Chapter 8
Hedge Fund Fraud
Hedge fund investors already face many traditional investment risks (market risk on each manager’s holdings, liquidity risk, credit risk through each fund’s choice of counterparty, operational risk in terms of accurate valuation and efficient trade execution). Then there are other risks more specific to hedge funds, such as style drift if a manager deviates from his original specialization and perhaps outside his recognized expertise in search of higher returns, and business risk in that the hedge fund manager needs to run a profitable business or the investor’s time spent on due diligence will be wasted as his capital is returned. But sitting on top of all these concerns as the investor analyzes a hedge fund investment is the possibility that the entire enterprise is a sham and that he will one day suffer a complete loss of capital. It should be a source of no small embarrassment to the hedge fund industry that there is enough material to justify its own book of frauds.
More Crooks Than You Think
The Hedge Fund Fraud Casebook, written by Bruce Johnson, examines industry frauds from 1968 to 2000. The very existence of such a book serves as a warning to all hedge fund investors. You can carefully analyze a manager’s investment process, consider the subtle ways that his inclusion in a portfolio of hedge funds will affect its return, Sharpe ratio, value at risk, and other risk statistics. You can run historic analysis to calibrate whether a 3 or 4 percent weighting is more appropriate. And hanging over the entire exercise is the inestimable possibility that in fact it’s a Potemkin hedge fund, and that the result may be a total loss with the consequent shredding of investor relationships, business model, reputation, and career prospects. Amazon.com fails to provide any matches for “private equity fraud” or “mutual fund fraud,” although of course plenty of public companies (Enron, Worldcom, and Tyco Industries to name a few from recent years) have ripped off investors.
But hedge fund investing exposes the investor to an additional risk that’s almost nuclear in its ability to visit devastation on its victims, and competent due diligence includes many steps to confirm the veracity of a manager’s presentation. CastleHall Alternatives is a consulting firm whose business is dedicated to helping investors avoid “operational risk,” a wonderfully anodyne way to describe fraud. CastleHall is meeting a real need—they don’t have to warn their clients about possible hedge fund fraud, the industry regularly generates sufficient examples to concern any investor. CastleHall maintains a database called “HedgeEvent,” and it consists of 327 “events” from inception through June 2009 with an estimated financial impact of $80 billion! Even without Madoff (which they estimate at $65 billion although ultimate losses were much lower), CastleHall identifies losses from operational failure of $15 billion (Hall, 2009). And it excludes episodes such as Long Term Capital Management and Amaranth, which lost substantial sums through a combination of incompetence and hubris. CastleHall goes on to estimate that approximately 3 percent of the universe of hedge fund managers has experienced an “operational event.” It suggests this is pretty good and concludes that “operational failure is material, but not pervasive.”
But investors are typically meeting new managers on a regular basis, often every week. If dining at a local restaurant carried a 3 percent chance of food poisoning you’d probably eat elsewhere. Simple probability theory suggests that if a hedge fund investor meets and considers 52 managers in a year, the probability is 79 percent that at least one of them is crooked.1 It’s not a stretch to suggest that every year most investors unwittingly meet with at least one fraudulent manager.
Bruce Johnson’s book lists 100 cases of hedge fund frauds, although it is by no means an exhaustive list. Of the 100 cases selected, 69 percent resulted in losses to investors totaling $2.5 billion (in 2005 dollars), arguably not substantial although the size of the hedge fund industry was only $237 billion at the end of 2000 where the study ends. In fact, the book doesn’t seek to provide a complete account, and since 2000 there have been many more contemporary episodes including Samuel Israel, Ed Strafaci (discussed later in this chapter), and of course the legendary Bernie Madoff.
