FRM’s SWT Unit

Clarifying valuations and salvaging value for illiquids and side pockets

HAMLIN LOVELL

The genesis of the Secondaries, Workouts and Transitions (SWT) unit was expertise developed inside FRM when it needed to deal with managers who invoked gates, suspended redemptions or created side pockets. FRM distinguished themselves from peers, by creating a dedicated team of professionals exclusively focused on addressing these situations. Elsewhere, FRM contend, analysts have to try and juggle these complex issues on top of regular duties. The two SWT experts, Michael Buerer and Connor Brown, both have backgrounds in operational due diligence. Head of the SWT team Buerer formerly headed the operational due diligence (ODD) team. Brown, who has been with the company for nine years, has experience of due diligence in terms of governance, valuation, and operational infrastructure for both funds and managed accounts. The SWT team is embedded in the manager research organisation, so it taps into all of the news-flow emanating from thousands of funds followed by FRM. The fact that fund of funds pioneer FRM has for decades been one of the biggest allocators always gave the team strong bargaining power in terms of accessing funds. The acquisition by Man Group in July 2012 has further extended the scope of the integrated group’s coverage and networking capabilities.

As the financial crisis approaches its fifth anniversary, concerns remain that some hedge fund managers are clinging onto lucrative investment management contracts, even though their teams have often been hollowed out to the point where they are too thinly resourced to best serve investor interests. Some managers operating with skeleton teams may therefore have incentives to delay dealing with illiquids in order to carry on milking cash cow contracts. Having successfully liquidated more than a billion dollars of its own illiquids, FRM is now in a position to take on more advisory client mandates that could help investors unlock the bottlenecks that are holding them back.

Are there any conflicts of interest?
They do not see any conflicts of interest with providing the service to advisory clients. FRM themselves do not trade in secondaries. As a general rule, FRM do not actively seek to take positions as principal, run no vehicles funded by proprietary capital, and don’t have a secondaries brokerage business. The advisory service is primarily targeted at institutional investors who are dissatisfied with the liquidity of their hedge funds.

How are FRM remunerated?
This depends very much on circumstances, because no two portfolios are the same. Investors’ liquidity requirements and time horizons will vary. FRM is open-minded around three core areas of fee structures. Fees can be fixed, asset-based, or customized down to the line item so that clients might only pay for items where monitoring can add value or where solutions can be found. In addition, realisation-based fee structures can also be devised that remunerate FRM according to the amount of capital returned (and not on reported net asset values, which may be open to question, more of which later!). Bespoke fee structures may combine one or more of the above elements, and clients can also pick and choose from a menu of services on a modular basis.

The first stage is for potential clients to share details of their portfolio with FRM (with a non-disclosure agreement in place), who will then conduct analysis, before agreeing to a mandate detailing levels of service. A lot of added value arises from synergies where FRM has experience with funds, so when portfolios overlap with names that FRM are already monitoring, minimum levels of fees can be lower than in cases where new names require fresh research. If new coverage does need to be initiated, a $20 million portfolio is likely to be the starting point for a mutually beneficial relationship. But the team is keen to stress that client objectives differ so they are flexible and negotiable. Moreover, fee structures need not be set in stone. The defining feature of SWT is change: how the profile of investments changes over time. Therefore it is natural that fee models are also dynamically adaptive to ensure that interests between clients and FRM remain aligned as portfolios evolve in complexity, value, valuation method, liquidity status, governance structure, and reporting requirements.

Do you work with secondary brokers or market makers such as Hedgebay?
“The secondary market is the place where the less experienced investor can leave the most value on the table,” says Buerer, alluding to the danger of ill informed sellers being vulnerable to predatory buyers. Nevertheless, selling hedge funds via the secondary market is one avenue for salvaging value from illiquids. FRM maintains close contact with about 12 brokers including Hedgebay, Tullet Prebon and Gottex. If clients are simply seeking a quick sale, they could consider approaching the secondary brokers by themselves. However, even in cases where rapid monetisation is prioritised FRM may be able to maximize proceeds from secondary sales. FRM has historically obtained better prices by aggregating smaller tickets to create a critical mass, avoiding the discounts that might apply to low value transactions, as well as by running a structured and competitive bidding process. Yet the real value of SWT lies in its versatility, which may permit more patient investors to realize more value through workouts or transitions than through fast sales.

