HEDGE FUND INFORMATION FOR INVESTORS
Hedge
funds are minimally regulated private investment
partnerships that historically accept only
high-wealth investors. The theory behind their
creation was that high-wealth investors are
"financially sophisticated" and
therefore did not need or want to incur the
additional administrative expense of reporting
to a regulatory agency. The label "hedge
fund" is not a specific legal term, but
rather is used to describe an investment vehicle
with great flexibility in the investment strategies
it can adopt; many of these strategies are
unavailable to traditional mutual funds. Hedge
funds can invest in equities, bonds, options,
futures, commodities, arbitrage and derivative
contracts, as well as illiquid investments
such as real estate. This gives hedge funds
the potential to profit in times of market
volatility. Hedge fund managers are compensated
on a contingency-based fee structure, which
typically earns them a 1% management fee plus
an incentive fee of 20% of annual profits.
Although
the exact number of hedge funds is difficult
to quantify due to a lack of centralized reporting
requirements, it is clear that hedge funds
have grown exponentially in the last ten years.
Industry trade publications indicate that
hedge funds have quadrupled in number (from
approximately 2,100 in 1996 to approximately
8,800 in 2006), have over $1.3 trillion under
management and account for 20% to 50% of the
daily trading volume on the New York Stock
Exchange.
Hedge
funds offer many benefits, but because of
the volume of assets under management, they
draw special attention when they fail. Hedge
funds can fail for a variety of reasons. A
hedge fund with a small asset base can experience
crippling cash flow problems following a period
of poor returns on investment. Excessive leverage
can precipitate sudden capital depletion when
investing in volatile financial instruments
or commodities. Of most importance to law
enforcement and regulators, however, is when
hedge funds fail due to fraud. Debate continues
among civil regulatory agencies and in Congress
as to what, if anything, should be done to
regulate the industry to control potential
fraud and abuse.
The
current investment climate, which lacks regulatory
scrutiny, may tempt unscrupulous hedge fund
managers to commit fraud. Hedge funds themselves
are not illegal; they are simply the vehicle
that facilitates fraudulent activity by managers.
The FBI has investigated a variety of frauds
that involve hedge funds. In the Daedalus
Capital Partners case, for example, a classic
advanced fee scheme was perpetrated by the
hedge fund manager; investors received false
financial statements claiming large profits,
when in fact the money was being siphoned
off and used to finance the manager's lavish
lifestyle. In the Global Time Capital Growth
Fund case, on the other hand, the hedge fund
manager was convicted of trading on material
non-public information regarding an impending
bank merger--a classic example of insider
trading. Finally, in the Bayou Management
LLC case, the hedge fund principals created
a legitimate hedge fund, suffered losses in
trading and later issued false financials
to their investors to hide those trading loses.
Civil
regulatory agencies like the Securities and
Exchange Commission and the Commodity Futures
Trading Commission have identified several
indicators of fraud in hedge funds:
-
Lack
of trading independence: hedge fund managers
trading through affiliated broker\dealers
-
Investor
complaints: investors being unable to redeem
their investments in a timely fashion
-
Audit
issues: lack of audits by reputable independent
accounting firms
-
Litigation:
hedge funds being sued civilly by investors
alleging fraud
-
Unusually
strong performance claims: hedge fund performance
claims are better than market average over
a long period of time (they can't always
win, but if they do, possible indicator
of insider information or false reporting)
-
Illiquid
investments: investing in a commodity which
is not easy to value (incentive to overvalue
investment to earn a larger commission)
-
Valuation
issues: use of related parties to value
illiquid investments or use of a non-independent
fund administrator
-
Personal
trading: hedge fund managers trading in
their own accounts
-
Aggressive
Bear Shorting: hedge funds take a short
position in a stock (bet it will go down)
and orchestrate efforts to disseminate unfounded
or materially false negative information
about the stock, eroding the price and allowing
the perpetrators to profit on the short
position
INVESTOR
DUE DILIGENCE - RED FLAGS
Depending
upon its investment strategy, each hedge fund
has its own unique investment risk and must
be assessed based upon its own merits. Investors
should fully understand the risk in investing
in hedge funds and should conduct appropriate
due diligence before investing.
Examples
of due diligence could include: