Due Diligence and Risk Assessment of an Alternative Investment Fund

MA-Thesis / Master von Ingrid Vancas

Introduction:

‘There can be few fields of human endeavour in which history counts for so little as in the world of finance’, John Kenneth Galbraith.

Alternative investment funds have been considered private pools attracting HNWI and endowments. The picture started changing after March 2000 when alternative investment funds stepped into the spotlight of investors’ interest. Institutional investors sought after an effective means of diversification to protect the capital from the falling equity markets and depressed bond yields. Many alternative investment funds became more mature, and put in place advanced investment processes, lower leverage, improved transparency and effective risk management to satisfy the increased selection standards of pension funds and large institutions. The industry has been growing at a double-digit pace since 2004, from approx. $970 billion to an estimated $1.9 trillion AuM by the end of 2007.

The picture dramatically changed in 2008. On March 16th 2008, JP Morgan Chase with the aid of Federal Treasury acquired Bear Stearns for $2 per share. Bear Stearns would have filed in for Chapter 11 in order to preserve Bear Stearns from the bankruptcy. The acquisition was consummated on May 30th 2008 at the price of $10 per share. Markets stabilised momentarily before the next greatly rescue in Europe took place. IKB needed a liquidity support of €10.5 billion, causing some worries, but not substantially jeopardizing financial markets. After being supported in a series of rescue actions since July 2007 by KfW, IKB was sold to US-based investment fund Lone Star as a part of state-backed restructuring plan in August 2008. On September 15th 2008 Lehman Brothers went bankrupt. A new era of rescue actions in the banking industry worldwide rolled the financial markets and amplified ongoing credit crisis.

The combined banking failures around the globe in 2008 caused the worst market crash since the great depression 1930s. The world financial markets struggled, thus creating an untenable strain on alternative investments. Since then, the financial institutions, asset managers and investors´ have lost billions of dollars. While worldwide banks were provided with liquidity to sustain the business, asset managers experienced panic situations where investors constantly kept pulling out the money. The industry was hit by further deteriorating prices, lack of liquidity, even in usually liquid assets, and the mismatches in assets and liability positions, as capital outflow continued due to markets turmoil.

In September 2008, investors redeemed $41 billion from alternative investment sector, which is the largest monthly money outflow since experts began tracking the numbers. The financial crisis generated the deleveraging of balance sheets and contraction of general credit. These conditions and further friction in the industry will force large number of funds to leave the business. In order to normalize the situation the industry regulation and fund fee structures will become an issue. As regulation changes going forward there will be tire competition and more transparency as the overall market changes to avoid the calamity that has fallen on itself over the last two years. Furthermore as disparities in the market continue and the overall structural changes will create inefficiencies in alternative investments going forward.

The fraud case charged against Bernard Madoff, money manager who had absconded more than approx. $30 billion under management was arrested on December 11th 2008 and accused of running a giant ‘Ponzi scheme”. A long list of Mandoff’s clients who were individually invested up to $7.5 billion with Madoff will according to data compiled by Bloomberg suffer approx. $50 billion loss. Astonishing about Madoff case was the fact that not only HNWI or endowments were affected but well-known financial institutions; asset managers and insurances who have also invested with Bernard Madoff. The list contains Banco Santander SA, BBVA, BNP Paribas SA, Dexia SA, Sumitomo Life Insurance Co, Nomura Holdings Inc, Societe Generale SA, Unicredit SpA, Pioneer Alternative Investments, Royal Bank of Canada, Clal Insurance, Nordea Bank AB, Man Group Plc to name some. Looking at the names there is a wide range of professionals in the financial services industry, who are presumed and supposed to have sound risk management practices as well as proper due diligence in place.

General expectation is that the future alternative investment industry will change, but won’t disappear. There always will be investors willing to invest in skill-based strategy, preferring active money management. Due diligence and risk management is a crucial tool in helping to select the appropriate fund. It protects from fraud and helps selecting superior risk-adjusted return provider.

Purpose and structure:

The focus of the thesis lays on risk assessment and due diligence. The thesis captures fund’s internal and external risk and the investment style specific risk. The aim is to provide sound guidance to alternative investment fund selection. UCITS 3 directive widens investment tools for traditional asset managers by allowing short selling of securities and diminishing the gap between traditional and alternative asset management industry and attracting traditional managers to the alternative investment universe. The importance of due diligence and fragmented risks due to diversity of the investment styles is an essential point in the investment process.

