SEC Advises Investors To Read Hedge Fund Documents, Especially The Secret Ones Containing All The FraudBy Matt Levine
I think if I were running a small hedge fund far from prying eyes, every quarter I’d take a look at my performance and decide if I felt good about it, and then (1) if I did I’d take a nice chunk of the profits for myself and (2) if I didn’t then I’d drink until I felt better and GOTO (1). Also I’m sure that when I started I’d plan to take a percentage of whatever I earned over some benchmark, and day one that benchmark would be, like, some relevant index matching the style of my fund, but over time it’d creep down to “well 0% is a benchmark” and then, I mean, negative 10% is a benchmark too is it not? What is special about zero? And if investors asked “can you explain your fees?” I’d just yell “can you explain YOUR fees?” and wander off muttering to myself. Scott Ferguson, hire us!1
According to the September 2001 Agreement, GEI Management was entitled to a quarterly annual management fee of three percent of the net asset value of the Fund. GEI Management also received a quarterly performance fee – called an “incentive allocation.” This fee was subject to a high water mark and a benchmark. The Fund paid a performance fee to GEI Management only if the Fund produced net profits over the prior quarter and on a cumulative basis from the Fund’s inception in 2001. If these conditions were met, GEI Management received an incentive fee equal to 25 percent of the amount by which net profits exceeded the performance of the S&P Healthcare Index.
But what if GEI underperformed the S&P Healthcare Index? A careful reading suggests that then they wouldn’t get performance fees, which hardly seems fair, because underperformance is after all a kind of performance. This is solvable by amending the agreement, which GEI did (deleting the cumulative high water mark and the benchmark, i.e. giving them all profits above zero). Further careful reading of the agreement suggests that they needed 75% of outside investors to agree to this amendment, but that was solvable by ignoring it:
Goldstein, Gatherum, and GEI Management did not secure the affirmative vote of investors owning 75 percent of the Fund’s partnership interests, the written approval of GEI Management, or the approval of investors holding a majority of outstanding interests in the Fund. Investors in the Fund did not know about the Amended Agreement; did not approve any changes to the September 2001 Agreement; and never received copies of the Amended Agreement.
GEI then proceeded to ignore the (less binding) high water mark in its secret amended agreement and took whatever fees it wanted, which were like $147,000 too big, and the SEC shut them down today, though “shut them down” is a nebulous term since they lost their Illinois securities license in 2011 and just kept right on trucking, so, yeah, we’ll be seeing them again.
I don’t know! The SEC has a big “what you need to know to invest in hedge funds” investor bulletin out today in connection with this enforcement action and another one in which “Lion Capital Management stole more than a half-million dollars from a retired schoolteacher who thought she was investing her retirement savings in [the] hedge fund,” which honestly I found too depressing to click on. “Lion Capital Management,” GET IT?
The investor bulletin is full of sensible advice like “Read a fund’s offering memorandum and
related materials,” “Understand the fund’s investment strategy,” “Understand any limitations on your right to redeem your shares,” “Ask about fees and expenses,” and the particularly useful “Research the backgrounds of hedge fund managers,” which would presumably allow you to rule out any managers whom the SEC has caught committing fraud, though of course that means that everyone gets one free fraud before bulletin-reading investors catch on. Goldstein & Gatherum must be disappointed that their freebie netted only $147K.
Robert Khuzami, who really cannot resist a chance to say things like this, said this thing:
“These hedge fund frauds have lured even the most sophisticated investors using the siren song of outsized returns or secured and guaranteed investments,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. “As fraudsters increasingly capitalize on the cachet of hedge funds, we will maintain our strong presence in policing this industry.”
So I mean the people who invested a total of about $3.6mm in a hedge-ish fund run by a guy who wouldn’t give them audited financials and was barred from the securities industry by Illinois – and that retired schoolteacher – are probably not literally the most sophisticated investors. And GEI don’t even seem to have been promising outsized returns or secured or guaranteed investments. They were just promising, like, “investments plus not fraud,” and delivering “investments plus fraud.”2
I have to assume that the SEC’s focus on small-scale hedge fund fraud has something to do with the fact that small-scale dubious hedge funds will soon have free rein to advertise their services to everyone. Of course they will be required to take reasonable steps to ensure that only accredited investors actually invest, but (1) “accredited investors” are only “the most sophisticated investors” in a verrrrrry loose sense and (2) I mean, they are also required not to commit fraud and yet here we are. I hereby assert that any hedge fund advertised in the Boca Raton Pennysaver will have inadequate screening for accreditation status.
You could imagine this advertising thing working out well for the SEC though. Highbridge, I will assume, is not going to take out ads in USA Today – most of the big hedge funds are not looking for new money from investors who could be swayed by mass advertising – but maybe someone more retail-oriented than Highbridge and less fraud-oriented than GEI3 will. If I were Vanguard, I’d be advertising the hell out of the Vanbridgetree Total Long/Long Hedge Fund, which is VGTSX but with 2-and-20 fees. Because as Khuzami points out, there is, God help us, a “cachet of hedge funds,” and someone might as well capitalize on it, and right now it’s fraudsters. (And, I mean, hedge funds.) Mass publicity for some retailish hedge funds – lookin’ at you, Mooch – could focus regulatory attention on the publicized ones, drive out the shadier fly-by-night-ones, and not least importantly tarnish that cachet.
But there’s still maybe room for improvement. If you are Facebook, say, and you want to advertise an investment in Facebook stock, you are required by law to say right there on the cover, things like “Investing in our Class A common stock involves risks. See ‘Risk Factors’ beginning on page 12.” and “The Securities and Exchange Commission and state regulators have not approved or disapproved of these securities, or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.” Because you don’t want people buying Facebook stock not knowing that it’s risky – or thinking that there was some sort of government guarantee of its documents. Hedge fund advertising, so far, seems to have no such requirements. This hedge fund investor bulletin is good advice; it’s a shame that it’s on the SEC’s website, which no one reads. If I were the SEC, finalizing my proposed hedge fund advertising rules, I might say something more like “hedge funds can generally solicit anywhere they want as long as each ad has a footnote directing readers to the SEC’s Investor Bulletin: Hedge Funds.”4
2. I kind of want to give them a gold star for delivering the investments. They actually invested money for clients and don’t seem to have done all that horribly; they just took more fees than they were entitled to. That’s not, like, good, but compared to the protagonists of the average SEC enforcement action they look like saints.
4. Of course no one reads footnotes either but it’s a start.