May 4, 2021 – Over the weekend, the Ontario Securities Commission dropped a bomb that reverberated throughout the Canadian capital markets.
Bridging Finance, a $2 billion Canadian private debt manager popular with some income investors, was placed into receivership amidst allegations of fraud and misconduct. PricewaterhouseCoopers LLP is managing Bridging’s affairs while in receivership as the Ontario Securities Commission investigates alleged management malfeasance.
A Tesla and Two Bentleys
I spent the weekend reading through the Bridging insolvency docket and the prognosis does not look good.
Investors in Bridging funds, such as the Bridging Income Fund and Bridging Mid-Market Debt Fund, will likely be facing significant losses. It appears that it is not a matter of when they’ll get their money back, but how much.
A material portion of the investor capital that Bridging lent out from its funds, nearly $800 million (or close to half of total AUM), was seemingly lent out to frauds or insolvent companies. Not only should investors be concerned about how much of investors’ funds can be recovered, but whether existing investors will be on the hook for clawbacks for previous distributions received.
Since many of the assets in the Bridging funds were not worth what the company said they were worth, historical distributions to investors may have been financed from new money coming in. This scheme is commonly referred to as a Ponzi scheme. In Ponzi schemes, the authorities sometimes go after earlier investors to claw back previous distributions, as they did in the Bernie Madoff Ponzi scheme.
The Bridging CEO has been accused of stealing many millions of dollars from investor funds. Some of the proceeds were used to finance luxury vehicles, including a Tesla and two Bentleys.
Sounding the Alarm on Private Debt Funds
I have sounded the alarm on the risks of investing in private debt funds like Bridging for years. Last April, we released a podcast, Fake Marks, Smoothed Returns And Gated Investors: A Warning On Private Debt Funds, that described my concerns regarding these highly-risky funds in detail. On the podcast, I stated:
“The reason I have such an issue with this is because if we look at the return profiles on a lot of these private debt funds, private mortgage funds, what they’re doing is they’re artificially smoothing returns and making investors oblivious to the underlying risks and the underlying volatility of the assets held by these private asset funds.
I looked at the return profile on one of these funds that actually halted redemptions and it goes for six years, nothing but positive monthly returns. That is right, not even a single negative month. Within a six-year timeframe, they claim to Sharpe Ratio above seven. No, correlation to the markets, etc.
Then all of a sudden, when bad things happen in the market, when there is some volatility, oh, they cannot honour redemptions. A lot of these funds are eliminating distributions, etc. And you got to think about why, and perhaps this is the reason.
It is because the NAV is made up. The underlying asset values and returns that they are telling investors since they are not mark-to-market; they are actually marking to model. Basically saying whatever they want on returns, and that’s why they disclose, or they say that every month their NAV, their returns are positive. It is going up, which is really just pure fiction, so investors really can’t believe that.
Time and time again, I see absolute nightmares in these private debt and private mortgage funds where investors look at their statement and see steady rising returns. No losses, everything looks great until one day they wake up and it is a calamity. They are bankrupt and the NAV is zero. This comes out of nowhere.
I often say that the return profile of these private asset funds sometimes looks like that life of a turkey graph where everything is going swimmingly for the turkey until Thanksgiving. That Turkey’s life goes to zero, it gets slaughtered and you kind of see the same profile on a lot of these private asset funds.
I think we are going to see a lot of bad things happen and we’ve seen it in the past where these illiquid funds, You wake up with no warning, the NAV is down significantly, they are winding up, and you get cents back on the dollar.
So I really caution investors against private debt funds, whereas they believe that they’re shielded from volatility.
But in this scenario, volatility can be your friend, because if you’re invested in a public fund that’s in trouble, maybe it’s down 50, 60 percent, that will get the alarm bells going off saying, hey, something’s wrong here, and that gives you a warning signal to perhaps revisit the investment. Perhaps you want your money out, you redeem, and you sell it so that volatility provides a great warning sign for investors.
However, you don’t get that in these private debt funds. Everything looks like it is going perfectly well until it is too late and they are down to zero”
- Absolute Return Podcast #63: Fake Marks, Smoothed Returns And Gated Investors: A Warning On Private Debt Funds. April 20, 2020
Source: Business Insider
It is evident that I am passionate about protecting investors and preventing shenanigans by other asset managers, which only damages the industry.
Hopefully, investors heeded my warning regarding private debt funds and were able to sidestep this calamity.
Two Lessons Learned
Investors can learn two key lessons from the Bridging Finance catastrophe:
1. Mark-to-market accounting is beneficial to investors
I have spoken to several sophisticated investment advisors who had allocated to private debt funds like Bridging. Many indicated that the main draw was “low volatility”. They weren’t referring to the actual low volatility or risk of the underlying assets, just that the mark-to-model accounting of private debt funds was “nice to look at” because it never changed. While the mark-to-model accounting and stale NAVs of private debt funds help from a client communication perspective, they conceal the warning signals displayed by the more realistic mark-to-market accounting that public funds have.
As an analogy, imagine a boiling pot of water. The unawareness that comes with mark-to-model accounting is equivalent to not having a sense of feeling in one’s hands. If one were to put their hands in a boiling pot of water, they would suffer severe burns. The sensation of pain provides a beneficial warning signal that one needs to pull back and eliminate the risk. Mark-to-market accounting of public funds offer investors that same warning signal and an opportunity to get out before it is too late. It never pays to be oblivious to pain and risk.
2. If it seems too good to be true, it probably is
Below are the historical “returns” for Bridging’s flagship fund, the Bridging Income Fund.
Source: Bridging Finance
The one thing that stands out is the unrealistic consistency of the returns, with over seven years of positive returns without one negative month. Even Bernie Madoff threw in the odd negative month into his fund’s made-up return stream.
Since private debt funds mark their assets to their models, they can effectively make up what returns they want to show investors. This internal valuation creates a dynamic that makes it far too easy to misguide investors.
For example, to attain its 2020 return, Bridging Finance marked up its largest loan position by 283%, which accounted for 97% of its return that year.
If you come across a fund claiming a return with an unrealistic consistency and no down months, run, don’t walk away from it as quickly as possible.
In investing, the old adage, “if it’s too good to be true, it probably is,” applies.
It is unfortunate to see alleged fraud and impropriety with an investment fund. My heart goes out to anyone subject to this mess. We work hard to educate investors on risks in investing in order to help them sidestep situations similar to Bridging. I have written whistle-blower complaints to the securities commissions regarding private debt funds trying to pull the wool over investors’ eyes.
The diversification provided by alternatives is needed more than ever in investors’ portfolios.
When considering alternatives, I recommend that investors only consider liquid alternatives for two reasons:
- Liquid alternatives are marked-to-market, which displays the actual performance of the underlying assets.
- Liquid alternatives offer full transparency, which allows investors to evaluate the true risk of the underlying portfolio.
Mark-to-market accounting is beneficial for investors and allocators should stick with public alternative funds with honest accounting and full transparency, and run by management with integrity.
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