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Hedge Funds Stung by Madoff Scandal

Dec 22, 2008 | Parker Waichman LLP Hedge fund managers could stand to shoulder a lot of blame for their clients losses if they invested with Bernard Madoff.  According to a report in the Associated Press, many hedge funds that invested clients' money with Madoff failed to perform due diligence, and for years missed or ignored warning signs that something was amiss with his investment advisory business.

The 70-year-old Madoff was arrested on one count of securities fraud late last week.  Madoff - once a chairman of the Nasdaq stock exchange - is the founder and primary owner of Bernard L. Madoff Investment Securities LLC. The firm is primarily known for its business in market-making, or serving as the middleman between buyers and sellers of shares. However, Madoff also oversaw an investment-advisory business that managed money for high-net-worth individuals, hedge funds and other institutions.

According to the FBI complaint against Madoff, that business was largely a Ponzi scheme.  The FBI said Madoff  “deceived investors by operating a securities business in which he traded and lost investor money, and then paid certain investors purported returns on investment with the principal received from other, different investors, which resulted in losses of approximately billions of dollars.” Madoff reportedly told employees that his fraud could cost investors as much as $50 billion.  

Wealthy investors and charities have been among those hardest hit by the Madoff fraud.  But hedge funds have also sustained substantial losses.  According to the Associated Press, hedge funds, which usually have minimum investment amounts of above $250,000, typically employ aggressive investing strategies.  In return hedge fund managers are supposed to employ "exceptional due diligence" when it comes to choosing investments, the Associated Press said.

But in many cases, that may not happen when hedge funds put their money with Madoff.. Madoff was notoriously secretive when it came to revealing his supposed investment strategy, and the lack of details he provided should have been a red flag to hedge fund managers.  

The Associated Press also listed several other factors that should have caused hedge managers to reconsider their Madoff investments.  Among those:

  • A lack of  third-party oversight.  According to the Associated Press, Madoff used Friehling & Horowitz in New City, N.Y. as an outside auditor.  This was an unknown three-person shop, not a large firm that specialized in institutions.
  • No one could replicate Madoff's investment strategy, but his returns were smooth and steady.
  • A major conflict of interest, in that one of Madoff's sons was the chief compliance officer.

It's hard to imagine that hedge fund managers, responsible for investing such huge sums of money, would fail to perform due diligence.  But as the Associated Press points out, the lack of scrutiny afforded Madoff by the funds could have been the result of two factors.  The first was hype that surrounded Madoff, both as a trusted investment advisor and a long-time fixture on Wall Street.

The other might have been costs associated with performing due diligence.  According to the Associated Press, due diligence costs between $50,000 and $100,000 per hedge fund.   That means the cost a performing due diligence on 10 funds for a fund of fund portfolio can reach $1 million, something many managers find hard to justify, the Associated Press said.

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