and (mostly) cons of full transparency, and our own view.

Current State of Hedge Fund Transparency

Hedge Fund transparency in the current state ranges from the Black Box Model on one side to the Full Transparency model on the other side. The most secretive funds provide their investors with monthly return and general leverage information. The leverage information is typically provided in the form of percent of equity allocated to long and short positions. These funds may disclose more information in due diligence meetings and conference calls, but most often will not report this information in the printed form. The funds that report full transparency may provide investors with full position data on either real (or close to real) time basis or on a lagged basis. Most hedge funds regardless of the transparency model usually provide their investors with monthly and quarterly letters.

While the content and quality of these letters differ widely, we found that there are certain commonalities among hedge funds in different strategies. For example, the majority of Equity Long/Short hedge funds report Industry and geographic allocations. Many report concentration and maybe even the names of the top five positions. Fixed Income Arbitrage funds often report their interest rate exposure by currency and maturity buckets.

While a diligent investor may be able to collect many pieces of the available transparency data, the absence of any standards in reporting this data makes it extremely difficult to use it on a consistent basis.

Full Transparency

There have been many calls for requiring hedge funds to provide full transparency. The hedge funds’ rebuttal that those calls are no more legitimate than calls to require Coca Cola to disclose its secret formula is valid in its own right. There is an even stronger argument against full transparency. It will likely do more harm than good for the investor.

Hedge funds invest in a variety of financial instruments that range from plain vanilla stocks and bonds to complex derivative instruments. Most hedge fund investors do not have the necessary systems, budgets, or the time to be able to take every position reported by every hedge fund in their portfolio and perform a meaningful analysis. There are, of course, software solutions that are available on the market that may be able to handle many of the instruments, but the cost and complexity of these solutions in the constrained budget environment may not be justified by the value added.

Obtaining full transparency and failing to analyze it may result in two problems for the investor.

1. After obtaining position data from the fund, the investor may experience a false sense of security and become complacent when analyzing the fund. Full transparency may justify putting a checkmark in a due diligence questionnaire, but may not result in any actionable steps.
2. The second problem may exist for the fund of funds and other professional investors in that failing to perform an adequate analysis of position data may actually imply the failure of fiduciary duties with respect to their clients or share holders.

If full transparency is not appropriate, then the natural question to ask is: What level of transparency should investors demand?

Our View

Transparency reported by hedge fund managers should be reasonable, informative, useful and timely.

Reasonable

To be reasonable, the required transparency should have the following qualities:

1. Reporting frequency should coincide with the fund’s liquidity. While it may be informative to know what the fund with quarterly liquidity is holding on a daily basis, it would not provide investors with any actionable steps, and would impose an undue burden on the manager.
2. Reports produced by the manager should be consistent. An investor should be able to obtain reports in the same format and with the same content.
3. Transparency should not be excessive. Managers should not be required to disclose their trade secrets. Conversely, investors should also be able to process reported information without undue burden and excessive costs.

Informative

Information provided by the fund should be both relevant to the manager’s strategy and comprehensive enough to be able to analyze the fund’s exposure. For Equity Long/Short hedge funds, an investor may want to collect Industry exposures, hedging positions, and top positions. For fixed income funds, an investor needs to collect the interest rate and credit sensitivities (in the form of DV01 and CDV01). Multi strategy funds may need to report a combination of the above.

Useful

There is no point in requesting transparency from hedge funds if the investor makes no use of it. Four types of analysis can be performed using the information collected from hedge funds.

1. Historical Trends. While hedge fund positions may change on a daily or intra-day basis, the overall trend in exposures may provide information about the fund’s style (and potentially about any style drifts).
2. Aggregate Analysis. Being able to collect data in a consistent form would allow investors to aggregate information across hedge funds in their portfolios and get a more complete picture of their investments.
3. Monitoring. Industry exposure and top positions exposures may provide investors with a way to monitor and quickly identify the hedge funds which may be exposed to market news or events.
4. Risk Analysis. Exposure data may be used to perform simulation analysis and estimate such risk analyses as Value at Risk, Drawdown Simulation, and Stress Tests. In the following section we describe the steps necessary for performing such analyses for an equity long/short hedge fund.

Timely

In order for information to be useful and actionable it needs to be delivered on a regular basic and in a timely fashion. Many hedge funds currently file form 13F disclosures that contain information about their long equity holdings. While 13F information may be interesting it’s not timely since it’s delivered quarterly with a lag that may extend up to 45 days. For hedge funds with moderate or high turnover in their portfolios such disclosure proves to be of limited use to investors.

