Where there’s smoke, is there fire? Some red flags in hedge fund fraud

Read the article in the Cayman Financial Review Magazine 

Sometimes investors lose some or all of their investments at the hands of frauds perpetrated through hedge funds. Because of the services KRyS Global provides, the firm is brought in to investigate these types of cases. Drawing from our varied and numerous experiences, we have identified certain red flags that we have seen in more than one situation and provide some practical guidance that investors may wish to consider to mitigate the risk of being victims of a fraud. 

Do you know and understand the investment strategy?

The hedge fund industry is continually growing and morphing, and the types of investment strategies are expanding. In the fraudulent funds that KRyS Global has been called upon to investigate, the firm has seen situations where the fund invested outside of its investment objective. This is referred to as strategy fraud (if intentional) or style drift (if not intentional). In other cases, the investor may never have fully understood the investment strategy.

The first issue is that strategy fraud or style drift can be tricky to identify.

One means of doing this is to analyse the audited financial statements, or detailed management accounts if the fund provides them more frequently.

The accounts can provide insight into the assets at a certain point of time.

As it is possible that the investment manager was in breach before or after filing the accounts, the position at the date of the accounts will give some assurance what the fund was invested in.

This can then be compared to the investment objectives, and possibly investment restrictions, to determine whether there is a strategy fraud or style drift.

The second issue is the ability to replicate the strategy, which investors should assess at the outset, before deciding whether to invest in the fund. If the strategy does not make commercial sense, it is a red flag that a fraud may be occurring.

Be wary of strategies too complicated to understand or that require a degree in brain surgery to explain. In addition, if the manager suggests that the investment strategy is proprietary, be sceptical as to what it is he may be trying to hide.

Do you know whom you are entrusting your money with?

The lack of due diligence by investors into the investment manager is one of the factors that we come across too often. Investment managers who either do not have the necessary qualifications or experience, who have previously been involved in shady activity or who show a tendency to lie can represent a serious red flag.

Before investors entrust money to a fund, they should conduct background checks on the key principals in the structure, verifying if possible the representations and credentials.

Finding out this type of information is usually relatively simple – a check on the internet. Most financial institutions have access to compliance databases. From these two sources, investors can gain access to publicly available information regarding any regulatory registrations, regulatory actions, media reports and court

Request a copy of the manager’s curriculum vitae and verify his education, experience and qualifications. If the investor is investing significant sums or has the resources to conduct further qualitative due diligence, an investor may want to consider gathering additional information directly from fund key personnel through questionnaires and meetings with fund managers.

In our minds, conducting this due diligence cannot be understated. In one case we were involved in, we learned that the fund we were investigating was the manager’s first stab in the fund industry. Previously he had been a dentist and, upon attending a fund conference, decided this was the way to go. Not surprisingly, the manager conducted a ‘root canal’ on the investors and wasted most of their funds.

Are the gatekeepers qualified, reputable and capable?

A further issue we often come across is one where the fund is using a third party service provider who lacks the qualifications, reputation and experience to conduct the role they are retained to do. Hedge funds usually take great care in the selection of service providers including prime brokers, administrator, legal advisors and auditor. A weakness in one of these links could suggest that the manager has found someone to collude with, or is intentionally selecting someone weak so he can perpetrate a fraud.

The fund’s service providers should be independent, reputable and adequately staffed with skilled and qualified professionals. Service providers that do not have these skills and resources either may lack the ability to detect the fraud and confidence to ask the tough questions, or if an issue arises, may not be willing to confront the manager on it.

Be extremely sceptical if there is a change in service providers. Successful funds typically maintain long-term relationships with service providers, and similarly service providers, given the investment they need to make, usually want a long-term relationship with the fund. While changes occur, for growth or market conditions, it is necessary that the investor receive an adequate explanation for the change. If not, this may be a red flag.

Who is checking the valuation of the assets?

Interestingly, at the heart of a lot of hedge fund fraud is the need to conceal losses. One easy way to do this is to inflate the value of the position of the fund’s investment portfolio. Over the years, we have seen multiple ways this has been achieved. Collusion with prime brokers, false revenue projections, false trading and the use of illiquid asset types just to name a few. In all of these, the common theme was the lack of an independent and qualified third party to value the fund’s assets. Many hedge funds give the manager significant discretion in valuing these asset types. When times get tough and a manager needs to find a way to conceal a big loss, this situation is a recipe for disaster.

Make sure you know who is going to conduct that independent valuation. Do not automatically think it is the independent director, administrator or the auditor. Normally they rely on the representations of the manager, who of course is the one wishing to conceal the losses. Moreover, while we are on this topic, another possible red flag is constant returns. Markets are volatile. Failing to see significant drops and waves in the fund’s net asset value could be a sign that the valuation of the fund is being intentionally manipulated.

We investigated a fund where the primary investment was the purported rights to bottle and distribute glacier water. What we found, however, was that no such business existed. Nonetheless, during the two to three years in which the fund operated, the value of the fund’s net assets had inflated by over 1,300 per cent. This arose because the investment manager had prepared numerous ‘back of a napkin’ projections of what revenues would be if the business ever got off the ground. As the net asset value increased, the manager paid himself a performance fee along with the investment fee, thus being able to skim out the liquidity in the fund for his personal benefit.

A lack of independent valuation of the asset allowed the fraud to persist. The independent directors did not verify the manager’s calculations, the administrator felt no obligation to make inquiries and the auditor relied upon the representation of management when conducting the audit. The ones who ultimately suffered were the investors.

Are you accessing and reviewing all the information you are entitled to?

One of the areas ripe for fraud in hedge funds is the use of related party vehicles for dealing with asset transactions or investing assets. While there can be good reasons for fund structures to engage in related party transactions, these types of transactions can also be vulnerable to fraud and be a red flag to investors. This can particularly be the case where the related party vehicle is located in an offshore jurisdiction.

It is not always easy to learn whether the fund manager is utilising related parties. A source investors can use to ascertain the existence of related party transactions is through a review of the audited financial statements of the fund. Under most recognised accounting standards, funds are required to disclose in the notes to the financial statements what transactions the fund has with related parties.

To the extent the audited accounts disclose such related parties exist, the investor should ask questions and request additional information from the investment manager and principals regarding the related party relationship, and understand how these transactions fit into the investment strategy or objectives of the fund. A lack of transparency in this regard is a sign that the related parties could be used to perpetrate a fraud. Investors may also inquire whether the funds have proper policies and procedures in place to address any conflicts of interest that may arise. A failure to have such policies and procedures can also be a red flag.

We started this article by explaining that the intent was to raise some red flags that investors will want to be sceptical about and provide some practical guidance that investors may wish to consider to mitigate the risk of being victims of a fraud. Comprehensive quantitative and qualitative due diligence cannot be understated.

Knowing who you are placing your money with and who is retained to act as the independent gatekeeper is paramount. Ask tough questions. Gain access to as much information as possible. Be sceptical and verify what you are told. Remember an ounce in prevention is worth a pound of cure. If it sounds too good to be true, it probably is. And if you suspect a fraud, don’t hesitate to retain the services of a good fraud investigator.