Madoff is not representative of the hedge fund industry

The Madoff Fraud is bound to have investors running from hedge funds. However, one should realize that Madoff was not structured as a typical hedge fund. The Madoff structure was unique, and allowed ample latitude for fraud.

Investors in Madoff:
-Did not buy shares in an offshore entity advised or managed by Madoff.
-Did invest in an offshore entity which in turn placed funds in a brokerage account.
-Had the said brokerage account held at Madoff Securities.
-Therefore had their assets custodied, managed, executed and reported by Madoff Securities.
-Lost an independent source of information and were thus vulnerable to fraud among other things.

The typical hedge fund is structured as follows:
-investors buy shares in an offshore entity.
-the entity would appoint an independent custodian to hold its assets.
-the entity would appoint an independent administrator to manage it on a day to day basis, such management to include the calculation and determination of the gross and net asset values.
-an investment manager would manage the assets of the entity.
-the investment manager would execute trades through independent third party brokers.
-the investment manager would not be able to operate the bank accounts of the company or limited partnership without the involvement of the third party, independent administrator.
-the company or limited partnership would engage reputable and independent third party auditors.

It is sad that a long standing and prominent member of the hedge fund community has succumbed to fraud. The reputational impact to the industry is significant, however, with time it is hoped that investor faith will be restored.

It is likely that the Madoff Fraud will precipitate certain changes in the industry. Whether these changes are useful or not is not the issue.

-Investors will lean towards having managed accounts.
-This will allow them to use service providers and counterparties of their choice, or at least influence the choice of service providers and counterparties.
-A managed account will provide investors better transparency as well confidence.
-This will allow them to live test the portfolio from time to time, albeit at a cost.
-Bespoke mandates eliminate style drift and allows better segregation of risk factors.
-Places control back in the hands of the investor.

Strategies for 2009

Strategies for 2009


Distressed Asian Convertible Bonds
Long only and unlevered
Closed end fund format
Asia has performing assets at distressed prices
Distressed investors, not distressed issuers
List of quasi sovereign issuers – which can later be hedged with sovereign CDS when counterparty risk is settled
Currently poor liquidity – market likely to return albeit smaller than before
Full exposure to credit default risk

Distressed Convertible Bonds
Long only and unlevered
Closed end fund format
Distressed investors purging convertible portfolios has created distressed pricing
Currently poor liquidity – market likely to return albeit smaller than before
Full exposure to credit default risk

Bond Basis
Long cash bond long credit protection through CDS
Closed end fund format
Wholesale deleveraging from cash bond investors has created arbitrage opportunity
Open to CDS counterparty default risk

Distressed Debt
Long biased
Closed end fund format
Recession has accelerated default rates
Technical selling pressure has created distressed pricing across performing and non performing assets

Capital Structure Arbitrage
Long Short
Closed end fund format
Technical selling has created arbitrage opportunities intra issuer
Long senior short sub – positive jump to default at low to non negative cost / no negative jump to default at positive carry

Capital Structure Arbitrage Distressed
Closed end fund format
Long short
Recession has accelerated default rates
Long fulcrum security – converts to equity
Short most senior non recoverable to hedge non-default spread duration

Trade finance
Open ended fund
Senior secured, over collateralized, liquid collateral, commodities or commoditized goods only
Acute shortage of capital has improved margins
Secondary market opportunities
Particularly attractive in emerging markets

Receivables finance
Open ended fund
Acute shortage of capital has improved margins
Shorter duration assets
Structured with limited recourse
Obligor / credit risk arbitrage

Deep value equity
Long biased / Long only
Open ended with lock up
Wholesale de-risking has created attractive valuations even under recessionary assumptions
Strategy variant: buy out (which would require either a closed end or long lock up fund)
Strategy variant: activist (financial restructuring)

Merger Arbitrage
Open ended with lock up
Value is available and there is a good proportion of corporates with cash
ROE and valuation differentials encourage cross border deals
Developed world acquirers, developing nation targets
Cross border skills required


Most of the above strategies would not survive a run on the fund situation and hence require a closed end structure. They are also vulnerable to mark to market divergence and thus should not be leveraged with a prime broker on standard terms. Many of these strategies could be leveraged if one could term finance the trade bundles and lock in financing rates.



Strategies I would be less inclined to recommend:


Convertible arbitrage – gamma or carry
Needs borrow that may be hard to get
Needs leverage that is hard to get
CBs are trading through their bond floors – no gamma

Risk Arbitrage - traditional in country
LBO deals are dead
There is no finance to leverage the large private equity buy out deals

Equity/Credit market neutral
Valuations not supportive of shorting
Broken business models in industries at risk of bailout
No liquidity in other shorts

Longer duration direct lending
Cyclical strategy – cash flow predictability is poor
Although spreads are highly attractive
Attractive only if it is the intention to acquire the collateral
Default rates likely to rise

Volatility – Long Biased
Long vega game is unlikely to continue to pay
Long gamma is opportunistic

Madoff

Last week Bernard Madoff decided to throw in the towel on his own Ponzi scheme and confess to one of the largest cases of alleged fraud in the hedge fund industry, known to date. The list of direct investors includes astute and reputable investors. The details of the scheme are as yet unknown but the opportunity for fraud and the vulnerability of the structure of the fund is immediately apparent and indeed has been apparent to investors since inception. In fact, the fund documents are transparent as to all the structural weaknesses of the fund.