Example:

Risk Analysis – Equity Long/Short Fund

An investor who has collected building blocks for Industry exposures data from an Equity Long/Short hedge fund may use that information to estimate Value At Risk (VaR) using the Monte Carlo techniques. To do that the investor needs to perform the following steps:

* Collect long/short exposure for each Industry
* Make an assumption about correlation between long and short positions
* Simulate results
* Calculate VaR

Collect Long/Short Exposure

Investor can collect information about industry exposure from each Equity Long/Short hedge fund in the portfolio. Exposure information can be mapped into MSCI World or S&P GIC scheme. This would allow investors to assign traded benchmarks to represent each industry exposure. Traded industry indexes or ETFs can be used.

Make an Assumption About Correlation Between Long and Short Positions

An investor must decide whether to use Net or Gross exposure when performing simulations. The decision depends on the relationship between the long and short positions.

For the funds that use short positions as hedges for their long portfolios, net exposure may be an appropriate metric to use since the short positions are assumed to be highly correlated to long positions. For the funds that take directional bet on either long or short side, the gross exposure may be the more appropriate measure.

A more sophisticated model may make an assumption on the actual correlation between long and short positions.

Simulate Results

Historical track records of the proxy ETF, or indexes assigned in Step 1 may be used to estimate the covariance matrix and expected returns. The information then can be used to simulate performance on either a daily, weekly or monthly basis. Different models can be used to perform simulation. In the simplest form, the multi-variate normal distribution may be used to generate return data. Since normal distribution may not be appropriate for capturing tail behavior, different distributions (e.g. student-T, extreme value) may be used to simulate the return data. Copulas may be used to preserve the desired correlation structure.

Once the returns are simulated, Value at Risk as well as other risk statistics can be easily calculated by examining the properties of distribution of the generated returns.

Conclusion

We have presented our views on the appropriate use of hedge fund transparency as well as what level of it should be required from hedge fund managers. While we believe that full transparency should not be required and may actually be detrimental to investors, we support the effort to improve the reporting standards across the hedge fund industry.

Aleksey Matiychenko, CFA, FRM, CAIA, is senior partner and CEO of Risk-AI, LLC. Gregory Dyra is a managing director at New Legacy Capital, LLC.

The issuance of Bearer Bonds has been discouraged for almost 3 decades with the passage of the TEFRA in 1982.

“The interest on any such bonds issued after 1982 would be taxable to the issuer in the case of corporate bonds, and taxable to the holder in the case of municipal bonds.”

I guess that did not smack in the face of the Italian authorities when they intercepted 2 Japanese men who held $134.5 billion in fake US Government Bearer Bonds.

“Italian law does not call for the criminal arrest of persons found to be taking funds without permission to another country. It might have been another matter if the police had determined immediately that the bonds were false.”

Which raises the question: If you have a client who has bonds in bearer form, or is dealing with Bearer Bonds, how can you vouch for their authenticity?

Sprint has launched a funny ad that looks like it was inspired by the folks at Apple…

Meanwhile, Maggie Reardon the rock start behind CNET Wireless, has some great analysis behind Palm’s numbers that’s worth a read.

By Marguerite Reardon, CNET

To be eligible for the $5 unlimited international calling plan, users must already be signed up to an unlimited national calling plan that costs $40, $45, or $50 a month. Making international phone calls from a cell phone has typically been rather expensive with major carriers such as AT&T and Verizon Wireless.

By Douglas M. Mancino, et al.
Partner, McDermott Will & Emery

Tax-exempt organizations are well-advised to attribute significant focus and attention to the governance questions posed on Part VI of the Form 990, and to the underlying governance concepts raised by these questions.

On May 29, 2009, the Internal Revenue Service (IRS) posted a series of “FAQs” and other “Tips” associated with the completion of Part VI to the Form 990 (Governance, Management and Disclosure). Part VI is the section of the new, redesigned Form 990 that reflects the IRS’s major focus on the corporate governance of tax-exempt organizations. Thus, the new FAQs are likely to be welcome news to these organizations as they respond to the dramatic increase in governance-related questions in the new Form 990. The FAQs can be found here .

The FAQs contain 11 separate questions focused almost exclusively on Form 990, Part VI, Governance, Management and Disclosure. In the FAQs, the IRS makes it clear that many (if not all) of the policies and procedures about which it is asking in the Form 990 are not required under the law. Nonetheless, the IRS makes equally clear that, while none of the policies and procedures are required under the law, answering questions about whether the filing organization has adopted such policies and procedures on the Form 990 is required by law. While the IRS traditionally has not imposed penalties on failure to file substantially complete Form 990s in the past, it is an open question whether the IRS would pursue such path for an organization refusing to answer the governance questions on the current Form 990.

General Comments on Form 990 Part VI and the FAQs

Governance, in general, has become a pillar of the IRS enforcement and education programs for tax-exempt organizations. Given continued congressional scrutiny on whether tax exemption is a worthy federal subsidy for any type of tax-exempt organization, proper governance and accountability to the local community are key factors that may distinguish the tax-exempt sector from the taxable sector. From the IRS perspective, whether correct as a matter of law or not, the answers to the questions contained in Form 990, Part VI, are significant with respect to continued tax-exempt status for most tax-exempt organizations.

The FAQs may be loosely grouped into two main categories: FAQs relating to the existence of written policies on conflicts of interest, whistleblowers and document retention, and FAQs relating to whether information from organizations related to the filing organization is required to be included in the Form 990. Set forth below are discussions of the more important FAQs for filing organizations.

FAQs on Policies and Procedures

FAQ #10
Form 990, Part VI-B, asks whether the filing organization has adopted a written conflict of interest policy (Part VI-B, Question 12a), a written whistleblower policy (Part VI-B, Question 13), and a written document retention policy (Part VI-B, Question 14). FAQ #10 clarifies that, in responding to these questions, a filing organization may not rely on the fact that its parent organization may have adopted such policies even if the filing organization is acting pursuant to the parent organization’s policies. Instead, a filing organization may only indicate that it has such policies if it has expressly adopted such written policies itself. Presumably, expressly adopting the parent organization’s policies should be sufficient to allow the filing organization to check “yes” in response to the applicable questions. As in many other parts of the Form 990, the IRS notes that the filing organization has the ability to discuss any special circumstances on Schedule O.

FAQ #3
FAQ #3 clarifies that, for purposes of reporting whether the filing organization has adopted a particular written policy or procedure (e.g., conflict of interest policy), it may only answer “yes” (i.e., that it has adopted such policy) if it adopted such policy prior to the close of the reporting year. In other words, if the filing organization adopted a policy after the close of its reporting year but before it filed the Form 990 for such year, it must still answer that it does not have such policy. Again, Schedule O may be used to explain that the organization has adopted such policies after the close of the reporting year.

FAQ #8
In FAQ #8, the IRS notes that it will not provide sample policies for filing organizations (even though it did so with respect to the IRS Model Conflict of Interest Policy in the late 1990s).

FAQ #5
FAQ #5 notes that there is no legal requirement for a tax-exempt organization to show the Form 990 to its board but, nonetheless, notes that the filing organization must indicate whether it has done so in the Form 990.

FAQs on Activities of Related Organizations

FAQ #7
FAQ #7 attempts to clarify the level of effort needed by filing organizations to ascertain information regarding independent directors and family relationships among board members. However, the only guidance provided by the FAQ is that “reasonable efforts” must be made. The IRS notes that a simple questionnaire that includes the name, title of person responding, date and signature, and attaches the Form 990 Glossary definitions of “independent voting member of governing body,” “family relationship,” “business relationship” and “key employee” may be all that is needed.

Practice Note: While the IRS suggests the use of a very simplified questionnaire, it is possible that a limited questionnaire may not capture all the information required to complete Part IV, question 28, regarding business relationships among directors, officers, key employees and their family members. In addition, such a simplistic questionnaire may cause greater problems for the filing organization by requiring greater diligence in educating board members and officers as to what information is required to be provided and by placing a greater burden on the filing organization’s general counsel or compliance officer to make certain that questionnaires were completed accurately. In other words, in preparing responses to Form 990 Part VI, Questions 1 and 2, the organization should be careful in following the IRS guidance in these FAQs and should consider using a more detailed questionnaire that is designed to more fully collect the appropriate information for all parts of the Form 990. Organizations will have to balance the need for information against the administrative inconvenience.

FAQ # 6
FAQ #6 attempts to clarify the IRS’s three-part definition of “independent director” by indicating that the filing organization must use the three-part definition of “independent member” contained in the Form 990 instructions even if that definition is in conflict with state law definitions of independent members or in conflict with the filing organization’s definition of independent member in its conflict of interest policy.

Practice Note: Addressing issues of “independence” may trigger some controversy at the board level given the difference between the IRS definition of “independent” director and state law definitions of the same; potential confusion between application of the “independence” and “conflict concepts;” and potential confusion between “independence,” “conflicts” and “disinterested director” (for rebuttable presumption) concepts. In addition, application of the IRS definition of “independent” director could prompt a restructuring of the board in order to ensure independent control.

