Hedge fund fraud less likely in Europe than U.S

Reuters
November 4, 2005
By Pratima Desai

LONDON - The risk that hedge funds will defraud investors is lower in Europe than in the United States, because most European hedge funds turn to independent administrators to value their books, hedge fund analysts said.

A lack of independent valuations contributed to the high-profile failure earlier this year of the U.S.-based Bayou Group hedge fund. Its founder and chief executive pleaded guilty to fraud by misrepresenting the value of assets, in a scheme prosecutors said cost investors $450 million.

"You should be wary of self-administered funds ... That's where the danger is," said Derek Stewart, a director of Mellon Global Alternative Investments.

In Europe there have been no major failures in recent years, because hedge funds normally use independent administrators, even though it is not a legal requirement. Over the years it has become a standard industry practice, which investors have come to expect.

"Hedge funds outside the United States without independent fund administrators are unlikely to have any serious investors," said Joe Seet, senior partner at Sigma Partnership, a specialist hedge fund advisory firm.

"Most hedge funds that collapse do not have fund administrators that are truly independent," he added.

The reputation of an independent administrator is also important, and that means being registered with a local regulator. In Dublin, for example, analysts estimate there are close to 40 fund administrators and that all are registered with Ireland's central bank. Hedge funds based in Asia have in the main taken their cue from Europe and use independent administrators to value their books, analysts say.

STARTING TO CHANGE

In the United States, new SEC rules requiring most hedge funds to be registered by February 2006 mean that funds are starting to change the way their books are valued and that more are turning to independent administrators. But many U.S. independent administrators do not yet have the specialist resources to properly value complex derivatives in hedge fund portfolios.

"Most of the really big hedge funds are still U.S.-based, and they are becoming more sensitive to issues about independent (valuations) ... independent fund directors and corporate governance," Seet said. Investors in hedge funds that trade liquid markets such as listed securities, government bonds or foreign exchange have less cause for worry.

Examples include managed futures funds that trade exchange-traded futures and equity funds that buy and sell stocks on major stock markets in London, New York or Tokyo, where prices are transparent and easily available.

Problems normally arise in less liquid instruments for which prices can be more easily manipulated, which include over-the-counter derivatives such as options, convertible bonds, private equity investments or loans.

"Valuation becomes more important with funds who have illiquid assets," said Doug Fulton, a principal at Westhall Capital. "If there is any reliance upon the fund manager for valuations or on (one) mainstream market source (bank or broker), then it's opaque."

Labels: Bayou Group