Why Is PSP Suing a Hedge Fund?

Ted Ballantine of Pension360 reports, Canada Pension Sues Hedge Fund Over Alleged Pricing Manipulation:
The full story was reported by Saijel Kishan and Katherine Burton of Bloomberg in their article, Boaz Weinstein's Revival of Saba Challenged by Pension's Lawsuit:
For Boaz Weinstein, whose credit fund had hemorrhaged money and investors over the past three years, April seemed like the turnaround moment.

The fund produced the best monthly return in its six-year history, a 10 percent jump that wiped out the pain of March when it suffered its biggest loss ever. From April on, there were no more losses, and he outpaced his rivals as volatility picked up in credit markets. Then on Friday, one of Canada’s largest pension plans and an erstwhile investor, said cheating may have contributed to the big swing -- allegations that Weinstein soon called “utter nonsense.”

In a suit filed by the Public Sector Pension Investment Board, once one of the biggest investors in the $1.6 billion Saba Capital Management, the pension fund accused Weinstein of “shortchanging” it by marking down a “significant” portion of the fund’s assets after the retirement plan asked that all its money be returned at the end of the first quarter. The next month, after the pension’s exit, Saba raised the value of the holdings, according to the lawsuit.

Whatever the outcome of the dispute, the accusations could curtail future money-raising for Weinstein, 42, as he seeks to rebuild his business, which has been hit by a 20 percent loss from the beginning of 2012 through last year. The tumble caused clients to pull billions, and employees, including three long-time executives, to leave the firm that once managed $5.5 billion.

‘Fully Vetted’

“Any suit of any nature against a fund manager will be a negative on a due-diligence checklist even if the suit is dismissed,’’ said Brad Balter, head of Boston-Based Balter Capital Management. “It’s not insurmountable, but it will be a hurdle to getting new investors.”

In a statement Sunday, Weinstein said he takes the allegations very seriously, even though they relate to only a “tiny portion” of the pension fund’s investment. “The valuation process was transparent, it was appropriate, it was fully vetted by auditors, counsel and others, and it was entirely fair,” he said. “The suggestion that I manipulated the valuation of two bonds for my personal gain is utter nonsense.”

The court fight could invite scrutiny from the Securities and Exchange Commission, which has cited valuations as one of its priorities this year and anticipates bringing cases involving pricing of portfolios.

SEC’s Concerns

“The SEC has several key concerns and valuation is one of them,’’ said Ron Geffner, a former SEC lawyer. In investigating cases of potential misvaluation, the SEC will look to see if a firm followed the methodologies disclosed in offering documents, its written policies and procedures and other client communications, said Geffner, now at Sadis & Goldberg LLP. If the investment manager deviated from its usual methods, the SEC will ask why the change occurred, he said.

John Nester, a spokesman at the agency, didn’t respond to a message seeking comment outside business hours.

The C$112 billion ($84 billion) pension fund, which oversees the retirement savings of Canadian federal public servants, said it was the Saba Offshore Feeder Fund’s largest investor, having invested $500 million over the course of 2012 and 2013 and accounting for 55 percent of the fund’s assets. The plan said it had asked Saba for its money back early this year, saying Saba’s 2014 losses appeared to be “unrelated to any market development that could or should have adversely affected the fund’s performance had the fund been properly managed,’’ according to the lawsuit.

McClatchy Bonds

Saba couldn’t adequately explain the losses, the Montreal-based pension fund wrote. The pension said it rejected a request by Saba to return capital in three installments, a move that allegedly would hide the redemption from other clients. By late January, clients accounting for 70 percent of the assets in the offshore fund asked for their money back.

The suit filed in Manhattan state court centers on hard-to-sell McClatchy Co. bonds owned by Saba. Between late January and the end of the quarter, there was only one trade done in the bonds that was for greater than $500,000 in notional value. Weinstein was looking to sell about $54 million in the bonds, according to a person familiar with the firm.

