Articles Tagged with Hedge Funds

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The Securities and Exchange Commission’s Asset Management Unit has been investigating whether hedge fund managers have overvalued assets in “side pockets” and then charged investors higher fees based on those inflated values. A side pocket is a type of account that hedge funds use to separate certain illiquid investments from the rest of their portfolio. Investors are typically not permitted to redeem their interest in a fund with respect to assets allocated to a side pocket until such assets have been liquidated or reallocated to the general portfolio by the investment manager.

Recent charges brought by the SEC highlight the need for hedge fund managers to establish reasonable policies for the valuation of illiquid assets and carefully adhere to such policies when valuing assets allocated to a side pocket. On October 19, 2010, the SEC charged two hedge fund managers and their investment advisory businesses with defrauding investors by overvaluing illiquid fund assets they placed in a side pocket. According to the SEC complaint, Paul T. Mannion, Jr and Andrews S. Reckles, through their investment adviser entities PEF Advisors Ltd. and PEF Advisors LLC, caused certain investments made by Palisades Master Fund, L.P. to be overvalued by millions of dollars.

Beginning in August 2004, the fund, at the direction of Mannion and Reckles, invested millions of dollars in World Health Alternatives, Inc. By July 2005, World Health was the fund’s largest single position and constituted at least 20% of the fund’s assets. As World Health (now bankrupt) began to experience financial difficulties, Mannion and Reckles became concerned about the value of the fund’s World Health assets and the potential for any report of substantial losses in relation to such assets to cause investors to redeem their interests in the fund. Recognizing the risk of large scale redemptions, Mannion and Reckles decided to place the World Health assets in a side pocket.

Palisades had adopted specific policies on how it would value different categories of securities and communicated those policies to prospective investors in its offering memorandum and financial statements. Mannion and Reckles allegedly valued the World Health assets contrary to the disclosed valuation policies, which resulted in such assets being significantly overvalued. Mannion and Reckles then charged management fees that were improperly inflated by their overvaluation of fund assets.

Robert B. Kaplan, Co-Chief of the SEC’s Asset Management Unit, commented:

Side pockets are not supposed to be a dumping ground for hedge fund managers to conceal overvalued assets. Mannion and Reckles deceived investors about the fund’s performance and extracted excessive management fees based on the inflated asset values in a side pocket.

The SEC is seeking injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.

 

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Under Secretary for International Affairs Lael Brainard recently delivered a speech at the Institute of International Bankers’ “Regulatory Dialogue with Government Officials” urging other nations to adopt the U.S. approach to hedge fund regulation:

It is also vital to have common agreement on the regulation of hedge funds, and to extend the perimeter of regulation to ensure stronger oversight of these funds. We have pursued international agreement on the same approach adopted by the United States: requiring all advisers to hedge funds, above a threshold, to register and report appropriate information so that regulators can assess whether any fund poses a threat to overall financial stability by virtue of its size, leverage, or interconnectedness. And to impose heightened supervisory and prudential standards on entities that do.

It is essential to ensure convergence of regulatory treatment for hedge funds to avoid a race to the bottom and promote a level playing field. Indeed, all the members of the G-20 committed to the same standards for oversight of hedge funds and to implementing these standards in a nondiscriminatory manner, and we are working hard to ensure these commitments are fulfilled.

The full text of the speech is available here.

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Bloomberg reports that the SEC is engaged in a probe of investment advisers who invest client assets in hedge funds, funds of funds, private equity, venture capital and other alternative investments. The SEC’s Office of Compliance Inspections and Examinations has recently requested that advisers provide extensive information about their alternative investments, particularly in regards to the due diligence processes used when evaluating alternative investments. A copy of the letter sent by the OCIE to examined advisers and the accompanying information request list is available here.

“This is further evidence of the SEC’s more proactive approach to the hedge-fund industry,” said Jay Gould, a partner at Pillsbury Winthrop Shaw Pittman LLP in San Francisco. “Hedge-fund managers, including funds of funds, can expect the agency to take a greater interest in their policies, practices and their relationships with investors and other fund managers.”