Why is enhancing governance important?
Co-ordination amongst disparate groups of investors increases their collective negotiating clout. If a majority of investors are united behind a request for information or action it becomes very difficult for directors to ignore them. And cases involving significant minorities of investors are also more likely to secure the attentionof fiduciaries. Sometimes FRM itself has been a significant minority, or a majority, of fund assets simply by virtue of its own size.

Institutional clients are now inviting FRM to orchestrate alliances that articulate their concerns and obtain greater transparency for all investors. FRM is experienced at participating in investor groups, investor advisory committees, and creditor committees of redeemed fund investors, and has often cast votes on behalf of its investors and advisory clients. These committees can task managers to pursue corporate actions such as restructurings or liquidations.

Names of funds are seldom mentioned due to non-disclosure agreements, but some examples of achievements can be given. When managers are assiduously working for investor interests, the best strategy can be to let them get on with it. In other cases varying degrees of effort are needed to attain, or accelerate, the delivery of investor objectives. Creditor committees, for instance, can start by acting as a conduit for channeling investor views to the manager in a more structured and time-efficient manner than ad hoc communication from multiple investors. Sometimes the clarity of the message is enough to prompt action from managers and/or fund directors. Where investors want more comfort that their concerns are being taken seriously, committees can bind managers to a liquidation plan that sets out milestones for returning proceeds according to preset schedules or timelines. Such predefined plans provide a strong source of discipline. Committees can also force managers to take action and over-ride the common manager excuse that market conditions are sub-optimal for selling assets.

Do myriad solutions need to be explored?
Unanimity among investors does not always apply. Where investor opinions diverge, it may be useful to split investors into continuing and liquidating groups. To help those that require liquidity, FRM can arrange for liquidity events such as competitive auction processes or tender offers, which can also be outsourced. Sometimes the only way to set in motion a liquidation process is returning assets in kind to investors. In some cases special purpose vehicles are created, partly to ensure client confidentiality. FRM is not an intermediary itself, but may sometimes be able to source third-party buyers. There is no single one-size-fits-all solution.

Do fee models and non-fee running costs need to be modified?
When investors choose, or are forced, to hang in there for the long haul, cost cutting becomes especially important. Removing or reducing fees for auditors, valuation agents or administrators is one angle, particularly if funds are being valued more frequently than is necessary or useful. “Traditionally fund of funds structures were not designed for illiquids,” says Buerer. Sometimes streamlining such structures can save money, by eliminating duplication of service provision where multiple entities can be collapsed into one. FRM has dealt with complex cases involving multiple feeders including leveraged share classes and various currency share classes, where the layers were steadily peeled off to create a leaner vehicle.

Just as FRM itself can accommodate a variety of fee structures, so too various models apply to manager fees. “The most complicated and least trivial part of our work is finding the right incentives, to obtain the best value of assets,” says Brown. Changes to fees usually involve reductions, and also graduated fees that may reduce or cease after certain dates to incentivise a timely return of capital. Occasionally high water marks might need to be adjusted downwards to create incentives to realise value, but changes to fee schedules are more often about sticks than carrots. As assets are returned to investors, managers need not continue earning fees on a full-sized fund. As boards of directors normally need to implement fee changes, FRM can add value by alerting directors to situations where fee models may not align investor and manager interests.

What is the most aggressive activist stance FRM would ever take?
Typically FRM do not appoint their own representatives to fund boards. The priority is to ensure a majority of directors are independent. This does not rule out the presence of some related party or non-independent directors, who can bring to bear vital knowledge and experience. So far, FRM has not sought to have any fund directors removed. And having a manager removed is only ever considered as a last resort; indeed this has only happened once. Almost always FRM wants to remain constructive and develop constructive, outcome-oriented dialogues with managers.

