The financial press has been busy recently with “sub-prime mortgage funds” and how some hedge funds in this sector are getting “into trouble” because of it. A recent article reported about the French bank Paribas refusing to pay off some hedge fund participants in “its” hedge fund in this risky area who wanted out. Yet, as Sherlock Holmes and Inspector Colombo teach us, the interesting evidence is often what is NOT said or what did NOT happen.
If I read the article correctly (the phrasing could be taken in more than one way) Paribas "declined" to honor withdrawal desires of some weak-hearted investors on the argument it could not "fairly value" these investors' interests. In other words the market for the assets which these investors owned a share had frozen up, like a stock having its trading suspended. There was therefore at that moment no orderly and smooth-functioning market (in Paribas’ opinion, at least); so “marking to market” was impossible and these investors’ “fair share” couldn’t be calculated.
I imagine they were given this news very politely; but it takes us back to some basic issues about “investing”. First, consider the following situation: Joe sells a thousand widgets to Harry for $5 each. Assuming that Joe doesn’t have to sell nor Harry to buy, does this mean that my 100 widgetts have a "fair value" of $500. Well, sort of, for the lack of any other way to get a number for their value. But it is basically a “soft” number, not something upon which I can rely.
Instead of widgetts, lets talk about something real. Suppose a neighbor sells her house for a tidy sum; and I extrapolate what I think my house might bring. This is the kind of mental arithmetic we all do, but it can only yield a “soft money” figure. Maybe my house would raise this much, and maybe it wouldn’t. We’ll never know, unless of course I actually sell it. But then it would not longer be my house. The amount I own on my credit card, on the other hand, is “hard money”. There it is month after month earning interest and waiting to be paid in full – very precise, very concrete, very real.
“Marking to market” - that is, extrapolating from a transaction involving something over here in order to get a valuation for another asset over there - can only produce a “soft money” figure. The best this can ever be is an estimate – maybe reliable, maybe not. No investor should ever loose sight of that fact.
A second basic point often overlooked is the issue of getting out of a placement if things go poorly, as indeed this case shows they sometimes do. The Paribas investors discovered their exit required a “normally functioning market” which would sustain the calculation of a “fair market value”. Yet it just such times as a very un-normal when you are likely to want out. My hunch is the formal documents, even if they did in fact say something about exit, didn’t specify meaningfully what “fair market value” means nor how or by whom it was to be designated. So the Paribas investors were actually in a situation where exit was at the discretion of the fund manager, who also has a vested interest against exit. When the market for that fund’s assets went crazy, the fund manager simply said: “Sorry ... no exit! I can’t do the numbers.”
This reply by the fund manager, although it is self-serving; is nevertheless logical. “Hard money” and “soft money” don’t have the same values, whatever the accounting arithmetic says. If there isn’t a market, there isn’t a valuation. Paper profits come and go; but cash has no “soft” edges, no fuzziness. There it is - blunt, concrete, unambiguous. This is another basic principle any investor should keep in mind.
Indeed, a thinking investor (as distinct from one who is siimply following the herd) will have learned from Sherlock Holmes and Lt. Colombo. It is not just what the perspectus says that counts; it is also what the perspectus doesn't day.