SEC Probes Inflated Hedge Fund Returns?

Matt Robinson of Bloomberg reports, SEC Probes If Banks Helped Hedge Funds Inflate Returns:
Wall Street banks are known to fiercely compete for hedge-fund clients because of the lucrative trading profits they provide.

The U.S. Securities and Exchange Commission is now investigating whether some banks crossed the line to win business by offering hedge funds bogus price quotes on hard-to-value bonds, said two people familiar with the matter. The SEC’s concern: As a reward for helping hedge funds make money -- by submitting quotes at requested levels -- banks got trades steered their way.

As part of its probes, the regulator is reviewing at least a dozen banks and brokerage firms to determine whether they provided inflated prices on debt securities that funds used to pump up the value of their investments, said the people who asked not to be named because the inquiries aren’t public.

JPMorgan Chase & Co. and Citigroup Inc. are among the banks being looked at, said one of the people who added that the SEC is also scrutinizing other large firms and several smaller ones. The investigations, which won’t necessarily lead to any allegations of wrongdoing, focus on valuations of mortgage securities and other thinly traded bonds where swings of just a few cents can have a big impact on hedge fund returns, the people said.

“It doesn’t take much to manipulate a bond price,” said Charles Geisst, a finance professor at Manhattan College in New York who has written books on the history of Wall Street. “It’s sort of an alternate reality. No one really knows the price of a bond until it’s traded.”

Spokesmen for the SEC, JPMorgan and Citigroup declined to comment.

The probes show the SEC isn’t letting up in its multi-year push to try to uncover illicit conduct in one of Wall Street’s most opaque markets. Bonds tied to home loans and other debt aren’t bought and sold on exchanges, and the securities can go months without trading. That lack of transparency prompts investors to value bonds by relying on estimates from brokers and other third parties, a system the SEC believes is ripe for abuse.

Hedge fund firms typically task internal committees with valuing thinly traded bonds, a process that prevents conflicted portfolio managers from assigning favorable prices to their own investments.

Still, portfolio managers can push back if they feel prices don’t reflect the current market. In such instances, they sometimes tap brokers at banks for additional, higher estimates.

The portfolio manager might argue that the higher valuation is more accurate because it comes from an actual market participant. If the hedge fund’s valuation committee accepts the broker quote in pricing a bond, it might make the difference between a good month or a bad one for money managers depending on the size of the position in their portfolio.

Significant Clout

Portfolio managers at hedge funds have significant clout with brokers because they are sought-after customers. Hedge funds engage in frequent buying and selling, they amplify their bets with borrowed money and they are big buyers of derivatives. Banks receive millions in fees from such services.

The SEC’s suspicion that brokers sometimes provide sham prices isn’t just theoretical. In June 2016, the agency accused two portfolio managers at Visium Asset Management of soliciting phony quotes from friendly brokers over an 18-month period to justify inflated valuations on distressed debt holdings.

Due to the scheme, Christopher Plaford and Stefan Lumiere were able to post a 0.68 percent gain in 2011 for the credit hedge fund they ran at Visium, instead of a roughly 4 percent loss, the SEC said. Plaford has pleaded guilty to related criminal charges brought by federal prosecutors, while a judge sentenced Lumiere to 18 months in prison in June for his role in inflating some of the firm’s bond investments.

Undervaluing Bonds

The SEC is also looking at Keri Findley, a former partner at Dan Loeb’s Third Point hedge fund firm, people familiar with the matter have said. The regulator is probing whether Findley, who left Third Point in February, caused mortgage bonds in her portfolio to be undervalued, the people said.

While it’s unclear how she might have benefited from her investments being worth less, it’s possible that undervaluing a position for much of the year could make it easier for a portfolio manager to then mark up the investment to match market prices at year-end when firms calculate fees and bonuses.

A spokesman for Findley has declined to comment. Third Point has said it has a rigorous process for pricing securities and that it is cooperating with the SEC.

Technological advancements have assisted the regulator. In recent years, it has been using computer algorithms to spot bond trades that occur at prices that are suspicious because they don’t reflect recent transactions. SEC officials say the algorithms have helped them to identify billions of dollars of problematic trades.
It's not the first time Bloomberg reports on hedge funds using shady pricing on illiquid bonds. Back in May, Matt Robinson, Christian Berthelsen, Chris Dolmetsch, and Matt Scully reported, Hedge Funds Are Facing a U.S. Criminal Probe Over Bond Valuations:
U.S. prosecutors are investigating one of Wall Street’s darkest markets, focusing on hedge funds suspected of inflating the value of debt securities in their portfolios to juice the fees they collect.

Having prosecuted traders who lied to customers about bond prices, the government is now scrutinizing hedge funds that allegedly solicited bogus price quotes from brokers, according to three people familiar with the matter who asked not to be identified. Such a practice would have enabled the funds to pump up the value of illiquid securities on their books.

