Fund investors turn to private investigators

The recent to turn to private investigators to digdeeper into fund managers and toconduct due diligence

A spate of hedge fund-related scandals in recent months has increased concern among investors about fraud, and is prompting many to turn to private investigators to dig deeper into fund managers and to conduct due diligence. "What's going on with Bayou, Refco and Man Financial makes people nervous. And nervous people call investigators," says Michael Thomas, a partner at Caveat, a Washington DC-based corporate investigation firm.

Intelysis, a multinational corporate investigation firm, has experienced a similar response from investors, says James Brenner, a New Jersey-based principal at the company. "Since August, the phone has been ringing quite often." The firm has seen a 60% increase in its hedge fund due diligence business since last year, with investigations in Europe, the Cayman Islands and Israel.

One of the latest scandals to hit the hedge fund sector involves Man Financial, the US brokerage arm of London-based alternative investment provider Man Group. In late September, C Clark Hodgson Jr, the receiver for troubled hedge fund Philadelphia Alternative Asset Management (PAAM), filed a motion with the Eastern Pennsylvania district court requesting Man Financial be held in contempt of court for not turning over documents relevant to the receiver's analysis of PAAM's assets.

Fraud complaint

The motion follows an investigation by the US Commodity Futures Trading Commission (CFTC) into PAAM and its president, Paul Eustace, for alleged fraud. On June 22, the CFTC filed a complaint accusing PAAM and Eustace of making false statements to investors and misrepresenting the value of its assets. The regulator also obtained a restraining order freezing PAAM's assets on June 23, appointing Hodgson as temporary receiver.

Hodgson's motion, filed on September 27, claims Man refused to hand over documents relating to particular trades and back-dated transactions. In addition, the motion states that the firm has not produced any tapes, emails, correspondence, computer records or notes relating to Eustace's dealings with Thomas Gilmartin, a senior vice-president at Man Financial, and identified by Hodgson as the broker who had most contact with Eustace.

The receiver's motion also alleges that Man Financial "permitted" Eustace to open two offshore funds, referred to as the 10 Account and the 50 Account, in his capacity as president of the offshore fund – even though no such position existed and Eustace did not have the authority to open these accounts. While the results of the 10 Account were disclosed to investors and UBS, the offshore fund's fund administrator, the 50 Account was hidden from investors. The motion alleges that losing positions were moved from the 10 Account and dumped in the 50 Account, and that "Man Financial had knowledge of the conduct… and consented to and assisted in that conduct". As of June 23, Man Financial recorded a deficit of $175 million in the 50 Account, the motion says.

Man Group has hit back at the claims. In its response, also filed with the East Pennsylvania district court on October 20, the firm says the motion for contempt of court includes "irrelevant, scandalous and prejudicial allegations [that] will potentially result in damage to Man Financial's business reputation and goodwill, as well as unduly prejudice Man Financial before [the] court". It calls for the court to deny the motion because it has "no basis in fact or law".

But it is not just Man and PAAM that have come under the regulators' microscope. In September, the US attorney for the Southern District of New York, David Kelley, filed a civil complaint against Stamford, Connecticut-based hedge fund Bayou Asset Management for alleged fraud (Risk October 2005, page 16). In a separate case, the US Securities and Exchange Commission filed a complaint with the Southern District of New York district court in mid-October against Wood River Capital Management, a hedge fund based in San Francisco and Idaho. According to the complaint, Wood River and its founder John Whittier made misrepresentations to investors regarding the oversight and diversification of the fund. No audits were conducted, while the firm invested a staggering 65% of its assets into one company – EndWave, a California-based electronic components firm.

Given some of these revelations, it's unsurprising that investors are keen to delve deeper into the backgrounds of fund managers and to find out more on auditing firms, performance and risk management of the fund. According to Intelysis's Brenner, the investigation firm has recently identified several managers who have been involved in federal securities litigation. "The cases may be three to five years old, but it's making our clients pause – to determine whether the cases are meritorious suits or a fallout from some large class action lawsuit," says Brenner.

Caveat's Thomas says investors' focus is broader than the financial markets when making investment decisions, and with good reason. Something as simple as a driving under the influence of alcohol or drugs charge might cause investors to withdraw cash from a fund manager, he says. Investors don't want there to be any kind of question mark hanging over the integrity, or principles, of a manager.

Jayne Jung