Mr. Gradante, however, provided Pensions & Investments with a copy of a letter sent to Hennessee clients. In it, Mr. Gradante wrote that after repeated unsuccessful attempts to contact Bayou staff and outside service providers throughout August, Hennessee Group officials contacted the Securities and Exchange Commission and the Federal Bureau of Investigation, as well as "every other federal and state authority we thought might have jurisdiction over the matter… We are continuing to cooperate with these prosecutors in their investigation."
Mr. Gradante's letter said press reports that suggested Hennessee Group accepts fees from hedge funds in exchange for recommending them "mischaracterize our services and business… Our business is operated in exactly the way we have described to you. We provide advisory services solely to you, our clients, and we receive no compensation other than what we have disclosed to you. We do not raise money for hedge funds; do not receive compensation from hedge funds for raising money for them; do not receive secret fees; and do not believe that we have a conflict of interest when we evaluate hedge funds for you."
Mr. Gradante went on to write that the firm's clients may request that hedge funds in which they invest pay some or all of Hennessee Group's fees, either through directing brokerage commissions to Hennessee for certain securities transactions through a broker or in cash. Mr. Gradante said all of those manager rebates are credited by Hennessee toward client fees. "Furthermore, it is an entirely elective payment option that each client, and each hedge fund, is free to reject, and is fully disclosed to both you and the hedge funds," Mr. Gradante wrote.
A client of Hennessee Group, who requested anonymity, said his understanding of the fee structure matched Mr. Gradante's description.
Silver Creek and Hennessee are part of small group of institutional hedge funds intermediaries caught up in alleged hedge fund frauds, said Randy Shain, executive vice president of First Advantage CoreFacts LLC., Chantilly, Va., and its BackTrack Reports subsidiary. New York-based BackTrack Reports conducts background investigations on hedge funds and their proprietors.
"It is very rare for institutional investors, like hedge funds of funds, to be involved in a hedge fund fraud. They do a much better job of due diligence than high-net-worth investors, for example. Institutions know that the ‘people due diligence' is so important, so essential to competent due diligence," Mr. Shain said.
So-called "people due diligence" is one of the most important due diligence factors for hedge funds-of-funds manager Harris Alternatives LLC, Chicago, said Justin Sheperd, partner and portfolio manager. Harris Alternatives manages $6.8 billion for a largely institutional client base and has not invested in Bayou.
Harris goes beyond checking references provided by the hedge funds, talking to past employers and acquaintances turned up by Harris' own resources, Mr. Sheperd said. "At the end of the day, it's the character of hedge fund managers that matters the most," he said.
"The quality of due diligence done by hedge funds of funds is a real question for institutional investors," said Barbara Lucas, managing director of Capital Market Risk Advisers Inc., New York, a risk management and investment consulting firm.
In the Bayou case, Ms. Lucas said, "it's very hard to tell what really happened, whether investors were lied to by Bayou. But there seem to be things that slipped through the cracks of normal due diligence. …"
"Institutional investors coming into hedge funds through funds of funds assume that their intermediaries are conducting appropriate due diligence for the fee they pay. This is something they need to check and be sure about," Ms. Lucas added.