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Hedge Fund Audit Firms and Agreed Upon Procedures

Hedge Fund Due Diligence Firm Discusses “Agreed Upon Procedures”

We’ve published a number of thoughtful pieces on this blog from Chris Addy, president and CEO of Castle Hall Alternatives (see, for example, article on Hedge Fund Operational Issues and Failures). Today we are publishing a piece by Chris which discusses hard to value hedge fund assets (so called Level III assets). In certain situations hedge fund audit firms will be engaged to perform an “Agreed Upon Procedures” review of the pricing of these assets. As discussed in the article below, agreed upon procedures engagements do not provide hedge fund investors with a great deal of comfort with regard to the pricing of these assets. It is unclear whether in the future investors will push back with regard to such engagements and require more robust pricing audits. The problem with more robust procedures, obviously, is increased cost (because of increased liability for the audit firms).

Managers who are engaging audit firms pursuant to agreed upon procedures should be aware that they may face tougher questions from investors going forward.

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Agreed Upon Procedures

A number of our recent posts have focused on the challenges of the hedge fund administrator‘s role in relation to security valuation. We will, of course, return to this topic – but, in the meantime, wanted to focus on some of the alternatives to administrator pricing.

One of the more common comments from today’s administrators is that, while an admin may be able to price Level I and Level II securities, they do not necessarily have information to price Level III instruments. (To recap, the US accounting standard FAS 157 divides portfolios into three levels, being Level I, liquid instruments readily priced from a pricing feed (typically exchange traded); Level II, instruments priced using inputs from “comparable” securities (essentially mark to model, albeit with mainstream models); and Level III, everything else.)

This leaves investors with a challenge – if administrators cannot price Level III instruments, who can? Moreover, to repeat one of our frequent comments, it is self evident that if a hedge fund manager wishes to deliberately mismark securities, they would most likely misprice a Level III instrument. It is, of course, very hard to fake the price of IBM common stock, but much easier to mismark emerging market private loans.

Two of the most common tools available to hedge fund managers looking for third party oversight over pricing for Level III instruments – assuming the administrator has washed their hands of the problem – are third party pricing agents and auditor agreed upon procedures, or “AUP”. We will return to the strengths and weaknesses of third party pricing agents in a subsequent post, but wanted to focus this discussion on AUP.

In an Agreed Upon Procedures engagement, the auditor completes specific procedures which have been dictated by the client. The procedures are specified and the auditor then prepares a report outlining the findings of that specific work.

We have two comments here: the first is to take a high level view as to the adequacy of these procedures, and the second is to dig a little more deeply into the actual audit guidance that covers this type of work.

Our first comment is, unfortunately, an Emporer Has No Clothes observation. The significant majority of hedge fund AUP engagements we have seen require the auditor to test a fund’s pricing on a quarterly basis. This usually involves (i) obtaining a portfolio list from the investment manager and (ii) testing the pricing support for those positions.

There are, however, generally two snags. Firstly, many AUP only test a sample of prices, not the whole portfolio. Sample testing clearly provides much less assurance than a price review of all positions: the administrator, for example, is usually expected to price the entire book (would any investor accept a NAV which has been priced on a “sample” basis???)

The bigger problem, however, is the type of testing completed by the auditor. In way, way too many cases, the auditor tests security prices back to the manager’s own pricing support and makes no attempt to obtain independent pricing information.

This type of work is, clearly, somewhere between minimal and absolutely no value for investors. If the auditor receives a spreadsheet from the manager showing the matrix of broker quotes received, how does the auditor know that the manager has not adjusted that spreadsheet to exclude quotes which were uncomfortably low? Even more importantly, if all the auditor does is to check prices back to pieces of paper in the manager’s own pricing file, how does the auditor know that those pieces of paper are genuine? As we have said before, and will keep on saying, it only costs $500 to buy a copy of Adobe Photoshop if you are of a mind to alter documentation.

When discussing this type of work, the manager typically notes that, if the auditor was to complete a full, independent pricing review, it would be too costly and too time consuming to be practical on a quarterly basis. A full, GAAP audit review is, of course, performed at year end – this does include independent pricing (although – investor fyi – auditors will still only sample test many portfolios.)

While these are fair points, it remains the case that this type of AUP provides minimal protection against pricing fraud. In the meantime, the manager gets the marketing benefit of being able to claim enhanced scrutiny and oversight from a Big 4 firm each quarter.

