Signs That A Hedge Fund May Be Trouble

Date: Wednesday, May 2, 2007
Author: Penny Crosman, Wall Street and Technology

If your firm is a counterparty to a hedge fund, invests in or partially owns a hedge fund or places clients' money in a hedge fund, it may be somewhat accountable if the fund commits fraud, losses money or goes bankrupt. Of course, not all hedge funds are run by crooks or mismanaged, but hedge funds do have an 8.5% failure rate, and that rate is growing. In 2005, hedge funds lost $1 billion, in other words one dollar out of every thousand.

Speakers at a panel discussion at the SIFMA show today offered advice on sizing up a hedge fund before doing business with it.

Are the managers trustworthy? Brian Dawson, managing consultant at PA Consulting Group in New York, recommended assessing the experience and reputation of the hedge fund's principals and portfolio managers. Things to look for, he advised, include a business continuity plan and a succession plan for top executives. Simon Fludgate, principal, operational due diligence and risk at Aksia Research & Management, New York, recommended doing a background check on the top managers. "Don't skip the character issue," he warned. "One thing you can't change is a guy's ethics." He added that if a hedge fund doesn't have a competent COO, it will have problems. And if a fund uses an outside auditor you never heard of, don't invest in it. One Connecticut hedge fund had what appeared to be a legitimate outside auditor who turned out to be the president of the fund itself.

Does the fund have effective technology and infrastructure? Dawson recommended asking yourself, "Do they have the right technology, is it scalable, do they have access to reliable data?" If the firm doesn't have the right infrastructure in-house, make sure it partners with well-regarded service providers. Fludgate pointed out, "There's a big difference between being a good trader and being a good business man. Many hedge fund managers come from large investment banks, where they had a team of people behind them to take care of the back office." Added Michael Butowsky, partner in the New York law firm Mayer, Brown, Rowe and Maw, "These managers assume that everything magically happens for them the way it did at the investment bank." Fludgate said he's seen billion-dollar hedge funds running entirely off an Excel platform -- "People in some of these small firms don't understand there are better systems out there," he said.

Is the fund prepared for disaster? Another consideration is location and weather patterns, said Brian Ruane, executive vice president at Bank of New York. For tax reasons, he explained, many hedge funds are administered in the Cayman Islands and Bermuda. "If a hurricane hits and the firm has no contingency plan, it may be out of commission for two weeks," he said. He knows of instances where a hedge fund relocated during a disaster and its counterparties never knew it had moved.

The greatest legal risk for an investment bank or broker dealer doing business with a hedge fund, said Butowsky, comes when it can be determined that the firm should have known better. "The hedge fund itself is usually gone by the time a scandal breaks," he pointed out, therefore legitimate business partners can be left holding the bag. In one case of hedge fund fraud, JPMorgan Chase and Royal Bank of Scotland were both sued for placing clients' money in the fund. If a hedge fund goes bankrupt, again investing firms are vulnerable. One thing to verify is that the valuation of the firm is correct -- there may be less than meets the eye.

Looking on the bright side, Fludgate said he thinks the hedge fund industry is becoming almost self-regulated by the larger firms within its ranks and by savvy institutional investors. "You don't see large sums of money going to shady characters any more," he said.