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Do Your Hedge Funds Homework

Investors in Bayou Management LLC’s hedge funds watched helplessly this summer as the funds collapsed because of fraud. Federal prosecutors referred to the money remaining in Bayou’s now-frozen accounts as “the proceeds of criminal activity.” What could Bayou’s investors have done to avoid this disaster?

Unfortunately, it is impossible to eliminate the risk of investing in a hedge fund that engages in fraud. The hedge fund industry comprises thousands of funds, managing more than $1 trillion. Most, of course, are managed honestly, though with varying degrees of success. But the industry is loosely regulated, which facilitates the occasional hedge fund implosion.

The latest example is Bayou Management, based in Stamford, Conn., which claimed to manage more than $400 million. Two Bayou principals pleaded guilty last month to fraud charges. As accountants know, if fraud is carried out to perfection, it can be nearly impossible to detect until the entire scheme self-destructs. There is no way that even the most diligent hedge fund investor can guarantee against fraud. Still, a careful investor can significantly reduce the chances of investing with a fraudulent fund.

When evaluating a hedge fund, focus on its operations. “Fifty percent of all hedge fund problems come from the back office,” estimates Eric D. Gordon, principal of Gordon Asset Management, a New York-based firm that manages funds of hedge funds. “There are two aspects of managing a hedge fund. The first is managing capital and the second is managing a business. When we evaluate a fund, we have to ask ourselves, can they manage a business?”

Evaluating a fund’s operations can involve some serious sleuthing. Find out whether a large, reliable institution maintains custody of the hedge fund’s assets. Learn how the fund carries out its securities trades and who is responsible for pricing the fund’s securities. This information can be obtained from the fund manager, but confirm any relationships with third-party vendors. If the fund is outsourcing these responsibilities, you can be more confident that the fund isn’t doing anything suspicious. Pricing is a particularly complicated area, because many hedge funds specialize in trading highly illiquid securities. If the fund’s manager is responsible for pricing its securities, that is a big enough red flag to pass on the investment.

One of the most important steps in the due diligence process is to examine the fund’s audited financial statements. The statements can be used to measure and verify the fund’s performance. But the investor should also evaluate the credibility of the auditor. ABig Four accounting firm’s seal of approval may require fewer questions as a result of its expertise and considerable resources. A closer look may be necessary if the auditing firm is very small and possibly incapable of carrying out a proper audit. Bayou Management’s auditor was Richmond-Fairfield Associates, a firm that prosecutors later charged was a sham established by Bayou’s management and that never conducted any audits, independent or otherwise.

If you have approved the firm’s operations, the next step is to evaluate the people working for the fund. Confirm any credentials or work experience mentioned in the fund’s promotional materials. If you find any discrepancies, be very concerned. If you find any information that raises serious questions about the integrity or ethics of the fund’s management, such as professional violations or illegal conduct, you should pass on the investment.

After you have examined the fund’s operations and its employees, you should still proceed with caution. Make sure that you fully understand the fund’s investment philosophy and strategy. After all, a hedge fund may not be engaging in fraudulent activities or have any major structural inefficiencies, but still can crumble as the result of an overly aggressive investment strategy. Visit the fund’s manager or a knowledgeable representative to discuss your potential investment, to make sure that you trust the hedge fund with your wealth. Take some time to monitor the fund’s performance from month to month, to ensure that the fund’s investment returns are consistent with its strategy.

After the due diligence has been completed to your satisfaction, you may allocate a portion of your portfolio to the hedge fund. Make sure your portfolio is still diversified after you make the investment. Generally speaking, allocating more than 5 percent to 10 percent of a portfolio to a single hedge fund is not a good idea. However, when a relatively small portion of your portfolio is invested in a hedge fund, your portfolio not only becomes more diversified, it is more sheltered in the event of a blowup. Your responsibilities do not end once you have invested in a hedge fund. Continue to monitor the fund for any new developments. Due diligence is an ongoing process, and the dynamic nature of the hedge fund industry forces all investors to continually monitor their investments.

If you do not wish to spend time researching hedge funds, you may choose to pay a consultant to recommend funds appropriate for your portfolio. Also, you can invest in a fund of hedge funds, which performs its own due diligence. However, remember to evaluate the potential conflicts of interest that these parties may be exposed to. For example, some consultants may receive commissions in exchange for steering clients to certain funds. In addition, some funds of hedge funds have brokerage businesses, and they may receive business from hedge funds that they recommend or invest in.

The hedge fund industry has grown rapidly over the last several years, and the Bayou Management debacle likely will not be the last. The government’s involvement in regulating the industry — despite requiring certain hedge funds to register as investment advisers with the Securities and Exchange Commission under the Investment Advisers Act — has been minimal. Of course, tighter regulation will be no guarantee against fraud, let alone poor performance. Of greater benefit may be the hedge fund industry’s desire to attract more money from pension funds and other institutional investors who may scrutinize these funds more closely than individuals do.

But the biggest lesson from the Bayou fraud is caveat emptor. If you want to consider investing in hedge funds, you should always rely on your own due diligence.

Managing Vice President Paul Jacobs, of our Atlanta office, is among the authors of our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. He wrote Chapter 12, "Retirement Plans"; Chapter 15, "Investment Approaches And Philosophy"; and Chapter 19, "A Second Act: Starting A New Venture." He also contributed to the firm’s book The High Achiever’s Guide To Wealth.