Tag: Aberrational Performance Inquiry

Vindication for Yorkville (mostly)

Back in 2012, the Securities and Exchange Commission filed suit against Yorkville Advisors for valuation failures.  According to the SEC complaint, the failure was two-pronged: one of misstatements and a second failure to follow the funds’ own policies and procedures on valuation. Yorkville denied the charges.

Legal action has continued and Yorkville has been largely vindicated in a motion for summary judgement.

The SEC lost virtually all claims in the asset valuation case brought against a fund and two of its officials.

As with most private fund managers, Yorkville’s ability to understand the valuation of its investments is critical to its strategy and results. So you would expect some discretion to be granted to the manager, without the SEC second-guessing the valuation. The SEC second-guessed the values and lost.

The key should be precision ahead of accuracy. Precision is getting close to the same result consistently. Accurate is getting close to the right target. You can be precise and inaccurate, and you can be accurate but imprecise.  With a hard to value asset, where its hard to know the correct target, precision is more important.

The SEC case was focused on 15 privately negotiated, customized securities in its portfolio that had little to no market activity.

Yorkville was using GAAP in calculating the net worth of each fund and marking the funds’ investments to fair value. It used one valuation adviser to help value some of those 15 positions. Yorkville ended up rejecting most of the first attempts because it thought the valuations were too high. Yorkville hired a second valuation company to help with some of the investments it had to foreclose on. Yorkville’s audit form signed off on the valuations. The auditor re-examined the work after the SEC was filed, discovered that it did not have some the draft valuation work, but concluded that it could still stand behind the audits.

Prior to 2008, the firm marked positions at the lower of cost or market value until gains were realized. The firm would recognize unrealized losses but not unrealized gains. Yorkville adopted FASB Statement 157 in 2008 which changes to the treatment to always be fair market value accounting.

The SEC claimed that Yorkville overvalued the 15 investments by at least $50 million as of December 2008 and $47 million as of the end of December 2009. The over valuations inflated the value of the funds which attracted investors and increased the fees that Yorkville charged.

The opinion starts with precluding a big chunk of the testimony of the SEC valuation expert. The court found that the Uniform Standards of Professional Appraisal Practice call for a review to be one of the quality of the of the valuation process and not to create a new value based on the review.

Then the court moves on to deciding if there was evidence to support a finding of scienter or intent to deceive. The SEC used three theories as to why the Yorkville principals had the motive and opportunity to commit fraud.

First, the court rejected the claim that motive and opportunity could be established from the Yorkville’s compensation structure. The court refers to established law that the mere desire to earn management fees is not sufficient to allege a concrete and personal benefit resulting from the fraud.

Second, although Yorkville was in a tough financial position (it was 2009-2009) and would be better off it could raise more funds from investors, it was not enough to prove an intent. The SEC was claiming that Yorkville kept the valuations high to attract more investors. That did not meet the test.

Thirdly, the principals redemption of interests in the fund did not have the facts to show fraud. Yorkville was actively marking the Fund down by $33 million at the time of the redemption request. .

The Court also rejected the SEC’s claim that the Yorkville principals had fraudulent intent because they failed to disclose key documents to the outside auditors and made affirmative misrepresentations regarding the 15 positions to the investors and auditors. The court rejected that, noting that the auditors still stood behind their audits. Although, the audit partner claims that a dozen documents, out of hundreds of others, were not provided to the auditors.

It looks like Yorkville was a bit sloppy in its statements regarding its use of outside consultants to help in valuations. Some of these sloppy statements were in investors’ DDQs. Some of those charges survived the summary judgment order and ill have to be contended. So, Yorkville did not come out of this case completely vindicated.

The Yorkville case  was one of several brought as part of the Commission’s Aberrational Performance Inquiry which was tied to about a half dozen cases.The Inquiry is supposed to use performance metrics to identify outlying performance and use that to suggest suspicious conduct.

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Private Fund Is Sanctioned for Valuation Issues

SEC Enforcement Logo

The Securities and Exchange Commission brought another case out of its Aberrational Performance Inquiry initiative in the Enforcement Division’s Asset Management Unit. That initiative identifies funds with suspicious returns and flags performance that is inconsistent with a fund’s investment strategy or other benchmarks forms a basis for further investigation and scrutiny. The initiative nabbed GLG Partners for overstating its stake in an emerging market coal mining company.

