Hedge Fund Round-up

Mathew Martoma’s Fatal Mistakes.   At the age of 40, Mathew Martoma just lost his criminal case on insider trading and is now facing nine long years in prison if he doesn’t succeed on appeal.  He has also lost his fancy house in Florida, the companionship of his wife and children and the $9.4 million bonus he earned from Stevie Cohen of SAC Capital in 2008, the year he pulled off his one blockbuster trade.

Martoma was found guilty of tipping Cohen that clinical trial results for an experimental Alzheimer drug called bapineuzumab would be disappointing to the market.  The drug was being jointly produced by Elan Corp. and Wyeth LLC, and the drug test was being overseen by two university doctors who testified in court that they had informed Martoma of the negative results before they were made public.  Martoma paid the doctors for that confidential information through an expert network.

From SAC’s phone records, Martoma inferrably passed the tainted information on to Cohen who quickly liquidated SAC’s entire $700 million position in both stocks (and then shorted additional shares), netting the fund a $276 million windfall.    

The critical phone call from Martoma to Cohen was not recorded, and Martoma’s lawyers tried to convince the jury that Cohen had made the decision to unload the two drug stocks on the basis of other adverse information gleaned from the marketplace, including an earlier press release from Elan and Wyeth presaging discouraging test results for bapineuzumab.   Martoma’s lawyers also failed to discredit the testimonies of the two doctors on the ground that they had received immunity from prosecution. 

Mathew Martoma chose not to testify on his own behalf.  His credibility as a witness would undoubtedly have been compromised by the fact that he had been expelled from Harvard Law School in 1999 for falsifying a transcript of his grades in order to win a place at Stanford Business School (which, for that reason, has since withdrawn his MBA).   

Because Martoma was not actually heard passing the negative test results onto Cohen, it took the jury a long time — 15 hours over three days — to return a verdict of guilty against him on charges of conspiracy and securities fraud.      

In retrospect, Mathew Martoma had two chances to beat this rap.  Before standing trial, he could have fingered Stevie Cohen whom prosecutors acknowledged was the real target of their investigation.  They even acknowledged that Martoma would have been treated leniently had he given Cohen up. 

Whether Martoma acted out of personal loyalty to Cohen is doubtful since he was sacked by SAC a year after the Elan/Wyeth trade for being a “one-trick pony”.   A more likely explanation is that he simply took up SAC’s offer to pay his legal expenses in order to prove his innocence.   After electing that option, however, Martoma could only have won the case, as it turns out, by personally rebutting the evidence presented by the two doctors, an opportunity he fatefully muffed by lying his way into Stanford.   

Now Martoma is the government’s poster boy for what happens to wayward Wall Streeters who don’t give up their superiors.

CalPERS Exits Hedge Funds CalPERS’ surprise decision this month to liquidate its entire $4 billion hedge fund portfolio sent shock waves through Wall Street.

The US’s largest pension fund with over $300 billion in assets blamed its decision on the “cost and complexity” of hedge funds (and funds of funds).  Ted Eliopoulos, its acting CIO, disclosed that CalPERS had spent $135 million in hedge fund management and performance fees over the past year.

He also pointed out that CalPERS’ hedge fund portfolio returned only 7.1% in its last fiscal year (compared to 18.4% for the entire fund) and averaged only 4.8% a year over the past decade, well below the 8.1% annual average of the S&P 500.

Eliopoulos reasoned that hedge funds constituted such a small proportion of CalPERS’ overall portfolio (1.3%) that it would have had to substantially build up its hedge fund investments to take advantage of their uncorrelated returns.  Its portfolio currently contains 30 different funds.  He and his staff just didn’t feel confident enough – even with their professional hedge fund consultants – to broaden a portfolio that frankly hadn’t performed that well.  Maybe they just realized they weren’t that good at picking winning funds.

