It’s sometimes difficult to tell how a hedge fund is doing until it blows up.
Case in point: the Bayou Group of Stamford, Conn., whose top two executives pleaded guilty to fraud on Thursday.
Founder Samuel Israel III and chief financial officer Daniel Marino, both 46, admitted that they faked quarterly and annual reports between 1996 and 2005.
In 1998, they created a phony accounting firm to serve as their auditor.
Hedge funds are risky investment portfolios, typically for the wealthy and large institutions. They employ unique investment strategies, and they are largely unregulated, under the theory that their investors are sophisticated folks and should know what they are doing.
Unfortunately, even sophisticated folks can be conned by people they think they know. Among Bayou’s victims were Martin Payson, the former vice chairman of Time Warner, and the Jewish Federation of Metropolitan Chicago.
Israel conned a former Goldman Sachs managing director, Steven Starker, into lending him $3 million. Israel repaid Starker with two bad checks imprinted with SpongeBob SquarePants, a cartoon character who is always under water.
Israel also rented a mansion from TV billionaire Donald Trump, whom he stuck with $64,000 in unpaid rent. Imagine Israel’s talent to be able to stiff such a stiff.
Israel was able to leverage family and industry connections to attract new investors to pay off his old investors. He allegedly ran a classic Ponzi scheme.
He boasted of his talents as a trader. He sold investors on a complicated trading strategy, but Bayou apparently never made money by trading. And as it hid its mounting losses, it resorted to more desperate schemes.
Bayou, for instance, allegedly invested about $100 million in a complex financial fraud uncovered in Arizona. This money, which Arizona authorities seized in May 2005, was allegedly used to help defraud investors in a prime bank scheme. This may be all that’s left of $450 million that Bayou managed.
Bayou investors received a July 27 letter announcing that Bayou would shut its doors and return their money. The money never came.
The hedge fund industry has been growing exponentially in a sideways market. Bond yields are low and the stock market is flat, so investors have turned to hedge funds for better returns.
Over the past five years, the hedge fund industry has more than doubled to 8,000 funds that manage about $1 trillion. Much of that money comes from institutional investors, including state and corporate pensions.
“Everyone is really seeking a rate of return in this world,” said Chris Reilly, director of alternative investments for Colorado’s Public Employees’ Retirement Association.
PERA, however, does not invest in hedge funds. “We don’t think the transparency requirements and the reporting is adequate,” Reilly said.
The hedge fund industry is perhaps the most secretive part of the financial world, and in that vacuum of information, the temptation to hide losses can be great, as the Bayou case illustrates.
In the past five years, the U.S. Securities and Exchange Commission has brought 51 cases against hedge fund advisers, accusing them of cheating investors of more than $1 billion. Additionally, several hedge funds were implicated in recent trading scandals with mutual funds.
Still, this is a tiny fraction of the nation’s 8,000 hedge funds, many of which deliver solid returns to their investors.
Beginning in February, most hedge funds will be required to register with the SEC and will be subject to random audits. Perhaps this will lead to the discovery of more fraud. Perhaps not. Bayou, after all, not only faked its books but created an auditing firm to sign off on them.
“Fraud is not something that can be regulated against – as the mutual fund and corporate scandals have shown,” said Jerry Paul of Quixote Capital Management, a hedge fund in Greenwood Village. “You have to count on the quality of the people who are managing the fund as well as their custodial, legal, accounting and prime brokerage relationships.
“In this case, a bunch of smart people missed the problem.”
Al Lewis’ column appears Sundays, Tuesdays and Fridays. Respond to Al at denverpostbloghouse.com/lewis, 303-820-1967, or alewis@denverpost.com.
