Check out the past

As money continues to flow into the hedge fund industry, so the risk of fraud increases. What are the tell-tale signs?

Fraud is one of the worst fears of hedge fund investors and several recent blow-ups within the industry have focused attention on what is a very real threat.

However, investing in a sub-par manager and not realising the envisioned returns is another risk investors want to minimise. Comprehensive background investigations can play an important role in weeding out managers who pose a strong fraud risk.

Effective due diligence can also be an important tool used to identify those managers whose backgrounds generally suggest that the possible reward of investment is not worth the evident risk of potential for fraud.

The first step an investor can take when conducting background due diligence is to use the CV the managers of that fund have provided. Investors may ask themselves whether the representations on the CV check out.

verification needed

Investors must verify that the managers worked where they say they did, when they claim they did, and in the stated positions ' one of the first things perpetrators of fraud will do is make investors feel comfortable with their past professional experiences, even if these are fabricated.

One should also keep in mind there are also those managers not intending to commit financial fraud, but who nonetheless misrepresent themselves in their CV.

A manager may state he was vice-president of a particular firm, when in fact he was an associate and consequently may not possess the skills and experience his CV claims, not to mention what it takes to make his current fund a success.

When examining managers' CVs, investors must also ask themselves whether the credentials make sense in relation to what the investor is expecting the manager to deliver. Claiming a PhD in chemistry or having worked in venture capital may be accurate, but that does not necessarily qualify the manager to run a convertible arbitrage fund.

But verifying the CV is only one part of the job. The tougher part is being proactive in identifying those things in manager's backgrounds that have been omitted from resumes.

This is achieved by broadly searching public records such as news, court, regulatory and corporate records. Certain managers' names are common, making it difficult to determine whether the person branded a failed mutual fund manager in an article eight years ago is in fact the subject. Cross referencing information becomes vital.

Based upon information investors know of a manager from initial research ' such as his middle initial, home address or spouse's name ' they can deduce whether important facts regard the manager in whom they are interested.

Identifying the truth

Proactively identifying these non-disclosed entities is extremely important ' fraudsters naturally will seek to hide a checkered past. In fact, it is rare that someone with a spotless background will commit fraud and people demonstrate patterns of behaviour throughout their careers and lives.

A manager who has run two funds where they have been alleged as misrepresenting returns on two seperate occasions is more likely displaying a 'modus operandi' than just bad luck or mere happenstance.

Though it may happen that someone with no prior issues will commit fraud, a pattern of behaviour is telling.

Litigation research is another cornerstone to use to identify a strong fraud risk. Most investors' first concern is to know about lawsuits a prospective manager has faced. If there are previous fraud issues in the manager's background one often need not conduct any further background due diligence. But consider other litigation issues ' simply because a manager has no fraud cases in their past, this does not mean their history of litigation does not point towards certain concerns investors must seriously consider.

Some managers sue their investors, some have the tendency to get sued by former employees, others may have a series of driving while intoxicated arrests. Even an ongoing divorce can be important because it might take the manager's attention away from running their fund.

The Seghers case

Conrad Seghers highlights the importance of understanding managers' litigation backgrounds. Seghers received more than $40m from the Chicago Art Institute, but earlier this year abruptly lost approximately $20m of that mandate, with much of the remaining money still being sought. Was a fraud perpetrated? This is for the courts to decide and feedback so far indicates that it was not. However, Seghers had some very interesting court issues in his background before receiving money from the Chicago Art Institute.

In 1994 Seghers had sued his medical school, essentially arguing that several people at the school, despite being aware of his epilepsy, pushed him to work long hours, standing, unnecessarily.

Then in July 2000, according to police records, Seghers was approached by a police officer after being observed trying to enter a hotel suite that was locked, and for becoming 'rude'. When the police arrived, they found Seghers in his car and asked him if he needed help getting a door unlocked. When Seghers tried to leave, the police officer unsuccessfully advised him not to. Several blocks later he was pulled over and arrested. He pled no contest, according to the court record. The judge's subsequent finding was that the 'evidence substantiates [Seghers'] guilt.' On September 19, 2000, he was fined $500 and received 300 days' probation.

