Risk Rap

Rapping About a World at Risk

Hedge Funds Navigating Industry Sea Change

This years Schulte Roth Zabel’s (SRZ) 19th Annual Private Investment Funds Seminar stuck a very different pose from last years event. One year on from the global meltdown of financial markets, languishing institutional certainty and the pervading crisis of industry confidence has been replaced with a cautious optimism. The bold swagger of the industry however is gone, in its place a more certain sense of direction and expectation is emerging. Though managers continue to labor under unachievable high water marks due to the 2008 market devastation, 2009 marked a year of exceptional performance. Investment portfolios rebounded in line with the upturn in the equity and bond markets. Liquidity improved and net inflows into the industry has turned positive during the last quarter as large institutional investors and sovereign wealth funds returned to the sector with generous allocations. These are taken as clear signs that the industry has stabilized and the path to recovery and the healing of economic and psychological wounds are underway. Yes the industry will survive and ultimately thrive again but it will do so under vastly different conditions. The new business landscape will require an industry with a guarded culture of opaqueness to provide much greater transparency while operating under a regimen of greater regulatory scrutiny.

The 1,900 registered attendees heard a message about an industry at a cross road still coming to terms with the market cataclysm brought on by unfettered, unregulated markets and excessive risk taking. SRZ offered an honest assessment in examining the industries role in the market turmoil. Speakers alerted attendees to an industry at a tipping point. To survive the industry must adapt to a converging world that believes that uniform market rules and regulations are the surest safeguards against catastrophic systemic risk events. A global political consensus is emerging that expresses support for industry regulation as an effective tool to mitigate the pervasiveness of fraud and market manipulation that undermines investor confidence and ultimately the functioning of a fair and efficient open free market.

Paul Roth, Founding Partner of SRZ, noted in the events opening remarks that the market is beginning to recover as evidenced by industry AUM once again exceeding the $2 trillion mark; but he warned that any exuberance needs to be tempered with the understanding that the new normal would not resemble the pre-crash world. The days of cowboy capitalism and radical laissez-faire investing are clearly over. Indeed Mr. Roth wryly observed “the industry must develop a maturity about the need for change. He concluded “that the industry must respond by playing a constructive role in forming that change.”

The conference subject matter, speakers and materials were all top shelf. Break out presentations on risk management, regulatory compliance, distressed debt deal structuring, tax strategies and compensation issues all reinforced the overriding theme of an industry in flux. The presenters passionately advocated the need to intentionally engage the issues to confront accelerated changes in market conditions. By doing so, fund complexes will be in a position to better manage the profound impact these changes will have on their business and operating culture. Subject issues like insider trading, tax efficient structuring, hedge fund registration, preparing for SEC examinations and the thrust of DOJ litigation initiatives and how to respond to subpoenas were some of the topics explored.

To highlight the emerging regulatory environment confronting the industry, a presenter pointed to the Southerization of the SEC. This is an allusion to the hiring of former criminal prosecutors from the Department of Justice, Southern District of New York to go after wayward fund managers. The SEC is ramping up its organizational capability to effectively prosecute any violations of the new regulatory codes. The growing specter of criminal prosecutions and the growing web of indictments concerning the high profile case of Mr. Raj Rajaratnam of the Galleon Group was presented as evidence of an emerging aggressive enforcement posture being pursued by regulators. Managers beware!

Presenters made some excellent points about how institutional investors are demanding greater levels of TLC from their hedge fund managers. This TLC stands for transparency, liquidity and control. Creating an operational infrastructure and business culture that can accommodate these demands by institutional investors will strengthen the fund complex and help it to attract capital during the difficult market cycle.

The evening concluded with an interesting and honest conversation between Paul Roth and Thomas Steyer, the Senior Managing Partner of Farallon Capital Management. The conversation included increased regulatory oversight, compensation issues, industry direction and matching investor liquidity with fund strategy, capacity, structure and scale. Mr. Steyer manages a multi-strategy fund complex with $20 billion AUM, his insights are borne from a rich industry experience. He made the startling admission that Farallon has been a registered hedge fund for many years and he believes that the regulatory oversight and preparation for examiners reviews helped his fund management company to develop operational discipline informed by sound practices.

Mr. Steyer also spoke about scale and that additional regulatory oversight will add expense to the cost of doing business. Mr. Steyer believes that it will become increasingly difficult for smaller hedge funds to operate and compete under these market conditions.

Another interesting topic Mr. Steyer addressed were issues surrounding investor redemption and fund liquidity. During last years SRZ conference investor liquidity was the hot topic. Fund preservation during a period of market illiquidity and a fair and orderly liquidation of an investment partnership were major themes that ran through last years presentations. Mr. Steyer struck a more conciliatory tone of investor accommodation. He confessed his dislike for the use of “gates” as a way to control the exit of capital from a fund. In its place he offered a new fund structure he referred to as a “strip” to allocate portfolio positions to redeeming partners in proportion to the overall funds liquid and illiquid positions. He stated he believed that strategy to be more investor friendly.

Schulte Roth & Zabel has once again demonstrated its market leadership and foresight to an industry clearly in flux, confronting multiple challenges. These challenges will force fund managers to transform their operating culture in response to the sweeping demands of global market pressures, political impetus for regulatory reform and the heightened expectations of increasingly sophisticated investors. The industry could not have a more capable hand at the helm to help it navigate through the jagged rocks and shifting shoals endemic to the alternative investment management marketplace.

You Tube Music Video: Beach Boys, Sail On Sailor

Risk: industry, market, regulatory, political

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January 16, 2010 Posted by | commerce, compliance, corruption, hedge funds, investments, legal, off shore, private equity, regulatory, reputational risk, risk management, SEC, sovereign wealth funds | , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , | 1 Comment

IRS Has Hedge Funds in its Crosshairs

irs_logo-bwThe earths axis seemed to have tilted way off course last year. The global capital and credit markets crashed. Venerated banking institutions moved dangerously close to insolvency forcing mergers with better capitalized banks. The bulge bracket investment banking institutions disappeared. Some were acquired by traditional banks, others converted to a bank holding company structure; while others declared bankruptcy. In response the Federal Reserve, Treasury Department and SEC initiated unprecedented concerted interventionist actions. The passage of EESA legislation and the implementation of the $750bn TARP program are the first in many expected moves by the government to maintain the solvency of the banking system as a national economic security issue. In addition to these initiatives the government has also passed a massive $750bn economic stimulus bill to kick start the economy. All told over $1.5 trillion dollars has recently been appropriated by the federal government to address the economic crisis. This massive capital infusion has ratcheted up the federal budget deficit. It will be incumbent on the Treasury Department and the IRS to make a concerted effort to uncover new sources of revenue to finance these massive spending programs.

Hedge funds, private equity firms, CTA’s and other corporations that utilize elaborate corporate structures, engage in sophisticated transactions and recognize uncommon forms of revenue, losses and tax credits will increasingly fall under the considered focus of the IRS. Times have changed and so has the posture and practice of the IRS. The agency is transitioning its organizational posture by moving away from a benign customer service resource and assuming the form of an activist body that is intent on assuring compliance and enforcement of US tax laws. In particular it is building up its expertise and resource to more effectively address the audit challenges the complexity and sophistication hedge funds present.

The IRS has developed its industry issue competencies. It has developed a focused organizational structure that assigns issue ownership to specific executives and issue management teams. This vertical expertise is further enhanced with issue specialists to deepen the agencies competency capital and industry issue coordinators that lends administrative and agency management efficiency by ranking and coordinating responses to specific industry issues. Clearly the IRS is building up its portfolio of skills and industry expertise to address the sophisticated agility of hedge fund industry tax professionals.

To better focus the resources of the agency the IRS has developed a Three Tiered Industry Issue Focus. Tier I issues are deemed most worthy of in depth examinations and any fund management company with exposure in these areas need to exercise more diligence in its preparation and response. Tier I issues are ranked by the IRS as being of high strategic importance when opening an examination of hedge funds and other sophisticated corporate structures. This is followed by Tier II and Tier III focus areas that include significant examination issues but are ranked according to the agencies strategic significance of the market vertical. Clearly the IRS is investing significant organizational and human capital to address an industry that will no longer fly beneath the agencies radar. This institutional investment will be called upon to generate a considerable return on the investment in the hopes that the discovery of lucrative tax revenue streams will help to pay down the massive spending deficits of the federal government.

This development has clearly raised the tax compliance and regulatory risk factors for hedge funds and other fund managers. Significant tax liabilities, penalties and expenses can be incurred if this risk factor is not met with well a well considered risk management program. In response to this industry threat, Sum2 has developed an IRS Audit Risk program that allows a hedge fund CFO to quickly ascertain its IRS risk exposures within the Three Industry Focus Tiers.