How does one invest in a fund managed by Madoff? Unless one has a sufficiently large checkbook, the only way to invest is through a feeder fund. Madoff’s business model is based on scale and to this end, rather than have in house distribution and marketing, Madoff uses intermediaries to raise capital in what is sometimes known as white labeled or private labeled products. An intermediary sets up a fund and raises capital for that fund. This fund then invests substantially all of its assets in a ‘fund’ or more accurately in the case of Madoff, a managed account managed by Madoff. Typically in a white labeled agreement, a feeder fund invests in a master fund. That is, an investor puts money in the feeder fund. The feeder fund then invests that money in the master fund. Corporate governance requires that each fund will have its own investment advisor, independent administrator, prime brokers, custodian banks, auditors. In the case of Madoff, the feeder funds did have their own investment advisor, independent administrator, prime brokers, custodian banks, auditors. The master accounts with Madoff Securities, unfortunately, did not.

In the typical structure of a Madoff run fund, the white labeled fund into which the end investor puts their money would have a reputable independent administrator, custodian, auditor (usually one of the big 4). The investment advisor would be the sponsor (and marketer) of the fund. The fund, however, would establish an account at Bernard L Madoff Investment Securities Inc, a registered broker dealer it should be noted, who would trade the account. The prime broker and custodian of the fund would also be Bernard L Madoff Investment Securities Inc. And here the independence is lost. Without independent oversight, the opportunity for fraud became abundant. One should note that the structure itself was not the fraud, it was the weakness in control that the structure introduced that provided the opportunity for fraud.

The marketing materials of many of these white labeled funds would often refer to the transparency that they were getting from Madoff Securities, and there is no reason to doubt this claim, however, one should question the value of receiving said transparency from a custodian which was a connected party to the fund manager.

In a sense, the white label sponsors were conspirators after the fact since it would have been very difficult to perpetrate a fraud without their involvement. An investor investing directly with Madoff, had there been such a fund offering would have seen the weakness of not having an independent custodian, let alone prime broker, let alone administrator. The auditors would have had to face individual investors for each and every round of due diligence. Too often, an end investor gaining access through the white labeled fund would have seen only the service providers of the white labeled fund and been satisfied with the quality of these service providers without delving further and asking the same questions of the managed account at Madoff.

At the heart of the problem is NOT a failure of due diligence, since the weaknesses of the structure were fully disclosed in fund due diligence materials and offering memoranda. There was no effort to misrepresent the structure or to cover it up. Investors therefore invested with full information or at least access to sufficient information to make an informed judgment. Why would reputable sponsors attach their reputations and fortunes to a deficient structure, and why did end investors knowing invest?

Some investment strategies for 2009

Closed end funds:
Fund structure mitigates investor risk
Suitable for arbitrage strategies
Suitable for relative value strategies
Suitable for distressed and private equity strategies
Lends itself to efficient and risk controlled deployment of leverage
Technically complex strategies which rely on multiple trade legs

Distressed investing:
Current cycle is attractive for distressed investing
Distressed assets and distressed pricing in developed markets
Distressed pricing and performing assets in emerging markets

Recovery strategies:
Distressed strategies are a subset
Deep value equity
Deep value credit

Direct lending:
Dearth of credit, easy or otherwise
Banks are retrenching from the market
Spreads and margins are priced for distress despite strong and performing obligors
Bespoke deal structures to mitigate specific risks
Trade finance

Stale strategies:
Short or market neutral credit
Short or market neutral equity
Long volatility - vega
Systematic global macro

Fresh strategies:
Long equity
Long credit (including CBs and private CBs)
Capital structure arbitrage
Distressed investing: control over asset
Factoring, receivables finance, trade finance
Fixed income arbitrage
Risk arbitrage – cross border strategic

Convertible Bonds

An opportunity exists today for a long only buy and hold strategy. The strategy is vulnerable to further mark to market losses but a strategy of investing in CBs from a credit point of view, as opposed to an equity arbitrage point of view yields interesting opportunities. Things could get cheaper next year, and indeed the way economic fundamentals are deteriorating this seems likely, but current pricing is already very attractive for the investor who can buy and hold.

Note that the classic convertible arbitrage construction doesn’t really work and one has to take on both the open equity and credit risk. Neither can one lever the portfolio, not that one needs to. Stock borrow, restrictions on shorting, terms of borrow make delta hedging a potentially futile exercise. Some converts are trading distressed to the extent that while a non zero delta has re emerged, convexity is no longer positive. Credit hedging the CB runs into all sorts of prime broker counterparty risk, and the correlation between CBs and straight bonds let alone CDS is broken at the moment. This makes life simpler, actually, since if one has the resources in credit analysis, there is no need to hire a hedge fund manager.

A Currency Call

Commodity prices are overly depressed. See post 27 Nov 2008, A Quick Macro Overview.

Buy AUD, sell USD.