UPDATE: We published this post last December, in the days after Bernie Madoff’s fraud came to light. As we note below, we suspected it was impossible that Fairfield Greenwich, which vaporized $7 billion with Madoff, could have done the due diligence on Madoff it claimed to have done (the claims below, which we got from FGG’s web site, have since been removed). Massachusetts AG William Galvin has now concluded the same thing and charged FGG with fraud.
EARLIER: The Bernie Madoff swindle caught a lot of folks asleep at the switch. Chief among them? Funds-of-funds and other third-party advisors who brag about the extraordinary diligence of their manager selection process.
These advisors charge huge fees–often 1% of assets and 10% of gains–and are staffed by seasoned professionals who often take home millions of dollars a year. Given the number of red flags that Madoff’s investment strategy and infrastructure raised among many experts, one would have expected these firms to have gone to extra-heroic lengths to make sure Madoff was legit. It will therefore be interesting to see what documents and testimony they produce to demonstrate that they did this.
For example, take Fairfield Greenwich Group, which is run by Jeff Tucker (right). The firm had $7.5 billion, more than 50% of its assets, invested with Madoff. The firm says it is “shocked and appalled” by the Madoff news. So, we expect, are its clients.
Here’s how Fairfield describes its initial manager research process–the process by which Fairfield screens a handful of super-promising managers from the hundreds it meets each year:
FGG is introduced to several hundred potential managers in the course of each year. A relevant subset of these leads are pursued and background information on promising potential relationships is collected and shared among FGG’s professionals for initial assessment.
The nature of FGG’s manager transparency model employs a significantly higher level of due diligence work than that typically performed by most fund of funds and consulting firms. This model requires a thorough understanding of a manager’s business, staff, operational practices, and infrastructure.
[That’s good to hear. So it will be interesting to see how FGG explains why Madoff’s strip-mall based accountant and tiny operating infrastructure satisfied its requirements. Also, if FGG really developed a “thorough understanding of the business, staff, and operational practices,” it may have been the only firm on earth to do so. Even people who worked for Madoff claim to have no idea what he was up to.]
At this stage, FGG begins qualitative and quantitative reviews of a manager’s past performance obtained from independent sources, as well as a series of manager interviews and reference calls.
[How many of the people who wrote to the SEC saying Madoff was a fraud did FGG talk to? What “independent sources” did they use to examine the returns. Madoff’s accountant?]
Through this process, a preliminary assessment evolves of a manager’s business and investment practices. Particular attention is paid to the extent to which each manager’s controls are reasonably suited to maintain operational, market, and credit risks at an appropriate level and as represented by the manager.
During this period, FGG personnel also have an opportunity to evaluate a manager’s attitudes and receptiveness (as opposed to his proclaimed intention) towards providing FGG with full transparency of its security level trading activity and access to its investment thought process.
[This is the real key. Some folks who looked at Madoff’s trading strategy in detail say they could not understand or replicate his returns. We look forward to reading the documents that made FGG comfortable that Bernie’s trading strategy wasn’t just some black box that spit out attractive-looking numbers on a page]
This close level of communication and access is the cornerstone of FGG’s ongoing relationship with the manager, without which a business relationship with FGG would not exist.
A small portion of managers who pass through this basic screening process are considered for further, significant investigation. Some do not progress beyond this stage; some are placed on a watch list for further monitoring.
FGG’s business model enables the firm to have privileged access to all aspects of a manager’s operation and investment process, including security level transparency for risk monitoring purposes.
And that’s just the initial screening process. Now look at the work FGG says it does for the handful of managers who pass this screen. Keep in mind that after conducting this research, FGG concluded that Bernie Madoff was apparently the single best manager in the world (judging by the percentage of FGG’s assets allocated to him).
FGG’s due diligence process is deeper and broader than a typical Fund of Funds, resembling that of an asset management company acquiring another asset manager, rather than a passive investor entering a disposable investment.
