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The SEC Is Pretty Sure It's Better At Investment Valuation Than At Least One Hedge Fund

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The SEC has a thing called the Aberrational Performance Inquiry that runs a screen of hedge funds, selects the ones whose performance looks too good to be true, then sees if it is. This raises questions from the empirical (what is the conversion rate of "looks too good to be true" to "is in fact too good to be true"?), through the practical (do they, like, investigate Bridgewater every quarter?), up to the philosophical, which goes something like "if your hit rate is, as theory predicts, above some threshold, where does that leave you?" I feel like this initiative stirs up deep questions and should have people worried, and not just the fraudsters. If I were advertising my hedge fund1 I would want to say "the SEC thinks we're an aberration, but not the fraudy kind." If your hedge fund can't say that, why invest?

Anyway the screen came up aces with Yorkville Advisors:2

Securities regulators on Wednesday sued Yorkville Advisors LLC and its top executives, accusing the New Jersey hedge fund of reporting false and inflated values for some of its investments.

Named in the lawsuit, brought by the Securities and Exchange Commission, were Yorkville, which has been one of the largest funds specializing in thinly traded micro-cap and small-cap companies, founder and President Mark Angelo and Chief Financial Officer Edward Schinik.

The firm misreported values as the financial crisis hit in 2008 and 2009 and market conditions deteriorated, and its returns during the period consisted mostly of unrealized gains from marked-up investments, the SEC said.

The SEC's release and complaint are deeply pleasant; we make fun of the SEC a bit around here so it's worth saying that this is impressive work and I Like It A Lot. Yorkville had a pretty good plan, as the SEC lays it out. Here's what you do:

  • Start a fund.
  • Charge fees as a percentage of assets.3
  • Invest in illiquid bits issued by tiny companies that (the bits, and sometimes the companies) don't have quoted prices.
  • Make up (high) prices.
  • Charge high fees based on those high prices.
  • Attract investment based on your strong track record of making up high and increasing prices for your assets.
  • Eventually be all "oh yeah those bits lost a lot of value this quarter, whaddarya gonna do, massive writedown."

This is generically a good plan if you want to swindle unsophisticated people, and with just a bit of panache it becomes a decent way to swindle sophisticated people too. It's a hard plan to catch because, y'know, how do you know that they're making up the wrong prices? The valuations are inherently subjective and opinion-driven; who's to say Yorkville's opinion is wrong?

The Aberrational Performance Robot, for one. And the subsequent investigation, for another, which turned up neat tidbits like:

In August 2007, Levitz issued convertibles to Yorkville with a face value of $22 million. Levitz filed for bankruptcy in November 2007 and sold all of its assets at auction to a company named Hilco. ... At December 31, 2008 and 2009 Yorkville valued its entire investment in Levitz ... at $17,536,250 and $17,332,058 respectively. In March 2008, however, Yorkville entered into a settlement in the Levitz bankruptcy pursuant to which it only received $1.285 million. Notwithstanding that it had settled the bankruptcy claims (which should have resulted in a write-down), Yorkville's valuation of the convertible remained unchanged from its presettlement valuation. ...

[I]n February 2008, a Yorkville investor relations staff member discussed with Angelo an email she received from a Yorkville senior vice president that stated the Funds' investments had a loan-to-value ratio of 234%, "because we do not have values for the collateral (if any) in the database and because many of our companies have no assets." Despite knowing that that Yorkville did not have values for its collateral, that many of its Portfolio Companies did not have assets, and the Funds' investments' loan-to-value ratio was 234% (i.e. that the loans were more than 2.3 times the amount of the collateral), Angelo told a prospective investor in an April 11, 2008 meeting that the Funds' investments' loan-to-value ratio was 33% ....

It goes on in this and related veins; for instance, they apparently told investors that an independent valuation consultant called Pluris provided their marks, but in fact rejected Pluris's valuations for being too low. On a quick read it seems not ironclad, but probably enough to make you settle.

One critique you could always make of any financial-enforcement action other than like BURNING LLOYD AT THE STAKE is that the enforcers are going after the bit players rather than systemic problems. Yorkville made perhaps-indefensible subjective judgments about the valuation of smallish investments in small-cap companies, and while these judgments induced about $280 million of investments, the actual profit skimming by Yorkville was much less, at around $10 million.4 Yorkville was honestly investing in things and hoping they'd go up; it was just inappropriately expressing that hope via its accounting. You're not supposed to hope in your accounting.

That critique is not too impressive; hedge funds present an increasingly important opportunity for investors to be fleeced so it's good for the SEC to be on top of them independent of whether anyone is on top of anything else. But you could also ponder the broader implications of this aberrational whatsit. Accounting for a large investment with no public marks at a substantial premium to realizable value is not, like, unique to small-cap convertible-bond funds. Remember Citi's 49% investment in a wealth-management venture that it carried at a $23 billion valuation, which was off by ten billion dollars? Remember the London Whale?

After things crash it is fun and expected for regulators to bop around saying "ooh you should have known that thing would crash, why didn't you disclose its badness, jail for you, or at least unpleasant congressional hearings," and that's ... great. Sort of great. Something. But you might notice that the regulators rarely catch the over-optimism before the crash, for mostly good and obvious reasons: as a banker or trader or investment manager or what have you, it's your job to get valuations right, not your regulator's, and you've got far better tools - technological and human and otherwise - to do that job than the regulators do.

But when you don't do your job, badness ensues, and the threat of post-badness enforcement is not obviously enough to counteract that. If you've got a regulator, and that regulator has a computer, and that computer is checking on your valuation work and spotting when your marks seem a little wishful, that would seem to be a good thing. And if they're actually good at it - and so far maybe the SEC is? - that's even better.

SEC charges Yorkville Advisors with securities fraud [Reuters]
SEC v. Yorkville Advisors, LLC [SEC]
SEC Charges Hedge Fund Adviser and Two Executives With Fraud in Continuing Probe of Suspicious Fund Performance [SEC]


2.This footnote contains a macro that puts the word "allegedly" into each sentence of the rest of the post in a syntactically correct way. Patent pending.

3.And performance? Yorkville seems to have charged 2% of AUM, flat; if you really wanted to boost your scamming you could charge 2 and 20. But there are tradeoffs: charging 20% of unrealized returns lets you make more money by faking those returns, but it also would, I hope, lead to more scrutiny and demands for third-party valuations from the sorts of pension and FoF investors who'd actually give you hundreds of millions of dollars to invest. I mean, I really hope.

4.As calculated by ... the SEC's own valuation model? That alone is interesting.