If $80 billion in redemptions in two months at the end of last year were not enough, hedge funds now have to deal with the reputational damage inflicted by Bernie Madoff’s spectacular hedge fund fraud. While most managers will hang their heads and lament that Madoff’s confession could not have come at a worse time, it is legitimate to argue the exact opposite.
The future of hedge funds is under scrutiny and the more examples of what can go wrong and how it can be avoided, the better the decisions on that future will be.
To regulate or not to regulate has been the question for some time but what Madoff’s case seems to prove is that regulation would not make a jot of difference. The SEC had looked into allegations that Madoff’s fund was not all it was said to be, and could see nothing wrong. If regulators cannot help, there is little point in regulation. Or, at least, this is a clear indicator that those working at the SEC should have a background in due diligence.
And who did know that Madoff’s fund was iffy? Those that conducted appropriate due diligence. One private banker says his firm banned investments in the fund five years back because there were unanswered questions in the due diligence process. He is not alone. Many funds of hedge funds refused to invest with Madoff. Those that picked up on the fraud will benefit now, and rightly so, for doing their job correctly. They can also teach their peers exactly what needs to be carried out in the due diligence process to weed out the fraudsters.
Feeder funds are now also likely to see themselves added to the growing pile of shamed products, and thank goodness. Madoff made millions from so-called funds being set up that simply invested directly into his under a different name. Managers of feeder funds have made tidy fees from clients for years from riding on someone else’s coat tails. One of them is now threatening to sue its accountant for not picking up on the fraud, but really? Given that the job of managing the fund is (in non-fraud cases) the responsibility of a third party, one would at least think there was time for the feeder to carry out proper due diligence. Feeder funds are a waste of time and money.
So undoubtedly there is pain from Madoff’s blunder, and there will be for some time as redemptions increase, former investors have to return profits and the term "hedge funds" becomes synonymous with Madoff, but to find a silver lining – better lessons are learnt now that the rules are due to be written.