Trader’s Narrative

Coming at the heels of such massive financial frauds as Madoff and Stanford, (as well as previous hedge fund collapses like Bayou) “Hedge Fund Operational Due Diligence” is well timed.

The recent batch of fraud dwarfs the largest trading losses in history, combined, and makes it crystal clear why all investors should take due diligence extremely seriously. The author, Jason Scharfman, previously at Graystone Research (a division of Morgan Stanley), is now at Corgentum, a full service hedge fund operational risk consultancy practice.

What is operational due diligence? Usually when we think of the risks involved with a hedge fund, the first we think of are related to the market. That is, how much an investment in them can depreciate as a result of trading losses. And although this is very important, there are two more areas of risk: credit and operational.

Credit is the risk associated with a counter-party being unable to meet their obligations (cough AIG cough). Operational due diligence encompasses a broad array of risks, including more ‘human’ frailties, such as internal controls, internal/external fraud, as well as business disruptions due to external or internal factors.

This is the risk that almost every single Madoff investor ignored - that says a lot because these were, by definition “sophisticated” but they ignored all the operational red flags and handed over millions of dollars.

Scharfman’s book explains not only how to diagnose and analyze the operational risks that may be present in a hedge fund, but how to continue to monitor them. This book is invaluable if you are running or thinking of starting a hedge fund, want to invest in one (or already have) or if you work in the field of asset management.

Because it is a thorough and exhaustive exposition, going through just about everything like a manual, it makes for an excellent reference resource. While the topic can be rather dry, Scharfman brings it to life by using nuanced hypothetical scenarios which read like stories (Chapter 5).

For example, would you or should you allocate money to a hedge fund if the head trader or manager has a criminal record? How would you treat this if the manager was pro-active in mentioning it? and not? what if it was not related to financial fraud?

If you’re impatient, you can skip to Chapter Six, which has the “Ten Tips for Performing an Operational Due Diligence”:

1. Avoid meeting with the wrong people or the wrong group
2. Get out of the conference room
3. Little white lies can turn into big problems
4. Be wary of phantomware
5. Focus on documentation and negotiation
6. Read the fine print (financial statement notes, etc.)
7. Reference checking: importance of in-sample and out-of-sample references
8. Credit analysis: are funds financially viable?
9. Long-term planning: Key staff retention, succession planning, and more
10. Growth Planning: is the manager proactive or reactive?

There has always been a struggle between hedge fund managers and investors. One side wants to disclose as little as possible, to protect proprietary strategies. And the other wants as much disclosure as possible to protect their assets. There has been an uneasy relationship between the two parties because of this. The trend is now shifting to more transparency not only because of the large fraud cases that have come to light but also because of a diminishing source of funds. Investors have a stronger position to make more demands for disclosure. And with Scharfman’s book, even the smaller investors have a blueprint to follow.

There’s a lot more in the book, of course, but that should give you enough to whet your appetite. You can purchase it at Amazon, or your favorite book seller (it is published by Wiley, a specialist in finance books).

Or be one of my lucky readers to win a free copy of Hedge Fund Operational Due Diligence. To enter for the chance to receive a copy of Jason Scharman’s book for free, just drop me a comment below. Make sure you write your email correctly (so I can contact you when you win the random draw!).

Here are just a few of the articles from this week’s reading list at news.tradersnarrative.com:

• Was Rick Santelli’s “rant” a pre-arranged PR stunt?
• Buffett’s Annual Letter - worst performance ever
• Lessons From 1921 - what if doing nothing is the best option?
• Gold Based Ponzi Scheme
• In Defense of the Bull Market - wide based indices above November lows
• The Formula That Killed Wall Street
• Consumer Confidence hits basement, starts drilling
• House Prices: Reversion to the Mean (long term chart)
• Soros sees no bottom for world financial collapse

And remember to check regularly since there are interesting links added regularly throughout the week.

To see what you missed, here are just a few of the articles from this week’s reading list at news.tradersnarrative.com:

• Legacy of a Crisis - A Generation Shy of Risk
• Inside the Meltdown - PBS Frontline
• Congress’ new blockhead idea: a ‘Trader Tax’
• Bear Market in Chinese mistresses
• Chinese liquidity - and stocks - go BOOM
• Stanford a mini-Madoff fraud shut down after 15 years of dawdling
• Eastern Europe may take down Western European banks
• Dow Theory: Be Leery
• CDS jump for US banks

And remember to check regularly since there are interesting links added regularly throughout the week.

After writing that Madoff offers the biggest due diligence lesson for investors, some argued that the red flags are only obvious in hindsight and wouldn’t have been if so clear if one had to make the decision before Bernard’s admission of running a Ponzi scheme.

To be generous, I’ve assumed that the whole nature of the trading strategy, the inability of others to reverse engineer it, and the eerie equity curve it created, were not red flags.

So let’s count the other red flags and see if they were numerous enough and obvious enough. (The thumbnails are from the SEC’s website and clicking on them will take you to the larger version.)

RED FLAG #1
Madoff Investment Securities was both the broker dealer and investment advisor:

RED FLAG #2
Madoff traded in the same securities that he recommended to advisory clients:

RED FLAG #3
Madoff not only was the broker dealer, creating a conflict of interest where his firm was trading in the same securities as he was trading for clients, but he actually had custody of the assets!
Continue reading ‘The Madoff Red Flags, Let’s Count Them’

Due diligence has many meanings depending on context. If you pressed me for a definition within finance, I would say it is:

The process of investigation undertaken by an party to gather material information on actual or potential risks involved in a financial transaction or relationship.

If you suffered losses as a result of Madoff’s fraud, then this lesson is extremely expensive. If not, it is probably the biggest gift Madoff has given the world.

As an investor or trader, you have to perform due diligence not on just trades or investments, but also on your broker or prop firm, your bank, your accountant, etc. Each link in the chain is vital. Never assume anything. Check and verify every little detail. As this most recent event has shown beyond a shadow of a doubt, you have to take personal responsibility and can not have the SEC or FBI do it for you.

Madoff’s Ponzi scheme has snared not just wealthy individuals but very large instititutions like Nomura, BNP Paribas, Neue Privat Bank, Santander, UniCredit, Lombard Odier, Royal Bank of Scotland as well as dozens and dozens of fund of funds that allocated portions of their assets under management to Madoff. These institutions supposedly have whole departments full of lawyers and accountants who are given the task of due diligence. Each and everyone of them failed their fiduciary responsibility and will probably be sued by those who experienced losses.

Just out of curiosity, I looked the website for Optimal Investment Services, the hedge fund arm of Banco Santander. Here is a snippet:

Optimal clients were exposed to the tune of 2.33 billion euros or $3 billion US dollars, according to a report from Bloomberg.

What sort of due diligence did they perform exactly? one that didn’t flag a potential problem with Madoff being the broker, custodian and investment manager, all rolled into one? one which missed the fact that a tiny one person accounting firm did their annual audit?

A lot of heads in “due diligence” and “risk management” departments are going to roll.