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Stanley Feldman On Misreporting Alternative Investment Values
Episode Transcript: Jim: Axiom Valuation has compiled some research recently about potential issues arising with reporting alternative investment values under Topic 820. Let's first talk about what types of organizations are heavily invested in alternative investments and why did alternative investments become so popular? Stan: Well the major investors in AI or alternative investments, are endowments, pension funds, foundations, not-for-profit organizations. The reason they've become invested in these is that there's been some research and there's also been a lot of market discussion and talk, that these investments generate very high excess returns at relatively low volatility. So if you're constructing the portfolio of securities, one of the things you want is high returns and low volatility. And AI has been sold to these investors with those characteristics in mind. So that's the major reason. Jim: In terms of percentage of the overall investment portfolio, how much exposure to alternative investments do these types of organizations typically have? Stan: If you divide the organizations in terms of those organizations that have less than a billion dollars in total assets and more than a billion dollars in total assets, the ones that are larger typically have 15% to as much as well over 50% in alternative investments. If you go below the billion dollar mark, you typically don't see percentages that are much higher than 20%. Jim: As you've pointed out, many funds have assets in excess of a billion dollars, so even a 10% allocation to AI translates to a sizeable dollar exposure. Why has the level of exposure to AI become an issue? Stan: Well the level of exposure to AI has become an issue for at least two reasons. The first and foremost is the Madoff scandal and the hedge fund vehicles that Madoff and the Madoff feeder funds used, those particular funds are very opaque. That means the underlying investments lack transparency and so on. So the investor really doesn't know what's in there. Given the scandals and the financial crisis, fiduciaries now who are responsible for the asset values on their balance sheet turn around and say to themselves, “How do I know what's in there and second how do I know that the values I'm being presented are accurate?” So it's essentially the financial crisis and the recent scandals that have raised the issue of transparency and how transparent are the valuations that the fiduciaries are receiving. Jim: Stan you've uncovered some research that indicates the potential for misreporting private equity and hedge fund performance and misreporting is pretty high. Can you give us a couple of examples? Stan: Well first there are a number of studies that have been done but the two studies of real significance on this and the two studies that I focus in on in my paper are a study by Bollen and Pool in 2009 and one by Phalippou and Gottschalg also in 2009. And what they report is that it appears to them that the self-reported hedge fund returns appear to be misreported. And the misreporting usually takes place when a manager has a return that is negative. Let's say for an example a return that's negative .5 and in terms of the evidence of the study suggests what they like to do is to say well that negative .5 it's possible it could be plus .1. So what they're doing is they're managing their returns in order to minimize the negatives and maximize the positives, and particularly maximizing positives around zero. This may seem small to some, but actually makes a fairly significant difference when you're representing yourself to future investors. That is when you're marketing your capabilities. So the Bollen and Pool study is very robust. The second is a study by Phalippou and Gottschalg, also from 2009, and there, they study private equity funds and returns generated by private equity funds. The thing that is so substantive about this particular study is what the authors actually do is they actually measure the returns from private equity funds. They measure returns two ways, the first way they measure is actual cash returns that funds actually generate, and they compare those returns to what the returns are that the managers self-report. What they find is is the managers are self-reporting much higher returns than the underlying cash flows coming from the funds indicate. Now this clearly implies that for the investments that had not been liquidated, that those investments are likely to be valued much higher than they in fact are, or much higher than fair value would suggest. So here's another case that's significant in terms of equity, or in this case private equity managers, not only misreporting returns but kind of characterizing their returns as something that are quite good; when in fact, they're not nearly anywhere near as good as the managers themselves, in the aggregate, would suggest, or has been suggested by people that are, say, investment advisors to pension funds for an example, or endowments looking at private equity and saying, “Well the results appear to be pretty good and therefore we should invest in these.” But yet the academic research supports the opposite conclusion, so this is a very, very powerful study. Both studies, by the way, appear in what we refer to as tier one academic journals, which means they're not studies done by consultants, they're studies done by academics. So they