Homework saves crying over Madoff

Institutions heeded the red flags raised by hedge funds of funds

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Bernard Madoff's trading strategy didn't make sense to a lot of institutional hedge fund-of-funds managers.

Bernie Madoff stood little chance of luring U.S institutions into his alleged $50 billion Ponzi scheme because elite U.S. hedge fund-of-funds managers stood solidly in the way.

The due diligence of hedge funds of funds that specialize in managing mandates for U.S. pension funds, endowments and foundations found too many inconsistencies in the trading strategy managed by Bernard L. Madoff Investment Securities LLC, New York. However, a few smaller hedge funds of funds were invested in so-called feeder funds, single-manager funds managed by Mr. Madoff's firm.

“The fact that so many institutional investors' hedge fund-of-funds managers insisted on transparency and therefore avoided Bernie's is a testament to the quality of their due diligence. They protected institutional investors from getting involved in this fraud,” said Eric Weber, chief operating officer and principal of Freeman & Co., New York, a boutique investment bank.

Among those steering clear were the largest hedge fund-of-funds managers of U.S. institutional assets, including Pacific Alternative Asset Management Co., K2 Advisors LLC, Mesirow Advanced Strategies Inc., Goldman Sachs Asset Management, Morgan Stanley (MS), JPMorgan Asset Management, UBS Global Asset Management, BlackRock (BLK) Inc. (BLK), Harris Alternatives LLC and the asset management unit of BNY Mellon Bank.

Grosvenor Capital Management LLC redeemed its small investment with Mr. Madoff in 1991. Arden Asset Management Inc. got rid of Madoff investments in 2002. The U.S. institutional clients of EIM Management (USA) Inc. were not invested in funds with Madoff exposure, though the firm did have $230 million invested in Madoff Investment Securities for non-U.S. clients.

“There were a thousand red flags, if you did the work. It didn't take much energy to reverse-engineer Madoff's track record and find that his split-strike conversion method just would not have worked in certain markets the way he said it did,” said the chief executive of a large institutional hedge fund-of-funds firm who asked not to be identified.

"Madoff was a joke"

Many observers agreed with another hedge fund-of-funds executive who said, on condition of anonymity: “Among serious people in the industry, (Mr.) Madoff was a joke. Some hedge fund problems are unknowable. Sowood (Capital Management LP) was unknowable. Long-term Capital Management (LP) was unknowable. Amaranth (Advisors LLC) was somewhat knowable. Madoff was very knowable. All the trouble signs were there, written in red.”

Mr. Madoff was arrested Dec. 12 in New York and charged by the Securities and Exchange Commission with securities fraud. According to the SEC's complaint, Mr. Madoff defrauded clients of as much as $50 billion. His firm managed $17.1 billion for 23 clients, according to firm's undated ADV Investment Advisor Disclosure form filed with the SEC.

Mr. Madoff's attorney, Daniel J. Horwitz, a partner at Dickstein Shapiro LLP in New York, did not return call seeking comment. Many investors accessed Mr. Madoff's investment strategies through third-party resellers that offered his approach in single-manager “feeder funds.”

Several U.S.-domiciled hedge fund-of-funds managers or allied companies that offered such funds were hurt by the relationship, including Fairfield Greenwich Group, which had $7.5 billion in its Madoff-managed feeder fund; Rye Investment Management, which had all of its $3.1 billion invested with Mr. Madoff; and MAXAM Capital Management LLC, which reportedly had $280 million in its fund managed by Mr. Madoff. Rye Investments' sister company, hedge fund-of-funds manager Tremont Capital Management Inc., had a 7% weighting, or $189 million, in Mr. Madoff's strategies. Both Fairfield Greenwich Group and MAXAM manage hedge funds of funds in addition to the single-manager feeder funds.

Sandra L. Manske, chairman and founder of MAXAM, did not return calls seeking comment. Andrew Ludwig, director of communications at Fairfield Greenwich Group, did not respond to repeated requests for an interview.

"Were all victimized"

Tremont Group Holdings Inc., parent of Rye Investment Management and Tremont Capital Management, said in a client letter obtained by P&I: “It seems we were all victimized by not just a person but a scheme and a complex process designed to deceive individuals and organizations, managers and analysts — including some of the largest, most sophisticated financial institutions in the world. We believe Tremont exercises appropriate due diligence in connection with the Madoff investments.”

“Bernie seemed to achieve good returns, but never super returns. It was part of his evil genius, never claiming too much,” said a source who has analyzed Mr. Madoff's performance for a decade without being able to satisfactorily explain it.

The anonymous hedge fund-of-funds executive said there was not a single reliable source of returns for the Madoff strategy because there were so many different feeders offering it.

By way of proxy, Rye (Investments) Select Broad Market Fund LP, which is invested in Madoff Investment Securities, returned an annualized 9.23% for the five years ended Nov. 10, with positive returns ranging between 8.26% and 17.1% each year since 1998, according to investment data from the company obtained from a public web site.

Two U.S. hedge fund-of-funds companies invested in Mr. Madoff's strategy through feeder funds, sources said. One was Meridian Capital Partners LLC, Albany, N.Y. Meridian officials did not respond to requests for comment.

Another Madoff investor was Austin Capital Partners Ltd., Austin, Texas. A statement from the firm said it “invested a limited amount in a fund managed by Tremont Partners. ... Like the many others who invested with Madoff, Austin Capital is outraged by his alleged behavior. More importantly, we are taking every measure to protect the interests of our investors.”

$12 million exposure

Massachusetts Pension Reserves Investment Management Board, Boston, had $12 million of exposure to Bernard L. Madoff Investment Securities through a $170 million allocation to Austin Capital Management. The $39.6 billion system is trying to assess its legal remedies, and it remains unclear how much it will be able to recover, said Michael Travaglini, executive director.

The $6.5 billion New Mexico Educational Retirement Board, Santa Fe, stands to lose $8 million to $10 million through its $170 million investment in Austin Capital's Safe Harbor Fund. Bob Jacksha, New Mexico chief investment officer, said fund officials and trustees still are evaluating the impact.

The $270 million City of New Orleans Employees Retirement System could lose about $350,000 from Madoff investments made in the $5 million allocations to hedge funds of funds managed by Meridian Capital Partners and UBP Asset Management, said Jerry Davis, chairman of the board of trustees.

The biggest institutional investor loss uncovered so far is the $41 million by the Town of Fairfield (Conn.) Retirement Fund. The $233 million plan had 17.6%, or $41 million, invested as of Nov. 30 in the MAXAM Absolute Return Fund LP, managed by Madoff Investment Securities.

In a statement presented at a Dec. 15 joint pension board meeting, Kenneth Flatto, a trustee of the police and fire pension funds said: “Now we have suffered a loss, not from a decision of this board, but from a deceitful dishonest system of fraud, the kind of fraud which is supposed to be prevented by all the professional advisers and outside auditors hired to protect funds like this.”

Douglas Appell contributed to this story.