The incentive to manipulate valuations has become more pronounced as investors have abandoned hedge funds because of poor returns and high fees. Assets managed by hedge funds declined last year for the first time since the financial crisis, with investors yanking more than $70 billion, according to Hedge Fund Research Inc. The opacity of certain parts of the debt market, with illiquid, sometimes distressed securities, had made it a prime target for deception because of the difficulty of determining prices.

It’s unclear how many funds are under scrutiny by federal prosecutors in New York for possibly seeking bogus quotes from brokers. But a witness testifying for the government this week in an unrelated trial of three former Nomura Holdings Inc. traders in Connecticut may have shed light on the investigation.

The witness, a former broker named Frank DiNucci Jr., said under oath that he provided bogus quotes to a trader at a mortgage bond fund, Premium Point Investments LP. DiNucci agreed to plead guilty last month in Manhattan federal court to conspiracy and fraud and says he has been cooperating with a criminal probe by New York prosecutors into Premium Point.

“I would extend marks to make them seem like they were my own,” DiNucci told the federal jury in Hartford. The goal was to “increase the number of trades we would do with this particular client,” he said.

Steven Bruce, a spokesman for Premium Point, which managed almost $2 billion at its peak and is now closing, declined to comment on DiNucci’s testimony or on whether the fund is under investigation. Nicholas Biase, a spokesman for Acting U.S. Attorney Joon Kim in Manhattan, also declined to comment.

A focus on bond funds would signal a new direction in enforcement. In recent years, prosecutors have brought dozens of high-profile, insider-trading cases against portfolio managers at equity hedge funds, securing more than 80 convictions.


Their target now appears to be the debt side. The Justice Department charged at least seven bank bond traders since 2013 with lying to customers about prices before shifting to the buy-side of the market. The probes began at the Securities and Exchange Commission’s complex financial instruments group, according to the people familiar, who declined to comment publicly on the confidential investigation. The SEC declined to comment.

Mismarking fraud was at the center of a case against fund managers at Visium Asset Management LP. Jurors returned a guilty verdict this year against one of its portfolio managers in just 90 minutes. Prosecutors have also brought charges over another scheme: lying to investors about bond prices. Former Jefferies LLC trader Jesse Litvak was convicted at a trial in January, and three former Nomura Holdings traders are now on trial in Connecticut, where DiNucci testified.

Some securities, including pools of mortgages, can be especially difficult to price. The debt can go months without trading. Without recent pricing data, funds rely on estimates of brokers and quotes from third parties to value the debt.

By carrying securities on their books at artificially inflated prices, hedge funds can show better performance. They can collect more in management and performance fees -- or hide poor performance for certain holdings.

DiNucci has been testifying against his former colleagues at Nomura, who he said lied to clients about bond prices. They deny wrongdoing. Under cross-examination by defense lawyers, DiNucci was asked about the mismarking of bonds. He said he worked at brokerages Auriga USA LLC and AOC Securities LLC after leaving Nomura. While there, he said he would provide fake quotes to traders including Jeremy Shor, formerly of Premium Point. Shor on Wednesday declined to comment.

Alex Hendrickson, a co-president at Auriga, declined to comment and referred questions to a lawyer, Jeffrey Plotkin, who also declined to comment. A person who answered the phone at AOC said its chief executive, Ronaldo Gonzalez, wasn’t available for comment.

Plea Agreement

As part of an agreement to cooperate in the “Premium Point investigation,” DiNucci said he told prosecutors in New York that there was “a lot more than that.” He didn’t elaborate. A copy of his April 6 plea agreement with New York prosecutors was entered into evidence at the Connecticut trial.

DiNucci’s lawyer, Daniel Zinman, declined to comment. A Nomura representative didn’t immediately return a request for comment.

Before the financial crisis, regulators had a hands-off policy in monitoring the securitized debt market in part because participants were considered sophisticated buyers and sellers. That assumption came undone when the market cratered following rising mortgage delinquencies. To deal with the fallout, the SEC created a specialized unit to examine the market.

The unit got a tip from AllianceBernstein after a spreadsheet was sent to an asset manager revealing that Litvak, then at Jefferies, had lied about the price paid for securities he sold, prosecutors said. Litvak was sentenced last month to two years in prison for securities fraud.
Welcome to the shady world of pricing illiquid bonds. I actually commend the increased scrutiny and enforcement from the SEC and think it's equally important to monitor shady bond pricing activity, not just insider trading activity in the stock market.

Now, before I get a bunch of fixed income hedge funds accusing me of spreading malicious lies or grossly distorting reality, let me assure GPs and LPs reading my comment that most hedge funds are following best practices when pricing illiquid bonds and other illiquid OTC instruments.

