SEC Probes Inflated Hedge Fund Returns?

Dec 05 21:12 2017 Print This Article

Matt Robinson of Bloomberg reports, SEC Probes If Banks Helped Hedge Funds Inflate Returns:Wall Street banks are known to fiercely compete for hedge-fund clients because of the lucrative trading profits they provide.The U.S. Securities and Exchange Commission is now investigating whether some banks crossed the line to win business by offering hedge funds bogus price quotes on hard-to-value bonds, said two people familiar with the matter. The SEC’s concern: As a reward for helping hedge funds make money -- by submitting quotes at requested levels -- banks got trades steered their way.As part of its probes, the regulator is reviewing at least a dozen banks and brokerage firms to determine whether they provided inflated prices on debt securities that funds used to pump up the value of their investments, said the people who asked not to be named because the inquiries aren’t public.JPMorgan Chase & Co. and Citigroup Inc. are among the banks being looked at, said one of the people who added that the SEC is also scrutinizing other large firms and several smaller ones. The investigations, which won’t necessarily lead to any allegations of wrongdoing, focus on valuations of mortgage securities and other thinly traded bonds where swings of just a few cents can have a big impact on hedge fund returns, the people said.“It doesn’t take much to manipulate a bond price,” said Charles Geisst, a finance professor at Manhattan College in New York who has written books on the history of Wall Street. “It’s sort of an alternate reality. No one really knows the price of a bond until it’s traded.”Spokesmen for the SEC, JPMorgan and Citigroup declined to comment.The probes show the SEC isn’t letting up in its multi-year push to try to uncover illicit conduct in one of Wall Street’s most opaque markets. Bonds tied to home loans and other debt aren’t bought and sold on exchanges, and the securities can go months without trading. That lack of transparency prompts investors to value bonds by relying on estimates from brokers and other third parties, a system the SEC believes is ripe for abuse.Hedge fund firms typically task internal committees with valuing thinly traded bonds, a process that prevents conflicted portfolio managers from assigning favorable prices to their own investments.Still, portfolio managers can push back if they feel prices don’t reflect the current market. In such instances, they sometimes tap brokers at banks for additional, higher estimates.The portfolio manager might argue that the higher valuation is more accurate because it comes from an actual market participant. If the hedge fund’s valuation committee accepts the broker quote in pricing a bond, it might make the difference between a good month or a bad one for money managers depending on the size of the position in their portfolio.Significant CloutPortfolio managers at hedge funds have significant clout with brokers because they are sought-after customers. Hedge funds engage in frequent buying and selling, they amplify their bets with borrowed money and they are big buyers of derivatives. Banks receive millions in fees from such services.The SEC’s suspicion that brokers sometimes provide sham prices isn’t just theoretical. In June 2016, the agency accused two portfolio managers at Visium Asset Management of soliciting phony quotes from friendly brokers over an 18-month period to justify inflated valuations on distressed debt holdings.Due to the scheme, Christopher Plaford and Stefan Lumiere were able to post a 0.68 percent gain in 2011 for the credit hedge fund they ran at Visium, instead of a roughly 4 percent loss, the SEC said. Plaford has pleaded guilty to related criminal charges brought by federal prosecutors, while a judge sentenced Lumiere to 18 months in prison in June for his role in inflating some of the firm’s bond investments.Undervaluing BondsThe SEC is also looking at Keri Findley, a former partner at Dan Loeb’s Third Point hedge fund firm, people familiar with the matter have said. The regulator is probing whether Findley, who left Third Point in February, caused mortgage bonds in her portfolio to be undervalued, the people said.While it’s unclear how she might have benefited from her investments being worth less, it’s possible that undervaluing a position for much of the year could make it easier for a portfolio manager to then mark up the investment to match market prices at year-end when firms calculate fees and bonuses.A spokesman for Findley has declined to comment. Third Point has said it has a rigorous process for pricing securities and that it is cooperating with the SEC.Technological advancements have assisted the regulator. In recent years, it has been using computer algorithms to spot bond trades that occur at prices that are suspicious because they don’t reflect recent transactions. SEC officials say the algorithms have helped them to identify billions of dollars of problematic trades.It's not the first time Bloomberg reports on hedge funds using shady pricing on illiquid bonds. Back in May, Matt Robinson, Christian Berthelsen, Chris Dolmetsch, and Matt Scully reported, Hedge Funds Are Facing a U.S. Criminal Probe Over Bond Valuations:U.S. prosecutors are investigating one of Wall Street’s darkest markets, focusing on hedge funds suspected of inflating the value of debt securities in their portfolios to juice the fees they collect.Having prosecuted traders who lied to customers about bond prices, the government is now scrutinizing hedge funds that allegedly solicited bogus price quotes from brokers, according to three people familiar with the matter who asked not to be identified. Such a practice would have enabled the funds to pump up the value of illiquid securities on their books.The incentive to manipulate valuations has become more pronounced as investors have abandoned hedge funds because of poor returns and high