UPDATED: IMPACT ANALYSIS: Saba Capital sued by investor over valuation practices; is SEC next?

October 20, 2015

By Todd Ehret, Regulatory Intelligence

NEW YORK, (Thomson Reuters) – A recent U.S. lawsuit filed by the Public Sector Pension Investment Board of Canada against hedge fund manager Saba Capital Management has drawn attention to fund valuation procedures.

The case pits one of the world’s largest pension managers against a well-known hedge fund. Institutional pension allocators, hedge fund managers, lawyers, accountants, auditors and compliance professionals everywhere are sure follow the case and take note of its resolution. More importantly, valuation procedures, which are at the core of the case, are also a top concern at the U.S. Securities and Exchange Commission (SEC).

In its suit the Canadian pension fund accuses Saba of “artificially manipulating” the value of securities so that the pension fund received less than a fair value for its investment at the time of their redemption. The case alleges that Saba later marked up the securities to more realistic prices, thus enhancing returns for other remaining investors, which included Saba and its management.

Background

Saba was founded in 2009 by Boaz Weinstein, the former co-chief of the credit business at Deutsche Bank, AG. Weinstein rose to prominence in 2006 and 2007 where his credit trading groups made over $1.5 billion in profits for the bank. Although known as one of the savviest debt traders on Wall Street, in 2008 it was widely reported that his group lost more than $1 billion for the bank.

Saba increased its assets under management (AUM) to a peak of around $5.5 billion after delivering solid performance in its early years. However, the firm posted negative returns in each of the past 3 years. These poor returns likely led to significant investor redemptions, causing Saba’s AUM to shrink to approximately $1.5 billion in mid-2014.

According to the complaint, Saba historically valued some McClatchy Company bonds using a third-party source. However, around the time of the Canadian fund’s redemption in March 2015, Saba deviated from this practice by using for the first time a different method of valuation known as bids-wanted-in-competition (BWIC). This purportedly drove down prices reflecting a significant liquidity discount from the previous practice.

The pension fund claimed that the bonds price dropped to a price of 31 after changing to the BWIC method of pricing and was far below the “price range of 50-60 contemporaneously quoted by external pricing sources.”

Weinstein said in a statement from Saba that he took the allegations seriously and looked forward to vindicating its position in court. He also defended the use of BWIC valuations. Saba said it took great care in redeeming the Canadian fund’s investment on a timetable dictated by the client, including by finding fair and accurate market prices for extremely illiquid positions.

In a later statement, Weinstein referred to a court motion dated Oct. 15 and said: “PSP recklessly and maliciously attacked me and my firm. Read our motion to dismiss – it shows that we did absolutely nothing wrong and that is why we will not settle this suit for one cent.”

BWIC Process

The Bids-Wanted-In-Competition process involved brokers or managers circulating lists of securities where they are looking for pricing indications in the fixed-income market. It is common for such lists to clearly state that the securities will trade or will not. Often lists only indicate small size such as sub $5 million in value to trade. It is very common for ETFs to use BWICs or OWICs (Offers-Wanted-In-Competition) when frequently buying or selling baskets of securities. These BWICs are known to market participants to always trade and are often sized reasonably in more liquid names.

Alternatively, other BWIC’s in less liquid names are considered simply as price fishing expeditions by brokers or managers. It is known that the bids or offers are not firm, and really are nothing more than indications of interest. This process is used in less liquid securities to support pricing and gauge potential buyer or seller interest. These BWIC’s are not widely circulated. Often they are kept only between the client and a broker.

Best practices and advice

Although Saba was faced with a difficult liquidity problem with a very large redemption, the firm had a fiduciary responsibility to act in the best interest of both redeeming investors and continuing investors. Saba had many options to deal with this liquidity and valuation problem and says in its dismissal motion it did everything correctly.

Much can still be gained from a discussion of the issues raised in the case. Below are some of the choices that can arise when a firm faces large redemption demands. There are also suggestions for managers to focus on so that they don’t find themselves in a similar situation.