The sheer scale of the Madoff deception is such that he surely deserves immortality by becoming an adjective. Ponzi schemes are so named after Charles Ponzi, who successfully (at least for a while) used later investors to pay off early ones thus maintaining the illusion of superior investment skill until the edifice collapsed in 1920. If “doing a Madoff” enters into common financial discourse it will have to represent a substantially more sophisticated conspiracy incorporating chairmanship of a major exchange (Madoff was of course chairman of Nasdaq during 1990 to 1991 and again in 1993) and regular rejection of new clients (creating an air of exclusivity). Investor account statements at the time showed $65 billion in largely fictitious balances, so Madoff represented more than 3 percent of the entire hedge fund industry in 2008 (although by 2011 the trustee Irving Picard estimated total cash losses at $20 billion [Bernard Madoff Overview, 2011]). Madoff typically isn’t included in the returns for that year reported by most databases—the year was already quite bad enough.
There is no book listing 100 frauds in mutual funds, private equity, or real estate, and while frauds and dishonest behavior have occurred in just about every commercial activity, the hedge fund industry has managed to subject its investors to a disproportionate number. As well as being catastrophic for the investor, allocating to a fraudulent manager can often be career ending for the allocator (no doubt rightly so). If you’re looking for the right investment vehicle with which to commit fraud, hedge funds are an obvious choice. Their private limited partnership structure, often-obscure trading activities, and unregistered status all help the would-be con artist. Publicly traded stocks and bonds are registered with the Securities and Exchange Commission (SEC), and while registration certainly doesn’t preclude fraud the required public disclosures make it less likely, particularly with the small army of short sellers out there constantly searching for crooked companies to expose. Mutual funds and closed end funds are also required to register and make public disclosures. Meanwhile, within the world of alternative assets (which includes private equity and real estate as well as hedge funds) your private equity manager typically tells his investors which companies he’s bought and those that are interested can often meet with them or do other fact finding. Real estate funds invest in tangible assets such as buildings that can be visited and are hard to fake. It’s not that any one of these is immune; it’s just that they’re all more difficult choices. If you want to run an investment scam it’s hard to beat a hedge fund as the vehicle of choice. Avoiding frauds is unfortunately a necessary component of successful hedge fund investing.
Once you’ve been lied to and confronted an individual over it, you realize that just about anyyone can surprise you. Over the years I’ve come across several situations with managers where things turned out to be different than they appeared, and although through judgment (and sometimes luck) I’ve avoided losing money, each episode can serve to shake one’s confidence in the integrity of the investment industry.
Madoff
I had my own opportunity to invest with Bernie Madoff back in 2003 and 2004. Fairfield Greenwich is the now infamous fund of funds that channeled large amounts of capital to the Madoff Ponzi scheme. We found ourselves in a meeting with representatives of the firm discussing Madoff and his remarkably consistent returns. As we probed during our meeting for the definable edge that was responsible for this success, the Fairfield marketers described the set-up: Madoff operated two businesses, a brokerage firm that executed trades for clients and a money-management firm that ran the hedge fund. The brokerage division and the asset-management division shared common ownership and, it was explained, might sometimes be executing the same trades. The rules on front-running exist to protect clients from brokers who place their own orders in the market ahead of the client. What they were describing sounded odd, but such meetings are not intended to review whether a manager is fully complying with all the relevant regulations. It’s assumed that he is, and the nature of such meetings is that to question something on the basis of its potential illegality is generally not appropriate. The conversation moved on to other topics and concluded uneventfully.
Years later, when Madoff was exposed and the tragic losses suffered by so many investors were becoming clear, I thought back to that meeting. Although the Fairfield marketers never used the term front-running and didn’t suggest anything illegal was taking place, it occurred to me that this was probably what they themselves believed was supporting the consistently successful results of Madoff’s hedge fund. Madoff’s investors, including those brought in by Fairfield Greenwich, were profiting at the expense of the brokerage clients. The further attraction of such a scheme to a hedge fund investor could be that they’d be the passive beneficiary of such activity, with no liability for doing anything illegal yet still able to profit from it.
That was our only meeting with Fairfield Greenwich or anybody related to Madoff. At the time we just didn’t pursue it, largely because we knew we’d be unable to negotiate the preferential economics that we sought. But the apparently free movement of information between the brokerage and asset management divisions, with its consequent potential to disadvantage some clients at the expense of others, would have made it unlikely to receive serious consideration. Regardless of the potentially convenient “passive” nature of the investment for the investors, it’s not something we would have felt comfortable pursuing.
