What do the unrelated troubles facing Refco and The Man Group have in common? They both imperil the surging hedge fund industry, threatening to bury the high-yield appeal of these alternative investment strategies under a mountain of bad press. While a private, individual investor is primarily concerned with real-money losses associated with an investment decision, an institution on the other hand is at least as concerned with potential reputational risk of being implicated in an investment-house related scandal.

Hedge funds have become somewhat more domesticated in recent years - moving from a solid base in individual wealth investors to a more diversified clientele of foundations, pension plans and institutional banks. But their increase in popularity has also increased their exposure to headline risk when something goes awry. Conal Walsh in this recent Observer article makes the point quite well and in the process, links the names and travails of our two unrelated, headline flak-catchers du jour - Refco and The Man Group:

Bennett's hidden life and frailties of Man

Conal Walsh
Sunday October 16, 2005
The Observer

Events of the past fortnight may have given rueful satisfaction to those who believe the hedge fund industry is an accident waiting to happen. America's Securities and Exchange Commission is probing claims that Man Group helped a client hide $175 million of losses. Separately, and much more seriously, Wall Street kingpin Phillip Bennett is facing fraud charges after allegedly hiding up to $540m in bad debts from investors...

...The demise of such a prominent firm would be a tremendous blow to market sentiment in itself, but others in the industry are already suffering. Refco, which acts as a middleman and counterparty on a host of transactions, has also been forced to freeze customer accounts at its capital markets unit, closing down billions of dollars' worth of deals and potentially threatening instability within the wider hedge fund market.

Even assuming a systemic crisis is averted, the affair could tarnish some august Wall Street reputations. News of the debts has taken Refco itself by surprise, and no mention of them was made when Refco floated just two months ago, raising $583m. There is a likelihood of lawsuits from aggrieved investors against Goldman Sachs, CSFB, and others who advised on the float. Investment banks that arranged Refco's bond issues could also face legal action...

Whatever the case, Bennett's alleged success in hiding the debts raises serious questions about how effectively the world of derivatives trading is being policed. Attention has been drawn to some of the potential risks highlighted in Refco's flotation prospectus, which seem all the more alarming with hindsight - they include 'our lack of formalised procedures for closing our books', and a warning that 'we could be harmed by employee ... misconduct or errors that are difficult to detect and deter'.

The hedge fund industry shrinks from any whiff of scandal - mindful, perhaps, of an epidemic of negative sentiment such as the doomsayers have long predicted. Shares in Man Group, as well as other hedge fund companies, fell last week as Bennett's entirely unconnected troubles started to mount...

Man was quick to point out that it had no financial exposure to the Refco collapse, but then, part of Walsh's point is that reputation and perception are equally important components of what constitutes exposure. And with the financial media currently tuned to the channel for hedge fund-related scandal, these are just the sort of incidents that make the whole market suffer.

There is at least one tangible connection between Refco and The Man Group, albeit only a potential one. Buried at the end of this article on Milberg Weiss's pending class action lawsuits against the various financiers and that underwrote and advised Refco's recent wall street float, is a connection of a different sort.

While no talks have taken place yet, The Man Group is apparently interested in purchasing Refco's futures business.

-- MDT

Labels: Phillip Bennett, Refco