A number of areas of inquiry are examined by a team of FGG professionals who specialize in evaluating respective areas of risk. Typically, a manager has been investigated and monitored for six to 12 months before that firm can be accepted onto the FGG platform. Long negotiating periods enable FGG to be more confident of its decisions before proceeding with a manager. Areas of examination are centered around the following:
1. Portfolio Evaluation, Investment Performance, and Financial Risks:
A core area for further analysis is to attempt to dissect and further understand investment performance, how a manager generates alpha, and what risks are taken in doing so. As portfolio management and risk management incorporate elements of both art and science, FGG applies both qualitative and quantitative measures. FGG:
- Examines independent prime broker trading records
[Except, apparently, in the case of Bernie Madoff, because he didn’t have any. He was his own broker.]
- Conducts detailed interviews to better understand the manager’s methodology for forming a market view, and for selecting and exiting core positions
- Analyses trading records
- Conducts a number of qualitative and quantitative tests to determine adherence to risk limits over time
- Confirms portfolio loss risk controls, diversification and other risk-related control policies, as well as any experience regarding unexpected or extreme market events
- Reviews the risk and return factors inherent in the strategy
- Evaluates capacity issues, which may affect alpha, as well as expected opportunities going forward within each candidate’s strategy
- Analyses the various drivers underlying a particular portfolio’s risk
- Evaluates credit risk and market risk both at the instrument and portfolio level
- Assesses the extent to which leverage is used by a manager, as well as how it is used, the funding sources, and the impact on the risk profile of the fund
- Investigate whether or not private or special registration securities are held, and determine how the daily trading volume and inventory held compares to the float and/or daily trading volume for a given security
FGG also conducts many quantitative reviews of investment performance in light of:
- Fees and fee structure
- Historical draw-downs
- Return volatility
- Commissions earned
- Performance return in calm versus volatile markets
- Current/historical correlation of the fund under consideration with standard industry benchmarks, peer groups, and other FGG or competitor funds used as benchmarks
FGG attempts to understand the return attribution for individual securities in the portfolio, and conducts a full suite of VaR analyses and stress tests to model the loss distribution function under extreme market scenarios. Leverage, concentration limits, and long/short exposures are examined over time to assess whether they have remained within operating guidelines.
Style fidelity is another key area of inquiry; the manager’s trading pattern over time and through various market environments, FGG determines whether the manager is prone to trade outside of their area of expertise.
2. Personal Background Investigation:
FGG examines the abilities and personalities of the individuals involved in managing the fund through extensive interviews, as well as background investigations.
Personal credit standing
Litigation and regulatory background
FGG explores the manager’s experience and qualifications relative to the strategy being managed. Prior professional associations of a manager’s key personnel can be crucial in understanding a person’s experience and character and how they run their investment management business.
3. Structural and Operational Risk:
“Operational risk” refers to the risk of loss resulting from inadequate or failed internal processes, human resources, or systems, or from external events. Operational failures, including misrepresentation of valuations and outright fraud, constitute the vast majority of instances where massive investor losses occur. Other operational risks include staff processing errors, technology failure, and poor data.
Pricing models, as well as the adequacy, independence, and transparency of valuation procedures, contingency plans, and other trading and settlement procedures are all matters for close scrutiny by FGG professionals.
FGG seeks a sound understanding of whether a hedge fund possesses key controls in the areas of portfolio management, conflicts of interest, segregation of duties, and compliance. FGG carefully assesses the controls and procedures that managers have in place and seek to determine actual compliance with those procedures, often suggesting modifications, separations of responsibilities, and remedial staff additions.
4. Legal, Compliance, and Regulatory Risk:
FGG’s legal, compliance, and accounting teams specialize in investment management regulation, securities compliance, corporate operations, and tax issues. Hedge fund managers function within an ever more complex legal and regulatory landscape, and the role of this part of the diligence exam is to determine the seriousness of any deficiencies in this area which may cause risk of sanction, loss, or reputational embarrassment.
Both in-house and retained legal professionals interview the management and staff of the manager, research regulatory filings, and review corporate organizational documents, as well as fund memoranda and related material contracts.