Thinking of investing in a hedge fund? Here are some tips for sniffing out potential fraud.
By ROB CURRAN
In the age of Madoff, small investors are rightfully leery of hedge funds with eye-popping returns and a low profile. But how do you size up the risk of fraud?
You might take some advice from professional investigators, who dig into hedge funds on behalf of potential institutional investors, searching for irregularities and trying to tell if the managers are trustworthy.
So, what warning signs do these investigators say you should watch for? Here are some of the biggest.
The fund came to you.
While it’s not unheard of for a hedge fund to approach a wealthy individual, reputable funds usually concentrate their prospecting on institutional investors, says Randy Shain, executive vice president of First Advantage Litigation Consulting, who has been looking into hedge funds for 20 years. Always ask for the names of a fund’s institutional investors, then contact them to verify that they are investors and have no qualms about the fund’s legitimacy.
The Fund has Done Too Well
The biggest hint that something was amiss with Bernie Madoff’s strategy was that it never missed. “Be skeptical: Very few people are better than everybody else all of the time,” says Chris Addy, chief executive of Castle Hall Alternatives, which appraises hedge funds for institutional investors.
So, if you’re looking at a fund with exceptional performance, be sure to ask the manager to explain it. “If a manager cannot provide sensible answers to sensible questions or is evasive…move on,” says Mr. Addy.
Janaya Moscony, a former Securities and Exchange Commission examiner, agrees. The fraudulent funds she encountered at the SEC shared a tendency to obfuscate, she says, adding that she would be wary of any fund that can’t answer questions in “layman’s terms.”
The fund’s watchdogs look suspect.
A fund’s watchdogs—such as bank, broker and auditor—each have some level of responsibility to monitor a fund’s finances, Ms Moscony says. So, the credibility of these third parties is important. Auditors are required to enroll in the American Institute of Certified Public Accountants’ peer-review program; you can search the reviews in the public-file section of AICPA.org. If the auditor doesn’t appear in the records, it should arouse suspicion.
Also look into potential conflicts of interest between the fund and its watchdogs, says Mr. Shain of First Advantage. Consider the arrangement Mr. Madoff had set up: He did his own brokerage services in-house—a fact that he long disclosed. This allowed him to falsify trade-execution data and statements of his returns.
Most funds now open their books to an independent administrator, which verifies performance and sends statements to clients. While the administrator likely won’t share the statements with a potential investor, Mr. Shain recommends contacting the agent to make sure the fund is in good standing.
What’s more, check all performance and asset-size claims made by the fund against bank statements and auditor accounts, whenever possible. “Call [the bank] to see if the money is there,” says Lorenzo Di Mattia, manager of Sibilla Global Fund. “It’s really hard to be a fraud if you have money in the bank and an auditor.”
Before you hand over money to a portfolio manager, familiarize yourself with his career and character. When hedge funds blow up, “a lot of the time they feature someone who had significant things in their history that don’t add up,” says Mr. Shain.
To see how a résumé checks out, Mr. Shain says, pick up the phone and call the manager’s former boss and former colleagues. Michael Allison, chairman and chief executive of International Business Research, which among other things conducts due-diligence investigations for prospective hedge-fund investors, advises another bit of résumé checking. He suggests requesting a release waiver from managers to access their records from higher education, the military and any government jobs.
Colleges, in particular. One of the areas “we see flags a lot is the area of academic credentials,” Mr. Allison says.
There’s trouble in the fund’s past…
Mr. Shain does a range of searches in public records to hunt down anything untoward in a firm’s history, including looking at corporate and court records. One of the most important details to establish is the credit history of the firm, he says. Start on the firm’s Web site, which should provide the street address to avoid confusion with similarly named entities. From there, use a service to check on the firm’s credit history; for instance, Dun & Bradstreet offers a report for $59.99.
Other places to look for the nitty-gritty on the firm include industry newsletters and analyst reports, Mr. Shain says. Next, check the Securities and Exchange Commission’s website, SEC.gov. While hedge funds are not required to register or report to the SEC, most fund managers are required to fill out an “ADV form,” the disclosure of their track record in the securities industry for investment advisers. Search managers by name in the Investment Adviser Public Disclosure link on the SEC site, and you can read these forms.
HedgeFund.net, a fund-data provider owned by Channel Capital Group Inc., recommends contacting fund officials and posing pointed questions. For instance, the site advises asking the fund’s lawyer or compliance department if the fund has ever been the subject of a public or private investigation.
…or the manager’s.
This is the trickiest part for an amateur: searching out the legal history of a fund manager.
First, make sure you are looking at the records of the right person, particularly if the manager has a common name. “The more common the name, the more difficult that process is, particularly when you don’t have any of the common identifying information such as date of birth or Social Security numbers,” says Andrew Harris, chief executive of investigative firm Bishops Services.
Mr. Shain likes to start this part of the investigation with services such as LocatePlus, which provides access to its databases of names, addresses, dates of birth and, in some cases, Social Security numbers starting at about $25 a month. Be sure to verify your findings on more than one service.
From there, you’ll be prepared for the toughest and most important part of the search: court records. Services such as Lexis-Nexis provide many case briefs and are a good place to start, but to find a more complete legal history, Mr. Shain says, you have to go to the state and local criminal and civil courts. The filing and retrieval systems vary; generally, the court clerk is the best person to contact about searching records.
For those averse to trawling through court records, Mr. Addy of Castle Hall says that many private investigators offer legal-background checks for about $1,000, a lot cheaper than a full due-diligence investigation.
Meanwhile, Mr. Allison of International Business Research says a search through newspaper clippings is worthwhile. “Some people have criminal records expunged, but you can’t expunge the press,” he says.
In the end, many experts advise trusting your gut. If your instincts tell you there’s something too good to be true about the fund, don’t invest.
Mr. Curran is a writer in Denton, Texas. He can be reached at firstname.lastname@example.org.