don't have any real skin in this game. They're not doing these reports and analyses with the idea that they need to represent this to the public in a positive light. If the results suggest that, that's fine, if not, which in these two cases they haven't. By the way these aren't the only two cases, but these are the most recent and the most robust from my look at the research. Jim: Stan do you think a large percentage of alternative investments are reported improperly? Stan: If you look at the experience of the studies, for example, if you take the Phalippou and Gottschalg study, it's pretty clear that a fairly large number of private equity funds do misreport. Now misreport doesn't necessarily mean fraud. Misreport could emanate from a variety of different sources: It may very well be that they used the incorrect valuation methods; they might have made just an outright mistake. Remember, there isn’t an independent third party coming in and valuing, looking at what methods that the private equity managers are using to value their portfolios. Yes, they're audited, but the auditors aren't doing valuations. So if a manager has an option to value a certain investment in a particular way that is favorable to the manager, but yet doesn't violate what we would consider ethical guidelines as it relates to valuation, the issue then becomes that they probably overvalued something and if an independent third party came in they probably would say that value is too high. So, I would say that based on our experience, in terms of doing this work, that for every 100 interests that we value, there's probably 20% of those that are questionable. And the questionable aspects go back to using incorrect valuation methods that some of the information used in the valuation is old, or inaccurate. And in some cases, you can't explain it other than to say that something is not right, and maybe a more in-depth forensic accounting exercise needs to be done. Jim: So bottom line an investor needs to be aware that private equity and hedge fund managers have both the incentive and ability to inflate the reported valuations regardless of economic conditions, right? Stan: That's true. Essentially if you're a private equity hedge fund manager, what are the issues? In terms of reporting values and returns, they are conflicted and the conflicts emerge one because we want high valuations, high returns so I can go to prospects and describe my track record, so to speak, and if the track record isn't good, you don't get new business. And the other, of course, has to do with fee structures. You know the higher the values the greater the fees that the managers are collecting, so they're conflicted. And so if you know that those conflicts exist, and we know from the financial crisis, the Madoff scandal, that those conflicts are real. They're not just of academic interest, they're real and since those conflicts are in place, it's very difficult for the private equity and hedge fund managers to manage those conflicts. So the fiduciary needs to be very, very careful and ensure that the values that they are receiving are in fact accurate. Jim: Let's talk about what these findings imply for fiduciaries that need to comply with Topic 820. What are some of the oversight problems for fiduciaries? Stan: First the AICPA Guidelines focus in on who's responsible for values that sit on a fund’s balance sheet. And the AICPA Guidelines as it relates to ERISA, for example, which is the oversight for pension plans, all say that the managers and the fiduciaries are responsible for those asset values and they need to have a system in place, they haven't described what that system necessarily is, but a system in place that allows them to validate the values that the managers are reporting to them. That system needs to be audited, or auditable if you will, by the auditors. It can't vary from year-to-year. It has to be very consistent, and has to be formalized. And that's kind of the major ingredient that has to be in place so the overseers, namely the auditors, can have something to audit. Jim: What are the oversight responsibilities for the auditor related to valuation of alternative investments? Stan: The auditors are there to audit a formal process that the manager has in place. The formal process includes having very discrete knowledge of the valuation metrics used by their managers, investment managers, and have evidence and proof that they have done enough due diligence to be comfortable with what their managers are doing. So that's the first thing. The second thing, they have to have literally is a process, or a document that documents the work they've done to understand how the valuations are put together by their investment managers. Again, prior to the financial crisis there's been a lot of work done by fiduciaries in collecting information from managers about what they're doing and how they do it, getting a certain level of comfort with the audit firms the investment managers have, who opine as to process that the investment managers are using. And then once you have enough of that what we call information due diligence, you've kind of collected all this information, you then have historically presented it to your auditor and then the auditor needs to opine on whether that satisfies their oversight requirement. I think what's clear now is both on the audit front and for well informed fiduciaries, that the older, former best practice is not good enough. It's an important input, needs to get