The underside of the boom in hedge funds is a boom in hedge fund fraud.
Last year saw guilty pleas from several hedge fund managers for issuing phony financial statements that falsely reported gains instead of losses. The funds involved were Manhattan Investment Fund Ltd., Cambridge Partners LP, Nidra Capital LP and Ballybunion Capital Partners LP. Charges have been filed against the managers of Ashbury Capital Partners LP and Maricopa Investment Fund Ltd., both accused of siphoning money out of their funds for personal expenses. The combined losses in these cases are in excess of $700 million.
There are two reasons hedge fund fraud is flourishing,
First, like the bank robbers of an earlier era, scam artists go where the money is. Right now, the money is pouring into hedge funds - about $75 billion last year with another $100 billion estimated to follow this year, much of it from institutional investors trying to stay topside of a sinking market. Some of the best-known hedge funds already have closed their doors to new investment, thus creating opportunities for new funds.
Second, fraud always thrives in the absence of regulation. Hedge funds are, of course, lightly regulated. Sophisticated investors understand that flying beneath the regulatory radar gives fund managers the freedom to maximize returns by concentrating heavily in a single investment or using high leverage. However, freedom from strict reporting requirements presupposes a high degree of trust between fund managers and investors.
Unfortunately, the frauds noted above suggest that not all fund managers are worthy of their investors' trust. The flow of billions of dollars into a regulatory vacuum is creating opportunities not only for legitimate fund managers, but also for swindlers and Ponzi-scheme operators. Financial predators find happy hunting in the opaque hedge fund world, camouflaging themselves with impressive websites and promotional literature.
The "buyer beware" nature of hedge fund investment mandates that investors conduct adequate due diligence to mitigate the risk of fraud. Nevertheless, because many hedge fund managers do not register with the Securities and Exchange Commission or National Association of Securities Dealers, investors often do not find information about fund managers' backgrounds in these agencies' records.
There are, however, are other effective means of checking out prospective hedge fund managers. At the absolute minimum, an investor's due diligence should:
* Verify the credentials and employment history listed in the fund's promotional literature or website. A surprising number of people claim academic degrees they never earned or jobs they never held, assuming nobody will bother to check. Resume inflation is frequently a harbinger of other forms of fraud.
* Identify "sins of omission." Beware of non-chronological resumes constructed to mask missing years. Richard S. Roon, who pleaded guilty in 2000 to siphoning $1.5 million invested with Nidra Capital, began his career at the notorious boiler room First Jersey Securities, a fact omitted from the summary of his career in the fund's brochure.
* Look for red flags such as criminal or regulatory proceedings. Maricopa's David M. Mobley Sr., indicted in October, was convicted in the 1980s of passing bad checks. Some managers got into the hedge fund game after serious run-ins with regulators. Michael L. Smirlock, an investment adviser indicted in December for disguising $71 million in hedge fund losses, paid a heavy fine to the SEC in his pre-hedge-fund career. (Messrs. Smirlock and Mobley have pleaded not guilty to the charges filed against them.)
* Search records of civil litigation for actions filed by investors alleging they were defrauded. Litigation records can bring to the surface other interesting issues, too. In a recent case, we discovered that a fund touting a proprietary trading technology was embroiled in litigation with a software company seeking a court order to bar the fund from using the technology, which the software company alleged had been obtained fraudulently.
* Conduct research in media sources to collect additional intelligence. In another recent case, press sources revealed that a fund's managers were all closely associated with a controversial, cult-like religious organization, raising questions about who actually made the fund's investment decisions.
Our experience conducting due diligence investigations of fund managers suggests that most possess clean records and solid professional experience. But we have found material issues in about 15% to 20% of such cases. That percentage is large enough for institutional investors to investigate before they invest.
Thomas Fedorek is a managing director in the New York headquarters of Kroll Associates, which specializes in conducting due diligence for financial services firms, business intelligence, investigations and security.