Normally, the hedge fund used independent pricing services or brokers who regularly traded the bonds, and these sources valued them at 50 cents to 60 cents on the dollar at the end of the first quarter, the pension plan said. When the pension asked for its money back, Saba used a different process called “bid wanted in competition,” a sort of auction used to trade a block of securities. That method valued the bonds at 31 cents as of March 31. Saba did not sell the bonds, and within a month, returned to its usual pricing methodology, marking the bonds in the 50s, the pension plan said.

Weinstein’s Response

“They did so to stanch further investor defections from the fund and to directly benefit themselves by boosting the residual value of their investments in the fund and other affiliated hedge funds with exposure to the same bonds,” according to the lawsuit. The pension plan, which is represented by law firm Skadden Arps Slate Meagher & Flom LLP, is asking for unspecified compensatory damages and disgorged profits.

Weinstein denied that he changed his pricing methodology in April. “We continued to use the auction to price those (and other) bonds in the second and third quarters of 2015,” he said in the statement. “PSP could have corrected its mistake with a one-minute phone call to me.”

Weinstein said he used the same auction process to sell 29 other bonds, prices that the pension fund didn’t challenge. “We couldn’t discard two of the prices resulting from the auction simply because PSP was unsatisfied with the outcome; to do so would have been improper and unfair to every other Saba investor,” he said. “I am 100 percent committed to treating all of my investors fairly, and I did exactly that in connection with PSP’s redemption."

‘Price for Liquidation’

Weinstein started Saba -- Hebrew for grandfather -- in 2009, after he stepped down as co-chief of the credit business at Deutsche Bank AG, where in 2008 he lost at least $1 billion. It was his only losing year out of 11 at the bank, a person with knowledge of the matter said at the time. At Saba, where he trades on price discrepancies between loans, bonds and derivatives, he initially produced strong profits, gaining 11 percent in 2010 and 9.3 percent the following year. Then he struggled as as central banks embraced quantitative easing that reduced volatility in credit markets.

Saba returned 7.6 percent this year through Friday.

Uzi Zucker, an early investor in Saba who pulled some of his money in the first quarter, called the suit unprofessional. “It’s just sour grapes,” he said. “He had to price for liquidation. I never questioned his judgment.”

The case is Public Sector Pension Investment Board v. Saba Capital Management LP, 653216/2015, New York State Supreme Court, New York County (Manhattan).
Antoine Gara of Forbes also reports, Canadian Pension Fund Says It Was Cheated By Boaz Weinstein's Saba Capital:
The Public Sector Pension Investment board, a pension fund for the Royal Canadian Mounted Police and the Canadian Forces is accusing Boaz Weinstein’s Saba Capital of incorrectly marking assets this year as it sought to redeem a $500 million investment in the hedge fund. PSP said in a Friday lawsuit filed in the New York State Supreme Court Saba and its founder Weinstein knowingly mis-marked assets during the redemption in order to inflate the value of the hedge fund’s remaining assets for investors, including top executives.

Weinstein, a former Deutsche Bank proprietary trader who lost nearly $2 billion for the German bank during the worst of the financial crisis, created Saba Capital in 2009 and quickly took in billions in assets from investors around the world. At its peak, Saba Capital held over $5 billion in assets under management. One of the firm’s most profitable trades was taking the other side of JPMorgan Chase’s so-called London Whale trading debacle in 2012, which cost the bank over $6 billion, but earned Saba significant profits.

When PSP made its $500 million investment in Saba in early 2012, the hedge fund had nearly $4 billion in assets under management. However, in recent years Saba’s assets quickly dwindled amid the fund’s poor performance. By the summer of 2014 Saba’s assets had fallen to $1.5 billion, PSP said in its lawsuit.

In early 2015, PSP reevaluated its investment in Saba and decided to redeem 100% of its Class A shares. At the time, PSP, a $112 billion fund, was Saba’s largest investor. To mitigate the impact of such a large redemption, Saba asked that PSP take its money back in three installments, however, the public pension fund refused.

Saba eventually agreed to a full redemption. PSP alleges that Saba knowingly manipulated its assets to depress their value during the redemption process, thus minimizing its payout.

