The popularity of hedge fund investing has engendered growth in the investigative industry, as wealthy individuals as well as institutional investors seek assistance in vetting potential investment opportunities. Hedge funds make lots of money for lots of very happy people, but as in any business endeavor there are the unscrupulous few who, in the interest of enriching themselves, turn an hontest transaction into a horror story for investors.

The following article, which originally appeared in the New York Times provides an excellent overview of the potential pitfalls of investing without adequate caution and preparation. In these areas, the services of a quality corporate investigative firm can be a tremendous asset.

Via The Ledger.com:

Want a Hedge Fund? Here's Your Homework

By Geraldine Fabrikant
New York Times
September 11, 2005

IF you're thinking about investing in a hedge fund, how can you steer clear of the likes of the Bayou Group, the recently imploded hedge fund company and brokerage firm run by Samuel Israel III? Unfortunately, getting information about individual hedge funds isn't easy.

While hedge funds have generally had positive returns, experts point out that some of them can be big money losers - and that this makes the decision to invest in any single fund a very risky business. A variety of databases provide information about hedge funds, but they are by no means infallible, and in any case many of them are often unavailable to the average investor.

The collapse of Bayou is a case in point. Federal prosecutors in Manhattan sued Bayou on Sept. 1, saying the company had defrauded investors since 1998 by misrepresenting the fund's performance. The complaint said that Bayou had misstated its assets and that its books, which it had claimed were evaluated by independent auditors, were certified by a bogus accounting firm whose registered agent, Daniel Marino, was also the chief financial officer of Bayou.

The case against Bayou began to develop in May, when Arizona authorities seized $101 million held by a man to whom Mr. Israel had turned it over in a seemingly desperate effort to make some fast money to cover his fund's losses.

For hedge fund investors determined to avoid such debacles, there are some free Web sites that offer data on legal and financial developments, including the sites of the Securities and Exchange Commission (www.sec.gov) and the National Association of Securities Dealers (www.nasd.com). While such sites contain a wealth of information, the often do not include the most telling signs of trouble in a hedge fund.

Randy Shain, the co-founder of BackTrack Reports, which researches hedge funds for institutions and some wealthy individuals, says that in the Bayou case, several red flags - including questions about Mr. Israel's character - would not have been evident to people contemplating an investment in the fund. For example, it would have been difficult to learn from publicly available data that Mr. Israel had exaggerated his position at one hedge fund, had been charged with drunken driving and had been accused in a lawsuit by a former employee of violating securities regulations.

A litany of problems like this is hardly typical of hedge fund managers, but it does underscore how difficult it is to vet a fund, said Charles Stevenson, a veteran hedge fund manager who now runs the Navigator Diversified Strategies fund, which is a fund of hedge funds. (A fund of funds is a group of individual hedge funds that has been assembled by a third party, an arrangement that provides diversification and, perhaps, a margin of safety.) "If a manager's character is not reliable enough for you to trust them with your wallet," Mr. Stevenson said, "then the returns will be less relevant than whether they actually return any of your money."

In promotional material for the Bayou funds, Mr. Israel told investors that he had worked as the head trader at Omega Advisors, a hedge fund run by Leon Cooperman, a former Goldman Sachs partner. But Mr. Israel had misrepresented the length of his employment at Omega as well as his position there, Mr. Cooperman said in an interview. Mr. Israel had worked there as a trader for 18 months, but had not been there for four years as the head trader as he had claimed, Mr. Cooperman said.

Many hedge funds do not have a public relations operation geared toward answering such questions raised by outsiders. Would Mr. Cooperman have taken a call about Mr. Israel's credentials from a prospective investor in the Bayou funds? "I can't answer that," Mr. Cooperman said. "If somebody calls me for a reference check, I will respond factually and appropriately. But certain firms are very cautious about talking about former employees."

Another cautionary piece of news for Bayou investors should have been that while Omega oversees two funds of hedge funds that invest money with 25 different managers, Mr. Israel's group wasn't among them. "We never invested in Sam Israel's hedge fund nor did one trade with his securities company," Mr. Cooperman said.