Which leads to our second point. Why would an auditor accept to complete agreed upon procedures when any reasonable accountant would rapidly conclude that the typical scope of these AUP provide pretty much nil controls assurance? Why does the auditor not insist that, if their name is to be associated to this work, then the procedures must be meaningful and sufficient to meet an actual control standard?

To this point, the actual audit standard applicable to AUP is available here. The standard states:

An agreed-upon procedures engagement is one in which a practitioner is engaged by a client to issue a report of findings based on specific procedures performed on subject matter. The client engages the practitioner to assist specified parties in evaluating subject matter or an assertion as a result of a need or needs of the specified parties. Because the specified parties require that findings be independently derived, the services of a practitioner are obtained to perform procedures and report his or her findings. The specified parties and the practitioner agree upon the procedures to be performed by the practitioner that the specified parties believe are appropriate. Because the needs of the specified parties may vary widely, the nature, timing, and extent of the agreed upon procedures may vary as well; consequently, the specified parties assume responsibility for the sufficiency of the procedures since they best understand their own needs. In an engagement performed under this section, the practitioner does not perform an examination or a review, as discussed in section 101, and does not provide an opinion or negative assurance. Instead, the practitioner’s report on agreed-upon procedures should be in the form of procedures and findings.

In practice, this all gets horribly circular. Per the standard, a client requests an auditor to complete AUP to assist “specified parties” to “evaluate subject matter or an assertion”. In our case, the assertion would be “are hard to value securities valued correctly at quarter end.”

However, the specified party is usually the manager itself, making the client and specified party the same person. The particular trick applied, in many cases, is for the auditor to seek to prevent the investor from actually seeing the AUP in the first place! However, if the investor is to have access to the AUP, the auditor universally requires the investor to sign a Catch 22 document which requires the investor to acknowledge that the AUP are “sufficient for their needs”. So, even if the investor believes that the AUP are not “sufficient for their needs” – which is hardly a long stretch – the investor has to sign that the procedures are sufficient if they are to even see the auditor’s work. With this magic piece of paper, the auditor has met its requirements and can sleep easy. Meanwhile, the auditor will send a bill to – guess who – the fund, meaning that investors have, once more, had to foot the bill.

As always, Caveat Emptor.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

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Bay Area Hedge Fund Roundtable Event

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Panel Discussion on State of Hedge Fund Industry

Yesterday afternoon (May 6th) the Bay Area Hedge Fund Roundtable, a group of professionals within the hedge fund industry, gathered for a panel presentation entitled “Change…Critical Legal, Tax, Acounting and Regulatory Updates You Need to Know.” The presentation was moderated by Pamela S. Nichter (Osterweis Capital Management) and included the following panel participants:

Vincent J. Calcagno (Rothstein Kass)
Geoffrey Haynes (Shartsis Friese)
Tony Hassan (Ernst & Young)
Anita K. Krug (Howard Rice)

Presentations like these are great because they allow professionals to share insights into what is going on in different parts of the industry – many of the topics discussed allowed the panelists to really dig deep into the issues and provide some context to what is happening at both the regulatory and investor levels. I took notes during the presentation and will summarize some of the main points discussed by each of the presenters (please don’t hold anything against the speakers if I mis-paraphrase or mis-interpret and as always nothing in this summary is tax or legal advice)…

Anita K. Krug

Anita discussed a number of the laws which have been discussed or proposed over the past 6 to 8 months including the following:

Barney Frank’s Recent Comments (see Reuters article)
Mary Shapiro’s Recent Comments (see Bloomberg article where Shapiro says she wants the ability to make rules regulating hedge funds)
Discussion of the Hedge Fund Transparency Act which was proposed in the Senate earlier this year (see also Overview of the Hedge Fund Transparency Act)
Hedge Fund Advisor Registration Act which was proposed in the House earlier this year
Geithner’s hedge fund proposals (see NY Times article for background information)
Discussion of the past short selling rules (see HFLB article) and the new short selling rules which will be closer to the old “uptick” rule (see SEC overview; note: I have not yet had an opportunity to thoroughly review these proposed rules)
European Rules which have been proposed which may have an effect on US based managers with EU investors (Anita raised many of the same issues which were also raised in this article)

Geoffrey Haynes and Vincent J. Calcagno

Geoffrey and Vincent went back and forth discussing some of the tax issues which managers are likely to face this year and potentially going forward. This discussion included the following issues:

Discussion of the new offshore deferral rules by dint of new Section 457A of the Internal Revenue Code (see generally this alert). Note: discussions on the ramifications of this new section to managers who currently have deferral arrangements took a majority of the time. There are a number of issues involved including issues with side pockets, options, and non-conventional performance fee periods.
San Francisco Payroll Tax of 1.5% (see background on this issue here)
Discussion of the Levin proposal to tax the carried interest as ordinary income (see Hedge Fund Carried Tax Increase?). [The panelists seemed to think that Congress would not vote on this bill until sometime in 2010 (if the bill was actually even voted on) with an effective date, if passed, of sometime in 2010 – the panelists did not seem to think it would be retroactively applied.]
Discussion of a bill which would eliminate UBTI for U.S. based non-taxable investors investing in U.S. hedge funds which utilize leverage (note: I was not aware of this bill and am not sure what bill exactly was referred to – please feel free to contact me if you know about this bill). The panelists seemed to think this bill was likely DOA.
Discussion of the Stop Tax Haven Abuse Bill by Senator Levin (see Senator Levin’s press release)
Discussion of Obama’s Offshore Tax Plan (see generally the White House press release)

Tony Hassan

Tony discusses what is changing in the area of hedge fund operations. Tony’s discussion of current topics was maybe one of the more important parts of the panel in terms of providing insight on current investing trends and due diligence requests. Many of the items in this section were part of a dialogue between Tony and Vince as noted in the parenthesis below.

There is no secret that due diligence is a more central and important part of the investing process than it was previously. (Tony and Vince)
Due diligence is also changing in many respects – at E&Y Tony has had specific requests from potential invests to send them directly the financial statements. Of course this brings up many legal and client issues (the hedge fund, not the potential investor, is the client of E&Y) and because of this these requests are often denied. (Vince)
Managers are providing verified transparency “quarterly reviews” which aim to show investors that the fund’s assets are actually there. (Vince)
Some funds are instituting a half-yearly audit (in addition to the end of year audit). (Vince)
Some funds are instituting agreed upon procedure reports. In these reports the auditor will come in an verify that certain procedures are being completed. This may be especially important with regard to the valuation of the fund’s assets. (Vince)
Tony noted that this is really a new form of due diligence and used the term “Hedge Fund Due Diligence 2.0” – a term I used in October of 2008 (see post).
Investor questions to hedge funds are changing. While previous questions would have stopped after “Do you have a 3rd party administrator?” Now the questioning continues – investors want to know about the administrators technical expertise, who exactly will be the account representative and what type of capital markets experience does that person or group have, what inputs will be used to value assets, etc. Investors also want to know what sort of contingency plan is in place should the administrator fail or if there is a disaster; investors will want to know if the fund is keeping shadow books. (Tony)
Tony also participated in the discussion with Pamela below with regard to managed accounts.

Pamela S. Nichter

Pamela, the moderator of the discussion, also weighted in on certain operational issues which fund managers should be prepared for in the new climate. In general Ms. Nichter is seeing more investor requests and communications. Now there is greater communication between the investor and the fund manager. Ms. Nichter also discussed the trend toward greater liquidity and transparency through separate account structures.

Separate accounts are something that more and more investors are seeking but there are many considerations for managers. Specifically separate accounts can be a drain on resources, especially if the investors request their own specific administrators or auditors. Because of the greater amount of resources which need to go into the back office to handle what is in essence a more traditional asset management business, the manager must be ready to change the business model to a certain extent. Specific issues will include:

having a robust trade allocation policy
understanding that there is likely to be a disparity of performance
potential registration issues
potential integration issues
performance reporting issues (may need to go back to GIPS)

Questions and Conclusion

After the panel finished their discussion the floor was open to questions. During this time there were a number of good questions. One issue focused on what will performance fees look like going forward which led to a discussion about creative performance fees (like instituting some sort of clawback provision like what is found in private equity funds). Another issue was whether and to what extent the Managed Funds Association will be representing the industry during this time of legislative/regulatory changes. The answer is that the MFA will be doing everything it possibly can to represent the hedge fund industry and it is our job to make sure that the MFA knows how the industry feels about many of the current legislative proposals.

Hedge Fund Audits Post Madoff

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Hedge Fund Audits Expected to Increase in Importance

The Madoff scandal has shown the hedge fund industry many things, not the least of which is the importance of hedge fund audits. While the details of Madoff’s audits are still a little unclear, it has been widely reported that the audit firm he used was a little known shop which is tightlipped. This article investigates reaction of hedge fund investors with regard to hedge fund audits going forward. (Please note, the Maddoff investment firm was not a hedge fund; however, the scandal will likely have a great influence on hedge fund due diligence and audit standards.) Continue reading →

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