How should illiquids be valued and how do investors respond to valuation changes?
Independent valuation agents and administrators value assets and strike fund NAVs. However, the price discovery mechanism for illiquid hedge funds is not a deep liquid market and valuations in administrator or audit statements may not reflect reality. While FRM is not a valuation agent, it can cross-reference valuations against those of its own databases of funds. FRM also has an independent pricing committee that reviews NAVs of illiquid funds on a regular basis and may recommend fair value adjustments. The committee has sometimes taken a different view from the fund administrators. In theory adjustments could be made in either direction, but in practice most revisions have been downwards, with examples including updating stale valuations of life insurance settlements and life premium finance assets. One event will nearly always trigger revised valuations: if transactions in underlying assets have been recorded, these provide a new reference point for valuations, according to the accounting rules that define fair value as what a willing, knowledgeable, and independent arm’s-length buyer would pay (other than in a liquidation sale). If FRM is making adjustments for its own portfolios, these will naturally read through to advisory clients, who are always keen to get more colour on the changes.

“Investors exhibit loss aversion about NAVs being impaired,” says Brown. In other words, investors can initially be in denial about the reality of valuations. But “Allocators need to realign their understanding of valuations, partly in order to communicate more equitably with their own clients. Everyone can then move forward on a more realistic basis,” says Buerer. Once investors can see the rationale for write-downs, they are understood and accepted.
 
How do FRM’s achieved realisations compare with where assets are marked?
It is hard to make a generalized statement, as each situation is different, with different policies and accounting standards applying. Some points can, however, be made. Secondary market sales of illiquid hedge funds almost invariably take place at a discount, which can reflect time horizons for returning capital, or the quality of managers and valuation uncertainty. In contrast, Lehman claims are perhaps the best example of illiquid assets that rewarded patience, and FRM has counseled those who owned Lehman paper to hang on for better prices. FRM has also stepped in to deal with more complicated cases of Lehman exposure that had been neglected by a manager who might not have had the necessary in-house expertise. FRM has dealt directly with the Lehman administrator, and collectively produced a better result for all investors involved. Brown points out that the experience of FRM is hard to replicate as you need to know if the people being dealt with are skilled, especially in areas such as real estate development. Buerer admits that litigation-related assets can be the hardest to value. Here FRM’s in-house legalteam can pass on economies of scale to investors who might otherwise be charged $15,000 or $25,000 by external lawyers for drafting a purchase and sale agreement.

Are some cases lost causes?
Historically FRM itself never had much exposure to asset-based lending, and neither FRM nor its current advisory clients has any Petters fraud exposure. But FRM knows enough about the space to admit that many situations are “at the more demanding end of the spectrum, and do not look promising”. It is also worth pointing out that FRM are dealing with hedge funds, and not generally seeking to directly sell the underlying assets of hedge funds.

At the same time FRM does not arrange for repayment or refinancing of debt attached to a hedge fund and is not likely to get involved in organising refinancing of bilateral loans, trade finance deals or life policies that sit inside a hedge fund. For instance, in the life premium finance space FRM has sometimes decided to sell funds into the secondary market, and at other times made write-downs, but has not directly traded individual life policies. Fraud recoveries are another area where FRM may not have the internal expertise to help. In these cases of lost causes, “a very candid conversation is required,” says Buerer. Some mandates might be turned down where clients have unrealistic expectations.

Transparent reporting
An important part of the service is to enlighten investors about the valuation and liquidity profile of their assets. Reconciliations with administrator records and coordinating legal documentation are standard parts of the reporting process. Reporting requirements can be tailored to investor needs for varying degrees of frequency and granularity of information. This is an important aspect of clients being able to demonstrate their fiduciary duty to their own senior management, regulators and end clients, so that they learn what the sometimes obscure or esoteric line items actually are. FRM can also save investors’ time and resources by keeping track of a wide range of corporate actions, including distributions, cash settlements, redemptions in kind, capital calls, shareholder votes, restructurings and auctions.

Conclusions
Years of advising on several billions of illiquid assets, across more than 50 portfolios, have given FRM’s SWT unit a wealth of experience and knowledge that can sometimes help investors to salvage some value from the remnants of the financial crisis, or at least provide the informational comfort of a medical checkup.

Clearly, investors need to be psychologically prepared to face the reality that realisable values may be lower than illusory valuations. When and if portfolios are reliquefied, assets can be redeployed into hedge fund investments, for example into customised managed account solutions that can help to avoid a recurrence of the liquidity drought that some allocators still face.