According to its complaint, PSP accuses Saba of arbitrarily recorded a markdown on some of its bonds during the March 2015 redemption. A month later, Saba then marked its assets upwards. “As a result of defendants’ self-dealing, the Pension Board incurred a substantial loss on its investment in the Fund, for which defendants are liable,” PSP’s lawyers at Skadden, Arps , Slate, Meagher & Flom said in the complaint.

Specifically, Saba is accused of valuing bonds issued by The McClatchy Company using a bids-wanted-in-competition (BWIC) process that created depressed bidding prices that the hedge fund used to value PSP’s investment assets. Other measures from external pricing sources, which the hedge fund had used previously, put the McLatchy bonds at far higher values. Once the redemption was complete, Saba immediately moved away from BWIC valuations and back to those that could be gleaned from external pricing sources.

“[D]efendants used the BWIC process in a bad faith attempt to justify a drastic and inappropriate one-time markdown of the MNI Bonds held by the Master Fund, thereby depriving the Pension Board of the full amount it was entitled to receive upon redemption of its Class A shares of the Fund as of March 31, 2015. By reason of defendants’ unlawful conduct, the Pension Board has suffered substantial damages,” the fund said in its complaint.

In recent weeks Saba partners including Paul Andiorio, George Pan and Ken Weiller were reported by Bloomberg to have left the hedge fund.

Jonathan Gasthalter, a spokesperson for Saba Capital, relied with this comment:

“Saba Capital is disappointed that the Public Sector Pension Investment Board (“PSP”) has chosen to file a meritless lawsuit over the valuation of two securities out of well over a thousand. The difference in value at issue amounts to merely 2.6% of the total of PSP’s former investment with Saba.

As was explained to PSP in writing earlier this year, these two securities were priced using an industry-standard bid wanted in competition (BWIC) process, soliciting competitive bids from every leading broker and dealer in the relevant securities. The BWIC process was fully consistent with Saba’s valuation policy, and was carefully vetted and approved not only by Saba’s internal valuation committee, but by at least four external advisors: auditors, outside counsel, fund administrator, and Saba’s external members of its board of directors.

Contrary to the allegations in PSP’s complaint, Saba did not use the BWIC prices for a single month and solely for purposes of PSP’s redemption, but rather continued to use BWIC pricing as appropriate in the second and third quarters of 2015. Moreover, the results of the BWIC process were accepted by PSP more than 90% of the time, for dozens of securities. In only two instances–the two at the center of PSP’s lawsuit–did PSP take issue with the prices obtained by the BWIC process. PSP’s cherry-picked objection to these two prices has no legal merit.