The IRS Audit Risk program provides a threat scoring methodology to ascertain level of risk within each Tier item and aggregates overall Tier exposures. The product also uses a scoring methodology to determine your level of preparedness to meet the audit risk, mitigation actions required and potential exposures of the risk. The IRS Audit Risk calculates expenses associated with mitigation initiatives and assigns mitigation responsibility to staff members or service providers. The IRS Audit Risk links to issue specific IRS resources and documentation that will help you determine if the issue is a audit risk factor for your firm and the resources you will need to addresses it.

The IRS Audit Risk for Hedge Funds product is a vertical application of Sum2’s Profit|Optimizer product series. The Profit|Optimizer is a C Level risk management tool that assists managers to uncover and mitigate business threats and spot opportunities to maintain profitability and sustainable growth.

The IRS Audit risk for Hedge Funds product is available for down load on Amazon.com.

The product can be purchased here: Sum2 e-commerce

You Tube Music Video: Beatles, Taxman

Risk: tax liability, penalties, reputation

March 3, 2009 Posted by | compliance, EESA, hedge funds, IRS, legal, off shore, private equity, regulatory, reputational risk, risk management, SEC, TARP | , , , , | Leave a comment

People’s Guide to Recovery Acronym’s

Carl Sandburg
“The People, Yes!”

The economic recovery program is creating new acronyms faster then Hank Paulson can spend a $100 billion of taxpayers money.

This is an modest attempt to develop a glossary of acronyms so taxpayers can keep track of where, how and who is spending the dough.

EESA: Emergency Economic Security Act

TARP: Toxic Asset Recovery Program

VEPP: Voluntary Equity Purchase Program

LIBOR: London Interbank Overnight Rate

FDIC: Federal Deposit Insurance Corp

SEC: Security Exchange Commission

The US passed EESA to legalize TARP and VEPP to lower LIBOR so the FDIC and SEC can help banks get us out of this xo#*!&^ mess.

Got it?

You Tube Video: Carl Sandburg: The People Yes!

Risk: language, communication, humanity

October 14, 2008 Posted by | EESA, Paulson, poetry, SEC, TARP | , , , , , , , , | Leave a comment

Bollywood Blockbuster: Wach & Wells

What may be a surprise to Citi’s CEO Vikram Pandit, his new bride Wach has left the nest and is now snuggled safely in the loving arms of its free market hero the west coast banking giant Wells. Apparently Citi’s arranged marriage with Wach was never consummated and looks like it’s heading for an annulment.

This one’s got all the drama of a Big Bollywood blockbuster. The young and troubled Wach is forced by her desperate father FedSec to submit to a loveless arranged marriage to Citi. FedSec has offered a worthless and mysterious dowry it calls EESA whose origins, authenticity and value is highly questionable.

Citi is one of the last vestiges of the crumbling rule of a decrepit Credit Markit Raj. The New York based Citi whose Brahmin’s family lineage is long past its prime is now desperate for the favors of FedSec’s EESA dowry. Citi believes that EESA can prop up the Credit Markit Raj and prolong its position of power and privilege.

Wells the fine looking paramour from California is rumored to have slain gigantic sub-prime mortgage monsters spawned by the evil excesses of Credit Markit Raj. Wells has recovered nicely from its battles and purportedly has a quality balance sheet and size that is preferred by Wach. Apparently size does matter and Wach may have found the true love with Wells it will never have with Citi.

Wells issued $20B in new securities as an example of it’s free market might and demonstration of love for Wach. Wach’s self-esteem has suffered throughout this entire drama. Wach was troubled by the public perception of her intrinsic worth. This past Monday when FedSec announced the arranged marriage to Citi, the marketplace said her value was the equivalent of $.75 per share. But Wells value and sense of self worth rose with Wells attention. As of this morning Well’s affection has raised Wach’s value to over $6.00 per share.

Wells capture of Wach’s affection may threaten FedSec’s mastery and attempted control of the Credit Markit Raj with the offering of the EESA dowry. Ultimately the riches promised by the EESA dowry may not materialize. A governing group of petite demigods called SENCONS may confiscate the dowry and abscond back to their ivory tower hideout.

Lawsuits and high highfalutin philosophizing by the SENCONS about an activist FedSec and letting free markets prevail assures that theater goers will enjoy many sequels of the Wach & Wells story of true love and capital market freedom. Stay tuned.

You tube music video: Bollywood Mix

Risk: EESA

October 4, 2008 Posted by | banking, EESA, SEC, soundtrack, TARP, Treasury | , , , , , , , | Leave a comment