The Wall Street Journal published an excellent summary of the challenges faced by hedge funds in 2008 a few days ago (available here.)
The key trends are familiar: poor performance; fund closures; "herd mentality" as too many funds chased the same investment ideas; Madoff; and funds which prevented investors from redeeming their capital.
The article also comments on issues which will impact investors going forward. Notably, Espen Roback, President of the specialist (and in our humble opinion, extremely good) independent valuation firm Pluris Valuation Advisors is quoted talking about hard to value securities and the role of the auditor.
"One looming problem for many hedge funds is the amount they still hold of hard-to-trade assets, such as loans, real-estate holdings and stakes in small, private companies. These illiquid investments at one time accounted for 20% of some fund portfolios, estimated to total about $400 billion. As financial markets have come under pressure, it has become much harder to get out of these investments, or even to value them accurately. That could hurt hedge funds as they try to attract new investors in 2009.
"Auditors do not, contrary to popular assumption, control a fund's valuation policy; management does," said Espen Robak. "An auditor auditing five different funds may sign off on five different valuations for a single investment."
We have often made exactly the same point as Espen. In our post on FAS 157 on November 8, 2008, we noted that:
"On this point, investors should also remember that the auditors of underlying hedge funds are not responsible for those funds' accounting policies: those, too, are set by the management of the underlying fund. As such, different funds holding the same security, audited by the same audit firm, may well hold that same security at different prices, yet still receive unqualified audit opinions. The auditors are not, to be clear, imposing any form of pricing standardization or consistency: the auditors do not have a central master pricing file that they force all hedge funds to use."
As an ex auditors ourselves, we are very familiar with all the challenges involved in auditing hard to value securities. FAS 157, in turn, introduces many new, extremely difficult issues. Nonetheless, this lack of consistency across audited financial statements, in our view, needs to be far more widely emphasized.
There are two problems. Firstly, hedge fund managers are very ready to tell investors that the auditors "signed off on our valuations" and that any investor concern over valuation is unjustified as the "auditors were happy". Audit firms cannot live in a bubble - they have to remember that the audit is used as a key bargaining chip in the push and pull between manager and investor during the due diligence process, as investors try to get comfortable over the pricing of often hard to value, opaque portfolios.
The second issue is more systematic. Investors should always remember that the auditor is hired and fired by the manager, not the investors, and throughout the audit process has contact only with the manager and no contact whatsoever with investors. As such, it is the manager who is the "client", and the party who has to be kept happy.
This actually reflects the core principle of auditing, being that the financial statements are the responsibility of management, not the auditor (and certainly not the investor.) All the auditor is hired to do is to form an opinion as to whether management's accounts are prepared fairly in accordance with GAAP, within a boundary of materiality (which, by the way, is never disclosed to investors.) The auditor is emphatically NOT hired to prepare the accounts themselves in their own preferred format, with the best numbers they can come up with independently.
Thinking about the audit process simplistically, it is possible to approach an audit in one of two ways. On the one hand, the auditor can seek to gather sufficient evidence to justify the manager's accounting: can we find evidence, for example, to support the manager's stated security valuations. On the other hand, the auditor can seek out audit evidence which actively tries to disprove the manager's accounting and financial statement presentation. Clearly, these are two very different things.
In reality, this is not a binary choice and most audits operate in a continuum somewhere between these two extremes. The expectations gap, however, is that most investors assume that the focus of the audit is always and solely on the latter point, being a concerted effort to disprove the manager's accounting. In reality, this is not the case at all.
Against this varied background, the roadblock for investors is that it is impossible to evaluate the audit in any way. If we think hedge fund managers are opaque, they actually operate in the full "sunlight of public scrutiny" compared to the audit firms, who provide absolutely no transparency into their work at all. Investors cannot speak to the audit firm to understand the scope of the audit (which may vary widely between firms and funds - did, for example, the auditor reprice all portfolio securities, or just reprice a sample?). They cannot evaluate the quality of the audit team to understand whether the partners, managers and seniors actually know anything about hedge funds. They cannot review the audit working papers. They cannot review the summary of unadjusted items (the changes the auditor had proposed but which were passed on the grounds of materiality.) As above, they cannot evaluate what materiality actually was. They cannot discuss the audit with the partner to determine whether this was a well run and clean audit, or whether the hedge fund manager was a nightmare who got their audited accounts only by the very tips of their fingernails.
In fairness to the auditors, one of their problems is the binary nature of the audit opinion itself - you either provide a clean audit opinion or you don't (we'll ignore the nuances of emphasis of matter paragraphs which don't really impact the overall "pass / fail" framework in any case.) There is no reporting framework which allows the auditor to express their professional opinion on the more nuanced aspects of the audit - how good actually is the manager in question? Was this a 92% or a 27% audit in terms of overall quality and confidence?
In reality though, the auditors would never want the liability to provide these opinions anyway, so the whole thing is a moot point. Our message to investors, therefore, is to treat the audited financial statements as a tool in the toolbox. They are important, but they are not, in any way, absolute - just because a hedge fund has a clean audit, it does not mean that that hedge fund has followed best practice accounting, operational or reporting practices. We would also add that the auditors' self appointed status as the omnipotent "gurus" of all accounting and operational issues - and the Big 4 are terrible for this - should be taken with a grain of salt.
In fact, what really started us thinking about the whole audit process was an innocent question from one of our clients a few days ago. In disbelief over Madoff and the tragic audit failures in that debacle, they asked us if we had ever seen a set of hedge fund financial statements which had received a qualified audit opinion.
We all know the answer to that.
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