done, but the other part that is needed to close the circle is what we refer to is analytical due diligence. All of that information you're collecting has got to go somewhere and it's got to be analyzed by the fiduciary, or the fiduciary staff, to ensure that the values they’re receiving from the managers are accurate. That's really what's changed. Jim: Is there a method for validating self-reported alternative investment values? Stan: Traditionally what's happened is that the fiduciaries have said, “Well the managers won't give me enough information to allow me to do the analytics. So I'm kind of stuck.” But there is a method, and the method is called The Replicating Portfolio™. And The Replicating Portfolio™ essentially says to the manager, you don't have to tell me the underlying investments, but you have to give me information as it relates to asset type, industry segmentation, countries where the investments are. And if you give me this information on how it's changing from quarter to quarter, which by the way is information the managers do have, and while there might be some reluctance or at least historical reluctance to provide it, in the current environment that reluctance, at least in our experience, has gone away. Once you've got that kind of information, you can then create, using public securities, a portfolio that replicates, that has the same risk-return characteristics as the private equity or hedge fund that you're invested in. Now what does this mean? It means that if I can replicate the structure of the portfolio, I should be able to replicate the returns reported by the investment managers. And if I can replicate those returns, that indicates that the returns that the manager are reporting is consistent with the risk-return characteristics of the portfolio that they describe. Now what happens is, and this is the reason why this methodology is so powerful, is that it doesn’t' necessarily simply rubber stamp what the managers have told the fiduciaries. What it says is, if it replicates that's fine, but if we don't replicate there's got to be a reason for it, or reasons. And then the issues become what are those reasons? And that communication between the fiduciary’s agent, let's say for an example, Axiom, and the investment manager, then becomes the foundation of the basis for what we would term a process document that subsequently gets audited by the auditors. So many of the questions put to the investment manager emanate from an analytical process where the returns they report and what they say doesn't match the returns generated by this replicating portfolio. So you can think of the replicating portfolio as kind of a customized index, and that customized index mimics the risk-return characteristics of the target portfolio, which could be a private equity portfolio or a hedge fund portfolio. So now there's a way to do it without knowing the underlying investments. You don't have to know the underlying companies you're invested in because the client, the pension fund or endowment fund, is really not invested in any one company, it's invested in a portfolio. And therefore we can use portfolio theory and all of the rich theoretical and empirical analysis that's been developed over the last 40 years to help us understand whether the returns reported are accurate or not. Jim: Does the replicating portfolio method meet AICPA Guidelines? Stan: Yes, the AICPA Guideline is about responsibility, knowledge and process, and the replicating portfolio creates the process that the AICPA requires fiduciaries to have in place. The answer is yes. Jim: Can those values provided by the replicating portfolio method be reported with confidence to meet Topic 820 fair value requirements? Stan: Yes. What it does is again, it goes back and it essentially validates what the manager has reported as fair value, that's what it does. In cases where the manager values and the values emanating from a replicating portfolio analysis don't match, then that's where the issues begin to arise. For example, if the differences between manager values and what the replicating portfolio indicates can't be removed, when I say removed what I mean by that is that there's additional information the manager might report which updates the replicating portfolio and once that information is there, then the differences kind of go away. There are cases where it's pretty clear that the manager, i) doesn't have the information and, ii) it's not so much that they won't share it with us or with somebody using the replicating portfolio strategy, but it's an indication that what the manager's reporting is not correct. And that's really the next step for the fiduciary because then they have to undertake perhaps a more in-depth forensic accounting associated with the manager in question. And in some cases they may simply withdraw their money and not even do the forensic accounting. They simply might say, “You know we'll just leave because this manager appears to be not following guidelines, is not providing enough information for what he's doing to be fully transparent.” Jim: You can call Dr. Feldman at 1-800-477-8258 or go to the Axiom Valuation website at www.axiomvaluation.com for information about valuing alternative investments. CapitalMarket Pulse with Jim Towne is brought to you by DerivActiv, Inc. a leading provider of web-based independent valuations for fixed-income, currency, and equity derivatives and other financial products. Copyright CapitalMarket Pulse 2009.
