This first case is one of the larger reasons that we care about the math described in an LPA. In the late 1980's, we invested in a substantial fund, where the GP was a well known professional and with capital being raised by some of the top brokers in the business. The private placement memorandum, which we still have, described an annual performance allocation and a high-water mark. Unfortunately, the math in the LPA was written by a member of the GP's staff and was very convoluted, actually calculating the incentive on a quarterly basis. After a profitable first half of the year followed by a dismal second half, the GP decided that the LPA was what he would follow, despite its discrepancy with the descriptive materials. The result being that, much to the surprise of his investors, he collected a nice performance fee in a year when he, in fact, lost money for his investors.
This case included an ethical lapse, but also illustrates the importance of having the accounting procedures checked by the firm that will automate the production of your numbers.
Early in 2002, we reviewed a draft Limited Partnership Agreement that attempted to set forth the GP's desired two-step incentive structure. What appeared to be a straightforward idea was actually mathematically impossible to effectuate, as it included differing rates over differing measurement periods. A direct quote from the GP: "I have sent our offering document to a number of Accounting Administrators and not one has pointed out the dilemma and spelled it out as you have. I understand the problem as you have outlined it; now the question is how do we solve it."
In the funds that we administer, we ensure that the procedures for additions by an investor increase his or her "high-water mark" so that the investor has a profit overall before an incentive is incurred. Sound obvious? Not so. Perhaps most of the LPAs used ten years ago (and some used today) permitted the GP to treat additional capital contributions from existing investors as simply another "Investor's Account #2" with its own separate high water calculation. This was done as an accounting short-cut, and viewed as pro-GP, since an incentive could be earned on that second account even though the "first account" was still underwater. However, the practice can have very negative effects. One short-seller we knew in the early 1990s who was attempting to get investors to add capital after a down first half year, was absolutely unable to get additions because investors had figured out that they would likely pay incentive fees during the second half of the year if they had a partial recovery even though they were way down on the year. We showed the manager that adjusting high-water marks would encourage capital additions and decrease the gain he had to make to get back to incentive territory (every investor 20% away from break even who "doubled up" was now only 10% away). Recognizing the "win-win" nature of the change, he adopted it mid-year.
In 2002, we reviewed an LPA that gave the GP the explicit choice of adjusting high-water marks or treating additions as new accounts, which seems like an undesirable conflict of interest.
One pre-existing fund that we began to administer in 2001 had its incentive allocation language carefully edited by the GP to ensure that the phrase "high-water mark" was contained in the description and the accounting procedures in the LPA. Unfortunately, the added language included a definitional error not caught by his attorney that tied the incentive to the size of the fund, not the performance of any capital account. Since his fund had grown in size, as well as having excellent performance, no harm had yet occurred, but we did assist the GP in an amendment to fix the problem.
Several years ago, in the process of vetting the boilerplate documents for a firm that has created a large number of funds, we noted a rather significant typo in the high-water mark process. In attempting to tie incentives to cumulative returns, the LPA actually required that the current period percentage return to exceed the total cumulative percentage return prior to the current period. Meaning that a fund that was up 50% cumulative prior to the current year could not collect an incentive unless the return for the current period was 51% or more. Clearly an unintended and misstated high-water concept, but not something that one would want to see challenged by an investor seeking to reduce his payments to the GP.
Many documents we see have been crafted for quarterly openings and additions of capital, on the mistaken assumption that monthly openings cost more. Many partnerships refer to "breaks" as if an army of accountants was marched in every time a new investor arrives or an existing one withdraws capital. At ALPS Price Meadows, we have had automated monthly numbers since the 1980s. Our observation has been that investors will inquire about performance more often than once a quarter, so we might as well have the numbers ready in advance. While some ALPS Price Meadows-administered funds still only report performance quarterly, we automatically generate monthly numbers on practically all.
On several occasions, we have reviewed LPAs with well-intentioned, but improper methods for allocating taxable income. For example, "Taxable income will be allocated among the Partners in proportion to their Partnership Percentages during the period such income is received." It doesn't sound dangerous, but such a provision removes the basic advantage that partnership accounting has over the share accounting of a mutual fund. The beauty of partnership accounting is that the taxable income can be allocated to the persons who enjoyed the economic income; not to those investors who simply happen to be there when the gains are realized.
Hedge Funds use “carve out” procedures to accommodate rules from the NASD as to just who can participate in IPOs – initial public offerings. The NASD’s purpose is to minimize self-dealing and other conflicts of interest between financial professionals and the investing public. Prior to the end of 2003, the relevant rule was the Free-riding and Withholding Interpretation, which was concerned with “hot issues” – IPOs that rose in initial trading. Early in the 1990s, ALPS Price Meadows observed that the conventional “hot” issue carve-out contained a subtle conflict. A "hot issue" – one that rose in the market after issuance – couldn’t be allocated to NASD-Restricted investors. But a security expected to be hot but which instead declined was shared by all investors if the carve-out procedures applied only to "hot issues." Noting that the Restricted investors in such an arrangement had a "heads you win, tails I lose" proposition, we installed accounting procedures providing that all new issues (hot or not) were carved out. This practice has now become universal, as the distinction was addressed in the new NASD Rule, which applies to all “new issues” – essentially every equity IPO.
Not infrequently, clients with typical "one and twenty" compensation arrangements have institutions approach proposing a customized fee arrangement. One of the flexibilities of the ALPS Price Meadows accounting system is the possibility of a separate compensation structure for each investor. The menu of choices range from straightforward reductions and waivers to hurdles over flat rates or indexes to more complex threshold arrangements. Our systems even provide for a fund-wide declining flat rate such as 2% on the first X million plus 1% over that (meaning that the flat rate for a $2X million fund would be 1.5%). This declining flat rate structure can be particularly helpful for newly formed funds.
Starting in the weeks and months after the Enron collapse, ALPS Price Meadows started getting calls from investors in funds that we administer. "Just wanted to know you were really there," was one comment. While the Enron event had little to do with hedge funds, it raised issues of the independence of the numbers. Investors in ALPS Price Meadows administered funds have two levels of protection: ALPS Price Meadows determining monthly results and the comfort of a separate auditing firm, chosen by each fund, verifying our work.