It’s probably no coincidence that the long list of victims of Madoff didn’t include any of the large Wall Street firms. Goldman Sachs, Morgan Stanley, Citigroup, Merrill Lynch were all notably absent, no doubt because even the most cursory due diligence revealed some insurmountable issues. Some have asked whether Wall Street firms knew about Madoff and should have done more to expose him. For my part, in one meeting I learned just enough to conclude that this wasn’t an investment that would make it through the first stage of JPMorgan’s predictably thorough due diligence review, but not enough to be at all comfortable crying fraud or contacting the SEC.
Of course, as it turned out Madoff was not front running his brokerage clients at all, but simply fabricating results and taking out their cash. And while we’ll probably never know, I suspect that Fairfield Greenwich believed what they were telling us. They were of course victims themselves, and somehow in their own all-too-brief review of Madoff’s activities had concluded that front-running clients were the source of his edge. If so, this was the basis on which they had been happy to invest $7 billion (Bray, 2010) of client capital. While the many individuals who trusted Bernie Madoff were unwitting, and often tragic, victims, there is a sweet irony in that professional investors, having willingly invested so as to profit unfairly from other clients, instead became victims themselves.
Know Your Audience
This was the most famous example of fraud with which I’ve had a passing encounter. There are other far less notorious cases, and while they range from brazen to almost clever, together they illustrate how thorough investors need to be before entrusting their capital to an unregistered vehicle run by an unregistered firm in a poorly understood strategy. Integral Investment Management came to us on one occasion with a foreign exchange (FX) arbitrage strategy. This was of particular interest because all of our investment committee members worked in the FX division of Chemical Bank, and as a result we felt we had more than just a passing familiarity with the markets that Integral traded. At that time I oversaw the trading of interest rate derivatives and forward FX across all the major currencies in New York. Interest rate parity is a condition in financial markets that links the future value of a currency to its value today through the interest rates in the two currencies. Just as the price of oil (and most traded commodities) to be delivered in six months is based on today’s oil price plus the cost of six months’ storage and the relevant six-month interest rate, forward settlement FX rates are determined by today’s spot rate and interest rates.
The FX markets are highly efficient at maintaining equilibrium amongst these moving parts, since if any component moves out of line a riskless arbitrage profit is available. Part of our FX business at Chemical Bank (and in any large FX trading business) was to exploit such opportunities, and taking advantage of the brief moments when things move out of line typically requires a well-constructed trading operation.
So we sat there in disbelief as Conrad Seghers from Integral Investment Management carefully explained how the FX markets were broadly inefficient, and that as a result he was able to use interest rate parity to generate risk-free arbitrage profits. He even showed us a successful back-test of his strategy (naturally all simulated back-tests shown to investors are highly profitable because they don’t involve actual money) to support his claims. Initial meetings with hedge fund managers are usually deferential affairs, with polite interest and the presumption of good intentions on all sides as the due diligence process unfolds. I am afraid on this occasion my observance of protocol failed me and I sat aghast as Conrad calmly described the profits he was able to unlock from the biggest, most efficient market in the world. I asked him if he realized that all the major banks focused substantial human and financial capital on exploiting such opportunities all day long in every financial center. After hearing his response I bluntly told him I felt his assertions were simply not credible and that I didn’t believe him. The meeting ended uncomfortably, and while we never pursued an investment with Integral it came as no great surprise when in 2006 Seghers and his partner James Dickey were both convicted of fraud in a Federal court in Texas, having raised over $70 million from various investors (SEC Litigation Release 19631, 2006).
Accounting Arbitrage 101
Some hedge fund investors have all too frequently carried out only the most cursory due diligence before investing. Chris Goggins was a proprietary FX trader at Chase in the 1980s and 1990s. Chris was from London but had lived in the United States for much of his career, and we met following the merger between Chase Manhattan and Chemical Bank. Chris was a likeable individual, typically good humored and always ready to discuss his views on the market quite openly. He often possessed an unusual insight or perspective and had a wide number of market contacts with whom he would share opinions on FX markets. Chris was also a highly profitable trader on a consistent basis. His daily trading results were uncannily steady, as he combined short-term trading with core interest rate and currency bets that he would hold for many months. Chris’s steady profitability over a number of years during the 1980s had earned him the respect of senior management, and as a result his unconventional hours were quietly tolerated. Chris would often arrive at work at 10 a.m. (unusually late for an FX trader), and would often stay until 6 or 7 p.m. Chris was seemingly a reliably profitable trader.
