Middle Office Takes Center Stage in Hedge Fund Valuation Fiasco

A recent fine of US$9 million the US Securities and Exchange Commission levied against a UK hedge fund advisor and its former US holding company shows the operational risk faced by alternative investment funds when middle-office controls fail to correctly handle the signs of a bad valuation.

The settlement, announced on December 9, 2013 arose from investigations by the SEC’s Aberrational Performance Inquiry Initiative. The SEC program  began in 2009 to analyze the performance data of registered hedge fund advisers to identify funds that were reporting suspiciously high returns based on their investment strategy. Relying on data mining analytics, the SEC has taken enforcement action against more than seven culprits for incorrect disclosures.

In the case of the hedge fund advisor, GLG Partners, the error came to a whopping US$160 million, or 60 percent, overvaluation of its 25 percent stake in a Siberian coal mining company from November 2008 to November 2010. That overvaluation, in turn, affected the net management and administrative fees which the fund could charge its investors. The damage: US$7.77 million in excess or inflated fees, says the SEC.

Although neither the UK hedge fund nor its US parent, GLG Partners Inc. (GPI), was registered as an investment adviser in the US, the SEC contended that the parent company, which had securities registered, violated its obligations to maintain adequate controls and included misleading information on various SEC filings. The Delaware-incorporated GPI was acquired by the UK’s hedge fund giant Man Group in October 2010.

Just how could GLG Partners make such an eggregious pricing error in its GLG Emerging Markets Special Assets 1 Fund? Based on a reading of the SEC’s documentation, it doesn’t seem that intentional fraud played a role. Instead there was a clear breakdown in procedures which turned into a comedy of errors in relaying the correct information to a pricing committee, which itself might not have been well-prepared for the task at hand.

Blind Led the Blind

Middle office operations specialists at GLG Partners had plenty of reason to suspect that that the US$425 million initial valuation was no longer valid, but apparently never told the firm’s pricing committee, because no one really understood who should take that on that responsibility and how frequently the information should be transmitted — either monthly or semi-annually. Although, the SEC nailed GLG’s senior management for mishandling of the fund’s investment in the Siberian coal company, it was the middle office — an amorphous phrase for all of the functions between trading and ultimate settlement of securities transactions — that was to blame, say compliance experts at several US and UK hedge fund managers contacted by FinOps. That middle office, responsible for portfolio accounting, didn’t create appropriate agendas and procedures to protect their firm and investors.

GLG bought its stake in the coal mine company for US$210 million in December 2007 and in March 2008 it was valued at US$425 million. During the first half of 2009, the independent pricing committee (IPC) was never informed of the continual drop in the coal company’s output or in the price of coking coal which would have clearly changed the valuation. The IPC was also never told that GLG’s own analysts were calling for lower valuations.

External Input

In January 2010, a financial services firm was finally brought in to conduct an auction of the shares of the hedge fund in question — the GLG Emerging Markets Special Assets 1 Fund — so that investors could get out. That firm, which the SEC never identified, came up with a final valuation of between US$246 million to US$284 million, reflecting changes in market conditions which would affect the value of the fund’s largest investment — a stake in the Siberian coal company. Once again, GPI’s pricing committee never found out about the lower valuation during meetings in September, October and November 2010.

Hedge funds often invest in exotic semi-liquid or illiquid assets, otherwise defined as Level Three securities in global accounting jargon. Because there is no readily accepted market value for such assets — typically private equity, asset-backed and mortgage-backed securities — hedge fund managers must make some tough decisions on which data inputs, assumptions and pricing models to come up with a valid price.

Although fund administrators often tout the merits of outsourcing operations to an independent third-party specialist, they readily admit that when it comes to the valuation of non-exchange traded assets, the buck stops with the hedge fund manager itself. “We can provide our input, but the fund manager has the responsibility for the valuation as the fund manager was the one who made the investment,” says Bill Stone, chief executive of SS&C, parent of hedge fund administrator SS&C GlobeOp.

As good practice, most hedge funds have established independent pricing committees or teams of specialists to agree on a price for a non-exchange traded instrument. But the IPC, often consisting of risk, trading, portfolio management experts, can’t do its job correctly, if it doesn’t get the right information on a timely basis. The right information — reflecting changes in market conditions, liquidity, and data inputs — typically comes from a variety of sources, including portfolio managers, traders and broker-dealers, and are collected by middle office executives to present to pricing committees.

Deborah Prutzman, chief executive officer of The Regulatory Fundamentals Group, a New York based regulatory compliance firm, points to two key lessons hedge funds should learn from GLG’s pricing fiasco. “First, make sure your firm and any fund committees, such as the pricing committee, consistently do what the policies say, in a meaningful way by acquiring all the needed information in a timely fashion and devoting the time needed for a full evaluation,” she says. “Having done this, maintain a full documentary record.”

GLG’s pricing committee, says Prutzman, didn’t address each Level 3 asset on a monthly basis as required by the firm’s own asset valuation policies; didn’t obtain information that the fundamental business conditions underpinning the initial valuation had changed; frequently met with a crowded agenda; and didn’t maintain the proper documentation.

The second lesson to be learned from the GLG fiasco: it is important for committee members and staff to be clear and accountable about expectations and their roles. “No one wants to be the bearer of bad news,” says Prutzman. “However, today more than ever, staff needs to know how to escalate issues up the line on a timely basis.” Senior management needs to know when and how issues are to be shared with other stakeholders, whether they be regulators, investors, the board or a pricing committee as in the case of GLG.”

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