Bernie Madoff fooled a lot of people with his purported hedge fund strategy. They included some of the most reputable fund-of-fund managers in the business who are now, as one insider puts it, “squawking like seagulls,” after years of freely scooping fish out of nets illegally cast in the first place.
But he didn’t fool Harry Markopolos, who tried to blow the whistle on Madoff’s unlikely returns time and again, to little avail. Markopolos was finally called before the U.S. Congress for clarification earlier this year, well after Madoff’s Ponzi scheme collapsed.
Is there anything more to learn about Madoff? Yes, says Frank Casey, one of Markopolos’s former colleagues. “We’re not defending the alternative industry. What we’re doing is telling a sad, Shakespearean financial tragedy.”
Casey is the Boston-based president of Fortune Group, which does due diligence on hedge fund managers for family offices and high-net-worth clients. He was in Toronto recently at the behest of Oakville-based HighView Financial Group, a similar manager of managers for advisors, family offices and institutions.
“It’s not so much a story about Frank Casey or even about Harry Markopolos,” he says. Much of the tale concerns inadequacies at the U.S. Securities and Exchange Commission — a failure to understand how a hedge fund strategy is likely to perform, for example — work that is fundamental to his own due diligence at Fortune Group.
“It’s something to do about Madoff, but not as much as people think,” he explains. “Really, it has a lot do with the recalcitrance — if that’s the right word — the intellectual arrogance and ineptness and incompetence of the SEC and government agencies, and it’s got everything to do with the victims.”
What Madoff was doing, or rather what he was not doing — Casey says Madoff would have to have been batting .964 to get the returns he was claiming — attracted little attention, he notes.
Yet, for due diligence experts, Madoff was a fraud in the open, there for anyone to see. Why didn’t the regulators catch on? For Casey, “really what it boils down to is that the SEC doesn’t understand the industry.” Capital markets trading experience is essential, he says. “I don’t care how much you study capital markets as a lawyer,” he insists; it’s how “you understand what can’t be done by the strategy — not so much what it’s purported to do, but what it cannot do — that tells you where the violation is.”
Madoff said he was pursuing a “split-strike conversion,” strategy. Casey traded that in the mid-1970s. “I knew what split-strike conversion cannot do. It cannot have really high rates of return without the markets going up because it is path-dependent — it’s a fancy word for meaning the stock has to go up. Stocks don’t usually go up in a vacuum. They go up when the market goes up, or the sector, and 80% of a stock’s return is its sector, so if it’s an oil and gas company, the oil and gas industry accounts for 80% of the move in that stock.”
So Madoff could not have had stable returns in a falling market. Yet, that’s what he claimed.
Understanding what a strategy can do is only a small part of the due diligence required for hedge fund investing, however.
“The qualitative discipline is about 70% to 75%,” Casey says. “What’s the pedigree of the guy? What’s the strategy? What was it going to produce with the risk profile of that strategy? What are the internal controls? Where are the third-party verifications?”
He can plunk down a matrix of due diligence tests and demonstrate how Madoff failed on almost every one.
That’s why he feels hedge fund due diligence should be outsourced. He cites small endowments that may have four investment specialists, or family offices that again, have one or two people with the expertise to do due diligence.
“Not to talk my book, as they say on the Street, I think clients really need many eyes that do the due diligence work and they need professionals,” he argues. “Maybe as an investor, before you make any major decision, you bring in your lawyer, your accountant, and if you have a family office, your chief investment officer there and you make it together.” That’s a start, he feels.
“You have to pay these guys for their time.” But it pays off, since “each guy, each expert on the board is looking after your interest and how to protect it.”
Casey deals with family offices that may have millions in hedge fund investments, but have lost sight of their original objective. “Next thing you know, you’ve got a portfolio of 15 hedge funds and you’ve got a million or two or three in each one of them and you don’t remember where you were going in the first place,” he remarks.
That requires a portfolio rebuild, and revisiting the investor’s objectives and the time horizon.
In the shifting world of alternative investments, not everyone can do everything. Casey thinks it’s better to outsource the manager selection — and the due diligence. With family offices or small endowments, “you look at their staff and they’ve got four people and they’re doing all this work. What makes them think that they can do what we do with 22 people, and we do that — and only that — full-time?” he asks.
“We’re trying to take legacy positions, clean up the toxic waste that they don’t even know they’re into and then we move the risk and build out to their objectives. That’s what we do for a living. It’s not that expensive. It would be a lot cheaper to hire a pro on an outsourced basis than staff up internally and try to train your own people.”
Which brings the issue full-circle to Bernie Madoff. Many professional fund-of-fund managers invested with him via word of mouth. Many were also told to keep their investments quiet, lest they lose their privileged access. They blame the SEC for not protecting them from a rogue fund operator. All the same, they were more intent on collecting the fees that come from gathering assets than offering a service of vigilance to the client.
As Casey puts it: “We don’t trust anybody.” He has private investigator reports on file on each manager he researches and they are available to his clients — along the way, he has also made some notes on squawking seagulls.
(11/30/09)