Monday, March 2, 2009

The Real World - A Due Diligence Tale

The author of this article is an active FOF manager who declined having his name used.

As a due diligence specialist in the fund of funds space of the financial world, my job consists of finding appropriately performing opportunities for others and receiving a fee for directing clients to these investments.  This process includes a stringent, often referred to as onerous, due diligence process, during which we meet the managers and   investment professionals.  We review every facet of their organization including: operations, back office, analysts, traders, partners’ history and even the managers’ personal credit. This process typically takes many months of countless hours of extremely hard work reviewed and agreed upon by a handful of dedicated employees who work with me as a team.  Together, we have made hundreds of recommendations over the last 20 years. This onerous, systematic form of due diligence has always been the process that leads to our recommendation, for better or worse.  This, over time has led to many relationships with managers all over the world (these as well, are for better or worse) and as such, I have come to know many of these people who managed my clients money, very well. 

Recently, many were caught completely off guard by the news of market maven, Bernard Madoff and the fact that the supposedly steady returns he had been delivering for decades, was nothing more than a ponzi scheme.  There were obvious exceptions.  Most notably, Markopolous and JP Morgan’s Jamie Diamond.  The former, had been trying to prove to anyone that would listen, including the SEC, that Madoff’s returns were not possible.  Markopolous had created an accurate financial model years earlier in 2001 that proved for a fact (and beyond a doubt for those of us who understood Mr. Matkopolous’ computations), that Madoff’s returns, based on his acknowledged strategy was not possible.  The latter, well they figured it out too.  In fact, many people on wall

street had it figured out.  This is exactly why no major investment bank was caught up in the Madoff scandal in its final stages.  As a member of a team (most of us work for many years on a team before we become managers) that performed due diligence on Madoff many years earlier, we too found, what many others in the industry found, these returns were not possible for a myriad of reasons.   This and situations like it, (Bayou, Stanford) continue to take the street by surprise.   With clients more nervous than ever I have become more concerned than ever with rumors and innuendo.  When mathematical modeling, credit checks and top down reviews check out, next we check the “rumor mill.”  It’s a big world, but a much smaller financial community within, than the average investor realizes.  While we never believe them at all, we still believe in doing as much homework as one can do.  Even doing it twice.  

Due it Over Stupid

From the wisest FOF manager to the normal investor - all are going through the typical due diligence steps again, with each and every current investment.  Needless to say, my team is not happy and has been sleep deprived and cranky for quite some time, as am I.  During the first 6 months of investment reviews we covered many hedge funds with many strategies.   Even the best of managers are currently under tremendous stress for obvious reasons and I must admit, we too feel the weight of the markets and the turning of the tide as many of our best clients demand their funds returned.  Regardless of return profile, in times of uncertainty, investors flee the markets.  It is an unfortunate fact, that history has never seen a greater time of flight from the stock market (and credit markets for that matter).  The fear is palpable and we are all guilty of the horrible crime of trampling over one another on our way out the door.  It seems we all vaguely recall the flight attendant warning us to walk, not run to the exit and still, we simply cannot help but sprint in an every-man for himself fashion, to a soon to be disclosed finish line.  It’s an odd position to be in, we did well for our clients in certain spaces, and not so well in others.  It doesn’t seem to matter.  The loyalty lies within the money.  Not toward any particular FOF or manager, rather it lies within the simplicity of the golden rule.  And everyone wants their gold back, yesterday, if not sooner.   We have an equal percentage of withdrawal in all.  One fund, the NIR Group, an alternative investment fund, had a strong return, another, Laurus Funds, a slight loss, yet we were invested in both. The percentage of requested redemption from each is nearly identical.  This shows us two things.  First, people want their money, but secondly and more importantly, they want their money regardless of profit and potential which is indicative of irrational behavior. We spoke to the independent auditor of one fund, Marcum & Kliegman, a regional firm with hundreds of employees and far more clients as well as a division dedicated and specializing in fund auditing.   They assured us, in regard to NIR, there were no issues they were aware of and had been the fund’s auditor since inception.  They also were quick to point out that they have over 300 professionals on staff, aren’t a small firm and represent hundreds of investment partnerships.  We were also referred to an independent 3rd party valuation firm who also had evaluated this particular funds portfolio, WTAS.  My team spoke with WTAS regarding their valuation in the market, FASB 157 and how they had worked with the fund in order to determine an independent 3rd party evaluation apart from the accounting firms audit to further assure investors that the methodology is sound and that it meets all legal requirements and regulatory standards of accounting.  This is a national firm with hundred of professionals, some of whom we had dealt with on previous evaluations of other funds, so we felt confident in their assessment abilities. 

Next, we went on to speak to one of the market makers who the fund works with and whom we believe is responsible for a sizable portion of the firms trading, which clears through Penson Financial Services (PFS), located in Dallas, TX.  He has traded micro-cap securities for many years and is considered an industry veteran.  He and his team, trade hundreds of millions of shares each day, many of those shares are on behalf of the fund in question.  We were able to discuss trading on these investments and the nuances involved in this niche market.  He described other like funds and their strategies from his perspective.  We spoke with him in detail about the overall market, its liquidity and where he believed micro-cap market was heading.     