Episode Transcript:
Jim: Axiom Valuation has compiled some research recently about potential issues arising with reporting alternative investment values under Topic 820. Let's first talk about what types of organizations are heavily invested in alternative investments and why did alternative investments become so popular?
Stan: Well the major investors in AI or alternative investments, are endowments, pension funds, foundations, not-for-profit organizations. The reason they've become invested in these is that there's been some research and there's also been a lot of market discussion and talk, that these investments generate very high excess returns at relatively low volatility. So if you're constructing the portfolio of securities, one of the things you want is high returns and low volatility. And AI has been sold to these investors with those characteristics in mind. So that's the major reason.
Jim: In terms of percentage of the overall investment portfolio, how much exposure to alternative investments do these types of organizations typically have?
Stan: If you divide the organizations in terms of those organizations that have less than a billion dollars in total assets and more than a billion dollars in total assets, the ones that are larger typically have 15% to as much as well over 50% in alternative investments. If you go below the billion dollar mark, you typically don't see percentages that are much higher than 20%.
Jim: As you've pointed out, many funds have assets in excess of a billion dollars, so even a 10% allocation to AI translates to a sizeable dollar exposure. Why has the level of exposure to AI become an issue?
Stan: Well the level of exposure to AI has become an issue for at least two reasons. The first and foremost is the Madoff scandal and the hedge fund vehicles that Madoff and the Madoff feeder funds used, those particular funds are very opaque. That means the underlying investments lack transparency and so on. So the investor really doesn't know what's in there. Given the scandals and the financial crisis, fiduciaries now who are responsible for the asset values on their balance sheet turn around and say to themselves, “How do I know what's in there and second how do I know that the values I'm being presented are accurate?” So it's essentially the financial crisis and the recent scandals that have raised the issue of transparency and how transparent are the valuations that the fiduciaries are receiving.
Jim: Stan you've uncovered some research that indicates the potential for misreporting private equity and hedge fund performance and misreporting is pretty high. Can you give us a couple of examples?
Stan: Well first there are a number of studies that have been done but the two studies of real significance on this and the two studies that I focus in on in my paper are a study by Bollen and Pool in 2009 and one by Phalippou and Gottschalg also in 2009. And what they report is that it appears to them that the self-reported hedge fund returns appear to be misreported. And the misreporting usually takes place when a manager has a return that is negative. Let's say for an example a return that's negative .5 and in terms of the evidence of the study suggests what they like to do is to say well that negative .5 it's possible it could be plus .1. So what they're doing is they're managing their returns in order to minimize the negatives and maximize the positives, and particularly maximizing positives around zero. This may seem small to some, but actually makes a fairly significant difference when you're representing yourself to future investors. That is when you're marketing your capabilities. So the Bollen and Pool study is very robust.
The second is a study by Phalippou and Gottschalg, also from 2009, and there, they study private equity funds and returns generated by private equity funds. The thing that is so substantive about this particular study is what the authors actually do is they actually measure the returns from private equity funds. They measure returns two ways, the first way they measure is actual cash returns that funds actually generate, and they compare those returns to what the returns are that the managers self-report. What they find is is the managers are self-reporting much higher returns than the underlying cash flows coming from the funds indicate.
Now this clearly implies that for the investments that had not been liquidated, that those investments are likely to be valued much higher than they in fact are, or much higher than fair value would suggest. So here's another case that's significant in terms of equity, or in this case private equity managers, not only misreporting returns but kind of characterizing their returns as something that are quite good; when in fact, they're not nearly anywhere near as good as the managers themselves, in the aggregate, would suggest, or has been suggested by people that are, say, investment advisors to pension funds for an example, or endowments looking at private equity and saying, “Well the results appear to be pretty good and therefore we should invest in these.” But yet the academic research supports the opposite conclusion, so this is a very, very powerful study.
Both studies, by the way, appear in what we refer to as tier one academic journals, which means they're not studies done by consultants, they're studies done by academics. So they don't have any real skin in this game. They're not doing these reports and analyses with the idea that they need to represent this to the public in a positive light. If the results suggest that, that's fine, if not, which in these two cases they haven't. By the way these aren't the only two cases, but these are the most recent and the most robust from my look at the research.
