Want a Hedge
Fund? Here's Your Homework
By GERALDINE FABRIKANT
IF you're thinking
about investing in a hedge fund, how can you steer clear of the likes of the
Bayou Group, the recently imploded hedge fund company and brokerage firm run
by Samuel Israel III?
Unfortunately,
getting information about individual hedge funds isn't easy.
While hedge
funds have generally had positive returns, experts point out that some of
them can be big money losers - and that this makes the decision to invest
in any single fund a very risky business. A variety of databases provide information
about hedge funds, but they are by no means infallible, and in any case many
of them are often unavailable to the average investor.
The collapse
of Bayou is a case in point. Federal prosecutors in Manhattan sued Bayou on
Sept. 1, saying the company had defrauded investors since 1998 by misrepresenting
the fund's performance. The complaint said that Bayou had misstated its assets
and that its books, which it had claimed were evaluated by independent auditors,
were certified by a bogus accounting firm whose registered agent, Daniel Marino,
was also the chief financial officer of Bayou.
The case against
Bayou began to develop in May, when Arizona authorities seized $101 million
held by a man to whom Mr. Israel had turned it over in a seemingly desperate
effort to make some fast money to cover his fund's losses.
For hedge fund
investors determined to avoid such debacles, there are some free Web sites
that offer data on legal and financial developments, including the sites of
the Securities and Exchange Commission (www.sec.gov)
and the National Association of Securities Dealers (www.nasd.com).
While such sites contain a wealth of information, the often do not include
the most telling signs of trouble in a hedge fund.
Randy Shain,
the co-founder of BackTrack Reports, which researches hedge funds for institutions
and some wealthy individuals, says that in the Bayou case, several red flags
- including questions about Mr. Israel's character - would not have been evident
to people contemplating an investment in the fund. For example, it would have
been difficult to learn from publicly available data that Mr. Israel had exaggerated
his position at one hedge fund, had been charged with drunken driving and
had been accused in a lawsuit by a former employee of violating securities
regulations.
A litany of
problems like this is hardly typical of hedge fund managers, but it does underscore
how difficult it is to vet a fund, said Charles Stevenson, a veteran hedge
fund manager who now runs the Navigator Diversified Strategies fund, which
is a fund of hedge funds. (A fund of funds is a group of individual hedge
funds that has been assembled by a third party, an arrangement that provides
diversification and, perhaps, a margin of safety.)
"If a manager's
character is not reliable enough for you to trust them with your wallet,"
Mr. Stevenson said, "then the returns will be less relevant than whether
they actually return any of your money."
In promotional
material for the Bayou funds, Mr. Israel told investors that he had worked
as the head trader at Omega Advisors, a hedge fund run by Leon Cooperman,
a former Goldman Sachs partner. But Mr. Israel had misrepresented the length
of his employment at Omega as well as his position there, Mr. Cooperman said
in an interview. Mr. Israel had worked there as a trader for 18 months, but
had not been there for four years as the head trader as he had claimed, Mr.
Cooperman said.
Many hedge funds
do not have a public relations operation geared toward answering such questions
raised by outsiders. Would Mr. Cooperman have taken a call about Mr. Israel's
credentials from a prospective investor in the Bayou funds? "I can't
answer that," Mr. Cooperman said. "If somebody calls me for a reference
check, I will respond factually and appropriately. But certain firms are very
cautious about talking about former employees."
Another cautionary
piece of news for Bayou investors should have been that while Omega oversees
two funds of hedge funds that invest money with 25 different managers, Mr.
Israel's group wasn't among them. "We never invested in Sam Israel's
hedge fund nor did one trade with his securities company," Mr. Cooperman
said.
Promotional
materials also stated that Mr. Israel began his career at F. J. Graber &
Company, a money management firm geared "toward high-velocity trading"
and run by its founder, Fredric Graber. One person who knew both men, but
requested anonymity, recalled that Mr. Israel had worked for Mr. Graber as
a summer intern, a position arranged through a family friend, but added that
Mr. Israel "never had a leadership role" at the firm. Mr. Graber,
who closed his firm some years ago, could not be reached for comment.
