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In association with Hedge Fund Intelligence |
The brouhaha surrounding the huge fraud perpetrated by Bernie Madoff could hardly have come at a worse time for hedge funds.
Performance in general was deeply disappointing in 2008. Even if the industry did on average beat the returns in most asset classes, a significant majority of hedge funds were negative on the year. And with an increasing number imposing gate provisions or suspending redemptions, all too many managers have also got themselves into highly fractious relationships with their investors or their prime brokers, or both.
With a lot of investors already planning, for various reasons, to cut back allocations to hedge funds, this was really not the time to discover that one of the longest-running managers of money in the business was in fact operating nothing more than a Ponzi scheme.
Two key questions will dominate the debate about Madoff for the foreseeable future. How did he do it? And how did get away with it – how did the extensive due diligence supposedly conducted on behalf of investors fail to discover that the emperor wasn’t wearing any clothes? There will be a lot more investigation and research before final conclusions are reached on those questions.
Lessons
Nevertheless, some key points can be made – even at this relatively early stage – about some of the lessons for the industry.
Yet again, for instance, this is another case of a fraud that occurred in the US – as have almost all hedge fund scandals since the industry began. And the US remains one of the few jurisdictions where it is still possible to run a hedge fund without having to be registered with a regulator. The US is also one of the few jurisdictions where it is still quite commonplace to run a hedge fund without appointing an independent administrator to verify the net asset value.
From the very first edition of our sister publication Absolute Return in 2003, we have argued strongly in favour of both registration and independent administration. And, to me, the Madoff case seems to demonstrate yet again just how important it is for the industry to have more checks and balances on its ways of doing business – as it already has in most other parts of the world.
Of course, there are arguments against registration, as well as against independent administration. Those who oppose such developments will not be slow to point out that the SEC hardly covered itself in glory in its regulation of Madoff as a securities broker/dealer – within which area of business this fraud was allowed to be perpetrated; and, secondly, that various of the Madoff feeder funds, such as Kingate and Fairfield Greenwich, did retain independent administrators – which were seemingly ineffective in helping detect the fraud.
There are various reasons, however, why I think Madoff presented a very special case – and hence why it does not invalidate the need for more industry oversight.
The Madoff funds were run within a very unusual – probably unique – structure, in which Madoff himself was not the manager but merely a kind of sub-adviser who charged commissions to the feeder funds. This meant that he could evade the question of whether he should register as a manager. This should of course have served as a red flag to potential investors – why would he willingly forgo the 20% performance fees picked up by a normal manager (and allow those to be picked up instead by the feeder funds)?
A second big difference was that – unlike most hedge funds – Madoff did not use an independent prime broker. Hence, any administrator that checked the prices at which trades were done during any reporting period would not be able to check the audit trail with an independent source such as a Morgan Stanley or Goldman Sachs – only with Madoff Securities.
In the case of these funds, the administrators might or might not have done their jobs properly – and they certainly have some tough questions to answer. But it was arguably neither the presence nor absence of independent administrators that was the problem. In this case, it was more the absence of independent prime brokers with which to check the trades. And this again, of course, should have raised a red flag for investors.
The fact that the Madoff fund itself did not possess a credible auditor is something else that should of course have been picked up by investors, or those doing due diligence on their behalf.
Suspicions
To us, it seemed for quite a long time that there was something suspicious – if not about the size of the returns reported by the Madoff funds then about the unbelievably smooth return pattern. When we investigated, it didn’t seem to add up. For it to be possible, I felt that Madoff must have discovered some new and undetectable way of front-running customer orders – or that he was a fraud. But, without any hard evidence, this was not something you could charge publicly – and especially not when he had so many apparently credible investors.
We now know, of course, that the SEC was approached by at least one party who argued forcefully that it should investigate. And not for the first time, the SEC appears to have not been up to the task.
Nevertheless, it does not seem to be the right conclusion to try to exclude the SEC from the industry, and even less likely that such a step could be taken in any case. A better solution is surely to make the SEC improve its game – and get to understand hedge funds better. If it can do that, through developing a system of registration and sensible (not heavy-handed) oversight – which I admit is a big if – then it might be possible both to deter future fraudsters and to encourage a healthier and more robust industry.
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In association with Hedge Fund Intelligence |