The problem was that Chris Goggins’s steady returns were the result of his ability to manipulate the bank’s accounting system. Chris traded in two related areas of the FX market—cross currency swaps and long-dated forward FX. There were often opportunities to arbitrage between the two, and Chris’s mandate included making profits from such trades. However, this required that he use two separate accounting systems since neither one was capable of booking both sides of these transactions. In order to avoid having to manually combine reports from two different systems so as to analyze his overall risk exposures, the bank had agreed to let Chris enter a hypothetical transaction between the two accounting systems whose sole purpose was to transfer risk from one to the other and therefore allow a consolidated view of exposures in one place. These hypothetical risk-transfer trades of course only existed within Chase’s accounting systems and as such it was critical that they only be used to transfer risk and not change the overall trading results.
Unfortunately, the monitoring of these trades was weak, and as a result Chris was able to generate hypothetical gains and losses which he used to offset the normal daily swings in his trading results. This was how he delivered such consistently reliable trading profits. He could use his manipulation of the accounting system to smooth out the normal daily swings in profit and loss. Steady returns are almost always preferable. Over time though, as has happened too often in recent history, the cumulative result was that his actual results were overstated, ultimately by $60 million (New York Times, 1999). Joe Jett’s 1994 fraud at Kidder Peabody relied on an accounting system flawed in its reporting of zero coupon bonds, and Nick Leeson similarly exploited Baring’s accounting system when his losses on Nikkei stock index futures brought down the entire bank in 1995.
Chris knew that bank accounting systems had been exposed before. He was not the perennially successful FX trader the bank had long believed him to be. How must Chris have felt as Jett and Leeson were each exposed earlier in the 1990s? In hindsight, his occasional hangover-induced late start to the working day is a little more understandable. In 1999 the accounting flaw was finally identified; Chris was confronted and his career at Chase was over. The bank even had to file a brief explanation with the SEC and the story was reported in the New York Times on November 2, 1999, under the headline “Chase Manhattan must cut its revenue after discovering some non-existent trading profits.”
Chris never faced criminal prosecution, though no doubt he had to forfeit whatever prior bonuses had not already vested. Although he had in effect committed fraud by misrepresenting his trading profits, such cases are often hard to prove before a jury. The bank’s accounting systems were clearly embarrassingly weak, and he was able to leave without a criminal record. To the extent that Chris had been paid bonuses in past years based on his inflated trading results, he had of course defrauded Chase Manhattan and its shareholders.
Amazingly, some years later, Chris set up his own hedge fund called Victory Investment Management, in Summit, New Jersey, where he lived. It represented staggering chutzpah on Chris’s part that he could bring himself to market his money-management abilities after being publicly identified as misrepresenting his trading results. It was also evidence of the almost complete absence of any meaningful due diligence by whichever investors entrusted their money to him. The circumstances of his departure were public information, and within Chase’s FX division the story was widely known. It was reported in the New York Times (in fact, even today a search on their web site for “Goggins” in 1999 will still reveal the story). It wouldn’t have been hard for even cursory research into his background to reveal his past.
Checking the Background Check
We always carried out background checks on managers before we seeded them. Although we followed a careful and thorough due diligence process using many of our own sources both within JPMorgan and outside the firm to vet people, we maintained a healthy insecurity that there might be some important information we didn’t have. Paranoia in investing can be a useful form of self preservation as long as it’s not so strong as to become debilitating and prevent any investments being made at all. In practice most investment decisions are inevitably made with less-than-perfect information.
