Bloomberg’s Jonathan Weil Probes Lehman-R3 Hedge Fund Relationship

Readers may recall that this humble blog, thanks to the information provided by a former senior person at Lehman, reported that some of the investment bank’s wondrous deleveraging (it was well distributed across products, geographies, and credit quality) was due to asset sales to newly formed hedge funds, R3 Capital Partner and One Williams Street, which had former Lehman MDs at the helm and in which the firm was a significant investor.

That of course begged many questions: were the sales really arm’s length? Were any financed? And if either of these funds got into difficulty, would Lehman wind up rescuing them?

The amount we believe was sold to One Williams Street was trivial, but Lehman confirmed that $5 billion went to R3, which isn’t chump change.

Bloomberg’s Jonathan Weil dug deeper and does not like what he found, or perhaps more accurately, what he didn’t find, thanks to the stonewalling he encountered in his efforts to get to the bottom of the two firms’ arrangements. From Bloomberg:

So let’s say you’re a big shot at Lehman Brothers Holdings Inc., trying to keep your firm from becoming the next Bear Stearns Cos. The stock has tanked. The market has doubts about your balance sheet. What do you do?

One step to avoid would be any action that might create needless public uncertainty about your company’s finances, because investors’ greatest fear is of the unknown.

So what does Lehman do? It sells billions of dollars of assets to a newly formed hedge fund that:

1) counts Lehman as a significant investor;

2) is run by seven recently departed Lehman executives;

3) is operating out of Lehman’s office space, three floors down from the office of Lehman’s corporate secretary.

You don’t need to know much more about Lehman’s transactions with the fund, R3 Capital Partners, to see the problem.

There’s no way for outsiders to ascertain whether Lehman’s dealings with R3 were at arm’s length, as Lehman and R3 say they were. And the last thing Lehman needs is for skeptical investors to be worrying about whether it is engaging in any opaque related- party transactions.

Lehman isn’t providing much information about its dealings with R3, and hasn’t mentioned the fund in its Securities and Exchange Commission filings. Some details about their relationship have been trickling out in news reports, including a June 18 article by Bloomberg News reporter Yalman Onaran.

Here are the basic facts I was able to gather:

As of June 12, one fund managed by R3 had raised $1.08 billion from a single unidentified investor and was seeking to raise $4 billion more from others, according to a Form D disclosure that R3 filed with the SEC.

Lehman has invested about $1 billion in R3, said Thor Valdmanis, a spokesman at R3’s public relations firm, FD. (After he told me this, Valdmanis asked me not to use the information, saying he wasn’t authorized to divulge it.)

Later, in a written response to my questions, R3 said it “is a wholly independent fund and has raised money from a variety of outside investors” and that Lehman “is one of several passive, minority investors in the fund.”

A Lehman spokeswoman, Catherine Jones, declined to say whether Lehman was the unidentified investor cited in R3’s SEC filing. Jones said Lehman “has sold approximately $4.5 billion of assets to R3 since its inception in May 2008,” all of which “were previously managed by R3 Capital team members when they worked at Lehman.”

Jones declined to say whether the $4.5 billion was how much R3 paid for the assets or the value at which Lehman had been carrying them on its balance sheet. She also declined to say whether Lehman will treat R3 as a related party for accounting purposes. Companies must disclose the effects that any material related-party transactions have on their financial statements, under generally accepted accounting principles.

“R3 is an independently managed fund in which Lehman Brothers is a limited partner and holds a passive, minority stake in the general partner,” Lehman said in a July 1 statement read over the telephone by Andrew Gowers, a spokesman. “Lehman Brothers has no control rights, and all transactions are on an arm’s-length basis.”

So, what are we supposed to make of all this? Beats me.

We have no idea if Lehman recorded gains or losses on these sales, how much money R3 paid for the assets, where it got the money to buy the assets, or the fiscal quarter in which the sales occurred. We don’t know whether Lehman plans to disclose any of this. There is no way to determine with the information available whether this is a related-party deal.

Even with more information, the relationship might not be transparent. The trouble with related-party deals — if that’s what these are — is that they “cannot be presumed to be carried out on an arm’s-length basis, as the requisite conditions of competitive, free-market dealings may not exist,” as Financial Accounting Standard No. 57 says.

Under the accounting rules, if Lehman’s stake in R3 were 20 percent or greater, this would lead to a presumption that Lehman could exercise significant influence over its policies. In that case, R3 probably would be deemed a related party.

As for the space R3 occupies on the 39th floor of the Time & Life Building in midtown Manhattan, it’s in the middle of a 10- floor block Lehman began subleasing from Time Inc. last year. R3 and Lehman say the fund is paying rent to Lehman at market rates.

R3’s chief executive officer, Rick Rieder, a 21-year Lehman veteran, sent me a letter explaining that the name R3 comes from the phrase “Reading, wRiting and aRithmetic.”

He wrote that the fund’s creation “was in discussion for years,” that he won’t take a bonus from R3 this year, and that “a substantial portion of future profits” will go to a new foundation to support “improvement in urban education in this country and abroad, a cause I have long supported.”

That’s all nice stuff. What’s important about R3 to Lehman investors, though, is how the transactions affect Lehman’s financial statements. Lehman is scheduled to file its second- quarter earnings report with the SEC later this month.

“Based on the information that’s publicly available, you can’t tell whether these are related parties, although there are indications there could be significant influence,” said Douglas Carmichael, the former chief auditor of the Public Company Accounting Oversight Board, now an accounting professor at Baruch College in New York and a litigation consultant.

And there lies the problem: You just can’t tell. That won’t keep investors from forming their own conclusions. If Lehman doesn’t like what they decide, it will have only itself to blame.

Two other factoids: one reader said that R3 is Lehman’s internal designation for restricted stock. The Bloomberg article that ran earlier said that Lehman would get upside benefit if the assets sold to R3 did well. That of course could simply be a general statement that would pertain to any investor, or could refer to arrangements between Lehman and the fund regarding those assets.

Our source, who proved largely accurate on other details regarding the hedge funds, also said R3 employees who departed Lehman would continue vesting any Lehman restricted stock they held. If true, that is a highly unusual arrangement.