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Commonfund CommentaryWere There Red Flags?By Jim Meisner, Managing Director, Marketable Alternative StrategiesThe headlines are staggering. How could a $50 billion Ponzi scheme continue unabated for ten years and evade the due diligence of investors and regulatory oversight by the SEC? The impacts of Bernard Madoff’s actions are sure to be felt across the hedge fund industry, and particularly among fund of funds. But more important is the impact on nonprofit investors, many of whom are now severely damaged: already a number of foundations and charitable organizations have announced that they will cease operations and no longer fund important programs. Other operating nonprofits will be forced to cut expenses and programs. Often lost in headlines of scandal and greed is this human toll that the collapse of the Madoff enterprise has created, and many are asking “what went wrong?”Looking ahead, what can investors do to prevent future occurrences of this type? Were there red flags as some have alleged? Was regulatory oversight lax? While many of the facts surrounding the Madoff case have yet to come to the fore, there were a number of warning signs that reinforce the importance of thorough and independent due diligence, particularly for marketable alternative strategies.We recognize that no one is entirely immune from manager risks and our intent here is not to cast aspersions on other organizations. Instead, highlighted below are some basic due diligence checks that should precede any hedge fund investment in order to avoid fraud. Of course, comprehensive due diligence goes well beyond these issues, and should include a thorough understanding of the investment process, but this is always a good place to start. If you invest in marketable alternatives through a “fund of funds” structure, it is important that you are confident in the thoroughness of your fund of funds manager to ask these questions of each underlying hedge fund in the portfolio.Where are assets held in custody?An independent and reputable custodian can serve to authenticate the holdings of the manager; and reporting from the custodian provides an important level of transparency. Madoff self-custodied assets which made it easier to hide their program from investors.Who is the firm’s auditor?While the audit industry in recent years has not been immune from its own problems, it is imperative that each of your underlying hedge fund managers engage a credible and known audit firm. Madoff, as with much of its operations, was billed as a close-knit family business that included an affiliation with a 3-person audit firm, certainly not with sufficient resources to be able to provide a comprehensive review of a firm the size of the Madoff enterprise.How do they generate returns?Be wary of a track record that appears to be too good to be true. In addition, the track record must be consistent with the strategy that is employed. For example, Madoff’s professed investment strategy of buying stocks and hedging them by buying index puts and selling index calls should not have generated positive returns during the bear market years of 2000-2002. Further, consistently positive returns with little volatility should be viewed with a healthy dose of skepticism.Are there any background, legal or regulatory issues?A simple web search turned up numerous red flags in the case of Madoff. For example, there was an extensive article in the May 7, 2001 issue of Barron’s that highlighted significant concerns about the Madoff funds. Investors should conduct thorough background, legal and regulatory checks before investing in any fund.
Disclosure
No Commonfund investment program has any investment exposure to any Bernard L. Madoff investment fund. In 2003, Commonfund reviewed Madoff’s investment program and, like many other firms, found that its operations did not satisfy our due diligence process. |
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