The thesis will not handle unregulated offshore funds as well as Fund of Funds. Offshore funds tend to have very limited restrictions on what they can do and usually their investment strategy is very vaguely explained in the fund prospectus. Regulated alternative investment funds tend to have very formalised maximum investment restrictions governing leverage and risk levels. Due to the fact that the alternative investment industry has its roots and longer history in USA as well as broader funds universe than in Europe or Asia, predominantly US funds examples were used. Commodity Trading Advisors and Private Equity Funds are substantial part of the Alternative Investment Funds Industry but will be not handled as this would get beyond the scope of the assignment. The author concentrates on the following three alternative investment fund categories: Relative Value and Market Neutral, Event Driven and Opportunistic. Whilst the industry is generally categorised into certain fund types it has to be stated that every fund is different and will have different risk attributes. Within the specific categories major risks will be the same, as the exposure towards the specific underlying will be similar. Still every single fund has to be examined on its own in detail, as it will have specific alpha generating competitive advantage, which is not only return but also a risk source.

Chapter 1 outlines the purpose and structure of the thesis and the relevant definitions. Chapter 2 suggests preselecting of a potential fund manager or management team by analysing the team and fund’s performance. The analysis goes through the quantitative figures and the qualities of the management team. Detailed knowledge about the strategies and its fit into the portfolio is worthless unless the investor is able to select the performing manager. Without that skill the probability of ending up with an underperforming alternative investment fund or a blow-up is huge. The analysis of the management team qualities shows behaviour patterns helping to detect management teams tending towards moral hazard. The question investors seek to answer is, who is the manager or the management team I intend to invest with?

Chapters 3 to 5 handle alternative investment fund style specific risks. The author gives an overview over major risks per investment style. The specific investment style risk depending on the combination of major risks can be a warning sign about the future performance. The question investors seek to answer is, what style specific risk level has the fund I intend to invest with?

Chapter 6 examines fund’s internal and external risks. Thereby internal risks are directly connected to the management team and its operations. External risks are diverse outside factors influencing fund’s performance, e.g. industry and macroeconomic risks.

Chapter 7 highlights the framework for the fund’s risk level assessment. It categorises risks based upon results commenced in previous chapters. Reflexive conclusions and closing remarks are represented at the end of the chapter 7. The alternative investment funds business is strongly driven by interpersonal relationships. It should be built on a strong, trustworthy relationship between investor or his advisor and the fund management. Even the best analysis based on historic data cannot fully capture behavioural changes nor can it reliably predict the future. It always should be complemented with human ability of logic thinking and reflexivity. ‘Nobody can predict the future, but you can understand the forces that will shape the future – and it is always better to play with forces than against them’.

Table of Contents:

Text Sample:

Chapter 3.1, Relative Value and Market Neutral Strategy Risk:

‘An investment operation is one in which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.’ Benjamin Graham.

Relative value and market neutral strategies are arbitrage trades in stocks, bonds, convertible bonds and subscription rights. The arbitrage represents the profit by capitalising on a temporary price difference of the same or correlating securities at different exchanges, i.e. assets moving away from their fair value or a historical norm. The investment strategy is based on the statistical and fundamental asset evaluation or a combination of both, e.g. pure quantitative models and algorithmic trading or a combination of statistical models and the fundamental securities analysis. In their plain structure both strategies are less correlated towards the securities markets than Event Driven and Opportunistic strategies. As the central part is realising the profit when assets converge to their fair value the fund seeks to hedge the alternative source of the potential return or risk, i.e. the exposure to foreign currencies, interest rates or broad market indices. To eliminate the potential risk of the mispricing fund holds long and short positions in the related securities.

In the efficient and less volatile markets there are fewer opportunities to generate alpha. As the manager won’t find the substantial price discrepancies spreads are low. The leverage increases the profit and the risk especially in an uncertain economic environment. Another profitable alpha source is less liquid assets, which are bearing the unexpected risk in the changing market or economic surroundings. Though the generic strategy characteristics are avoidance of the direct long or short bias risk along with the consistent moderate returns and low volatility funds operating with the high leverage, errors in historical market data collection or the quantitative model errors can be anything else than the low risk profile funds. Any flaw in the parameter assumptions or the market data can cause discrepancy between the actual and the perceived risk.

Relative Value and Market Neutral strategies offer net, excluding fee, average annual returns between 9.70% and 12.65% combined with a low annual standard deviation between 0.38% and 0.53%, which demonstrates the average expected risk/return profile of the strategy. If the fund is far out of the range the ultimate deviation cause has to be examined as the fund might bear unexpected risk either due to the management team providing false information, IT or operational bugs or the fund taking far more excessive risks than expected within the strategy or the investment mandate.

