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Kinetic Partners: How best to avoid hedge fund fraud? Red flags for hedge fund investors attract increased attention

Wednesday, July 01, 2009 Share

Opalesque Industry Updates - Hedge fund managers need to step up their game in order to compete effectively in today’s era of increasingly savvy investors, says Kinetic Partners in its latest newsletter.

Amid the backdrop of recent high profile frauds, historic market declines, and related fund closures, the hedge fund industry faces a new set of concerns emanating from the heightened emphasis on investor due diligence.

Victims of Bernie Madoff ’s Ponzi scheme lost up to $50+billion, businessman Tom Petters’ fraud scheme cost investors approximately $3.5 billion, and the Bear Stearns fiasco resulted in a $1.5 billion loss. In addition, let’s not forget names such as Bayou, Beacon Hill, Lancer, Lipper & Company and Philadelphia Alternative Asset Management. The list goes on, and includes types of fraud ranging from Ponzi schemes and misappropriation of fund assets to mis-valuations and mis-representations. Clearly, the days of lackluster hedge fund due diligence are over. High net worth and institutional investors alike are clear on the need to heed the warning signs that a fund may not be implementing best practices in all aspects of its operation.

How best to avoid hedge fund fraud?

Prospective investors need to beware of funds with few points of detection (e.g. annual external audit, outside administrators), realize that a “blow up” can occur quickly, and be cautious of virtual organizations, complex structures and unnecessary opacity - both in terms of investors and strategy.

In retrospect, many of the recent frauds should have been easy to detect but, for many reasons, were not brought to light until much harm had been done. In the end, one’s gut feeling is important; however, the following are clear red flags that a fund may be in trouble sooner rather than later.

■ Lack of or weak valuation policy - significant attention needs to be paid to valuation as a component of operational risk issues in a hedge fund. All funds, regardless of size or strategy should have well documented processes for valuing the assets of the fund. Furthermore, a clear and consistent application of the process should be evident

■ Substantial change in assets under management - a substantial change in AUM should be considered a potential warning sign that operational capabilities may be strained, or that the fund may be an “asset gatherer” versus an “asset manager”

■ Personnel concerns - lack of segregation of duties, especially related to cash controls, as well as turnover of key personnel, should be reviewed carefully

■ Establishment of side pocket investments - the use of side pockets has been a reality at hedge funds for many years, but is of increasing concern to regulators and investors during the recent market volatility and upti...

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