Wednesday, 11 March 2009

Fund of funds? F@&k tae F@*k more like

One of the joys of the credit crunch has been the Bernie Madoff scam where one of the great and the good of Wall Street turned out to have been running a ponzi scheme. What makes it even better, besides the sound of rich people nashing their teeth on realising they’ve been scammed, is the list of institutions that fell for it as well. These include RBS, HSBC, Banco Santander and BNP Paribas (notice the lack of any Wall Street banks there? Makes you wonder what they thought of a US company that’d been the subject of a 17 page memo called “The World's Largest Hedge Fund is a Fraud” sent to the U.S. Securities and Exchange Commission in 2005).

Of the institutional investors that were taken in my personal favourite is Bramdean Asset Management, a closed-ended Guernsey-based investment fund of funds. Bramdean, judging by an interview in the Daily telegraph, is run by an absolutely ghastly person who after losing almost 10% of her fund’s assets to the Madoff scam was described as being “angry. Very angry”.

Aye right. Personally, I think its the people that lost money to Madoff via a fund of funds investing in his businesses on their behalf who are the only ones with the right to be angry. On the other hand the "experts" who handed their clients' cash over look like fools. I mean what exactly where they charging a turn for given Madoff’s investment vehicles were audited by a totty wee accountancy firm not registered with the Public Company Accounting Oversight Board created under the Sarbanes Oxley Act of 2002 to help detect fraud?

There again given how things were in the run up to the credit crunch you can kind of understand. You see people were so desperate to believe the various alternative investments that suddenly came to prominence, the hedge funds, infrastructure funds and private equity houses and what not, really had discovered a means of turning base metal into gold that they were queuing up to throw money at them.

Private equity funds for one had more money than they knew what to do with, so much so when they went to raise funds they were regularly oversubscribed to the point where the fund raisers increasingly found themselves debating whether to turn away some investors. Eventually they did, but not before cranking up what they were charging those lucky enough to be allowed to invest in them. At the same time they were getting cheaper and cheaper credit from lenders just as desperate to believe that the returns being generated were due to more than cheap credit and a rising market. So the people doing the actual transactions were getting the gravy at both ends (or 3 ways if you include their tax treatment in the UK).

In this kind of environment a fund of funds appears less like an intellectual powerhouse picking and chosing the best fund managers to invest in on your behalf and more like an organisation with the connections necessary to invest in funds you couldn't otherwise access. For me the most obvious comparison are those blokes who get in the queue to buy some super deluxe sports car before you and then sell you their place so you only have to wait 6 months rather than 3 years i.e. no expertise, no value add, just enough contacts to leech off everyone else.

Except calling them leeches is way to kind. A fund of funds provides an obvious means of spreading risk – rather than invest your savings in one fund, you invest it in a fund of funds that invests in lots of different ones. The reality, judging by the fact Bramdean invested 9% of its portfolio in just 2 Madoff funds, is that the risk might not get spread as widely as you originally thought.

The other thing is that at a system wide level fund of funds helped concentrate rather than spreading risk. Here’s how –

Private equity firm A wants to raise £20 for its “buying company B fund”.
It raises the £20, then goes to Bank C to get the £80 debt needed to buy company B for £100. Bank C says of course leaving it on the peg for £80 of a company purchased for £100.

Except Bank C is a bit racy and via a different department has also directly invested £5 in the private equity firm’s “buying company B fund”. So that’s £85.

Even better a different Bank C department has also invested £50 in a fund of funds that’s invested 10% of its assets in the same “buying company B fund”, which takes us to £90.

But c’mon this is pre-credit crunch days and theres this cheeky wee investor who likes leverage so much he’s also borrowed from Bank C to help fund his investment in the “buying company B fund”, so lets call it another £5 or £95 in total.

Shame over the last 12 months the FTSE has fallen from over 6000 to under 4000 i.e. yer average big company has lost over a third of its value, which implies Bank C lent out and invested directly and indirectly £95 to buy a company now valued at £66. And this really is a shame because the payback to investors was based on selling company B for more than the £100 it originally cost. Oops!

As fer the long term future of fund of funds, well the risk management principle remains sound, but on the basis that the “alternative investments” being invested in were based on being able to access cheap credit at rates and levels we’re unlikely to see for years, they’re well stuffed for the time being give or take the vulture funds that are already being established.

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