June 20, 2005

Hocus Crocus
Crocus failure should prompt greater disclosure

Aside from keeping the media busy, labour sponsored investment fund (LSIF) Crocus Fund has caused a lot of grief for Manitoba investors. Its trading freeze last December was followed by a flurry of terminations, big cost cuts, allegations of wrong doing, and most recently the announcement that they were throwing in the towel.

Does this mean investors should give up on LSIFs or venture capital as an investment class? No. Rather, it should remind investors and advisors of the need for real due diligence in alternative asset classes.

The lowdown

At the root of Crocus’ problems is the thorny issue of fairly valuing investments not priced by or traded on any public exchange. (See my previous column on valuation from 2002.) Between the Manitoba Securities Commission and the Auditor General of Manitoba, they allege that the Valuation Committee (a subset of Crocus Fund’s board of directors) did not meet for months while there were concerns voiced of deteriorating values.

There were also allegations of extravagant spending by the fund for its former CEO on trips seemingly unrelated to Crocus business. Just prior to the official launch of a RCMP probe, Crocus made the only obvious decision – i.e. to either wind up the fund or dispose of its investments and other assets to interested bidders.

This has taken a toll on the often beaten up class of LSIF investments. But should all of this turn everyone off of LSIFs?

Due diligence

I have always stressed, even for traditional investments, how important it is for investors and advisors to do their homework. But once investments actually have had time to attempt to fulfill the big promises made during sales presentations, and after a few good scandals – i.e. Portus, Norshield, Crocus – investors are likely to overreact. I’m not going to condone investing in things that are not well understood. But instead of swearing off such investments forever, perhaps those burned by these or other investments gone bad should simply learn what went wrong in the decision-making process and if there are actions that can be done in the future to help detect investment risks.

The fact is that there is no way to objectively confirm that LSIFs, hedge funds, or other alternative asset investments actually do what they say they do with respect to their investment processes and other internal procedures. This has long been a point of frustration for me as an analyst trying to evaluate some of these products.

With any investment, one must look past the hype, past the sales pitch and all of the promised benefits. We all want to believe that a great investment offering great risk-reward potential exists. And some do. But investors and advisors would do themselves lots of favours if they approached all such products with more scepticism and ask tough questions.

Plus, if you don’t really know how something is structured, refuse to invest in it or recommend it to your clients. That will motivate the person or company selling the product to help educate you on the aspects of an investment not found in the sales pitch – i.e. the finer details within which the devil often hides.

LSIF disclosure

In the mid-1990s, prior to the growth in LSIF assets, the funds used to provide cost and market values for each individual investment. Today, and for the past several years, funds provide individual cost figures but only provide aggregate market value figures (i.e. for the venture portfolio as a whole). As a result, we’re demanding better transparency for my firm’s annual LSIF research report. One fund allowed us a peak at its internal documents including investee company financials and due diligence documents.

In my firm’s future LSIF research efforts, we will continue to make additional disclosures mandatory – or face being removed from our annual survey. Realistically, investors aren’t in a big bargaining position to demand such disclosure. But advisors influencing significant client money have some pull – particularly with some of the small and mid-sized LSIFs.

Look for LSIFs to voluntarily provide additional portfolio disclosures – as another fund did early this year. But if they don’t, advisors should push for more information. No longer should they accept a negative response to requests for greater disclosure. It is within advisors’ power to influence greater LSIF disclosure. And while I believe that Crocus’ problems are not indicative of the LSIF industry as a whole, the very existence of its demise provides us all with greater bargaining power regarding improved disclosure.

Regulators will help a bit in this regard as CSA’s National Instrument 81-106 (Continuous Disclosure) contains some tidbits for LSIFs. While 81-106 requires all funds, including LSIFs, to disclose market values for individual investments, it offers LSIFs exemption. They can get out of that requirement by breaking down its venture investments by stage of development and industry class (and then by number of investments, cost, and market value). This will help in narrowing down carrying or market values that LSIFs use for their venture investments.

Recall that LSIFs must get an external valuator to review each investment. LSIFs will now have to file the valuator’s report along with its audited financials. It won’t contain valuations of individual investments in the respective funds. But expect them to resemble the auditors’ reports that accompany most funds’ audited financials. Most are pretty standard but where the valuator has real concerns, it should be disclosed along with other filings.

NI 81-106 doesn’t provide a quantum leap in LSIF disclosure, but it’s certainly a step in the right direction.