We regularly used a private investigator (we’ll call him Magnum, not his real name) to review all public sources and some proprietary channels on each manager. Magnum consistently reported back on each successive manager with a clean bill of health, combining public sources with almost unimaginable access to the human resources (HR) departments of major banks where each manager had worked. It was extraordinary to hear personnel records describing an individual as “highly talented, a regrettable loss when he resigned” and so on since HR records are supposedly completely confidential. Through several investments in new hedge funds Magnum consistently found nothing that should prevent us from moving ahead with each investment. It seemed that our own screening process was so thorough we were weeding out any dubious characters well before they reached the level of serious consideration. Each call with Magnum concluded in the same way, that our target was “clean.”
After a while though, we thought it might be useful to run a check on Magnum himself. After all, while we were happy that each manager checked out, we had no way of knowing if he was really obtaining these confidential HR records from a surprisingly large number of banks and other sources. Magnum seemed to have extraordinary access, but was it too good to be true? What we needed was to run a check on someone that we knew had a bad past. Like Chris Goggins.
So we went ahead and ran our “test” of Magnum. He of course passed with flying colors, commenting that “we have some problems with this one” at the outset of the phone call during which he reported his findings. Naturally he’d quickly found the New York Times article, but in addition Magnum obtained a quite detailed description of Chris’s accounting manipulation that was so accurate it could only have come from someone within Chase, perhaps from HR or the FX trading division. He further found that while both the SEC and NASD were aware of Chris’s actions and had notes to that effect somewhere in their files, the CFTC (which in theory regulated Victory Investment Management) did not. And Magnum also discovered that the IRS, in their classification of taxpayers, had placed Chris in a higher risk category not normally used for salaried employees because he’d had to restate prior years’ income.
We couldn’t know why, but since Chris would have had to forfeit unvested bonuses from prior years as a result of being fired he might have had to reclaim Social Security taxes, which were typically withheld and therefore no longer owed if the bonus wasn’t going to be paid. It seems no information is reliably confidential, and we were now 100 percent sure that the background checks we were receiving on other managers were reliable. Magnum was the real deal. It was a relief to know he was that good and quite sobering to see his access to information.
Perhaps 10 years later, with the changed regulatory environment that followed Madoff and the mortgage market collapse, Victory Investment Management would never be possible as a sequel to Chris’s prior failure. And while Victory never grew to any consequential size, it was evidently successful in bringing on some investors, presumably on the back of the many years Chris enjoyed as an FX trader at Chase Manhattan. Perhaps fortunately for Chris and his investors, Victory was never a big success. In fact, in 2010 I played English football against him in a league (older men in their 40s and 50s who ought to know better) and Chris told me he’d finally had to close the hedge fund down because it was becoming hard to raise money.
Politically Connected and Crooked?
Sometimes the connections a manager has can add legitimacy. In 2002 we were looking for interesting hedge fund seeding opportunities with which to launch our Incubator Fund. Ed Strafaci came with apparently strong credentials. Ed was managing a convertible arbitrage hedge fund at Lipper Holdings, part of Ken Lipper’s business. Ken Lipper was well-connected within the New York political and social scene. He had been Deputy Mayor of New York City from 1983 to 1985, co-wrote the screenplay for the movie Wall Street (which starred Michael Douglas), and ran a hedge fund. Ed Strafaci was introduced to us through Chris Brady, who ran a boutique investment business called The Chart Group and was the son of Nick Brady (Treasury Secretary under President George H. W. Bush). Ed’s initial references at least appeared promising. Ed described his growing frustration with Ken Lipper over business strategy and compensation, and said he believed the returns they had generated in convertible arbitrage trading could be replicated outside of Lipper. All they needed was seed capital to get them started. We decided to spend some time drilling down into Strafaci’s strategy, and invited him to meet with one of our colleagues (Remi Bouteille) who was familiar with many of the convertible arbitrage hedge funds currently operating.