Promotional materials also stated that Mr. Israel began his career at F. J. Graber & Company, a money management firm geared "toward high-velocity trading" and run by its founder, Fredric Graber. One person who knew both men, but requested anonymity, recalled that Mr. Israel had worked for Mr. Graber as a summer intern, a position arranged through a family friend, but added that Mr. Israel "never had a leadership role" at the firm. Mr. Graber, who closed his firm some years ago, could not be reached for comment.

Potential investors might also have been concerned if they had learned other information. Mr. Israel had been arrested in New York State in 1999 and accused of "driving under the influence" and charged with criminal possession of a "controlled substance," Mr. Shain of BackTrack Reports said; the case was discontinued a year later. That case was reported without elaboration on LexisNexis, a subscription data base, where Mr. Shain's firm found it while researching Bayou for a potential investor. In order to get details about the case, Mr. Shain had to send a researcher to State Supreme Court in Manhattan.

Sometimes red flags are more immediately visible. The documents that Bayou made available to its investors say that Richmond-Fairfield Associates was Bayou's accounting firm. Charles Levenberg, a private investigator who researches hedge funds, said that lack of information about the accounting firm was a warning sign. "If they are not using somebody you have heard of, that is a big red flag," he said. "You have to wonder why." The government has contended that Richmond-Fairfield was controlled by Bayou.

Evidence of possible problems can sometimes be uncovered in news reports. James R. Hedges IV, a partner at the Imperium Partners Group, a hedge fund based in New York, recalled that in 2002 his firm was looking into an investment in the Lancer Group, a hedge fund based in Manhattan. But Mr. Hedges said he had seen a news report about a lawsuit filed in Federal District Court in Miami that same year in which the S.E.C. had accused Bruce Cowen, a managing director of the Lancer Group, of participating in a conspiracy to divert funds from Lancer investors and, ultimately, funnel some of it to his own pocket. That information "told us to stay away" from the Lancer Group, Mr. Hedges said.

A year later, the S.E.C. accused the Lancer Group of inflating the net asset values of its funds in an effort to mislead auditors and attract investors. The agency continues to seek fines, permanent injunctions against the group and penalties. For investors who are intent on picking hedge funds themselves, despite the risks, experts say that it may pay to subscribe to services that track lawsuits. For example, an investor can subscribe to Pacer, an online index to federal civil, criminal and bankruptcy cases nationwide.

A Pacer subscriber could have found that a suit was filed against Bayou in 2003 in Federal District Court for the Eastern District of Louisiana by a former employee, Paul T. Westervelt Jr., and his son. The plaintiffs contended that Bayou had failed to provide them with necessary business documents and that Mr. Westervelt discovered "possible violations of the S.E.C. regulations governing the operating of hedge funds."

The case has moved from federal court to arbitration. Lawyers on both sides did not return phone calls seeking comment. In 2004, Mr. Israel wrote to investors telling them of the suit. But an earlier warning of a former employee's decision to sue the company might have been helpful to investors. The problem for individual investors is that many of them "have made a lot of money doing something else," Mr. Shain said. "They have a false sense of security about their own sophistication in analyzing financials," he added.

To winnow out potential problems, investors may want to look for some common-sense warning signs. In addition to checking for evidence of possible deception or illegality, some analysts say they try to check whether the manager is in the midst of a difficult divorce, as Mr. Israel was, which can add psychological and financial pressures.

One basic metric is the manager's employment record. Michael Steinhardt, a manager who ran his own fund for 29 years and is now starting a group of exchange-traded funds, said, "A long track record is the best endorsement." In 1997, a fund run by Barbara Doran, who had previously been an institutional equity sales executive at First Boston and then a senior vice president at Lehman Brothers, shut its doors after losing 80 percent of its value. Ms. Doran had started the fund just three years earlier. At its height it was worth only $35 million. Ms. Doran declined to comment last week.

Of course, big financial institutions have made bad bets on hedge funds, too. Through a fund offered by an investment unit, J. P. Morgan had $662,602 in Bayou as of March 31, which it has written down to zero. A spokeswoman for J. P. Morgan said that as a result of the investigation, the firm was no longer marketing the fund to investors. But over all, the odds favor big institutions. "They have a better chance of weeding out the problem funds," Mr. Shain said.

The original article appears here.

-- MDT

Labels: Bayou Group, Louisiana, Milberg