Commentary: Refco: The Reckoning

Perils lurk in the shadows of private finance. Will investors learn?

If investors needed a wake-up call about the potentially dangerous flood of money surging into private equity firms and hedge funds, they're getting it with the collapse of Refco Inc. (RFX ) Clients continue to flee the giant derivatives dealer that buyout legend Thomas H. Lee took public just two months ago. In bankruptcy court, other investment groups haggle over Refco's surviving futures-trading business. And federal investigators are expanding their search for wrongdoers beyond ousted CEO Phillip R. Bennett. He has been charged with fraud in a scheme that employed a New Jersey hedge fund to help hide $430 million in debt owed to his former company.

After a series of hedge-fund implosions in recent months, the Refco fiasco offers only the latest warning that peril lurks in arcane and secretive corners of the financial world. Investors frustrated with a lackluster stock market have pumped more than $1 trillion into lightly regulated hedge funds and private-equity firms, much of it in the past few years. Both types of investment pools promise outsize returns, and the technical distinctions between them are blurring. They are snapping up dozens of companies. Investment banks and auditors are rushing to help them realize gains by reselling those acquisitions or taking them public. Impressed investors are now giving the funds and buyout firms even more money -- starting the cycle all over again.

But some experts fear that too much money chasing too few good opportunities for investment will lead to further hedge fund blowups -- and possibly to future Refcos. Pointing to the late 1980s, Steven Kaplan, a professor at the University of Chicago Graduate School of Business, says: "The last time you had so much capital sloshing around and easy [lending] markets, a lot of deals were done with marginal companies that probably should not have been."

Responsibility doesn't rest only with the cash-bloated funds and buyout groups. Major investment banks and auditors are giving stamps of approval to initial public offerings that emerge from the murky private-investment world. Some sophisticated investors are growing increasingly distrustful. "There is no way you can rely on an auditor or an investment bank for a seal of approval or a guarantee of no chicanery," says veteran money manager Michael F. Holland at Holland & Co. "The lesson to be learned from Refco is that you must do sleuth work yourself."

Yet the flood of money continues. Investors have handed over at least $65 billion to buyout firms so far this year and are expected to give them a further $85 billion in 2006, estimates one banker who tracks the field. Meantime, investors gave hedge funds an additional $9 billion in the third quarter of this year alone, according to Hedge Fund Research Inc. Nothing if not confident, Thomas H. Lee Partners is starting a new $7.5 billion fund, despite the Refco scandal, says a person familiar with the Boston firm. And investors are already lining up. The Securities & Exchange Commission is moving ahead with a mild new requirement that hedge-fund managers must register with the agency beginning in February. But most advocates and critics of the rule agree that it will only make a modest difference.

Refco's bankruptcy proceedings have focused on the auctioning of its most valuable asset: an ever-shrinking futures brokerage. The company agreed on Oct. 17 to sell the unit for $768 million to private-equity investor J. Christopher Flowers. But Flowers backed out after a group of rivals turned up in bankruptcy court in New York this week, including Interactive Brokers Group LLC and an investment arm of Dubai's government. The court plans to auction the unit on Nov. 9, but customers keep streaming out, leaving Refco with $3.4 billion of deposits, down from $7.5 billion before Bennett's alleged misdeeds came to light.

Investing in the companies that buyout firms and hedge funds take public is risky. The returns of such IPOs so far this year range from more than 100% to complete wipeouts like Refco. The number of these initial offerings has nearly tripled in the past four years, to 65 so far this year, according to research firm Dealogic. These IPOs account for 55% of all of the initial-offering money raised in 2005.

Lee Partners has told its investors that it did extensive due diligence before buying into Refco last year. "This is not Enron; this is a real business," says a person familiar with Lee, pointing to the vigorous bidding for Refco's remains. Still, Lee's recent IPO track record isn't pretty. The three companies it took public prior to Refco are trading below their offering price by an average of 26%. The firm's long-term results are much better: 11 out of 12 earlier deals have been big winners. Recent losers such as Warner Music haven't been on the market long enough to make a final judgment, argues the person familiar with Lee.