The investor needs to distinguish between the correlation and the exposure. This matter in illustrated with the following example. The fund can switch between short and long future positions in the VW equity in such way that the correlation on average nets out. Thus, switching between the short and long future positions, on an average will show a net zero correlation towards the equity. Although during the observed period of time fund was alternately exposed to the underlying risk by holding either long or short future positions. If the fund on average displays a zero correlation towards the market it does not necessarily mean that the fund at any point in time was not exposed to the market risk. The investor seeking portfolio diversification and a downside protection along with the constantly moderate returns and overall low volatility is rather looking for a ‘hedge” instead of the excessive market exposure, which is equal to an unexpected risk and not corresponding to the investor’s mandate.

Relative Value and Market Neutral strategies can have an investment mandate to boost the return. In such case a higher volatility as well as market exposure have to be accepted and cannot be regarded as an unexpected risk. The investor has to answer following question; do I expect and accept low, mid or high exposure inside my alternative investment mandate and the specific strategy? The specific strategy and the market exposure will influence fund’s risk profile in line with the market movements especially in highly volatile markets. The liquidity of the underlying assets matters most when the fund’s leverage is excessive. The liquid assets can turn nonliquid in crisis scenarios. A best-known example was the Russian crisis in 1998 when LTCM almost caused a systemic collapse. A highly leveraged fund held most of the positions in particular securities dominating the market. During the summer 1998, macroeconomic scenario dramatically changed as the liquidity in the underlying assets dried. The liquidity risk at times outweighed market risk in high-yield bonds, emerging markets and mortgage-backed securities. An actually from the plain strategy perspective low risk fund was due to its size, leverage and the position size moving the market and almost caused a systemic collapse.

Fixed Income Arbitrage:

Fixed income arbitrage strategies capitalise on the price disparities in the interest rate related assets and their derivatives through an establishment of the long and short positions. The manager should possess a deep asset pricing and a quantitative modelling skill. The positions establishment and the strategy execution require a profound mathematical and statistical knowledge as well as programming and data modelling skill. The essential skill is an accurate pricing of the fixed income assets as well as the estimation, the establishment and the adjustment of the open and the hedged positions. A quantitative insight, the risk management and the securities trading experience are the necessities in order to appropriate interpret the market movements. The aim is to detect temporary credit anomaly in the similar fixed income securities that are mathematically, fundamentally or historically interrelated. Alpha stems from the capitalization on disparities in the credit spreads, the yield curve movements on a single maturity grids, the volatility spreads, the cash versus futures spreads, the counterparty rating changes and the special bond and option features, i.e. MBSs or CDOs, which offer potential profits as long as many investors fail to explicitly value these.

Fixed Income Arbitrage strategy offers a net average annual return of 9.80% combined with a low annual standard deviation of 0.68%. An example of the basic strategy would consist of the long government bond position and a sold bond future contracts on the particular bond. Such construction automatically provides natural hedge though it is imperfect due to the unlike duration in future 3 months and bond up to 12 years interest rate movement sensitivity. The profit is expected from the disparity of the cheapest to delivery bond for the sold future contracts, as shifts in the demand and supply of the underlying bonds varies over the holding period.

In following different risks within the strategy are considered. The long or short bond positions entail credit risk. In order to eliminate the credit default and the liquidity risk fund will trade in the liquid issues usually government or corporate bonds although the fund is not constrained to such bonds and also can invest in junk bonds depending on the skill or the risk appetite. The changes in the interest rates or the yield curve structure involve market risk. As the long and short positions do not have the same duration and might not have the same interest paying character the interest rate risk is not perfectly hedged. This exposes the portfolio to the value changes along with the yield curve moves on the different interest rate grids. The liquidity risk can result in the increasing financing costs. As the borrowing becomes cheaper the lending financing costs are expected to drop. If the financing profiles reverse the liquidity risk will arise. The legal risk can occur in taxation law changes.

The extraordinary financial situations or political debacles can cause instability of the asset correlation, i.e. the derivative instruments and their underlying assets lose the stable correlation relationship and natural hedges break. The fund’s leverage is up to 30 times the fund’s equity. In a ‘normal” market conditions the spreads in fixed income assets are small ranging between 3bp and 20bp. The normal market condition refers to low spreads for the credit risk premiums and not an inverse or flat yield curve. In the stable macroeconomic and political environment holding a credit spread risk equals a low credit risk while in market turmoil credit spreads widen and the fund’s positions depending on the bet can substantially lose money. The rare events are a substantial threat for the credit spreads. The high market volatility and a worsening credit risk perception are dangerous if the fund’s positions are not properly hedged. The exposure to a yield curve, FX rate or inter-market spread risk means that the fund is taking directional bets. Combined with a high leverage it can end up in a massive risk taking, which actually is not what the low risk appetite investor would expect within Relative Value strategy.