Remi is French, one of the many graduates of the elite universities in France that produce a regular supply of mathematically gifted graduates. In fact, the equity derivatives business is disproportionately filled with math alumni from L’Ecole Polytechnique just outside Paris. Remi is a smart guy whose manner can sometimes appear abrasive or condescending. However, I’d always found that his opinions were typically well supported by facts and analysis. During the interview with Remi, Ed repeatedly avoided being drawn into discussing the specifics of different hedging techniques. Remi was looking for numerical answers to demonstrate Ed’s technical knowledge of his strategy, and Ed’s answers were frustratingly imprecise and vague. Ed appeared mildly insulted by Remi’s manner of questioning, no doubt feeling that his track record and connections ought to be sufficient to demonstrate his proficiency. Remi felt Ed was being evasive.
Following the meeting, Remi confidently and memorably declared that Ed Strafaci was most likely a fraud. I must confess I was not at all convinced that Remi was right. I thought Remi’s cold and impersonal style was not conducive to drawing people out of themselves, and that he was reacting in part out of his frustration with Ed’s imprecise answers. Ed also came highly recommended by Chris Brady who was eager to fund an independent Ed Strafaci but was also keen to have JPMorgan in at the outset as a partner.
Over the next few weeks we continued our research, carrying out discrete reference checks and drafting an investment proposal. And then the news broke that Lipper’s fund had been misvalued by (as it later turned out) $350 million, and that Ed Strafaci the portfolio manager was to blame. Remi (who to his credit did not brag about this) was right in his assessment on the basis of a single interview. Ed Strafaci was subsequently convicted of securities fraud and sentenced to six years in prison. Many investors had invested with Lipper either without a thorough meeting with the portfolio manager, an indefensible omission or (perhaps worse) after meeting with Ed. Clearly few other investors had gone to the trouble of exploring the mechanics of the strategy in intimate detail, and had instead relied on Ken Lipper’s oversight and Ed’s folksy style.
Paying Your Bills with Their Money
In 2004 we met Scott Stagg and Gary Katcher who were running 3V Capital. Gary had left Merrill Lynch to found Libertas Partners, a broker-dealer, and brought on Scott from Lehman Brothers because of his experience in distressed debt. Scott and Gary were smart and had come up with a novel way to raise capital for Libertas Partners. A broker-dealer often needs to hold inventory, since buyers and sellers don’t always want to transact at the same time. In order to provide liquidity to its clients in distressed debt, Libertas needed capital so it could hold bonds when clients wished to sell them, even if only for a few hours or days while they found a buyer. Being a willing buyer when clients want to sell, and having bonds available when buyers want to buy, is market making and is an important element in the structure of most bond markets.
The problem facing Gary was that Libertas was small and raising capital from traditional venture capital investors to allow it to hold larger inventory was expensive. The cost of equity that most private equity investors wanted to charge was in their view too high. So Gary and Scott came up with a novel solution. Since hedge fund capital was seemingly abundant, why not start a hedge fund and have it hold the inventory for Libertas. They figured they could easily raise $250 million this way, and then they’d have enough capital to hold inventory and support Libertas. Clients of Libertas would sell bonds which would then be passed on to 3V, to be held until Libertas had a buyer who would then buy back 3V’s bonds through Libertas. It was an ingenious way to access the capital available to hedge funds and use it in effect as venture capital. While we admired their out-of-the-box thinking and thought they had the industry knowledge to probably be successful, we had several problems with the structure.
Broker-dealers like Libertas, that transact on their own behalf, and investment advisors like 3V, that act on behalf of clients, have conflicting objectives and therefore need to operate at arm’s length. The fact that they had overlapping control meant that the potential existed for 3V to buy bonds at a loss in order to support Libertas in its drive to build market share. The office layout was clearly designed to allow the two firms easy communication—indeed, that was the point of their business model. In addition, we recognized that our hedge fund investment would create value for Libertas, and we wanted to make sure that our investors would be fairly compensated for jumpstarting the broker-dealer.
We had several discussions around these topics, but ultimately the concerns we had over potential conflicts of interest as well as inability to agree on the economics stopped us going forward. Eventually though, other investors including Weston Capital funded 3V (which changed its name to Stagg Capital) and AUM reached $550 million by 2007 (Vardi, 2009). We never understood how other investors resolved the issues we had identified. Sadly though, the very conflict of interest that had concerned us came true when in 2009 their chief operating officer Mark Focht was convicted of grand larceny for transferring money between the hedge fund and the broker dealer which was ultimately used to meet payroll expenses (Vardi, 2009).
