Wise Before the Event

Perspective on hedge fund fraud

NATHAN SEWELL, MANAGING DIRECTOR, PROTEAN INVESTMENT RISKS

From Bayou to Lancer to Manhattan to Madoff and now Weavering, we have all seen the headlines. So much has been written about hedge fund fraud over the past year that one could be forgiven for thinking it had become a daily occurrence. These (relatively few) high profile incidents have spawned conferences, books, training programs – in fact a whole industry. Even having a quiet pint in the local pub on Sunday lunchtime, the guy in the corner is bemoaning these terrible events, rather than his usual complaints about everything else in the world. There is no doubt that fraud is a scourge on the hedge fund industry and the victims are real. Some of the amounts involved have been colossal. Nevertheless, fraud is still a relatively rare event. It can be perpetrated by those crooks who either decide that it is easier to take their clients’ money than to invest it for them, the lure of fast cars and fast living being too much.

Then there are those who mean well but decide either to fabricate gains or cover up investment losses. They may never pocket ill-gotten gains but they commit fraud against their investors nonetheless.
So is the problem really that bad? Some “facts” about hedge fund fraud:

• Before Madoff it was estimated that investors in hedge funds had been defrauded of in the region of US$11 billion of assets.
• There are approximately 80 cases of known fraud. (We always need to be cautious about stating absolute facts about cases that are still ongoing.)
• Estimated losses from Madoff range between US$17 billion and US$65 billion.
• At its peak the industry was said to have around 10,000 funds and more than US$2.5 trillion in assets.

I think we can take these figures as best estimates, but to me the picture is clear.

Fraud is a rare occurrence that needs to be eradicated or mitigated to the point that is realistic when we consider the added ingredient of human nature. So how can this be achieved?

– Greater regulation
– Better due diligence
– Greater transparency and self regulation
– Improved management of conflicts of interest
– Increased awareness of fraud risk

Much has been written about how much regulation should be imposed on hedge funds and it is not something to tackle in this article, other than to say that most if not all of those in the industry, in whatever capacity, think that the move towards better practices can only be a positive thing but not at the price of stifling the creative and added value of hedge funds to the point of suffocation.Table 1 shows a no-names assessment of several historical fraud cases including a summary “red flag” analysis.

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It is the case that in a number of the major fraud cases, certain investors avoided losses because they carried out thorough due diligence and either found something they did not like or could not find sufficient information to get comfortable. Other investors either:

• Did not carry out the depth of work they should have;
• Relied on another party’s work and did not do their own checks; or
• Were in a conflicted position and invested anyway.

These are all avoidable and it should be the case that investors have learnt from these events.

A common theme is also the reluctance of a manager to open the doors to scrutiny by a prospective investor or their due diligence advisers. Whilst an initial openness is not a guarantee against fraud, it is a major indicator.

Focus on fraud
Another factor is that due diligence has, in the main, focused on investment returns and related risks and not specifically on fraud. Whilst operational due diligence contains elements of a specific fraud due diligence, and can be supplemented by thorough background checks, it is rarely specific enough. To carry out effective diligence against fraud risk it is essential to first analyse and assess how and why fraud has occurred in the past. Questions such as:

• What common features did the fund or manager have?
• Is there a specific strategy that is more prone to fraud?
• Is fraud more common in one jurisdiction than another?
• Do the assets under management make a difference?

There are many such questions that need to be considered. In addition it is important to understand operational controls and procedures and how they affect the likelihood of a fraud taking place. Hedge fund fraud is a deliberate act consistent with fraud in any organisation. The complexity of hedge funds sometimes creates a mystique that is misplaced in the fraud context.

We have also seen instances of inadequate or even non-existent background checks and worse, cases where issues have come up and not been acted on. In the Bayou case, there were a number of indicators involving previous dealings and several lawsuits that may have given cause to be concerned about bad faith dealing. Fraud will never disappear but it is in all our interests to see it minimised in the future.

ABOUT THE AUTHOR

Nathan Sewell is Managing Director of Protean and has extensive experience in the insurance market with specialist skills in broking and underwriting. Prior to setting up Protean he was Director at Dual Corporate Risks, and has also held senior positions with Willis Limited. Prior to joining Willis, Nathan was an Executive Director with Aon.