fees. Assets managed by hedge funds declined last year for the first time since the financial crisis, with investors yanking more than $70 billion, according to Hedge Fund Research Inc. The opacity of certain parts of the debt market, with illiquid, sometimes distressed securities, had made it a prime target for deception because of the difficulty of determining prices.It’s unclear how many funds are under scrutiny by federal prosecutors in New York for possibly seeking bogus quotes from brokers. But a witness testifying for the government this week in an unrelated trial of three former Nomura Holdings Inc. traders in Connecticut may have shed light on the investigation.The witness, a former broker named Frank DiNucci Jr., said under oath that he provided bogus quotes to a trader at a mortgage bond fund, Premium Point Investments LP. DiNucci agreed to plead guilty last month in Manhattan federal court to conspiracy and fraud and says he has been cooperating with a criminal probe by New York prosecutors into Premium Point. “I would extend marks to make them seem like they were my own,” DiNucci told the federal jury in Hartford. The goal was to “increase the number of trades we would do with this particular client,” he said.Steven Bruce, a spokesman for Premium Point, which managed almost $2 billion at its peak and is now closing, declined to comment on DiNucci’s testimony or on whether the fund is under investigation. Nicholas Biase, a spokesman for Acting U.S. Attorney Joon Kim in Manhattan, also declined to comment.A focus on bond funds would signal a new direction in enforcement. In recent years, prosecutors have brought dozens of high-profile, insider-trading cases against portfolio managers at equity hedge funds, securing more than 80 convictions.Buy-SideTheir target now appears to be the debt side. The Justice Department charged at least seven bank bond traders since 2013 with lying to customers about prices before shifting to the buy-side of the market. The probes began at the Securities and Exchange Commission’s complex financial instruments group, according to the people familiar, who declined to comment publicly on the confidential investigation. The SEC declined to comment.Mismarking fraud was at the center of a case against fund managers at Visium Asset Management LP. Jurors returned a guilty verdict this year against one of its portfolio managers in just 90 minutes. Prosecutors have also brought charges over another scheme: lying to investors about bond prices. Former Jefferies LLC trader Jesse Litvak was convicted at a trial in January, and three former Nomura Holdings traders are now on trial in Connecticut, where DiNucci testified.Some securities, including pools of mortgages, can be especially difficult to price. The debt can go months without trading. Without recent pricing data, funds rely on estimates of brokers and quotes from third parties to value the debt.By carrying securities on their books at artificially inflated prices, hedge funds can show better performance. They can collect more in management and performance fees -- or hide poor performance for certain holdings.DiNucci has been testifying against his former colleagues at Nomura, who he said lied to clients about bond prices. They deny wrongdoing. Under cross-examination by defense lawyers, DiNucci was asked about the mismarking of bonds. He said he worked at brokerages Auriga USA LLC and AOC Securities LLC after leaving Nomura. While there, he said he would provide fake quotes to traders including Jeremy Shor, formerly of Premium Point. Shor on Wednesday declined to comment.Alex Hendrickson, a co-president at Auriga, declined to comment and referred questions to a lawyer, Jeffrey Plotkin, who also declined to comment. A person who answered the phone at AOC said its chief executive, Ronaldo Gonzalez, wasn’t available for comment.Plea AgreementAs part of an agreement to cooperate in the “Premium Point investigation,” DiNucci said he told prosecutors in New York that there was “a lot more than that.” He didn’t elaborate. A copy of his April 6 plea agreement with New York prosecutors was entered into evidence at the Connecticut trial.DiNucci’s lawyer, Daniel Zinman, declined to comment. A Nomura representative didn’t immediately return a request for comment.Before the financial crisis, regulators had a hands-off policy in monitoring the securitized debt market in part because participants were considered sophisticated buyers and sellers. That assumption came undone when the market cratered following rising mortgage delinquencies. To deal with the fallout, the SEC created a specialized unit to examine the market.The unit got a tip from AllianceBernstein after a spreadsheet was sent to an asset manager revealing that Litvak, then at Jefferies, had lied about the price paid for securities he sold, prosecutors said. Litvak was sentenced last month to two years in prison for securities fraud.Welcome to the shady world of pricing illiquid bonds. I actually commend the increased scrutiny and enforcement from the SEC and think it's equally important to monitor shady bond pricing activity, not just insider trading activity in the stock market.Now, before I get a bunch of fixed income hedge funds accusing me of spreading malicious lies or grossly distorting reality, let me assure GPs and LPs reading my comment that most hedge funds are following best practices when pricing illiquid bonds and other illiquid OTC instruments.Those of you looking to understand the issues surrounding pricing these illiquid instruments can consult some or all of the documents below:

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About Article Author

Pension Pulse

Leo Kolivakis is an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. He has researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). He's also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system.

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