Hedgefund.net recently reported that a group of Louisiana Pension funds won a judgment in the Cayman Islands against Fletcher Asset Management, a hedge fund based in New York. The judge is forcing Fletcher Management to liquidate after not paying back these pension funds.
The Firefighters’ Retirement System of Louisiana, the Municipal Employees’ Retirement System of Louisiana and the New Orleans Firefighters’ Pension and Relief Fund invested $100 million in Fletcher Asset Management in 2008 and were suing to get approximately $145 million back in accrued earnings.
These pension funds invested with Fletcher after they were promised a 12% yearly return. The first signs of trouble arose when two of the pension funds requested a $32 million redemption. Fletcher did not return the money in cash, but instead, gave the pension funds IOUs.
A fund’s offering memorandum outlines the general rules for the payments of redemptions. There are a number of specific guidelines that investors can evaluate during the operational due diligence process with respect to redemptions by evaluating documents including a fund’s offering memorandum. These can include:
- when redemption requests can be submitted by investors
- when a fund will generally pay them
- in what form (i.e. – in case, in-kind) a fund will pay them
- how much the fund will pay immediately
- if the fund has the ability to not pay any portion of an investor’s redemption request until after the completion of the audits – (this is sometimes referred to as an audit holdback)
- the ability of the manager to invoke gates
- specifics concerning prohibitions on early redemption (i.e. – hard lockups) or penalties for early redemptions (i.e.- soft lockups)
If an investor further takes the time to fully read a fund’s legal documentation, such as the offering memorandum, they will effectively learn that all of these rules can effectively be changed at the whim of the General Partner (for onshore funds ) or Board of Directors (for offshore funds). While, some legal documents may contain language which places limits on these rule changes (i.e. – changes which “materially affect” an investor require majority consent), others may not.
Returning to the case of Mr. Fletcher, a manager replying to redemptions requests with an IOU is bizarre to say the least. While there may be nothing technically illegal or theoretically wrong with an IOU in this case on face value, it certainly raises the obligation of investor’s to perform further due diligence. Yellow flags lead to red flags and in this case, the IOU was a bright yellow flag which should have been investigated further in part by a detailed operational due diligence review of Fletcher’s firm.
A representative from Fletcher said that the returns could not be guaranteed and are looking toward an appeal in the case.
This is a perfect example of the importance of operational due diligence. It may have been beneficial to the pension funds to perform some sort of operational due diligence before investing with this hedge fund. Potentially, a review of cash management policies may have signaled yellow flags to investors. Between questionable cash management policies and the IOUs, unmitigated and undetected operational risks clearly played a part in contributing to losses. Although operational due diligence does not always uncover something as serious as outright fraud, operational problems can still abound in honest organizations. Detailed operational due diligence reviews coupled with an ongoing monitoring program can help funds stay out of court attempting to recoup losses and avoid Fletcher type funds.
