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Capital Flows into Alternative Asset Funds – September 2017

Attached is our inaugural quarterly research report on capital flows into alternative asset funds.  The alternative asset industry continues to grow!  Through the first 3 quarters of 2017, we saw capital flows up 32% when compared to 2016 and we are forecasting $1.4 trillion of new capital flowing into alternative asset funds and 6,700+ new issues for the full year 2017.

Capital Flows into Alternative Asset Funds September 2017
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Insight #16 – Complexity Continues to Drive Operating Risk

Earlier this month, Convergence saw another adviser on the receiving end of a significant fine levied by the SEC.  In this instance, Capital Dynamics incurred a $275 thousand fine for “improper allocation of certain expenses to a private equity fund client.”   Fund expenses have been an SEC hot topic for some time now and Convergence has published several research papers on the factors that drive operating risk at advisers.  In this case, subscribers to Convergence’s Complexity Profile™ Service would have seen the high levels of operating risk at Capital Dynamics.  Based on a 3-year review, it was consistently assigned a “High-Watch” Complexity Profile™ and there are several red flags among the 40 complexity factors that Convergence reviews to identify operating risk.  The attached research paper discusses why Convergence believes Capital Dynamics is a “High-Watch” manager based on the red flags identified by Convergence.

Convergence Insight _16 - Complexity Continues to Drive Operating Risk_FINAL-2
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FundFire Alts Feature: Hedge Funds Cut Costs by Trimming Ops Shadowing Efforts

Article published on August 9, 2017
By Lydia Tomkiw


Hedge funds are increasingly looking to shadow only core areas of their fund administrators, amid performance pressure and a hunt for ways to cut costs, industry watchers say.

While full shadowing – essentially duplicating an administrator’s functions to verify and secure fund data – remains in the market, more managers are eyeing a model of “oversight and governance,” which entails shadowing only key areas of their administrators.

“It’s a significant shift and it does reflect the evolution of the hedge fund industry and the challenges the industry is facing – and how those drivers are shifting how a hedge fund is run,” says Samer Ojjeh, a principal in the financial services organization at Ernst & Young, who co-authored a recent paper on the subject.

Approximately 90% of the managers Ojjeh works with have debated moving to an oversight and governance model, including about 40% that have taken steps such as gradually shifting away from shadowing reconciliation or trade settlement activity, he says. Part of the process involves managers doing a lot of homework around their service providers and understanding the processes and procedures when it comes to business continuity plans.

“We are seeing a significant focus on this because of the cost pressure and the fee pressure they are under. It’s not sustainable to pay for two sets of books or two sets of back offices,” he adds.

Under an oversight and governance model, managers can reduce some operating costs by outsourcing those shadowing functions to admin firms, including back-office processes such as NAV calculation, according to the paper.

The overall market has improved so far in 2017, with inflows picking up and hedge funds posting their strongest performance of the year in July, gaining 1.2%, according to Hedge Fund Research’s weighted composite index. Despite the performance turnaround halfway through 2017, investors have become increasingly averse to fund pass-through expenses, including research and travel, according to EY’s 2016 global hedge fund survey. But the highest level of respondents, at 34%, said it was acceptable for managers to pass through expenses related to outsourcing back-office shadow functions.

Managers increasingly want to spend more time focused on trading and research, which is driving them to outsource other aspects to third party providers, says David Young, president at Gemini Hedge Fund Services.

“It reduces their cost structure internally, which allows them to be much more competitive from a fee perspective,” he says. “Obviously as funds are under fee pressure… it does put on additional constraints in regards to your ability to properly staff. And by outsourcing they can get the efficiency of what an outsourced third party can provide.”

Some hedge fund managers are now even looking to hire a second fund administrator to check the work of their current admin, Young says, noting approximately 15% of Gemini’s hedge funds clients are using it for this service.

Part of the process of deciding on a correct fit when it comes to shadowing arrangements is asking the right questions, he adds. “If you’re spending money to have a shadow process, whether internal or external, do you have the right process in place? Are you assured that you’re going to come up with a true secondary check?”

While some managers are eyeing the switch, the process is more of an evolution than a revolution, moving at a slower pace, argues John Phinney, co-founder of Convergence, Inc., a firm that identifies, tracks, and reports changes across the alternatives industry on a daily basis.

Mangers face a tough decision when settling on which model is right for them, prompting a lot of talk, but not as much action, he says. Part of the problem for managers is finding the right cultural fit with their admin providers.

“The reality of the opportunity is really rooted in culture. The advisor has to be willing to give up certain [control] or they have to create a whole different level of transparency around what they are doing,” Phinney says. “So while it has interesting economic [implications]…. more people opt not to do it because they do not want to give up certain [control] they have.”

Hedge funds employing the oversight and governance model range in size from those above the $25 billion assets under management mark to start-up managers and across strategies, the EY paper found.

Hedge funds have increasingly been looking at different shadowing arrangements, says Sidney Wigfall, managing partner at SCA Compliance and Consulting. From a compliance standpoint, “delegation without abdication” is the principle that has been reinforced by the Securities and Exchange Commission, with managers needing to have oversight of key service providers, he says.

“For those firms that were doing it at a full 100% shadowing, it shouldn’t be too difficult to get to a place where they pull back and only need to do cross validation on key areas,” he says.

While questions may arise over business continuity and cybersecurity, cost pressures are likely to keep driving hedge fund managers to reevaluate their set-ups, he says. “I think you’ll see more and more firms at least revisiting their structure to see if there are cost savings they can capture.”

