Fingers Crossed Behind Back

Hedge Fund Lies

Fingers Crossed Behind Back

Where is South Carolina Representative Joe Wilson when you need him? The shouting of “You Lie!”, although inappropriate during a joint session of congress, may just be warranted when pointed in the direction of Hedge Fund managers. In a new study entitled Trust and Delegation, authors Stephen Brown, William Goetzmann, Bing Liang, and Christopher Schwarz of New York University’s Stern School of Business dig deep into the due diligence reports performed on hedge funds from 2003-2008.

Performed by independent firms at the request of potential investors, due diligence reports offer quantitative and qualitative assessments of hedge fund operational risk (i.e., trust). Trust is of enormous importance to hedge fund investors. As the study points out:
 
“In part because the SEC does not allow hedge funds to engage in general solicitation, they have historically relied on trusted referrals as a prime distribution channel. This reliance on referrals and the limited transparency with respect to performance and operations are potential reasons why the Madoff scheme could last so long. Relatively few third party entities had access to performance statistics, information about firm auditors, pricing policies, self-administration and custody. In an environment lacking multiple, comparable sources of information about an agent’s credibility, trust is even more important, as are mechanisms to verify trustworthiness.”
 
So, what do Brown et al find in their study of 444 due diligence reports regarding the trustworthiness of hedge fund managers? Misrepresentation of legal and regulatory problems was, as they put it, “frequent” (21%). To be clear, this is not the percentage of hedge funds that had legal and regulatory problems, but rather those that lied about it during the due diligence investigation. In fact, 41% of the funds have some form of legal or regulatory problem.  Furthermore, the study found it necessary to separate these liars into two categories:
 
  1. “Strategic liars” - those who voluntarily disclosed a past problem, but additional legal or regulatory items that should have been disclosed were found by the due diligence company.
  2. “Liars” – these managers disclosed no past problems, but were later found to have legal or regulatory problems.
 
The above figures focused on past issues and the representation of these issues by fund managers. What about their current procedures? The study found that, “42% of the funds…had either a misrepresentation or an inconsistency problem.” An inconsistency problem occurs when the due diligence company is given an answer by the fund manager that conflicts with the answer given by an administrator or an auditor. These included, but were not limited to, internal control signature procedures for transferring funds, the pricing of portfolio assets, and performance data. 
 
In addition, the study comments on the use of these due diligence reports. They note that “…investors are selecting funds [for a due diligence report], on average, exactly at the peak of their performance and investor flows.” This is important for a couple of reasons. First, investors are chasing performance which is almost certainly a doomed investing strategy. Second, a suspect, untrustworthy manager (i.e., Bernie Madoff) may be inflating performance. As the study comments, “artificially high performance could attract more flows from other investors, allowing such things as performance smoothing or allowing fraudulent Ponzi schemes to continue over long periods.”
 
The lack of transparency in hedge funds must be compensated by high levels of trust for a prudent investor to invest. Brown, Goetzmann, Liang, and Schwarz offer a bleak indictment of hedge fund managers’ abilities to fully compensate investors with appropriate levels of trust. If trust is paramount, then be wary of your hedge fund investment. 
 
Let every eye negotiate for itself and trust no agent.”
– William Shakespeare