Jim: Stan do you think a large percentage of alternative investments are reported improperly?
Stan: If you look at the experience of the studies, for example, if you take the Phalippou and Gottschalg study, it's pretty clear that a fairly large number of private equity funds do misreport. Now misreport doesn't necessarily mean fraud. Misreport could emanate from a variety of different sources: It may very well be that they used the incorrect valuation methods; they might have made just an outright mistake. Remember, there isn’t an independent third party coming in and valuing, looking at what methods that the private equity managers are using to value their portfolios. Yes, they're audited, but the auditors aren't doing valuations. So if a manager has an option to value a certain investment in a particular way that is favorable to the manager, but yet doesn't violate what we would consider ethical guidelines as it relates to valuation, the issue then becomes that they probably overvalued something and if an independent third party came in they probably would say that value is too high. So, I would say that based on our experience, in terms of doing this work, that for every 100 interests that we value, there's probably 20% of those that are questionable. And the questionable aspects go back to using incorrect valuation methods that some of the information used in the valuation is old, or inaccurate. And in some cases, you can't explain it other than to say that something is not right, and maybe a more in-depth forensic accounting exercise needs to be done.
Jim: So bottom line an investor needs to be aware that private equity and hedge fund managers have both the incentive and ability to inflate the reported valuations regardless of economic conditions, right?
Stan: That's true. Essentially if you're a private equity hedge fund manager, what are the issues? In terms of reporting values and returns, they are conflicted and the conflicts emerge one because we want high valuations, high returns so I can go to prospects and describe my track record, so to speak, and if the track record isn't good, you don't get new business. And the other, of course, has to do with fee structures. You know the higher the values the greater the fees that the managers are collecting, so they're conflicted. And so if you know that those conflicts exist, and we know from the financial crisis, the Madoff scandal, that those conflicts are real. They're not just of academic interest, they're real and since those conflicts are in place, it's very difficult for the private equity and hedge fund managers to manage those conflicts. So the fiduciary needs to be very, very careful and ensure that the values that they are receiving are in fact accurate.
Jim: Let's talk about what these findings imply for fiduciaries that need to comply with Topic 820. What are some of the oversight problems for fiduciaries?
Stan: First the AICPA Guidelines focus in on who's responsible for values that sit on a fund’s balance sheet. And the AICPA Guidelines as it relates to ERISA, for example, which is the oversight for pension plans, all say that the managers and the fiduciaries are responsible for those asset values and they need to have a system in place, they haven't described what that system necessarily is, but a system in place that allows them to validate the values that the managers are reporting to them. That system needs to be audited, or auditable if you will, by the auditors. It can't vary from year-to-year. It has to be very consistent, and has to be formalized. And that's kind of the major ingredient that has to be in place so the overseers, namely the auditors, can have something to audit.
Jim: What are the oversight responsibilities for the auditor related to valuation of alternative investments?
Stan: The auditors are there to audit a formal process that the manager has in place. The formal process includes having very discrete knowledge of the valuation metrics used by their managers, investment managers, and have evidence and proof that they have done enough due diligence to be comfortable with what their managers are doing. So that's the first thing. The second thing, they have to have literally is a process, or a document that documents the work they've done to understand how the valuations are put together by their investment managers.
Again, prior to the financial crisis there's been a lot of work done by fiduciaries in collecting information from managers about what they're doing and how they do it, getting a certain level of comfort with the audit firms the investment managers have, who opine as to process that the investment managers are using. And then once you have enough of that what we call information due diligence, you've kind of collected all this information, you then have historically presented it to your auditor and then the auditor needs to opine on whether that satisfies their oversight requirement.
I think what's clear now is both on the audit front and for well informed fiduciaries, that the older, former best practice is not good enough. It's an important input, needs to get done, but the other part that is needed to close the circle is what we refer to is analytical due diligence. All of that information you're collecting has got to go somewhere and it's got to be analyzed by the fiduciary, or the fiduciary staff, to ensure that the values they’re receiving from the managers are accurate. That's really what's changed.