Why It’s Hard to Invest in Russia
When we first set up the Incubator Fund in 2001 we had few competitors. Although we rejected 99 percent of the opportunities that came our way, we were able to indentify some promising candidates. By 2006 competition amongst seed capital providers was increasing and we had started to consider opportunities outside the United States. Russia had never been high on our list—an emerging market dealing with the legacy of Communism where property rights and the rule of law seemed to follow a wholly different set of rules than in the west. In addition, there were so many stories of people being ripped off, whether by a cabdriver from the airport, a local gang, or the government itself. So we weren’t planning to invest in Russia. But then we met two people that made us feel, well, if we were ever going to invest in Russia it would be with them.
The fund was run by two Americans: Michael McGuire spoke fluent Russian and had spent many years there in various commodity businesses; his partner Arthur Heath had a Harvard Law degree and had previously been JPMorgan’s local legal counsel in Moscow. Their fund was named Triple Trunk, after a local tree in Michael’s neighborhood. Of course their proposed investment strategy and business model would need to be thoroughly reviewed for viability, but at least in terms of integrity we were unlikely to find a better qualified pair. We spent many hours with them taking apart their trading strategy (which involved the trading of physical commodities), reviewing the risks, the business plan, funding needs, market outlook, and so on. We started negotiating a formal investment agreement with them that would govern the terms under which we would invest along with our participation in the financial success of the business. One of my colleagues, Andreas Deutschmann, traveled to Moscow to meet some of the banks they proposed to use as counterparties and to learn more about the specific opportunities.
And then, in a routine background check on Michael, we discovered that Chase Manhattan had placed liens on two properties that he owned for failure to repay a business loan. You might think that if one department of our bank had a commercial dispute with an individual it would be known to any other relevant department. But it’s a huge company with appropriate information barriers between divisions and there was no known internal database from which we could obtain information on legal disputes between any other division of the company and a certain individual. Nonetheless, we had information highly relevant to our transaction, and confronted Michael with it in our next meeting. It is almost always a sobering experience to hear someone you believed to be honest admitting that it is not the case. While the legal dispute itself related to a loan Chase had made to a failed business Michael ran and didn’t allege any dishonesty, his failure to make us aware of it clearly was dishonest. His memorable response was that you don’t tell a new girlfriend all the bad things about yourself on the first date. We had wasted time, but happily not any investor capital. His partner Arthur Heath was devastated and claimed quite credibly that he had no idea of this element of Michael’s past. Arthur insisted on buying us lunch at the Harvard Club by way of drawing a line under the episode, and we all moved on.
We even had a meeting with Paul Eustace, formerly of Tewksbury Capital. Tewksbury had pulled off a rare feat in the hedge fund industry—smooth transition management. Most successful hedge funds are so closely identified with their founder, who has invariably retained close control over the invested capital, that maintaining success when the founder retires is difficult. Monroe Trout had run a highly profitable fund in Bermuda for many years, and when he decided to retire the business moved seamlessly to his longtime deputy Matthew Tewksbury. The name changed, but at least for the investors little else appeared to. Paul Eustace came to see us and claimed he was responsible for the development and implementation of forecasting as well as trading systems while at Tewksbury which had contributed to their overall profitability. He told us he had been the Chief Operating Officer, had felt underpaid at Tewksbury, and was therefore leaving to set up his own firm.
Somehow, although Tewksbury was highly regarded, Paul’s story wasn’t convincing. We just doubted that he could generate the returns he claimed, even though he offered to provide former colleagues at Tewksbury as references. We didn’t pursue it and he soon set up his new firm, Philadelphia Alternative Asset Management Co (PAAM). In 2010 he was indicted on fraud charges (United States of America v. Paul M. Eustace, May 6, 2010). Had we decided PAAM was an attractive opportunity, we would have contacted Tewksbury and presumably been advised to avoid Paul. However, we rejected him simply based on his trading description—we had little reason to think he was a fraud until much later. It never ceases to amaze me though how some people will quite readily lie and misrepresent their past, even when the risk of exposure is quite high. People can always surprise you.
