Madoff debacle may pressure Fund of Funds concept

It was quite a week.

Some very serious people (Illinois Gov. Rod R. Blagojevich, New York Lawyer Marc S. Dreier, and Bernard L. Madoff) appear to have been so driven by greed that they’d stop at nothing to live the high life.

For the investors that have lost billions in the Madoff debacle, the question isn’t “why did he do it?”. The issue is, frankly, “where were the Fund of Fund analysts and risk managers?” Banco Santander is said to have lost US$3.1 billion of their $8 billion Fund of Fund program. Can you imagine a University Endowment hiring Santander to manage their hedge allocation, with the expectation that a “fund of fund” strategy was the perfect way to diversify the risk inherent in hedge funds. And Madoff’s primary business wasn’t even a hedge fund, but a broker dealer registered by the Securities Exchange Commission.

38% of the Santander sub’s capital was in one firm’s jeans. Can you imagine how confident the risk manager at Santander would have to be to feel that such a large allocation was the prudent thing to do. How much primary research would have been done to warrant such confidence? To think that one man could trick one of the largest banks in the world with fake trading records and cash dividends paid out of the capital account of other investors.

Perhaps Madoff used some leverage in the fund, which enhanced the downside as the market collapsed this year. But at its core it is still just a shell game that nobody noticed.

Much like the subprime crisis, you have to wonder if the people who were paid to do the due diligence even knew what they were looking for. A Chief Financial Officer I know once criticized the due diligence that some law firms do on behalf of the underwriters when equity offerings are announced; lawyers come in and scour the issuer between the time an equity deal is announced and closing. He was convinced that “these young people don’t understand what they are looking at. They are looking at the contracts, and the leases, but they are junior and don’t have the experience to know what the files mean.”

You have to wonder if the same issue arose here. And if it will shake the confidence that institutions have in using a fund of fund strategy to “manage their exposure” to the hedge fund industry.

We don’t do a transaction without spending some time at the corporate office of the prospective borrower; and our average deal size is just $5 million. You can’t outsource due dili, and that’s unfortunately what happens all too often when you hire a middleman to do your research for you.

MRM