The recent high-profile blowups of two hedge funds, Bayou Management and Wood River Capital Management, have raised an important question: What can hedge fund investors do to avoid getting burned by unscrupulous managers? The answer: Quite a bit, as long as you're willing to spend time or money vetting these investments.
That's not as hard as it may sound. As hedge funds have proliferated, so have resources for checking them out. For fees ranging from $1,000 to several thousand dollars, a growing number of hedge fund "sleuths" will conduct background checks on these secretive partnerships and their managers by searching for such red flags as bad credit histories and padded résumés. And thanks to the dissemination of information on the Internet, individual investors can tap into some of the same tools the professionals use. "There's a lot more information available online now than there was just a few years ago," says Jeffrey Brenner, principal at Intelysis, a Cherry Hill (N.J.) firm that does a booming business in hedge fund investigations.
The warning signs that Bayou and Wood River clients missed offer lessons for other investors -- many of whom rely heavily on personal recommendations when selecting funds in this clubby world. Among the most important: Verify the manager's credentials and the fund's claims, says Randy Shain, executive vice-president at First Advantage CoreFacts' (FADV ) New York-based investigative unit, which conducts background checks, known as the BackTrack Report. For example, a firm that Wood River named as outside auditor never performed any audit work for the fund, according to the Securities & Exchange Commission. And a lawsuit filed by the Jewish Federation of Metropolitan Chicago on Sept. 2 in U.S. District Court in Connecticut alleges that Bayou founder, Samuel Israel III, "advertised to investors" that he had been a head trader at New York hedge fund Omega Advisors. While employed at Omega, though, Israel had no discretion to call the shots on trades, the suit adds. "There were some major flashing lights," says Leslie Rahl, president of Capital Market Risk Advisors, a New York firm that specializes in hedge fund due diligence, among other things.
Meanwhile, Wood River investors could have spared themselves trouble by turning to the Internet. Indeed, an Intelysis search of various public databases -- including those maintained by federal and state criminal, civil, and bankruptcy courts -- dredged up enough pre-scandal dirt on the fund and its manager to raise serious concerns. These include a 2002 lawsuit initiated by Wood River's San Francisco landlord for failure to pay rent for three months and a tax lien filed by the state of Idaho on Dec. 1, 2004, for $86,527. "When you see a pattern, it's a warning to steer clear," Brenner says.
Don't think you can rest easy if you invest in a fund of funds, which spreads bets among a diversified array of hedge funds, or if you have a hedge fund adviser. Clients of some prominent hedge fund advisers -- including Hennessee Group -- were among those burned by Bayou. As a result, it's important to quiz these advisers on how they conduct due diligence on the hedge funds they select, says Chris Cutler, founder of Manager Analysis Services, a New York firm that specializes in hedge fund advisory services. You should also make sure they themselves have clean backgrounds.
If you're thinking about hiring a sleuth, first decide what kind of information you need. Investigative firms, such as Kroll (MMC ), Intelysis, and First Advantage CoreFacts, perform background checks on funds and their employees. Their fees range from $1,000 to $30,000, depending on the number of funds or managers involved. These firms call former employers, track down credit reports, and contact auditors and administrators to verify that they're on the job. To vet obscure auditors, they research those firms' owners and principals. If a manager has spent time overseas, they'll investigate there.
Other hedge fund advisory services assess whether a fund's investment strategy is right for a client's portfolio and size up the managers' investment credentials. They can use complex statistical tools to predict how a fund will perform under a variety of conditions, says Peter Rajsingh, executive vice-president at vFinance, a diversified financial services firm that invests in hedge funds. They also probe for checks and balances designed to prevent fraud. For example, a fund should employ an outside firm to verify the portfolio's value, says Edward Hawthorne, managing principal at Capco, a New York-based financial-services consulting firm. That's something Wood River did not do, according to the SEC.
If you don't want to pay investigators' fees, you can take a number of steps on your own. Check whether a manager had run-ins with regulators by perusing Web sites maintained by the SEC and state securities agencies (table). Starting in February, the SEC will require hedge funds with more than $25 million in assets to register with it by filing form ADV. (Some funds do this voluntarily now.) This form lists SEC disciplinary actions against a firm, says Sean Laird, a Philadelphia-based vice-president at PNC Advisors (PNC ), which works with wealthy clients. Meanwhile, if a manager is registered as a broker with the NASD -- or has been registered within the past two years -- look up employment and disciplinary records on the NASD site.
To find federal district, bankruptcy, and appeals court records, search PACER, a service sponsored by the federal judiciary that charges 8 cents a page. If you know where your hedge fund manager lives, you may be able to get access to court records in that jurisdiction for free through www.uscourts.gov/courtlinks/. To conduct a more comprehensive search that includes federal and state court documents, you can pay for services such as LexisNexis. On LexisNexis, you can also search for liens and news articles.
For a quick, free search of various public records, go to pretrieve.com. "It won't give you everything, but with one click you can hit a variety of Web sites," says Intelysis' Brenner. A lien against Wood River popped up this way. Do-it-yourself searches have obstacles. Not all courts publish case information on the Net or through PACER. Private investigators say they sometimes have to visit courts. Moreover, without knowing your hedge fund manager's past addresses -- something private investigators can get through nonpublic databases -- you may not hit all relevant jurisdictions. To get your hands on credit reports and verify résumés with past employers and schools, ask the manager to sign a consent form, Brenner advises.
How can you make sure your fund of funds is taking due diligence seriously? Ask to see copies of background checks they've commissioned. They may not let you take them, but you can ask to look them over in the office.
When examining funds, look for policies designed to prevent fraud. Back-office employees -- who keep track of investors' money -- should report to someone aside from the manager. That way, "if they see anything wrong, they can report it," Rahl says. Ask who has authority to transfer money. "Two signatures are better than one," says Jose Dios, CEO of Global Hedge Strategies, a venture between Citigroup (C ) and Pacific Alternative Asset Management Co., an Irvine (Calif.) firm that sponsors hedge funds of funds.
Make sure a fund employs reputable, independent firms to perform audits, prepare client statements, and assign prices to hard-to-value securities, such as convertible bonds. And favor funds that trade through independent brokers. Why? When a fund uses an affiliated broker, as Bayou did, the setup undercuts the fund's motivation to bargain over trading commissions. In the case of a fund of funds, the administrator should calculate the net asset value based on valuation data it receives from the underlying hedge funds -- not from the fund-of-funds manager, Dios adds. With professional hedge fund sleuths saying they're finding red flags in about 10% of all due diligence probes, you can't afford not to be vigilant.
By Anne Tergesen