Those of you looking to understand the issues surrounding pricing these illiquid instruments can consult some or all of the documents below:
And the list goes on and on, pricing illiquid investments in public and private markets is a very hot topic, and organizations like ILPA and AOI are doing a good job covering these topics for their members.

For hedge funds investing in illiquid instruments, the biggest issue is when there is no pricing policy and potential conflicts of interest arise.

Are they using independent brokers to value an illiquid bond? Independent data sources? Is the administrator the hedge fund is using knowledgeable about pricing illiquid instruments? What happens when the administrator objects to the pricing the hedge fund's prime broker is using to value an illiquid bond? If a conflict arises between the hedge fund, prime broker, and administrator on pricing, how is it settled?

Trust me, these aren't straightforward questions with easy answers. Most of the time, the manager will come to an agreement with the administrator on pricing but sometimes they will bow down and agree to lower the pricing. Other times, they will stick to their guns and argue their point well and maintain their original pricing (most administrators are price takers and rarely question managers on their pricing).

This is why it's paramount for investors investing in hedge funds that make significant investments in illiquid securities to hire people who understand the risks and pay external consultants who really know how to drill down and ask the necessary questions.

And I'm not talking about some external advisor who hires juniors who copy and paste a cookie cutter template and then forward it on to a hedge funds (GPS) and investors (LPs). I'm shocked at how many big pension funds, even here in Canada, are all using the same advisors who offer them cookie cutter templates.

That approach is fine as long as markets are liquid and doing well but when the tide turns, good luck going back to your operational due diligence advisor and getting a straight answer if something goes wrong. This is why I often promote my friends at Phocion Investments because I know they will offer you a lot more than standardized garbage (I'm sure there are other great independent consultants, but the point is you need to find them and use them and stop being lazy!!).

Another approach is to invest in hedge funds using a managed account platform like Ontario Teachers' and CPPIB do, placing a big portion of their hedge funds on Innocap's managed account platform. Inncocap's professionals can then flag any pricing that seems off with the portfolio managers overseeing hedge funds at these large pensions (the two biggest hedge fund investors in Canada).

Anyway, there is no question that banks have helped hedge funds inflate their returns. Hedge funds and private equity funds provide big banks with their bread and butter revenues so some banks are incentivized to "fudge" the numbers when they are pressured to do so (I would think the smaller ones are the ones which are more careless but big ones are also guilty of doing this from time to time).

Why would a hedge fund inflate returns? Because it gets paid on management and performance fees and is incentivized to play fast and loose sometimes, especially when it's trying to garner more assets.

And it's not always about inflating returns to garner assets. Two years ago, PSP sued a well-known hedge fund, Boaz Weinstein's Saba Capital, accusing it of deflating returns at a time when PSP was redeeming a significant amount.

Mr. Weinstein and PSP eventually settled this civil case (not SEC case) out of court (good move for both parties):
In 2015, Ottawa-based Public Sector Pension Investment Board (PSP) sued Manhattan-based Saba Capital Management LP and its founder, Boaz Weinstein, in New York state court, arguing that the hedge fund manager had marked down some assets after the pension asked for its $500 million investment back earlier in the year. The move, PSP argued, essentially allowed Saba to keep more money than it should have.

Saba and PSP said in a joint statement that they had “resolved this matter as a commercial dispute involving a good faith disagreement over the valuation of two highly illiquid corporate bonds.”

The terms of the settlement were confidential, according to a related legal filing.

The court previously dismissed other claims by PSP against Saba and Weinstein, allegations Saba denied.
[Note: Bloomberg reports Boaz Weinstein lost money this year in his flagship credit fund as he waits for turbulence in the debt markets to return. Saba Capital Management's main fund, which manages about $1 billion, dropped 7 percent in the first 11 months of 2017 after being one of the top hedge fund performers last year, according to a person with knowledge of the returns.]

All this to say, there is nothing wrong with hedge funds investing in illiquid securities that are "marked to model" not marked to market, but investors need to be aware of the potential risks and pricing conflicts and they'd better understand these risks and how conflicts are resolved prior to investing with any manager, no matter how famous and wealthy they are.

Below, Bloomberg's Matt Robinson talks about why some hedge funds are facing criminal probes over bond valuations (May, 2017). Bloomberg’s Jason Kelly also reports on the SEC probe.

This is huge, I don't want to underplay it but also don't want to overplay it and have a bunch of investors throw the baby out with the bathwater. There is a reason why you pay top hedge funds to invest in illiquid securities, to exploit inefficiencies and generate excess returns.

Just make sure the hedge funds you're investing with are kosher and upfront on their pricing policy and how they resolve any potential conflicts of interest.