Fighting fund fraud
Recently, Frankfurt’s public prosecutor began a criminal investigation into a senior employee at Phoenix Kapitaldienst, a German hedge fund manager that has now been told by the financial services regulator (BaFin) to cease trading. The employee is alleged to have siphoned off E700m from the fund. And while those hardest hit by the losses are Phoenix’s 29,000-30,000 retail investors, industry experts say it is time investors paid more attention to hedge fund fraud in an effort to mitigate risk.
“Frauds have been few in number, but when they do happen, they can often be measured in tens if not hundreds of millions of dollars. So it’s important for investors to do adequate due diligence in order to give themselves the maximum protection and minimise the likelihood that they will be the next victim,” says Harry Davis, a litigation partner with New York-based law firm, Schulte Roth & Zabel.
While investors may have become savvier about hedge funds, Davis feels that there is still a culture of chasing returns. He advises institutional investors to make sure they understand the investment strategy and performance numbers of their fund managers. “If it sounds too good, it probably is.”
Take the case of Michael Berger, the manager of the Manhattan hedge fund which blew up in 2000. Experts say that investors did not understand how Berger was able to gain significant returns by shorting technology stocks at a time when they were going through the roof. Still, many decided not to ask questions, given that performance was apparently so high. In fact Berger, who lost $400m (e317m) of investor assets in total, (Swiss and Austrian pension funds were the hardest hit) managed to cover up the losses by paying old investors with money from new investors, in a so-called ‘Ponzi Scheme’. Many things about Berger never added up. For one thing, he claimed he was 29, when he was a decade younger. Even the smallest amount of background checking would have brought up a red flag.
Peter Turecek, managing director and co-manager of the hedge funds practice at Kroll, the risk consultancy firm, identifies two types of hedge fund fraud. The first is when an individual actually goes into the business but is wholly unqualified to manage money. In most cases, the individual lies about qualifications and their background. This type of information can easily be checked. The second type of fraud occurs on an operational level, from a mis-marking of numbers or as a result of strategy drift. “The only way to monitor that is when you have someone to provide independent verification,” he says. Kroll has seen a steady increase in business in last five years, from investors who want background checks on their managers, or after the event, want to find assets hidden away in offshore bank accounts.
For his part, Davis advises investors to find out how their hedge fund portfolio is valued. Many funds provide independent valuation by administrators, but in a lot cases administrators are taking values provided by the managers themselves, and have no control over the information provided. “If you aren’t comfortable with your initial due diligence, then get a manager’s permission to talk to third party providers, such as the prime brokers of the fund. Don’t take the manager’s word for it,” he says.
Of course, asking a much-sought-after manager with scarce capacity to open up their books is hardly going to be easy. Randy Shain, co-founder of BackTrack Reports, suggests that pension funds with limited resources would be well served to pay the extra fees a fund of hedge fund charges, in an effort to be more secure. “Fund of funds are worth what they charge – they ferret out things like fraud, they visit so many managers.” BackTrack wins a significant amount of business from fund of hedge funds that are looking for someone to do due diligence on managers’ past records. Shain points out that most frauds occur with smaller firms or individuals that do not even get on the radar screen of the fund of funds. “I can name 50 extraordinarily reputable funds of hedge funds that have been in the business for a long time and have good track records.”
Others say it is complacent to rely on advisers. Brian Shapiro, chief executive of CarbonBased Consulting, a New York-based research and advisory firm, points out that many of the advisers on the long-only side have yet to build a strong discipline set when it comes to alternatives. And according to the firm’s research, the average time spent by organisations (be it an institution or a fund of hedge funds) on due diligence, is actually only three hours. “This can create a false sense of security,” Shapiro warns. A study conducted by French business school Edhec last year, showed that one-third of European fund of hedge funds do not have a dedicated team for risk analysis. They rely more on the reputation of their counterparty’s service providers – the prime brokers, custodians, and auditors, than on operational analysis itself, according to the survey.
In the past, when things have gone wrong, investors have also been quick to blame third party service providers. In the case of Lancer Partners, for example, investors such as the University of Montreal sued Bank of America, Citco Fund Services, and Pricewaterhouse
Coopers because as the prime broker, administrators, and auditor of the fund, they should have been aware of the fraudulent activity there.
But observers say in many cases third parties providers are just as deceived as investors, and it is time investors stopped playing the ‘blame game’ and took some responsibility for monitoring their managers.
Shapiro also believes that investors rely too heavily on stale and static checklists for their due diligence, often provided by industry associations and not tailored to the specific needs of each investor. “There is a difference between examining a $200m long/short fund versus a $600m emerging market manager or convertible arbitrage fund. The questions you ask aren’t the same.”
And investors who believe that mandatory registration of hedge funds, both in the US and in Europe, offers some legitimacy should think again. “The fact that funds are registered only tells you that they don’t have a disciplinary history, it won’t tell you what their experience is,” points out Ken Berman, a partner at law firm Debevoise & Plimpton.
Most experts agree that it is operational risk that investors should focus their attention on. According to one Capco study, half of hedge fund failures can be attributed to operational issues. The most common issues have been the mis-representation of fund investments, misappropriation of investor funds, unauthorised trading, and inadequate resources. In 70% of operational issues cases which have led to the failure of a fund, there has been a combination of fraud and misrepresentation, says Ludwig Caluwe, a partner at Capco. “What we recommend is doing operational due diligence specifically,” he says. Investors should look at transparency, third party pricing, the quality and control of people, and internal processes.
Ultimately, however, investors should also put fraud into perspective.
“I don’t think the problem is rampant. On the whole the industry is pretty good,” says Davis. “But do your homework. Always do what you can to protect yourself.”