Potential investors
might also have been concerned if they had learned other information. Mr.
Israel had been arrested in New York State in 1999 and accused of "driving
under the influence" and charged with criminal possession of a "controlled
substance," Mr. Shain of BackTrack Reports said; the case was discontinued
a year later. That case was reported without elaboration on LexisNexis, a
subscription data base, where Mr. Shain's firm found it while researching
Bayou for a potential investor. In order to get details about the case, Mr.
Shain had to send a researcher to State Supreme Court in Manhattan.
Sometimes red
flags are more immediately visible. The documents that Bayou made available
to its investors say that Richmond-Fairfield Associates was Bayou's accounting
firm. Charles Levenberg, a private investigator who researches hedge funds,
said that lack of information about the accounting firm was a warning sign.
"If they are not using somebody you have heard of, that is a big red
flag," he said. "You have to wonder why." The government has
contended that Richmond-Fairfield was controlled by Bayou.
Evidence of
possible problems can sometimes be uncovered in news reports. James R. Hedges
IV, a partner at the Imperium Partners Group, a hedge fund based in New York,
recalled that in 2002 his firm was looking into an investment in the Lancer
Group, a hedge fund based in Manhattan. But Mr. Hedges said he had seen a
news report about a lawsuit filed in Federal District Court in Miami that
same year in which the S.E.C. had accused Bruce Cowen, a managing director
of the Lancer Group, of participating in a conspiracy to divert funds from
Lancer investors and, ultimately, funnel some of it to his own pocket.
That information
"told us to stay away" from the Lancer Group, Mr. Hedges said.
A year later,
the S.E.C. accused the Lancer Group of inflating the net asset values of its
funds in an effort to mislead auditors and attract investors. The agency continues
to seek fines, permanent injunctions against the group and penalties.
For investors
who are intent on picking hedge funds themselves, despite the risks, experts
say that it may pay to subscribe to services that track lawsuits. For example,
an investor can subscribe to Pacer, an online index to federal civil, criminal
and bankruptcy cases nationwide.
A Pacer subscriber
could have found that a suit was filed against Bayou in 2003 in Federal District
Court for the Eastern District of Louisiana by a former employee, Paul T.
Westervelt Jr., and his son. The plaintiffs contended that Bayou had failed
to provide them with necessary business documents and that Mr. Westervelt
discovered "possible violations of the S.E.C. regulations governing the
operating of hedge funds."
The case has
moved from federal court to arbitration. Lawyers on both sides did not return
phone calls seeking comment.
In 2004, Mr.
Israel wrote to investors telling them of the suit. But an earlier warning
of a former employee's decision to sue the company might have been helpful
to investors.
The problem
for individual investors is that many of them "have made a lot of money
doing something else," Mr. Shain said. "They have a false sense
of security about their own sophistication in analyzing financials,"
he added.
To winnow out
potential problems, investors may want to look for some common-sense warning
signs. In addition to checking for evidence of possible deception or illegality,
some analysts say they try to check whether the manager is in the midst of
a difficult divorce, as Mr. Israel was, which can add psychological and financial
pressures.
ONE basic metric
is the manager's employment record. Michael Steinhardt, a manager who ran
his own fund for 29 years and is now starting a group of exchange-traded funds,
said, "A long track record is the best endorsement."
In 1997, a fund
run by Barbara Doran, who had previously been an institutional equity sales
executive at First Boston and then a senior vice president at Lehman Brothers,
shut its doors after losing 80 percent of its value. Ms. Doran had started
the fund just three years earlier. At its height it was worth only $35 million.
Ms. Doran declined to comment last week.
Of course, big
financial institutions have made bad bets on hedge funds, too. Through a fund
offered by an investment unit, J. P. Morgan had $662,602 in Bayou as of March
31, which it has written down to zero. A spokeswoman for J. P. Morgan said
that as a result of the investigation, the firm was no longer marketing the
fund to investors.
But over all,
the odds favor big institutions. "They
have a better chance of weeding out the problem funds," Mr. Shain said.
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