the Dots. Find the Fees.
TO many investors,
the collapse of the Bayou Group - a hedge fund company and brokerage firm
run by Samuel Israel III - may seem like just another financial mishap, and
a calamity only for those who had the bad luck to invest with Mr. Israel or
to be steered his way by advisers they were wrong to trust.
the mess at Bayou, which federal prosecutors are now calling a $300 million
fraud, should be a clarion call for caution among the many investors who have
been throwing money at hedge funds recently. This is especially true for institutions
-- endowments and public pension plans -- that have flocked to hedge funds
with the hope of increasing their returns. Because many of these institutions
are having financial difficulties -- low interest rates are cutting deeply
into their returns -- they are too often captivated by investments that seem
to promise outsized gains with little risk.
multifactor risk model acts as a road map for navigating risk and provides
investors with alternative routes to reach their investment summit,"
Steve Henderlite, a co-founder and principal of Trail Ridge Capital L.L.C.,
said in a press release from October 2003. Trail Ridge Capital is a hedge
fund and fund-of-funds company that had clients in Bayou. Mr. Henderlite did
not return a phone call seeking comment.
is also an adviser to a new investment fund, the Undiscovered Managers Spinnaker
Fund, offered to wealthy individuals by the investment unit of J. P. Morgan
Chase. The fund, which started last November and had $7.3 million in assets
as of March 31, held $662,602 in Bayou. J. P. Morgan says it has written that
investment down to zero.
Central to the
Bayou story, and to almost every other financial disaster of recent years,
are conflicts of interest. At Bayou, these conflicts began in its brokerage
unit, which executed trades for the hedge funds. Because the brokerage unit,
Bayou Securities, was wholly owned by Mr. Israel, he was able to profit personally
from the rapid-fire trading conducted by the funds he oversaw.
But some Bayou
investors who got into the funds on the recommendation of investment consultants
were confronted with another layer of conflicts. That is, the consultants
who recommended the hedge funds to their clients and the funds of funds that
bought Bayou shares for their investors often received compensation from
Bayou for sending assets its way.
While some investors
may not find fault with such an arrangement, institutional investors who have
a fiduciary duty to their beneficiaries should definitely steer clear of the
view, if a hedge fund manager wants to pay a particular level of fees to a
marketing agent, that's their business," said Orin Kramer, chairman of
the New Jersey Investment Council, the oversight board for the state's pension
system. "But as a fiduciary, I would be very uncomfortable dealing with
a gatekeeper who is being paid on both sides of the trade."
not all fiduciaries know where these conflicts lie. They are often well hidden.
consultants frequently have undisclosed financial arrangements with hedge
fund managers that create a conflict of interest," said Edward A. H.
Siedle, president of Benchmark Financial Services, in Ocean Ridge, Fla., a
company that works for pension funds to investigate possible wrongdoing among
outside money managers.
Mr. Siedle says
the nature of these deals varies. Sometimes the payments come in the form
of commissions on trades steered by a hedge fund to a brokerage firm that
is affiliated with the consultant; in other cases the payments are fees paid
by the fund based on the assets the consultant brings in. In one case, Mr.
Siedle said, he found that a pension consultant received a partnership
interest in the hedge fund to which it was steering clients.
were a part of the picture at Bayou. According to materials provided by the
fund to a prospective investor in 2003, Bayou had several outside marketers
that it paid either as a percentage of assets raised or through commissions
to the promoters' "designated broker/dealer."
One of the firms
that Bayou listed as an external promoter at that time was the Consulting
Services Group of Memphis. Bayou also gave prospective investors the name
of E. Lee Giovannetti, chief executive of Consulting Services, as a reference
and as an institutional investor in Bayou.
Joe Meals, a
spokesman for Consulting Services, said that the firm did act as a reference
for Bayou in 2003 and that it had recommended Bayou funds to clients. But,
he said, "We became uncomfortable with the operations at Bayou and made
recommendations to all our clients that they redeem their accounts, and they
did so long before any of these issues came to light." He added that
Bayou "may have executed commissions through our affiliated broker dealer
at one time, but not recently."
did the right thing in advising its clients to exit Bayou before the debacle.
Others weren't so lucky.
In coming weeks,
federal and state investigators will try to sort out what happened to the
money that investors entrusted to Bayou. Because Bayou's minimum-investment
requirement of $250,000 was smaller than that of most hedge funds, the firm
unfortunately attracted a lot of individual investors. The United States attorney
in New York is seeking the forfeiture of all of Bayou's assets, including
$100 million seized by authorities in Arizona last May. How much Bayou's investors
ultimately get back is anybody's guess.
especially those who are fiduciaries, should take a lesson from the losses
at Bayou. Conflicts of interest in the financial world are often hard to uncover.
But refusing to do the necessary digging is downright irresponsible.