An additional aspect of background due diligence which can be extremely important to both fraud risk and assessing general manager ability is interviewing independent sources. Nearly every investor contacts references provided by the manager.

However, better sources to contact are those familiar with a manager, but who are not on the manager's provided list. An ex-boss who did not make the manager's reference list, or the person who left the fund a year ago in which you are now looking to invest are good starting points. Such independent sources are identified through earlier public records research, the news, secretary of state documents, litigation records and so forth.

These sources might have very different things to say about the manager than the references that were self-provided. Maybe they will comment about an abrasive management style or describe a tendency towards style drift. There is also the chance that a source, for example, will end up discussing that while he was at the fund two years ago he witnessed a levelling-out of returns.

While the first two observations are valuable and can cause an investor to request a side letter or pay closer attention than they otherwise would have to certain details in the future, the third observation is a red light warning of possible fraud.

This increased concern of fraud in hedge funds stems from the flood of money coming into the industry over the past few years. With the money has come a huge increase in the number of managers, many from large hedge funds where they held junior positions. But many others are coming from less traditional backgrounds, simply following what to many may seem like easy money. Add to that the tight economy and the financial community's substantial job cuts and you have a herd of people from investment bankers to pharmacists setting up hedge funds.

It is of concern that the calibre of hedge fund managers as experienced specialists is being challenged. Unfortunately, maybe more alarming is that in the course of this industry change, fraud perpetrators who follow the hot industry du jour are also creeping in. As they blend into the much more populated and less known crowd of today's hedge fund managers, it is increasingly more difficult to ferret them out.

The very nature of the hedge fund industry, with its lack of transparency and lack of regulation, does not help the fight against fraud. Neither does the capacity issue which hedge fund investors face. Because investors are shut out of certain established and successful funds, they find themselves going to newer managers who come with the risk of more unknowns.

Investors may also sometimes feel compelled to go after new managers because the best returns are often found in a fund's first few years. Though there are many ways in which fraud may have an easier time harvesting in hedge funds, the reality is that fraud creeps into any hot sector, from telecommunications to real estate, from the internet to hedge funds.

imposing regulation

Currently, America's Securities and Exchange Commission (SEC) is looking at the industry and determining what regulations it may want to impose to prevent or minimise the risk of fraud. With structured products being developed and new distribution channels being explored, hedge funds are moving ever closer to the retail investor, either directly or through their pension funds and it is no surprise the SEC is paying more attention.

In turn the industry is studying ways to self-regulate so that important aspects that allow the business to succeed, like the protection of proprietary trading strategy and the ability for agile investment moves not being telegraphed, are not altered by people outside the industry.

To gain access to pension funds and other new investors, hedge funds have found success through the fund of funds structure. Fund of funds combine expert understanding and research of hedge funds with diversification, to minimise risk, and outsource specialised due diligence needs. The fund of funds community is on the front lines of fraud prevention and quality manager selection. Clients are paying for the guidance these firms provide.

In the end, however, there is no sure-fire way to prevent fraud. No matter how diligent a fund of funds or an individual investor is, if people want to steal, they will find a way. That notwithstanding, bringing together thoughtful and layered due diligence to hedge fund investing is the best way to minimise the risks of the fraud threat and sub-par manager selection.

Investors working on their own have to lie in their own bed, but if certain fund of funds do not succeed in this regard, they will be held liable by their ultimate authority, their clients, who will not hesitate in moving their money elsewhere.

Key Points

Investors must look closely at what is on a manager's CV, but also what has been omitted.

Hedge funds is a ~hot' industry and will therefore inevitably attract fraudsters.

SEC is looking st redressing regulations in order to minimise fraud.

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