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Graham Macdonald MBMG International Ltd. Nominated for the Lorenzo Natali Prize |
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Do not be conned, part 3
Many of the leading names in our industry regularly and nobly
attach themselves to responsible social causes; equally, many people with
unimpeachable reputations - built up over many years - are keen to maintain and
defend them.
The point is that due diligence on any investment, particularly in this day and
age, needs to be undertaken much more precisely than, heretofore, has often been
the case.
Which leaves us with the question: Just how does an adviser ensure that an
investment is reliably free of any trace of Ponzi DNA? Well, 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
cannot 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 life-cycle 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 pray 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 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 six 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 any asset whose value you cannot
verify should be avoided like the plague, unless you want to face the almost
certain outcome of writing off 70 cents in every dollar.
The above data and research was compiled from sources
believed to be reliable. However, neither MBMG International Ltd nor its
officers can accept any liability for any errors or omissions in the
above article nor bear any responsibility for any losses achieved as a
result of any actions taken or not taken as a consequence of reading the
above article. For more information please contact Graham Macdonald on
[email protected] |
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