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Strapped Pension Funds and the Hefty Investment Fees They Pay

Every Pension Plan CIO, Board Member, Due Diligence Director and their Plan participants should carefully read the Gretchen Morgenson’s piece titled “Strapped Pension Funds, and the Hefty Investment Fees They Pay” recently published by the NY Times on May 14, 2017.  While many Pension Plans are actively working to reduce the management and incentive fees they pay, Convergence believes that Pension Plans and their Investment Consultants can further improve their ability to negotiate lower fee and expense levels by understanding the organizational “complexity” and operating risk for all Advisers they invest with today and those they may add in the future.

Click here to read the full report!

Originally posted on LikedIn


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May 20, 2017 Premiere of HBO Movie “The Wizard of Lies” The Story of Bernie Madoff – Convergence is Working to Make Sure it Does Not Happen Again

On May 20th, The HBO movie “The Wizard of Lies” (airing Saturday) showcases the legendary talents of both its star and director, Robert De Niro and director Barry Levinson, by re-telling this shocking tale of greed and betrayal. Yet, despite the very public stories shared by his many victims and the myriad lessons supposedly learned, investors continue to be skinned by frauds and scams and cleverly disguised fee and expense skimming operations by unsavory Advisers. While the SEC cannot save investors from fraud, investors can help avoid it themselves by paying closer attention to Form ADV, a regulatory filing requirement for exempt and non-exempt State and SEC registered Advisers. Had today’s version of the Form ADV been in place when Madoff was up to no good, investors would have seen some important red-flags that may have spooked them enough to avoid what was, for many, a life shattering experience.

It seems like only yesterday that a Wall Street scion named Bernie Madoff was publicly cuffed and arrested for concocting the biggest Ponzi scheme in history, literally in plain sight, despite the facts that clues to his malfeasance were abundantly available. So, what clues existed then and why did so many who suspected Madoff of fraud choose to remain silent? Was it out of their fear of political, business and social reprisals or was it simple greed? Who knows, yet Convergence has stepped into the breach by developing a clear and simple way to communicate these potential red-flags, or clues, to investors and other members in the Advisers eco-system.

Convergence uses the terms “complexity profiles and factors” to describe the operating risks in an Investment Adviser based on the responses they provide to questions raised in their SEC Form ADV and other regulatory filings. We have identified 40 business conditions derived from the Advisers Form ADV responses that provide key insights into operating risk. Operating risks need to be understood and may be well-controlled by the Investment Adviser’s staff and their group of third party service providers. Yet, if they are ignored, or are not being managed, then investors beware, it will cost you dearly.

Harry Markopoulos presented a compelling analysis to the SEC pointing out 30-red flags to support his view that Madoff could not have generated the returns he boasted without either (1) running a massive Ponzi scheme or 2) illegally front-running client trades, twenty-nine of his thirty red-flags required advanced math and market aptitude, well beyond the grasp of mere mortals, to understand Mr. Markopoulos. The one red-flag that could be understood by mere mortals, was the simple fact that his brother-in law, a strip mall accountant, was the only accounting firm allowed to see into the “Madoff secret sauce”.

Convergence reviewed Madoff’s last Form ADV filing dated 1/7/2008 and, while not nearly as robust as today’s form, identified additional red-flags worthy of review by investors at the time.

  1. Madoff did not disclose management or incentive fees, he earned commissions. He would have collected much more by charging Management and Incentive based-on his asset levels and performance returns than the Brokerage Commissions he claimed to generate. This was noted in the Markopoulos research.
  2. Madoff was a broker dealer and traded and cleared his own securities, not a Prime Broker, so he manufactured his own trade confirmations.
  3. Madoff was not the General Partner or Investment Adviser to a registered fund-What form of account held the $17bn in assets he reported.
  4. Madoff disclosed that he had no employees or third-party firms soliciting clients on his behalf.

Well who was raised the $17bn?

  1. Madoff disclosed 10-25 clients yet disclosed a broad distribution of client types, suggesting massive average client account holdings.
  2. Madoff reported 51-100 employees yet only 1-5 that performed investment advisory functions, including research. The percentage of non-investment-to-investment staff ratio is between 9:1 (46/5) and 19:1 (95/5), which is unheard of and suggests an army of non- investment staff. What type of work did they do, given the highly-automated type of trading being conducted by Madoff?
  3. Madoff disclosed providing continuous supervision over securities portfolios yet disclosed that he did not Advise a private fund. What type of account or fund held his $17bn?
  4. Madoff’s Chief Compliance Officer was also his Director of Trading, not exactly the segregation of duties one would expect in a $17bn fund.
  5. Madoff disclosed several regulatory violations on his Disclosure Reporting Pages (DRPs).

In the revised Form ADV post-Madoff, Advisers are required to report additional information that would have raised additional red-flags had they been in place during the Madoff era. These include:

  1. Disclosures around the names of the funds that he was sub-advising
  2. Amount of Cash and Securities held in Custody for clients
  3. If he disclosed a private fund he would have had to disclose its Fund Administrator, which would have probably been “Self-Administered”
  4. Its Fund Auditor, who we know was his brother in law and not a Big 4 firm, would be considered unusual for a fund of that size.
  5. Its Custodian Bank, which was a small local community bank, was not known to have the competency to perform the activities expected to administer the billions of dollars in cash and securities it was deemed to control.
  6. Its Prime Broker, which was himself or his related affiliate.
  7. Disclosures on whether the valuation of fund and account assets are done by parties unrelated to the Adviser would have been answered 0%. Unusual for a portfolio comprising public securities and OTC options.

Convergence invites investors, service providers and Advisers to call us to learn more about the factors and conditions that can lead to operating risk and fraud that may be developing in the markets.

Working together, we will evaluate and expose red-flags that will help many from becoming another unwitting victim of fraud.