On Dec. 19, 2016, after years of mounting stress due to investor redemptions, key staff of Platinum Partners were arrested and its funds were placed into liquidation. Prior to this, many believed Platinum Partners had about $1.7 billion in assets under management and a stellar track record; this is now unclear. 

Platinum appears to have suffered from multiple ailments, including structural issues, which exacerbated management and investment risk. Ultimately, the picture that emerges from a forensic examination is a hedge fund time bomb: An investment fund structured for more liquid investments with quarterly redemptions that invested in highly illiquid and difficult to value investments, and conflicts of interest surrounding cash management and valuation.

At the core of Platinum’s structural issues was a mismatch between the investment strategy and the fund’s principal terms. Platinum used an open-ended fund with quarterly liquidity to target high-value, illiquid investments in large concentrations, which ultimately could not be realized when investor redemptions forced their funds to generate cash. This raises questions on how managers with illiquid strategies can best structure their funds to meet their liquidity needs and legal obligations. This is a timely question, as illiquid investments are in vogue.

Managers of illiquid funds seeking to meet redemptions may need to hold outsized cash on hand or limit liquidity (e.g. side-pockets or gates). It appears that Platinum planned for neither. For example, one of Platinum’s marketing document notes that its flagship fund held 60% of its assets in special investments, though its fund did not have side pockets, and for some time Platinum continued to honor redemptions. As a result, rather than allocating a pro-rata share of the illiquid investments to investors, documents indicate that Platinum may have sold the liquid securities in the portfolio, thereby increasing the percentage of illiquid assets in the fund for those who remained invested.

Much of the Securities and Exchange Commission’s (SEC) case against Platinum hinges on the value of certain energy holdings, including speculative oil ventures, which the SEC claims were overvalued by as much as 1,000%. Illiquid strategies result in book entries with hard-to-value assets; in order to value these holdings, managers may become actively involved in valuation. This is a significant conflict, as asset valuation affects performance, and performance drives the manager’s compensation. 

Instead of engaging an independent valuation agent, Platinum provided valuation data, while an independent agent reviewed valuations on a quarterly basis in reliance on Platinum’s data. The SEC alleges the independent valuation agent diligence was extremely deficient.

Additionally, compensation terms of Platinum’s flagship fund increased the possibility of a conflict. Platinum’s incentive compensation was subject to a waterfall structure in which all excess return would go to investors until receiving an 8% return with Platinum receiving up to 20% of profit; the remainder if any would be split. This regime resembles a private equity compensation model with one exception; Platinum was eligible to receive incentive compensation annually, including realized and unrealized gains. Ordinarily, closed-end funds limit incentive compensation to realized gains to align the manager’s and investors’ interests.  

A hedge fund facing a liquidity crunch can either sell its assets at bargain-basement prices or freeze redemptions. The SEC alleges that Platinum managed its liquidity crisis by raising cash from new investors by touting annualized returns of 17% and, in turn, allegedly used those assets to pay off liabilities. The SEC also alleges that Platinum relied on inter-fund lending to manage its liquidity needs. An investment manager has a fiduciary duty to act in the best interest of its clients. Transactions between multiple funds managed by the same manager require careful consideration. Although Platinum’s offering documents empowered Platinum to engage in inter-fund lending “in its sole discretion,” Platinum is now exposed to a claim of breach of fiduciary duty, as well as claims of unjust enrichment, manipulation and the triggering of anti-fraud provisions of securities laws.

Fund managers and investors can gain valuable insight by examining the Platinum collapse. The combination of investor liquidity, substantial portfolio illiquidity, weak valuation policies and non-traditional compensation methodologies not ideal for an illiquid portfolio allow for conflicts and may harm both manager and investor alike. Designing the proper fund structure and implementing effective policies on valuation, marketing and governance, promote sound management and provide valuable safeguards against regulatory action.