Madoff debacle may pressure Fund of Funds concept part 2

Cluck, cluck. The chickens are coming home to roost. Or are they turkeys?

It appears that at least one hedge advisory business is under pressure in the wake of the Madoff debacle, and the fees in question are astounding (see prior post “Madoff debacle may pressure Fund of Funds concept” December 14-08). According to the NYT, Fairfield Greenwich Group earned US$500 million in fees since 2003 on their sales of Madoff products:

Internal documents from Fairfield show that the firm has taken more than $500 million in fees since 2003 alone from the money it placed with Mr. Madoff. Nearly all those fees went to a handful of Fairfield executives, including Walter M. Noel, Fairfield’s founder, who used the money to build a glamorous life, splitting his time between homes in New York, Connecticut, Florida and the Caribbean.

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Another document, this one prepared in 2007 as Fairfield Greenwich considered selling itself in what at the time was a very rich market for hedge-fund advisory companies, shows just how much money it made from its relationship with Mr. Madoff.

According to the document, Fairfield generated $250 million in revenue and $200 million in profit for the year that ended Sep. 30, 2007. Nearly 65 percent of that money came from fees on Sentry [Madoff], and nearly all the profits were distributed among the firm’s 21 partners. Fairfield’s employees were also lavishly compensated, with at least four receiving more than $5 million in pay.

80% net profit margins! Find me another business with margins like that. Trafficing cocaine, for example, seems less lucrative on the margin front based upon the number of people involved in Denzel Washington’s team in the movie “American Gangster”.

Fairfield undertook to segregate accounts at Madoff, and promised its investors that it would check account values weekly. And it would compare all trades with Madoff’s custodial records. Another group, Citgo Fund Services, would double check the records.

What a false sense of comfort all of this provided Fairfield’s investors. What’s interesting isn’t that Fairfield generated US$200 million of profit each year, it’s that US$50 million a year wasn’t sufficient to hire enough qualified staff to find out that Madoff couldn’t execute the trading strategies he claimed were the source of the stable profits that Fairfield was skimming in their “1 & 10” business.

Another firm, run by Jacob Ezra Merkin, raised US$1.8 billion from other investors, and put almost all of it into Madoff. Not the best example of diversification strategies. For the access to Madoff, Mr. Merkin charged 1.5% per year. That’s US$27 million per annum for connecting the likes of Tuft’s University to Madoff. Oh, and due diligence services as well.

Banco Santander had 38% of their hedge fund of funds in Madoff, while Fairfield and Mr. Merkin were far higher. For the investors who entrusted their funds with these intermediaries, you’d have hoped they might have been concerned at the concentration levels. It’s not as though this fraud hasn’t gone on for years. There was ample time to ask questions.

If your hedge fund of fund advisor put all of your capital into one or two funds, and the money is now gone — whether it be due to fraud or bad investment decisions (the more common afflicition) — perhaps it’s just desserts.

An institutional investor pal told me recently that the hedge fund model is dead. So too, you would assume, is the hedge fund advisory business.

In the wake of the glaring lack of due diligence, the rest of the Fund of Funds players will have to justify their “value add”. A perfect chance to separate the wheat from the chaff in that business.

MRM