History repeating

An alleged hedge fund fraud, the overstating of gains and losses, questionable practices around the auditing of financial statements - it sounds a little too familiar. It is. Back in October 2005, the US attorney for the Southern District of New York filed a civil complaint against Connecticut-based hedge fund Bayou Management, the details of which bear a striking familiarity with the alleged fraud committed by Bernard Madoff (see page 8).

The suit alleged Bayou's quarterly financial statements overstated gains, in some cases reporting positive returns when the fund had in fact recorded losses. Astonishingly, the accounting firm named as the asset manager's auditor apparently did not exist. More shocking is the fact its investors, which included some large funds of funds and investment consultants, didn't pick up on this - something that could have been achieved by a simple Google search.

The Bayou case triggered a period of hand-wringing by investment advisers and funds of funds. Many pledged to improve due diligence - to conduct in-depth analyses on managers, strategies and investment processes, as well as review the organisation and reporting practices at firms.

Roll forward three years and the same failures have occurred again. Madoff allegedly used a small accounting firm for auditing purposes, was reluctant to meet investors, declined opportunities to join managed account platforms, and generated returns that were a little too good for the strategy it was apparently following.

Some participants, who did not invest in Bernard Madoff Investment Securities, claim there were plenty of red flags that should have alerted investors something was not right. Yet some of the biggest and most respected names in finance racked up hefty exposures to the fund, with total losses likely to stretch to $50 billion, according to some estimates.

On the one hand, it is always difficult to watch against fraud. On the other, it is clear dealers, private banks, advisers and funds of funds need to make dramatic improvements in their due diligence practices. There need to be clear minimum levels of disclosure and transparency, which must be met before investments can be made. While a complete overhaul of the regulatory framework for hedge funds may be an overreaction, regulators should act to draw up a due diligence check list - another thing to add to their already sizeable to-do list.

Nick Sawyer, Editor.