For years, the US hedge fund market has been largely unregulated, and had little impact on the financial markets.
That may soon change, after founders of Bayou Capital Management pleaded guilty to fraud last week in a New York federal court. Samuel Israel III and Daniel Marino, the CEO and CFO, respectively, of the Connecticut-based hedge fund group, were a part of the most publicized—and one of the most creative—hedge fund fraud in history.
The scandal was publicized after Arizona state authorities seized US$100 million of suspicious bank transfers that had Bayou shuffled around the world in a desperate attempt to cover up its impending collapse. The US$100 million will be returned to Bayou investors, state authorities said.
Investors gave more than US$300 million to Bayou in 1996, in exchange for the promise that the fund would grow to about US$7.1 billion in ten years. According to federal prosecutors, Bayou had lied about its operations since the beginning, by “overstated gains, understated losses, and reported gains where there were losses.”
According to court documents, Bayou never made any money, even though in mid-2004, a letter to investors claimed that its assets totaled well over US$450 million.
“I knew that what I was doing was false and fraudulent,” Israel said in court. The date of sentencing is set for January 4, 2006.
Invisible to most investors in the past, the hedge fund industry and its high promised returns have caught the public’s attention. The industry grew to over US$1 trillion in managed assets last year.
A Niche Investment
Typically, hedge funds are partnership firms engaging in unconventional—and sometimes risky—investment strategies. They do not need to register with the SEC and cannot advertise to the general public. Due to a lack of regulation, hedge funds seldom disclose their activities to third parties, and public information regarding the industry is scarce.
Hedge funds generally use strategies such as short selling, risk arbitrage, trading in derivatives, “high-growth” securities, foreign exchange contracts, and highly leveraged transactions.
Because of their risk and high minimum investment, hedge fund participants traditionally have been wealthy investors. However, in the past few years there have been increasingly higher advertised returns and lower investment minimums, and in turn, more ordinary and institutional investors are tapping into the hedge fund market.
Bayou Fraud Raises Concerns
What makes the Bayou debacle particularly alarming was that most of its participants were seasoned investors, institutional investors, and “funds of funds”—which are investment companies that invest in a portfolio of different hedge funds—that typically have the resources and expertise to thoroughly investigate the quality of the funds.
But the investors’ due diligence failed miserably in this case. “[Bayou] demonstrates that even experienced investors in hedge funds can be victims of unscrupulous operators,” US attorney Michael Garcia told the Wall Street Journal.
It turned out that Israel and his associates were able to dupe investors due to his perceived experience, competence, and the overall unregulated environment of hedge funds. Doug Hirsch, an attorney from Sadis & Goldberg, told CNN, “People invested with [Israel] because he had a Wall Street pedigree and had worked with people at hedge funds who seemed to think he was bright and a good trader.”
According to prosecutors, in 1998 after Bayou lost millions of dollars, it fired its independent auditing firm, and hired a “sham” auditor owned by Marino, to collude with Bayou in reporting fake earnings. By 2004, it had stopped trading securities and focused all of its energy and resources to covering up losses and fabricating exit strategies.
How did all of this escape the eyes of the public, or at least Bayou’s investors? Perhaps the lack of regulations and an overly laissez-faire attitude throughout the hedge fund industry had something to do with it. With more and more institutional investors—which manage valuable pensions for millions of workers—investing in hedge funds, it is quickly becoming mainstream and no longer a niche investment vehicle.
The Future of Hedge Funds
The US Securities and Exchange Commission (SEC) has finally taken notice. The rapidly growing hedge fund market is quickly becoming a major component of the financial markets, and any future missteps could spark huge losses.
Recently appointed SEC Chairman Christopher Cox said, in an interview with the Wall Street Journal last month, that he plans to continue implementing regulations that will require some hedge funds to register with the SEC. This new rule, first proposed by former chairman William Donaldson, would apply to all hedge funds with more than US$25 million under management.
Experts remain divided over the effectiveness of such regulations to deter fraud, and others wonder whether they will permanently alter the nature and landscape of hedge funds. Any prudent investor should know that more oversight equals less risk, which almost guarantees lower returns.
But due to the unscrupulous nature of a few fund managers, it is a painful, but necessary, step in the right direction.