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| Feature |
Pruning the Thicket
John Ferry
12/01/2004
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In the 1990s, Ken Lipper displayed the kind of investment-world gravitas that
convinced celebrities such as Julia Roberts and corporate chieftains such as
Michael Eisner to invest in his hedge funds. Formerly a partner at Lehman
Brothers and an occasional movie producer, Lipper held degrees from leading
universities and a reputation as both a smart dealmaker and a wise investor,
having originally set up his asset management company in 1986 to oversee his own
family’s fortune. When Oliver Stone needed a role model to show Michael Douglas
and Charlie Sheen how Masters of the Universe fought their battles for his 1987
movie Wall Street, he turned to Lipper.
 His repute was soon to be of another variety. In early 2002, Lipper’s
flagship convertible arbitrage hedge fund admitted losing $315 million—more than
40 percent its value—the previous year, shortly after claiming to have made a
profit. Lipper’s standing with investors crumbled, and his company eventually
liquidated all its hedge and mutual funds as it was consumed in a paroxysm of
investor recriminations. As later described by the Securities and Exchange
Commission, the collapse of Lipper’s funds was a classic case of “mischief in
hedge fund portfolio valuations.”
Dire Omens
Lipper’s appeal to investors before the scandal was
understandable: His record as a hedge fund manager was ostensibly impeccable.
If, however, the individuals who invested in his funds had taken the time to
conduct a thorough review of his operations and portfolios—due diligence—before
committing their capital, they almost certainly would have found red flags.
Chief among them was that Lipper & Co. estimated the value of its own
positions. “It’s very unusual not to have a third party marking the portfolio,”
says Philip Chapman, president of New York-based Adler & Co., a family
office and investment company. To do otherwise brings into question the
credibility of the prices the fund reports to investors, creditors and trading
partners.
However, the search for problems of this nature takes time, and
investors gushing over an exclusive opportunity to invest in a hot manager’s
latest fund may be loath to risk their access by asking scores of detailed
questions. Managers often discourage investors from doing so by arguing that the
information they seek could undermine the fund’s positions, or reveal
proprietary trading secrets.
TOP VIEW
Hedge fund investors sacrifice liquidity and information about their
investments, while paying enormous fees, in the hope of obtaining market-beating
returns. Because hedge funds operate with little regulatory oversight, and have
wide discretion over how they invest, we need to take the initiative and conduct a thorough review of each fund’s policies, portfolios and personnel—before committing our capital. |
Those funds destined for ruin (see "Roques Gallery," at the end) are often the most furtive; they hope to stonewall legitimate
queries from investors about accounting, operational policies, personnel and
risk management by touting their expertise and, in some cases, mystique. (The
partners of failed leviathan Long-Term Capital Management were notorious for
this. They included two Nobel laureates, a former senior Federal Reserve
official and a legendary bond wunderkind. They barred their investors from
bringing pens or paper into meetings with their portfolio managers.)
Unfortunately, as Lipper’s investors discovered, taking even a renowned manager
on faith can lead to catastrophe.
Nasty, Brutish and Long/Short
While the average retail investor has the
considerable expertise and formidable authority of the Securities and Exchange
Commission protecting him from asset managers’ fraudulent claims, incomplete or
misleading disclosures and overly risky strategies, hedge fund investors are
largely on their own. Even the SEC’s new initiative to require hedge fund
managers to register as investment advisors will not bring them under its
purview to the same extent as, say, mutual funds or brokerage houses are.
“Investors should not assume that SEC registration will make them safe,”
cautions David Matteson, a partner specializing in hedge funds at Chicago law
firm Gardner Carton & Douglas. “Today, registered investment advisors get
inspected by the SEC every three to four years. If that’s the case and we go
throwing another 2,000 or more managers in there, then you’re looking at [each
being reviewed] every five to six years. Are investors really protected then? I
don’t think so.” While the SEC’s plan may keep convicted fraudsters and others
banned from the securities industry from hanging out a shingle and opening a
hedge fund, the onus will remain overwhelmingly upon us to scrutinize the funds
in which we invest.
As anyone who has sat through a fund manager’s pitch can
attest, this is not a simple task. Hedge funds tend to engage in sophisticated
trading strategies and use leverage and financial options to a far greater
extent than do other asset managers. They also divulge few performance details.
Many only reveal quarterly net asset value (NAV) figures. Some will also provide
a risk statistic, such as their value-at-risk (VAR) numbers, which is the
maximum dollar figure the fund expects it could lose in a given period. However,
both of these are snapshots of performance; unscrupulous fund managers can
arrange their portfolios at the end of each quarter to make their NAV and VAR
figures look good for reporting purposes, thereby hiding their longer-term
problems.
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