Due Sue 

Legal due diligence has become very important.  We live in the most litigious society in the world during a time of world wide economic strife, so we not only have to review all litigation, we also have to determine the effect, if any, such litigation may have on our decision to invest or directly on our currently existing underlying investments. Over the past few years, the firm had restructured and grown, but had also had several departures, as well as their fair share of bad press, all of which, is disconcerting.  The rumor mill had this particular fund named in several lawsuits, as it turns out, they were the plaintiff in, all but one litigation.  Mostly, these were standard suits against portfolio companies for not adhering to their deals.  Non-performance seemed to be the common thread.  The company invariably seems to make the claim that the fund(s) manipulated the stock and/or shorted when it agreed not to short.   It is important to note that we reviewed all litigation the firm has been involved in (since inception) and all the times the firm had to deal with this counter claim (of shorting), not once has any company proven that they or anyone associated with their firm committed any wrong doing.   Our legal due diligence determined that in all likelihood no shorting occurred.  In addition our conversation with traders all pointed in the same direction.  The suits were frivolous and most likely just a tactic in an attempt to scare the investor (fund) into settlement.  None of these companies have every proved any of their allegations and, in fact, all counter-claims against the fund, were dismissed with prejudice.  

During our review, we found one case in which our client fund was the defendant.  As we came to understand it relates to the company restructure.  According to the law enforcement report, “two large gentlemen entered the offices of NIR and demanded to see the fund manager over the restructuring.”  We confirmed with the manager that an investor had indeed hired and sent two big guys to ‘collect’ their investment on the investors’ behalf.  The firm’s general counsel took an impromptu meeting at which time the gentlemen explained that the investor wanted their money returned immediately; anyway possible and if not, the manager and his family were at risk.  The firms’ owner immediately spoke to counsel and law enforcement personnel giving them all the information, which include the clients’ name, Tucci and the fact that this particular client was part of as larger investment group introduced by disgruntled former partner, Kenny Yellin.   Yellin had resigned almost a year earlier and had been threatening the manager, the employees and counsel ever since.  Yellin was the topic as we find out of an investigation into an insurance claim that he made under a homeowners insurance policy.  This came up from our discussions with law enforcement.  

As you can see, legal due diligence provides us with many challenges as it has infiltrated every aspect of our society and become impossible to avoid.  Therefore we find this area of our expertise must not only be empirical, but more importantly, it must be viewed with a fluid understanding of its effect on our underlying and future investments in order to adapt to the rapidly changing environments.   In other words, it has become our job to interpret the legal consequences as it relates to investment as opposed to how it relates to legality.

Just Due it

When determining initial suitability of a fund we look at many aspects of company.  Paramount is independence.  Auditors, they must be independent.  In addition, they must be sizable and they must be well known and respected firms.  In addition, many funds are turning to independent 3rd party auditors or valuation experts who review and evaluate the funds portfolio evaluation methodology, in addition to the primary auditors.  This provides the manager and the investor with another layer of protection and an even greater assurance that the underlying accounting valuation methodology is quite sound.  This theme of individuality must also be applied to traders, market makers and clearing agencies.  The same basic principles apply.  They must all be independent of the fund, sizeable and widely recognized as respectable known entities in their respective fields.  Once we have made these determinations and are comfortable with our financial due diligence, we combine it with our legal due diligence.  In this case, legal exposure as it related to the underlying investment was determined to be minor and would most likely have little to no effect on the underlying investment.  

On it’s own, financial due diligence is an obvious must for any fund of funds.  It is crucial however, to avoid the mistake of under estimating any appearance of impropriety, especially as it concerns related party entities, their inter-dependence and its possible effect on the underlying investment.  In addition, legal due diligence hinges on the ability to not only understand the law, but equally as important, is the ability to fluidly determine a possibly undetermined outcome and its affect on an investment.  It is only when these two partners in due diligence are combined, than one can finally see the whole picture.   It’s absurd to believe that a Madoff feeder fund like Ascot Partners or Fairfield Greenwich, did the appropriate underlying due diligence, in my opinion.  There are far too many obvious red flags, including the methodology and especially the incestuous relationship between trading firm and clearing agency.  Finally, anyone who has followed the story is now aware that their auditor, Friehling & Horowitz was a firm so tiny, experts scoff at the possibility of such a firm handling the multi-billion dollar accounting necessary if Madoff’s trades and accounts had actually existed.

As time goes on, we find our jobs harder and harder to do and recently, even tougher to keep.  Day to day we find more and more phone calls to be redemption requests from panicked investors.  While we certainly cannot blame them for giving in to their emotions in this market many looking at tremendous losses, I am personally looking forward to a day where we can all look back and confidently think to ourselves, “we made it through.”  I’m not exactly sure when this turmoil will cease or when that day will come.  I’m not even exactly sure what this melt-down we will have made it through is, but I am confident that when that time arrives, my due diligence process will prove its resilience and the managers that warrant it, the ones that adapt, that persevere, they will be the ones who receive my clients investments.