FAQ #4
FAQ #4 only applies to filing organizations that have members or that have local chapters, branches or affiliates. The purpose of this FAQ was not to provide additional instruction to filing organizations but, instead, merely to explain why the IRS included questions on members and local chapters, branches and affiliates in the first place.

FAQ #9
FAQ #9 discusses whether the filing organization must provide governance information regarding its related organizations. The IRS indicates that, as a general rule, the answer is no.

Practice Note: While it is not generally required, there are many situations where a filing organization should provide information about the governance of related organizations. For example, many health care organizations may not have “independent” boards (as defined in the Form 990) because they are controlled by a tax-exempt organization that has a community (i.e., independent) board. This structure has been expressly approved in IRS guidance regarding community-based boards and exemption. See, “Tax-Exempt Health Care Organizations Community Board And Conflicts Of Interest Policy,” 1997 Exempt Organizations Continuing Professional Education Text at 21, which may be found here. Unfortunately, Part VI of Form 990 fails to recognize that as a possible structure. For these filing organizations, Schedule O is the only place in Form 990 where they may describe the existence of the community (and independent) board at the parent level.

Further, many exempt organizations are exempt under the so-called integral part theory of exemption, which looks to the activities of related organizations to justify their own exemption. In isolation, these integral part organizations may appear less charitable than other exempt organizations since their exempt status is derived from another entity. Schedule O presents an opportunity for these organizations to explain the full array of charitable activities provided by the tax-exempt system. Similarly, Schedule O may be used to report community benefits provided by other tax-exempt entities within the filing organization’s tax-exempt system, to more accurately portray the true scope of activities being conducted by the filing organization’s family of tax-exempt organizations.

Discussion

Part VI to the Form 990 and the issuance of these FAQs underscore the importance that the IRS attributes to effective corporate governance by tax-exempt organizations. Over the last several years, IRS officials have repeatedly expressed their belief that the existence of an independent governing board, combined with well-designed governance and management policies and procedures, increases the likelihood that an organization will comply with the tax laws. To that end, the promotion of good governance, management and accountability has become a new “pillar” of the IRS’s compliance program for the tax-exempt sector. Furthermore, governance accountability is an important feature distinguishing the nonprofit model from the for-profit model for purposes of hospital tax exempt status.

There is no explicit statement of IRS jurisdiction over corporate governance of tax-exempt organizations in either the Internal Revenue Code or the associated Treasury Regulations. Rather, the IRS focus on governance is based upon what it refers to as “implicit jurisdiction,” i.e., the concept that the quality of governance affects all aspects of the IRS’s oversight over exempt organizations—furtherance of exempt purposes, private inurement, excess private benefit, reasonable compensation, informed and fair decision making regarding investments and fundraising practices, and self dealing. Furthermore, principles of good governance by nonprofit organizations are actively enforced by state charity officials, such as the attorney general, and actively monitored by donors’ rights organizations. Effective corporate governance is also favorably recognized in the credit rating analysis process.

While one can argue that the IRS is overreaching in prescribing specific governance procedures, tax-exempt organizations are well-advised to attribute significant focus and attention to the governance questions posed on Part VI of the Form 990, and to the underlying governance concepts raised by those questions. In that regard, these newly released FAQs offer helpful guidance.

Here is a link to the full article at McDermott Will & Emery.

I love when I come across a cool topic and it covers two categories…

Famed Wine expert Natalie MacLean has an awesome app for your iPhone or BlackBerry called Mobile Matcher.

This app will give you over 380,000 meal/wine pairing recommendations!

As her site says, “You’ll find matches for every dish, from appetizers and cheeses, to main courses and desserts. Never get stuck in a liquor store or restaurant wondering which bottle to choose again. It’s like having a sommelier and a bartender in your pocket.”

Just saw this really cool app for your BlackBerry called Call Informer. The app is designed to help sales people quickly identify and respond to incoming calls. Having contact notes available before you answer a call allows you to make informed choices about your response.

When you receive an incoming call from a contact in your address book, CallInfomer displays the following; Caller Name, Organization, Number (inc. type such as Home, Work, Mobile etc), Contact Notes (and previous call notes) and the date/time of the last time this contact called you and the date/time of the last time you called them.

You can update the contact notes right there or you can choose to send an sms to the caller and all of this can be done from one screen before you choose to answer the call.

Features:

* Information displayed on screen as call arrives
* Contact notes and time of last phone contact is displayed
* Update contact notes without having to leave screen
* Send sms to caller without having to leave screen
* Perform all actions before answering the call
* Allows you to make informed decisions about your call response