  • Consistency Although managers often use valuation policies that give them much discretion in valuing some assets, they should be consistent with using them throughout the entire life of an investment. Switching valuation methodologies is sure to raise questions.
  • Documentation Valuation policies must be detailed and rigorous. They also must be consistent and easily repeatable. Additional written documentation to support any deviation from such policies is critical. It is even more important when there are conflicting or multiple valuations available. Continual testing and documentation that the policies are being followed and that the firm has acted in the best interest of the clients is the objective of documentation efforts.
  • Compliance versus accounting  Policies and procedures often directly involve accounting. These actions and decisions have a direct financial impact on the client. It is critical that compliance professionals thoroughly understand this financial impact and include it in their analysis. Choosing one valuation method over another should not be taken lightly, as there can be a direct monetary impact to the client. Not fully understanding accounting and the financial impact of their decisions is unacceptable. Compliance officers also must be accountants in some instances.
  •  Consider payment in kind Managers often have the ability to “PIK” redeeming investors. Payment-In-Kind (PIK) is often an unpopular option as it essentially passes the problem securities to the redeeming investor. Managers might also consider a partial PIK or a perfect slice representing the investor’s pro-rata holdings in the entire portfolio.Threat of a PIK gives the manager some leverage when negotiating with the redeeming investor. The perfect slice transfer of the assets, although cumbersome, leaves little doubt in the area of valuation. Saba says a PIK was not an option in its situation as it was not allowed in its Subscription Agreement and Offering Memorandum.
  • Sell in advance of redemption date Managers know well in advance of redemptions. Most require 60- or 90-days’ notice on redemption requests. This allows them to prepare portfolios by raising cash and to true-up positions. When a portfolio has liquidity challenges, managers must deal with illiquid positions in advance of the redemption date. Selling after the redemption leaves the manager with a larger position in percentage terms for continuing investors which may be even more risky. A planned liquidation over time in advance of the redemption is in the best interest of both redeeming and continuing investors.
  • Invoke the gate or side pocket Most private funds have a clause in their operating or partnership agreements where the manager may elect to invoke a clause known as the “gate” where essentially the manager can suspend redemptions and elect to pay out the redemptions at the manager’s discretion. This is often an option when a manager is faced with sizable redemptions (often 20 percent of assets).Managers can also designate a particular security as a special investment (also known as side pocket) for all investors and essentially freeze it and its valuation for all investors until its liquidation. Although these are considered unattractive options because of the unknown timeline for liquidations and additional accounting work, it is often the most equitable option for all investors and mitigates the valuation risk.
  • Communication is critical
    As mentioned above, managers have myriad choices at their disposal when it comes to dealing with how to pay a redeeming investor as well as how to deal with and value illiquid securities. Communication with the redeeming investor is critical. It would likely head off lawsuits and possibly a solution that works for all can be agreed to. The two sides agree that Saba attempted to negotiate a more staggered redemption but the Canadians rejected the request.
  • Best practice failure by the Canadians At its peak, Saba was managing approximately $5.5 billion. Therefore, a $500 million allocation to this size manager would have been appropriate as it would account for less than 10 percent of Saba’s AUM. This was likely the case when the Canadian fund conducted its initial due diligence. However, at the time of the fund’s initial investment of $300 million in February of 2012, and the later addition of another $200 million in June of 2013, the redemptions at Saba were already underway, and this $500 million put them well in excess of 10 percent. At the time of their redemption request on January 23, 2015 it is believed that Saba’s AUM had shrunk to around $1.5 billion. The suit alleges that the pensions fund’s investment represented more than 55 percent of the funds’ value at the time of the redemption. Any way you slice it, the pension fund allowed itself to become too large in percentage terms within Saba as other investors fled. Many institutional investors mandate that they are never more than a fixed percent of their manager’s AUM (usually 10 to 20 percent) depending on liquidity and other circumstances. As Saba’s AUM shrunk, the pension should have made partial redemptions along the way maintaining a no greater than 10 percent of AUM policy.

The regulators take
Earlier this year, the SEC’s Office of Compliance Inspections and Exams list of exam priorities for 2015 indicated that “Alternative” Investment Managers and their valuation policies and practices were a top concern. The Canadian fund’s case against Saba might not be a regulatory action, but it certainly appears to be along the lines of what OCIE may have been referring to. Other valuation cases involving private fund managers include the Yorkville Advisors Case in October 2012, the Tilton Case in March 2015 and the GLG Case in 2013.

GLG is a subsidiary of UK based Man Group, PLC. Note the footnote in the SEC’s release where the SEC appreciated the assistance of the FCA in the case. This cross-border cooperation is likely to continue.

Saba says it followed its own policies and procedures and likely has a strong legal defense supported by their Subscription Agreement and Offering Memorandum.

Besides the valuation questions, the allegations in the case also raise other potential regulatory concerns such as conflict of interest.

Such ingredients are the kind of issues that can draw SEC interest to a firm. Since the case involves the Public Sector Pension Investment Board of Canada, it could also catch the attention of the Canadian regulators as well.

(This article was updated from the version initially posted. It adds a comment from Weinstein referring to the suit against Saba, a link to the motion to dismiss, and additional editing changes reflecting the motion.)

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Oct. 12. Thomson Reuters Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @RiskMgment)

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