After Hours Due Diligence
Some of the shrewdest hedge fund investors I know have developed a sixth sense, an ability at self-preservation that uncannily steers them away from trouble. They may not be certain a manager is lying to them; indeed, they may concede that the individual is “probably good, just not a good fit for me.” But today’s successful hedge fund investors have avoided “headline risk” (what happens when an investor’s hedge fund makes page A1 of the Wall Street Journal for the wrong reasons) and protected both their client’s capital as well as their professional reputations.
In 2000 Michael Berger’s firm Manhattan Capital Management collapsed after its efforts to hide $400 million in losses from investors were ultimately exposed. One friend of mine, a seasoned hedge fund investor, told me that he’d avoided Manhattan simply because of a conversation he’d had with a third-party marketer representing Berger’s fund. Over drinks one evening the marketer had complained about one wealthy hedge fund client who was persistently late in paying the marketing fees owed. Eventually and after several drinks the marketer confided to my friend the identity of the delinquent client, and this information was enough for him to conclude that everything was not as it appeared at Manhattan. The hedge fund investor’s due diligence toolkit includes some unconventional techniques.
Dishonest people unfortunately operate in all walks of life. Routine dishonesty in most businesses may mean inflated travel and expense (T&E) expenses, inefficient use of resources, and many other actions that can eat away at the return on an investor’s capital. However, what sets hedge fund investing apart is how disastrous it can be if the investor has the grave misfortune to choose unwisely. A complete loss of capital is not out of the question, and it’s these consequences as well as the unfortunate prevalence of dishonesty that adds measurably to both the risks and the costs faced by hedge fund investors. Hedge funds are the perfect vehicle if you want to defraud investors. The funds and the firms that run them are unregistered. Although the laws against fraud in the United States apply as much to hedge funds as any other activity, the SEC doesn’t have the ability to carry out routine inspections of firms they don’t regulate.
Hedge funds operate in the regulatory shadows, although in many other ways they are in plain sight. Other common features that make hedge funds convenient vehicles for dishonesty are the commingled nature of the capital (the investors’ funds are all pooled) and the lack of complete transparency. While thorough due diligence can protect the investor from these features being used against him, it’s still unfortunately the case that the combination of non-regulation, indirect ownership of underlying investments, and incomplete access to information are all attractive elements for the dishonest money manager. Best practices have changed somewhat in recent years in response to events, but whether the risks of fraud are measurably lower than in the past is something strenuously argued by the industry but ultimately not yet known.
Summary
People can always surprise you. I believe that most people are fundamentally honest. But in business we typically deal with so many different individuals that if only a small percentage of the population is crooked you still need to keep it in mind. The statistics mean you have to “trust but verify” as President Reagan once famously said. Most of us place great stock in our ability to assess others and to judge character in another. Therefore there are few things more sobering than to find that someone you thought was honest is not, and to confront them about it.
An unfortunate feature of hedge funds is that if you want to defraud people, a slightly mysterious trading strategy with an apparently strong history of performance in a limited partnership structure generally outside the regulatory framework is one of the best ways to do it. It’s not that hedge fund managers are inherently dishonest—far from it. Most of them are far too intelligent and in any case able to make substantial money legitimately. But the hedge fund industry has, sad to say, attracted more than its fair share of ethically challenged people. Committing fraud is simply easier there than in many other areas of finance. It’s not a systemic problem, but it is an additional risk facing investors. Greater transparency and increased use of separately managed accounts can help protect the investor.
Note
1 A 3 percent probability that a manager is a fraud implies a 97 percent chance that he’s not. 0.97N (where an investor holds N meetings a year) is the probability of not meeting a fraud all year. So 1 − 0.97N is the probability of meeting at least one. Assuming one meeting per week, the one-year probability of meeting a fraud is: 1 − 0.9752 = 1 − 0.2052, = 0.7948 or 79 percent.