In theory, Wall Street has gatekeepers -- the major investment banks -- to scrutinize dubious deals. But in practice, the banks are hungry for fees and sometimes appear to take this critical job more lightly than the public expects. The federal courts have held that banks underwriting securities can bear legal responsibility to investigate and verify the information presented to investors in a public offering. That's what U.S. District Judge Denise Cote of New York wrote in a ruling last December in the tangle of litigation that followed WorldCom's collapse in 2002. But after years of reforms designed to avoid a repeat of Wall Street scandals, says John C. Coffee, a securities-law professor at Columbia University Law School, "our current system of due diligence by underwriters seems to be dysfunctional." Investment banks, he adds, "are doing inadequate due diligence to catch the kind of frauds that should be caught."

Indeed, even when serious problems surface, some banks are still willing to take companies public. Refco's underwriters -- Credit Suisse First Boston (CSR ), Goldman Sachs (GS ), and Bank of America (BAC ) -- may have been ignorant of Bennett's alleged fraud. But they moved ahead with the IPO even though there were substantial deficiencies in the way the company handled its books, according to its own prospectus. The shareholder lawsuits are already flying. Bank of America says it will defend itself "vigorously" in court. CSFB and Goldman declined comment.

Outwitting the Auditors

Up until September -- a month after the IPO -- Refco's auditor, Grant Thornton LLP, had failed to pick up on Bennett's alleged concealment of a rogue $430 million receivable. The accounting firm did warn of the financial-control problems. But Bennett seems to have outwitted the auditor by shuffling the bad debt between his private company and a New Jersey hedge fund, according to the federal criminal complaint. The shifts, to the Liberty Corner fund, allegedly let him avoid admitting a related-party transaction, an admission that would have weakened Refco's financial standing. Grant Thornton was assured that the highly mobile debt was owed by an outside party that could repay it, according to a person familiar with the situation. The auditor was willing to believe this claim because Refco was in the business of lending money, this person says. (Bennett has paid off the debt with a bank loan.)

Assessing the enormous array of complex transactions such as the ones that Refco handled has become an "auditor's nightmare," says Robert Willens, an accounting-industry analyst at Lehman Brothers (LEH ) Inc. Nevertheless, "it was surprising that the auditors wouldn't have been checking very carefully on an issue like this," Donald C. Langevoort, a securities-law authority at Georgetown University in Washington, contends. Grant Thornton said in a statement that it had acted appropriately, noting that Bennett's deception evaded "numerous other detailed financial inspections performed by many of the most well-respected financial institutions in the country." Liberty Corner has stated that it did not know about Bennett's alleged fraud. A hearing in the criminal case was scheduled for Oct. 31 in federal court in New York.

Repeated Scrapes

One might have approached Refco with skepticism. Throughout the 1990s it had repeated scrapes with regulators, and its commodities unit was hardly the type of stable, dull business that buyout firms have traditionally targeted. But Bennett, who became CEO in 1998, was perceived as having cleaned up the company. Buying a majority stake in Refco in 2004 enabled Lee Partners to tap the white-hot futures-trading market. As a titan in the rough-and-tumble futures arena, Refco no doubt looked as if it might repeat the success of the Chicago Mercantile Exchange, which has seen its stock soar from a $35 offering price in late 2002 to about $360 now.

Don't weep for Lee Partners or its investors. Even with the Refco debacle, they'll come out just fine. First, Lee sold a big chunk of its Refco stake in the Aug. 11 IPO, clearing $210 million. The firm retains 38% of Refco, worth more than $1.4 billion two weeks ago but now likely to get wiped out in the bankruptcy. Nevertheless, this deal was merely one out of 20 investments made by one of Lee's private-equity funds. "Even with a total write-down of the Refco deal, that Lee fund still has pretty terrific numbers," says Josh Lerner, a professor at Harvard Business School. The fund in question is generating an overall return of more than 30%, says the person familiar with the Lee firm.

And what about the regulators? The SEC relies on information provided by company directors, officers, auditors, and bankers -- and tries to hold them accountable if anything goes wrong. "Congress has never asked the SEC to do more than eyeball" documents to see that they conform to disclosure standards, says Georgetown's Langevoort. The Refco trauma may lead to calls for tougher SEC oversight, but "almost no amount of regulation would have cured or caught" a CEO determined to fudge the numbers, says David B.H. Martin, former director of the SEC's division of corporate finance.

Maybe so. But Refco's fiasco "points to failures at all levels," says Barbara Roper, director of investor protection at the Consumer Federation of America. "How many blowups do we have to suffer before investment banks, auditors, regulators, and sophisticated investors start to take these risks seriously?"

By Emily Thornton, with Aaron Pressman in Boston, Joseph Weber in Chicago, and Amy Borrus in Washington

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