Wednesday, December 17, 2008

A Telling Look At Who Didn't Invest in Madoff

This fraud is going to be as much about the lack of due diligence as it is about Madoff's fraud, his compliance officer marrying an SEC attorney who investigated the firm, and his $65 haircuts.

It is going to be about the apparent lack of due diligence by the individuals who invested in Madoff, and those who recommended the investment.

As the story develops it appears that we are going to find completely inadequate due diligence, flagrantly fraudulent account statements, and a lack of follow up by investors and their other advisers.

I have been convinced of that since the start of this story, and my conviction is gaining strength every day. Securities Docket pointed out this story from Fortune Magazine - "Who isn't a Madoff victim? The list is telling"

The author makes my point. Sure, some investors made direct investments with Madoff, and they got scammed. But a significant number of investors made an investment at the recommendation of their own adviser. Fortune's point is that anyone who did their homework should have known something was wrong.

And to make the point; look who is missing from the list of investors. The managers for large institutions did not invest with Madoff. I mentioned the blacklisting by Societe Generale in an earlier post, an event which occurred because of due diligence performed by the bank. And other hedge fund managers who did not invest because their due diligence revealed that the returns were not possible.

The Fortune article points out that Universities and large institutions did not invest. In the list of investors, "[t]here's no Harvard management, there's no Yale, there's no Penn, there's no Weyerhauser, no State of Texas or Virginia Retirement system."

Why not? A $50 billion dollar fraud by a major Wall Street figure should have snared a University or two. Why did they avoid the fraud?

Simple. Due Diligence. Madoff's funky account statements, improbable returns and is "black box" of investing would have not survived an institutional quality due diligence review. Quoting from the article "when you get to page two of your 30-page due diligence questionnaire, you've already tripped eight alarms and said 'I'm out of here.'"

The manager quoted in the article claims to have seen those signs in 1997. (Societe Generale claims they saw it in 2003, this claim goes back 11 years!) According to the article and the manager

"I found him stylistically like a lot of traders: fast-talking, distractable, not remarkable," Hedges says of Madoff. But during their two-hour meeting, