Games Fund Managers and Investment Advisors Play and How to Avoid Getting Played

Sometimes the Best Way to Avoid Being Played
Is Not to Play

Among other things, Alicia McElhaney at II keeps a close eye on academic research on the “investment space”.

She’s had quite a run with outlining the games fund managers play.

Here are just two examples.

• 27 May - VC Firms ‘Inflate’ Portfolio Valuations Ahead of Fundraising, Study Shows 
• 9 February - Private Equity Firms ‘Try to Manipulate Their Performance’ When Raising Money

Anyone who is sentient on the buyside has experienced this. 

But it is nice to see academics confirm what we've learned.

So how does one minimize getting “played”?

The first thing to understand is that similar to other sellers of goods fund managers are looking to make a sale and a profit. Sales pitches run from “puffery” to outright misrepresentation.

The second is that these PE and VC and similar products are sold to “sophisticated” investors--the so-called “big boys”. 

Regulators make the laughable presumption that the “big boys” don’t need the usual protections given retail investors.

That means disclosures and sales materials are allowed to be less robust and less detailed. One example relates to presentation of past returns, modelling, etc.

Professional standards of care are also lesser because the imaginary big boys are imagined to be able to take care of themselves. 

Careful investors will draw the following conclusions from those “facts”.

Healthy skepticism is warranted.

Verify first, then give provisional trust, but keep verifying.

If it seems to be too good to be true, you're probably right. 

Begin by carefully reading the prospectus/offering memorandum.

I have had representatives of major firms misrepresent products to me.

During one pitch, I commented that apparently their prospectus was wrong and cited “chapter and verse” from the prospectus to contradict the statement an earnest sales rep had just made.

Whenever I’m given a 1,000 page offering memorandum for all the seller’s products with a central definitions section separate from the product description so that the reader has to jump from here to there to make sense of a product, my antennae get more sensitive.  

Complexity is not the friend of the investor.

Be sure you understand the product.

That means you need to do your own research if this is your first "rodeo" with a product.

But also ask the sales rep to explain the product.  

Be wary of excessive use of jargon which is sometimes designed to deflect questions.  Who wants to admit that they don't really understand "vol" or the "greeks" on derivatives?

As well be wary of vague phrases,  waving of hands, and then the implication that a miracle occurs and you get rich.

The risk section and product/transaction description in the prospectus/offering memorandum can provide a good source of questions. And a check on the what is said in the "pitch".

Presentation of results that do not comply with CFA Institute GIPS (Global Investment Performance Standards) should not be relied on.

Non GIPS results can generally be managed to show whatever the seller wants.

GIPS also requires certain disclosures and prohibits certain practices.

Make sure benchmarks and historic performance make sense.

No one beats the market consistently.

Benchmark selection can affect relative performance.

See my earlier post on Infinity Q Diversified Alpha Fund.

If you do not understand how financial models may be “gamed”, you really should NOT invest in Level 2 and Level 3 assets.

This isn’t just about growth and discount rates, but also how “multiples” that are used to “determine” terminal value can disguise unrealistic assumption about those two previous factors.

If return is tied to or dependent on derivatives, you would be well advised to make certain you understand the downside risks.  

Ask the utilities in Texas who found derivatives a rather costly tuition.  

Or you could ask the good folks at JBS Spain about the derivatives they purchased.

Upward revisions of valuation should be examined carefully.

If one is being pitched, a very simple question is when the last revaluation took place and what the direction and impact was.

Amounts, timing, and the basis for the upgrade.

New funding provided by the fund manager at a higher valuation should not be considered as definitive proof the value has actually risen.

Sales of investments from one of the fund manager’s investment vehicles to another should be questioned, especially when the sale results in increasing the IRR of the selling fund. 

Or sloughing off a dog into a fund that can bear a subsequent loss of value.

Yes this occurs.

Watch out for debt financing tricks that drive IRRs and presumed value. Oh and just incidentally affect the fund manager’s compensation.

On the “outgoing” cash flow from LPs: funding LP drawdowns with debt to delay capital calls.

On the “incoming” cash flows to LPs: refinancing equity with debt to generate a “return of capital” without any realisation of the investment, e.g., trade sale or IPO.

Be sure you understand the skill set of the fund manager and how deals are accessed.

When the fund manager's primary skill seems to be the use of leverage, you may want to consider fund managers with skills in developing the underlying business. 

If the fund manager is buying assets from other funds or via auctions, ask whether he or she is getting a good price?  

If the fund manager is buying an investment from another fund, why does he or she think they can turn another fund manager's "cast off" into gold?  And is it credible?

Be sensitive to offers of preferential treatment.

Once we had a major fund management firm tell us that they were poised to revalue (upwards) investments in their existing fund. 

We could invest in that fund now and take advantage of the lower current (entry) price before mark-up.  Thus, earning a "guaranteed" return.

Needless to say, we not only declined the invitation for this investment opportunity but put them on our “blacklist” on the basis that if they were going to “screw” their existing LPs, we would be better off not becoming one.

Sometime later that fund had what might be charitably described as “disappointing” returns.

Creditor on Creditor Violence

Annual Leveraged Loan Investors Conference

Over the millennia our ancestors have passed down important life lessons to us in the forms of proverbs and other sayings.

Sometimes the author’s name is known. Most often not.

“Measure twice cut once”. Or in one country measure seven times before cutting.

“Don’t run with scissors” (ascribed, I believe, to Plato by Aristotle).

“Tie your camel first, then trust in God. (اعقلها وتوكّل)” ascribed to the Prophet Muhammad (SAWS) by Anas Ibn Malik via Al-Tirmidhi. (2517)

A recent article by Alicia McElhaney in Institutional Investor under the above title reminded me these and other similar sayings.

She describes how some members of leveraged loan syndicates are suing other syndicate members charging that when the obligor became distressed those lenders converted their “old” loans (those under the syndicate agreement) to “new” loans (outside the syndicate). 

In the process making the old loans subordinate to the new ones.

What those lenders did was take advantage of apparent deficiencies in the loan agreements.

AA finds it hard to have much sympathy for lenders stupid enough to sign syndicated loan agreements with inadequate protective covenants.

In the case at hand failing to insist that the loan agreement contain what were once standard covenants requiring:

1. 100% lender agreement to allow material changes to the loan conditions (rate, repayment, maturity, collateral)
2. pro-rata sharing of any repayments received by one or more syndicate member among all syndicate creditors 
3. limitations on market purchases of debt, along with a careful definition of what constitutes a “market purchase” etc.

While not the case here, this failure to “tie one’s camel” is similar to covenant lite loans that impose no real controls on the borrower. That is, no real triggers for creditors to call a default and accelerate the loan.

Both are “sins” in every kind of loan.

But more so for much riskier leveraged loans.

This asset class is supposedly where sophisticated investors—those able to analyze and bear the risks--”play”.

One might forgive a retail investor on the Robin Hood platform a “wise” investment in Tesla as a rookie mistake.

But “sophisticated” institutional investors with access to high-priced “elite strike force” legal teams?

I think not.

This is yet another cautionary tale--like that of Golden Belt Sukuk, Bernie Madoff, Abraaj, Wirecard, etc--for those who cling to unfounded myths about the innate wisdom of markets.