This case’s headline caught my attention because it’s a challenge of a hard-to-value asset.  A private equity stake in a company is a Level 3 asset that can’t be determined by outside data sources. I would expect that a fund that used a thoughtful process and could justify its assumptions in a valuation should not have the value challenged by the SEC.

For private funds, valuation is a key area of focus for the SEC. I’ve heard from examiners that they are looking for consistent valuation process with justified assumptions for hard to value asset.

GLG appears to have a few red flags on its valuation that would raise questions. GLG bought the 25% stake in Sibanthracite for $210 million March 20, 2008. Just 11 days later, GLG wrote up the value to $425 million on March 31. That’s a big jump in value.

The asset stayed at the $425 million valuation until December 2010. That’s a long time for an asset to stay at the same value. According to the SEC order, there was a failure in GLG’s process to determine the fair value of the investment.

I hope one of the reasons that the action was taken was because of the resulting impact the valuation failure had on the management fees earned by GLG. The inflated valuation resulted in GLG earning extra management and administration fees of about $7.8 million.

GLG was a hedge fund and earned its management based on valuation. That is unlike the private equity fund model where the fund does not typically earn a management on an increased valuation, but instead earns a promote on a realized value.

The investment happened just before the financial crisis in the fall of 2008 and the improper valuation occurred during the turmoil of 2009 and 2010. According to news reports, GLG created a side pocket for the Sibanthracite holding, limiting investors’ ability to redeem from the fund.

The SEC also piled on and faulted GLG for improper statements of AUM on its Form ADV filings.

The reports are not clear on how GLG came to the attention of the SEC. The press release credits the Aberrational Performance Inquiry initiative. I’m skeptical that GLG was flagged for over-performance when the investment was not subject to market pricing. Perhaps the Aberrational Performance Inquiry initiative it just running all of the cases where there are valuation issues.

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SEC Targeting Suspicious Investment Returns

Last week, the SEC announced THREE actions against investment advisers for compliance failures. The Securities and Exchange Commission has turned the dial a little higher and announced FOUR enforcement actions against multiple hedge funds by identifying abnormal investment performance. (Does their dial turn all the way up to 11?)

The SEC launched an initiative to combat hedge fund fraud by identifying abnormal investment performance — the Aberrational Performance Inquiry. Back in March, SEC Enforcement Director Robert Khuzami revealed during congressional testimony that the SEC had launched an initiative that would focus on funds that consistently outperform the market.  Enforcement is now focusing on hedge funds that outperform “market indexes by 3% and [are] doing it on a steady basis.” Khuzami referred to such performance as “aberrational,” and stated that Enforcement is “canvassing all hedge funds” for such “aberrational performance.” The SEC Enforcement Division’s Asset Management Unit uses proprietary risk analytics to evaluate hedge fund returns. Performance that appears inconsistent with a fund’s investment strategy or other benchmarks can form a basis for further scrutiny. This initiative came directly from from the Madoff scandal. If they had focused on Madoff’s consistent and aberrational returns, the SEC may have caught him sooner.

Half a year later, Khuzami is crediting Aberrational Performance Inquiry initiative with these four enforcement actions.

Michael Balboa and Gilles De Charsonville

These two were nabbed for overvaluing the reported returns and net asset value of the Millennium Global Emerging Credit Fund, organized to invest in sovereign and corporate debt instruments from emerging markets. Among the fund assets were Nigerian payment adjusted warrants and Uruguayan value recovery rights.

In October 2008, the hedge fund’s reported assets were $844 million. The SEC’s complaint alleges that Balboa, the fund’s former portfolio manager, schemed with two European-based brokers including Gilles De Charsonville to inflate the fund’s reported monthly returns and net asset value by manipulating its supposedly independent valuation process.

Apparently the SEC found Balboa’s action particularly egregious because the the U.S. Attorney’s Office for the Southern District of New York announced the arrest of Balboa and filing of a criminal action against him.

According to the SEC complaint, from at least January to October 2008, Balboa provided De Charsonville and another broker with fictional prices for two of the fund’s illiquid securities holdings for them to pass on to the fund’s outside valuation agent and its auditor. The scheme caused the fund to  overvalue these holdings by as much as $163 million in August 2008.  That meant falsely-positive monthly returns, millions of dollars more in management fees, another $410 million in new investments, and the avoidance of  about $230 million in redemptions.

The SEC is crediting their new initiative with this enforcement action, but the fund has been in liquidation since October of 2008.