Jim: Is there a method for validating self-reported alternative investment values?
Stan: Traditionally what's happened is that the fiduciaries have said, “Well the managers won't give me enough information to allow me to do the analytics. So I'm kind of stuck.” But there is a method, and the method is called The Replicating Portfolio™. And The Replicating Portfolio™ essentially says to the manager, you don't have to tell me the underlying investments, but you have to give me information as it relates to asset type, industry segmentation, countries where the investments are. And if you give me this information on how it's changing from quarter to quarter, which by the way is information the managers do have, and while there might be some reluctance or at least historical reluctance to provide it, in the current environment that reluctance, at least in our experience, has gone away. Once you've got that kind of information, you can then create, using public securities, a portfolio that replicates, that has the same risk-return characteristics as the private equity or hedge fund that you're invested in.
Now what does this mean? It means that if I can replicate the structure of the portfolio, I should be able to replicate the returns reported by the investment managers. And if I can replicate those returns, that indicates that the returns that the manager are reporting is consistent with the risk-return characteristics of the portfolio that they describe.
Now what happens is, and this is the reason why this methodology is so powerful, is that it doesn’t' necessarily simply rubber stamp what the managers have told the fiduciaries. What it says is, if it replicates that's fine, but if we don't replicate there's got to be a reason for it, or reasons. And then the issues become what are those reasons? And that communication between the fiduciary’s agent, let's say for an example, Axiom, and the investment manager, then becomes the foundation of the basis for what we would term a process document that subsequently gets audited by the auditors. So many of the questions put to the investment manager emanate from an analytical process where the returns they report and what they say doesn't match the returns generated by this replicating portfolio. So you can think of the replicating portfolio as kind of a customized index, and that customized index mimics the risk-return characteristics of the target portfolio, which could be a private equity portfolio or a hedge fund portfolio. So now there's a way to do it without knowing the underlying investments. You don't have to know the underlying companies you're invested in because the client, the pension fund or endowment fund, is really not invested in any one company, it's invested in a portfolio. And therefore we can use portfolio theory and all of the rich theoretical and empirical analysis that's been developed over the last 40 years to help us understand whether the returns reported are accurate or not.
Jim: Does the replicating portfolio method meet AICPA Guidelines?
Stan: Yes, the AICPA Guideline is about responsibility, knowledge and process, and the replicating portfolio creates the process that the AICPA requires fiduciaries to have in place. The answer is yes.
Jim: Can those values provided by the replicating portfolio method be reported with confidence to meet Topic 820 fair value requirements?
Stan: Yes. What it does is again, it goes back and it essentially validates what the manager has reported as fair value, that's what it does. In cases where the manager values and the values emanating from a replicating portfolio analysis don't match, then that's where the issues begin to arise. For example, if the differences between manager values and what the replicating portfolio indicates can't be removed, when I say removed what I mean by that is that there's additional information the manager might report which updates the replicating portfolio and once that information is there, then the differences kind of go away. There are cases where it's pretty clear that the manager, i) doesn't have the information and, ii) it's not so much that they won't share it with us or with somebody using the replicating portfolio strategy, but it's an indication that what the manager's reporting is not correct. And that's really the next step for the fiduciary because then they have to undertake perhaps a more in-depth forensic accounting associated with the manager in question. And in some cases they may simply withdraw their money and not even do the forensic accounting. They simply might say, “You know we'll just leave because this manager appears to be not following guidelines, is not providing enough information for what he's doing to be fully transparent.”
Jim: You can call Dr. Feldman at 1-800-477-8258 or go to the Axiom Valuation website at www.axiomvaluation.com for information about valuing alternative investments.
CapitalMarket Pulse with Jim Towne is brought to you by DerivActiv, Inc. a leading provider of web-based independent valuations for fixed-income, currency, and equity derivatives and other financial products. Copyright CapitalMarket Pulse 2009.
