In this final part, I’ll explain how good old-fashioned due diligence is the answer to avoiding structures that mirror the anatomy of previous investment failures, such as Ponzi’s infamous scheme.
Before getting to that point, though, I would like to address the matter of longevity, as this can trip up otherwise shrewd investors. By longevity, I mean the length of time that an investment has been on the market, and generating profits for its investors.
Lately, for a variety of factors, longevity has ceased to be the guide to a sound scheme that it used to be, as many inherently flawed schemes now survive for as long as 10 to15 years before they implode. Bernie Madoff, who defrauded investors of billions of dollars before his massive Ponzi scheme was finally busted in 2008, for example, was in business for more than 40 years.
A more reliable test than longevity is the liquidity of an investment’s underlying assets. And this must not be confused with whether the fund promises monthly, weekly or daily dealing.
We must bear in mind that flawed schemes invariably promise liquidity they can’t deliver, and so, this is something investors must be aware of. Whether investing in jatropha oil, student accommodation schemes or life policies of the terminally ill, investors must assess whether the fund manager could realise assets at the assumed prices in a reasonable period of time.
An important pointer to this is the divergence between observed and inherent volatility. In layman’s terms, this means that in general, the more illiquid the asset, the greater its inherent volatility, and therefore also the greater the potential valuation gap over time between market and model prices.
This is exemplified by the fixed returns of some litigation debt funds, compared to the volatility of publicly-listed litigation funding vehicles.
The extraordinarily consistent valuations of open-ended property funds (versus listed property trusts) are another case in point. The lifecycle of this kind of divergence is generally observed in the following typical chain of events:
1. A scheme, investing in illiquid assets launches, and – via its administrator if one exists – adopts an entirely subjective basis of valuation, often derived by the scheme’s promoters, rather than a market-based valuation (if one even exists for such assets).
2. The scheme’s NAV typically gets marked around 1% higher every month, because the adopted model assumes the underlying assets generate annual gains or income of 12% (an assumption that is generally untested).
3. With an attractive record and/or targeted or fixed return, combined with attractive incentives to introducers, the scheme sees inflows, leading to:
i) Comfort/complacency by the fund administrator that demand for the asset is both real and increasing, justifying the valuation model a posteriori
ii) Such redemptions as there are may be honoured, since inflows are consistent
4. However, the available inflows tend to be finite, and crowding out soon occurs, as rival mark-to-model schemes start to chase the same market share. Once outflows match inflows, the need to pay excessive fees to both the original promoters and to introducers causes worsening cash deficits, which historically tends to coincide with scheme investors developing itchy feet.
5. Funds typically respond to this crisis by extending redemption notice and settlement periods, applying exit penalties, increasing promised returns and paying higher incentives to introducers.
6. Devoid of liquidity, schemes’ redemption periods become outflows plus fees divided by inflows. Lately there seems to be increasing pressure building up in this phase, as many illiquid schemes were distributed through similar channels of networks and advisors, and have tended to suspend or go bad simultaneously, increasing the need for the remaining unsuspended funds to provide liquidity. The Arch Cru debacle may prove to be the thin end of a very fat wedge.
Final collapse follows stage 6. With inflows becoming a smaller proportion of ever-increasing outflows, the waiting period spirals uncontrollably. The game is up. Typically redemptions are suspended indefinitely.
Legal disputes and negative publicity ensue, as schemes prey for miraculous events such as selling underlying assets at
prices similar to the fantasy prices in scheme’s models.
This is usually impossible, partly because the listed value of the assets has over time diverged so greatly from the realisable value, and partly because the illiquid assets are inherently unmarketable anyway (the pool of buyers or the alternative uses for a block of student flats adjacent to Leeds University – for example – is virtually non-existent).
The invariable appointment of receivers leads to overpriced, esoteric asset fire-sales, realising something like 30 cents on the dollar.
How to guard against this? For starters arm yourself with the following checklist:
1. What’s the underlying asset? Does it have a secondary market? If not, then it’s generally best avoided.
2. Does the fund have extraordinarily low volatility with no obvious explanation?
3. Are there any early signs of the five steps above?
Any mark-to-model investing in traded endowments, traded life policies, senior settlements, student accommodation, care homes, green energy, development mortgages (in Australia or anywhere else), commercial, residential or retail property, ground rents, forestry, untraded commodity oils, caravans, storage containers, litigation funding, receivables or anything asset whose value you can’t verify should be avoided like the plague, unless you want to face the almost certain outcome of writing off 70 cents in every dollar.
Paul Gambles is managing partner of MBMG International, the Bangkok, Thailand-based advisory firm. To read Part 1 of this series, click here. To read Part 2, click here.
