Big frauds and small starts

Big frauds often start small. Unforgivably, they often start with small omissions.

Let’s take Bernard Madoff Investment Securities, whose managed accounts are now out $50 billion. It’s not clear whether that $50 billion was lost or if it was the supposed profits on $17 billion clients’ investments.

It is clear that the numbers are big; the numbers of big investors are too, and so are the numbers of people affected in charities and endowments.

But biggest of all is the extraordinary abuse of trust.

Let’s examine the trust equation, because that’s what bears on advisors the most. Client relationships are built on trust, for the basic reason that investment performance cannot be predicted beforehand. Clients expect advisors to have a process they can trust; a repeatable, self-correcting process. Otherwise, investing becomes a random series of tosses at a dart board.

Clients trust that advisors have a process for picking reliable managers. Similarly, with complex questions of estate planning, no advisor possesses all the skills to navigate the legal and accounting intricacies, and perhaps also the insurance issues, needed for a fail-safe plan. But clients trust advisors to know the people who have those skills.

Advisors live with those realities day in and day out.

And the Madoff affair is a humbling reminder of just how important it is to manage those realities every day.

What makes the Madoff affair so remarkable is just how many bright people failed to follow up on basic matters of due diligence. Not yield-chasing investors — who by all accounts wanted modest but steady returns — but their advisors —wealthy people in their own right, by many accounts — who mistook steadiness for safety.

Here’s what one fund-of-funds manager — an investor in Madoff — wrote about its due diligence process:

“The investment process is systematic and disciplined. Due diligence is at its heart and around three to four months are typically spent analysing a potential manager, a process which includes a number of on-site visits with that manager. The process culminates in the provision of a detailed report that is then presented to and discussed at …[the] Investment Committee, where a selection decision will be made on all private equity funds, specialty funds, and transitional investments. That Committee has to approve an investment unanimously before it can proceed.”

The due diligence for this and many other — but not all — fund- of-funds managers was clearly deficient.

So while Madoff was not operating a hedge fund, nevertheless, he represents a massive black eye for parts of the hedge fund community. It’s not because his fund blew up; hedge funds, for a variety of reasons, blow up all the time. That risk can be mitigated by diversification. But some fund-of-funds providers evidently didn’t diversify. They had up to a third or more of their money in a single manager, supposedly running a single strategy. Their own investment process failed.

But what’s worse is that some of these fund-of-funds managers were pioneers in the business, with pedigrees reaching back over the decades. They let their guard down on the smallest, the most basic of things: an audited track record with independent verification.

More than that, they missed the obvious — not in retrospect, but what was staring them plain in the face. The same warning flags were there as there had been for Bayou Capital Investments (whose manager tried to fake his own suicide before reporting to jail earlier this year). Indeed, like Bayou, the accounting firm that did the audits was obscure. There was an associated broker-dealer. There was no evidence of a custodian to hold title to client assets, nor was there an independent administrator to set net asset values.

Any one of these is a warning sign. That’s not to say that having a highly regarded broker-dealer, or accountant, or custodian, or fund administrator will prevent problems. After all, the bankruptcy of Lehman Brothers International has left some hedge funds in the lurch. But the danger of having related parties doing the investing as well as the back-office work is all too clear.

Which is another way of saying that no pedigree — not even the former chairmanship of Nasdaq — is a substitute for process. Trust and reputation get you in the door; a meticulous and skeptical process ensures that you stay in the door — for your investors, and for your business.

(12/18/08)