Nevertheless, Eliopoulos is apparently sticking with CalPERS’ private equity portfolio which, at $31.6 billion, is eight times the size of its hedge fund investments.  CalPERS’ PE investments also charge “2&20” and are way more complicated than hedge funds, but they have also reaped double-digit returns for CalPERS.

CalPERS’ divestment decision has attracted a lot of press, but most commentators feel that it will not slow down the wave of pension money – public and private – flowing into hedge funds.   According to Preqin, 30 of the top 50 institutional investors in hedge funds are pension plans and more than half of US pension plans are currently below their targeted exposure to hedge funds.  Public plans alone make up more than a fifth of hedge fund assets and the largest hedge fund investors among public plans allocate from 7% to just under 25% of their assets to hedge funds.   

Even Eliopoulos admitted that CalPERS had never really committed a huge proportion of its assets to hedge funds even though it was one of the earliest public pension funds to invest in them (2002).  He also said that this was purely CalPERS’ decision based on its experience with hedge funds and that smaller pension plans could take advantage of their diversification benefits.   

Just as a footnote, PMT, a €55 billion pension plan for Dutch metalworkers, coincidentally unloaded all of its hedge funds because of excessive fees and is putting the proceeds into residential mortgages.

Are US Funds Still Marketing in the EU?  Thanks to Leonard Ng, a financial services partner in the London office of Sidley Austin, we now have a sense of how US hedge funds have been responding to the implementation this July of the EU’s new directive for managers of private investment funds being marketed in its member states (AIFMD).   Ng’s informal report on EU marketing activity reveals that a fair number of big US hedge funds (> $4 billion) are continuing to market under EU private placement regimes while most of the smaller funds (< $1 billion) have given up marketing in the EU altogether.    

The EU member states attracting the most US fund marketing are the UK, the Netherlands, Finland and Sweden which have substantial investor bases and the lightest private placement requirements.  Germany and Denmark, on the other hand, have actually toughened their private placement regimes by requiring non-EU funds to engage third-party service providers to custody their assets, monitor their cash flows and provide general fund oversight. 

Pursuant to the AIFMD, any US fund manager marketing in the EU must now (1) prepare a supplement to its PPM containing additional disclosure regarding “side letters”, brokerage relationships and use of leverage, (2) file with the regulator in each EU member state where its fund is being marketed a detailed, Form PF-style report as frequently as quarterly (depending upon AuM), (3) file an annual report containing financial statements and aggregate staff remuneration with EU regulators and make it available to its EU investors and (4) comply with the AIFMD’s asset-stripping and employee notification requirements regarding fund investments in listed and unlisted EU-incorporated companies.

US funds relying entirely on reverse solicitation and not on EU private placement regimes must play by the rules of each member state and carefully document their initial investor inquiries.  The UK, for example, simply requires the UK investor to confirm in writing that its US fund investment was made at its own initiative, but the French require their investors to specify the particular US-managed funds that they sought out.  Most other EU member states have provided no guidance on the issue, so it’s unclear throughout most of the EU whether any general marketing activity by a US-managed fund could later foreclose the possibility of its reliance on an EU investor’s reverse inquiry.

As an alternative to private placements and reverse solicitation, EU service providers are now offering non-EU fund managers platform solutions for their funds which can then take advantage of the pan-EU “passport”.  Under these arrangements, an EU fund manager would create an EU umbrella fund, register it under the AIFMD in its home state and then engage one or more non-EU fund managers to establish sub-funds under the umbrella which replicate their hedge fund or private equity strategies.  Under the AIFMD, however, such an umbrella fund manager must have the authority to supervise the portfolio and risk management of each of its sub-funds, and so each sub-fund manager would probably end up having to comply with most other provisions of the AIFMD (including, for example, the EU’s restrictive staff remuneration guidelines).   

In July of next year, the EU will take up the issue of offering non-EU fund managers the opportunity to register for pan-EU passports.  In 2018, it may decide to terminate all private placement regimes.