Saba Capital took great care in redeeming PSP’s investment on a time-table dictated by PSP, including by finding fair and accurate market prices for extremely illiquid positions. Saba Capital looks forward to vindicating its position in court.”
This is an interesting case on many levels. Let me quickly share some of my thoughts:
  • First, PSP made a sizable investment in Mr. Weinstein's hedge fund, having invested $500 million over the course of 2012 and 2013 and accounting for 55 percent of the fund’s assets when it redeemed. I understand scale is an issue for the PSPs and CPPIBs of this world but whenever you make up over 25% of any fund's assets, you run the risk of significantly influencing the performance of this fund or its ability to garner assets from other investors who aren't going to invest knowing one investor makes up the bulk of the assets.
  • Second, why exactly did PSP invest so much money in this particular hedge fund and what took it so long to exit this fund? Saba Capital Management suffered losses over the past three consecutive years! I would love to know the due diligence PSP's team performed, especially on the operational front, and understand their rationale after reviewing the people, investment process, operational and investment risks at this fund. It looks like PSP was lulled by the fund's decent performance in 2010 and 2011 but investing $500 million with a manager who lost $1 billion back in 2008 is crazy if you ask me. There certainly wasn't a lot of backward or forward analysis on PSP's part in making such a sizable investment to this hedge fund.
  • Third, on the operational front, did PSP perform a due diligence on this fund's administrator (one that has the expertise to rigorously analyze the fund's NAV) and was the way the fund prices bonds clearly spelled out in the investment management agreement (IMA)? This lies at the heart of the issue. When you're investing in a quant/ credit hedge fund that invests in illiquid bonds or derivatives, you need to understand the method it prices these investments and you better be comfortable with it before you sign off on such a sizable allocation. If Mr. Weinstein violated the IMA in any way, then PSP is absolutely right to sue him. If not, PSP will lose this case no matter what it claims. It's that simple.
  • Fourth, this case also highlights why more and more institutional investors are moving to a managed account platform when investing in hedge funds. Go back to read my comments on Ontario Teachers' new leader and on his harsh hedge fund lessons. Following the 2008 debacle, Teachers' moved most of its hedge fund investments onto a managed account platform to mitigate operational risk and more importantly, liquidity risk which is currently a huge concern. But even if you have a managed account platform and have transparency, it's useless unless the underlying investments are liquid. And again, did the manager violate the IMA? That's the key issue here.
  • Fifth, this lawsuit is a black eye for Saba Capital Management which has suffered from redemptions and key departures. As one investor stated in the article, it's a negative for a due diligence checklist and it will be a hurdle to getting new investors. But the lawsuit also reflects badly on PSP Investments and it will make it harder for this organization to approach top hedge funds which can pick and choose their investors in this tough environment. Nobody wants a litigious pension fund as a client and win or lose, this lawsuit is a lose-lose for both parties involved in the case. Mr. Weinstein claims “PSP could have corrected its mistake with a one-minute phone call to me.” If this is true, then why didn't PSP call him to rectify the misunderstanding or why didn't Mr. Weinstein reach out to PSP to make this suit go away?
  • Lastly, I would love to know which other pension funds invested in this hedge fund and how this lawsuit and recent redemptions are impacting their impression of the fund. 
Those are my brief thoughts on this case. One expert I reached out to shared this with me on this case: 
"The situation may have been averted if the proper controls were in place to monitor the fund's pricing and ongoing monitoring of funds redeeming from it. In this case, it's a credit hedge fund investing Level 2 assets. The price was most likely derived from broker prices. However, if the controls were put in place, then PSP may have a point and the manager may be at fault."
There is nothing that pisses off institutional investors more than operational mishaps or fuzzy pricing when they are redeeming from a hedge fund. I remember when I was working at the Caisse investing in hedge funds and we had trouble with a CTA as we wanted to move from a highly levered fund to one of his lower levered funds. It took forever for this manager to execute a simple request and here we are talking about a CTA who invests in highly liquid instruments! I called him a few times and warned him that we weren't pleased at all and he gave me some lame excuse that the funds were tied up with his administrator.

News flash for all you overpaid hedge fund Soros wannabes out there. When an institutional investor wants to redeem, please stop the lame excuses on your pathetic performance and don't get cute on pricing. In fact, you should be bending over backwards to accommodate these investors on the way out just as hard as when you were schmoozing them when you wanted them to invest in your fund.

As always, if you have anything to add on this case, you can email me at LKolivakis@gmail.com. Let me end by plugging a couple of Montreal firms that specialize in operational due diligence for hedge funds, Castle Hall Alternatives run by Chris Addy and Phocion Investments which is run by Ioannis Segounis, his brother Kosta, and David Rowen (Phocion specializes in performance, operational and compliance due diligence. In fact, performance analysis is Phocion's bread and butter which gives them a real edge over their competitors).

As far as a managed account platform, Montreal's Innocap is still around and provides excellent services to institutional investors looking to gain more transparency on their hedge fund investments and significantly mitigate their operational and liquidity risks (for a small fee, of course, and Innocap also makes sure the hedge fund managers are properly pricing all their investments on a daily basis and raise flags if they see discrepancies in the pricing).

Below, an older Senate Banking Committee (1998) where you will hear testimony from Brooskley Born, the former head of the CFTC discussing operational risk at large hedge funds investing in the OTC derivatives market. It's too bad President Clinton, Alan Greenspan and Robert Rubin never heeded her warning and foolishly marginalized her. She would agree with me and tell all investors to beware of large hedge funds, now more than ever.