ThinkStrategy Capital Management and Chetan Kapur

The SEC charged ThinkStrategy Capital Management LLC and its sole managing director Chetan Kapur with fraud in connection with two funds. ThinkStrategy Capital Fund was an equities-trading fund that ceased operations in 2007.  TS Multi-Strategy Fund was a fund of hedge funds. At its peak in 2008, ThinkStrategy managed approximately $520 million in assets.

The SEC’s complaint alleges that ThinkStrategy and Kapur engaged in a pattern of deceptive conduct designed to bolster their track record, size, and credentials. They materially overstated the performance of the Capital Fund and gave investors the false impression that the fund’s returns were consistently positive and minimally volatile. ThinkStrategy and Kapur also repeatedly inflated the firm’s assets, exaggerated the firm’s longevity and performance history. In 2008 they reported a 4.6% return when they actually had a -89.9% return. It looks like the trouble started in June of 2006.

They also made claims about the quality of their due diligence checks. Unfortunately, they ended up invested in the Bayou Superfund, Valhalla/Victory Funds and Finvest Primer Fund, each of which was revealed to be engaged in serious fraud.

ThinkStrategy also faked a management team, listing several individuals as principals or directors who had no affiliation with the firm. A few were Kapur’s classmates at Wharton. Kapur himself claimed to have an MBA from Wharton, even though he only had an undergraduate degree. Kapur claimed to have over 15 years of experience as an “investor, money manager, researcher, and system designer”. That means he would have started his career in 1988 at the age of 14.

As with most SEC settlements, these are merely allegations against Kapur and ThinkStrategy which they neither admit or deny.  The funds wound down over a year ago and other investors brought suit. In this case, I’m not sure you can credit the SEC with shutting down a bad fund using this Aberrational Performance Inquiry initiative.

Patrick Rooney and Solaris Management

According to the SEC’s complaint, Rooney and Solaris made a radical change in the fund’s investment strategy, contrary to the fund’s offering documents and marketing materials, by going all in for Positron Corp. In late 2008, Solaris held over 1.1 billion shares of Positron stock and had liquidated all of its non-Positron investments.

That’s certainly a risky binary bet on one company. You don’t usually see concentrated, undiversified, and illiquid position in a cash-poor company with a lengthy track record of losses.

The big problem was that Rooney was also the Chairman of Positron  and received salary and stock options from Positron.  Rooney and Solaris hid the Positron investments and Rooney’s relationship with the company from the fund’s investors for over four years. Although Rooney finally told investors about the Positron investments in a March 2009 newsletter, he allegedly lied by telling them he became Chairman to safeguard the fund’s investments.

It’s hard to see how Solaris would have been outperforming the market by more than 3% and fallen under the watchful eye of the new initiative.

LeadDog Capital Markets, Chris Messalas and Joseph LaRocco

The SEC instituted administrative proceedings against LeadDog Capital Markets LLC and its general partners and owners Chris Messalas and Joseph LaRocco. The charges were for misrepresenting or failing to disclose material information to investors in the LeadDog Capital LP fund.

The Fund was almost entirely invested in illiquid penny-stocks or other micro-cap private companies, each of which had received “going concern” opinions from their auditors, all but one of which had a consistent history of net losses, and most of which they or their affiliates owned or controlled

In addition, LeadDog, Messalas, and LaRocco allegedly misrepresented to, and concealed from, existing and prospective investors the substantial conflicts of interests and related party transactions that characterized the fund’s illiquid investments. For example, to induce one elderly investor to invest $500,000 in the fund, LeadDog, Messalas, and LaRocco represented falsely that at least half of the fund’s assets were liquid and could be marked to market each day, and that the investor could exit the fund at any time. In February 2009, the SEC alleges that 92% of the fund’s non-cash assets were illiquid and could not be marked-to-market on a daily basis.

In October 0f 2009, the fund’s auditors learned about some of the problems, resigned, and issued a retraction letter. Let’s assume that the date the problems were discovered. We could credit the initiative with taking action in this case. It would just be two years before charges were filed.

Assuming the allegations are true, these four cases are good cases for SEC enforcement. The consistent out performance initiative is a good one. However, these four just don’t seem to fit in the right time frame for the new enforcement initiative. Since these fund managers were not registered with the SEC, there is no good database for the SEC to check returns and easily find the outliers. Perhaps once Form PF reports start flowing, the SEC will have a better database to go looking for problems.

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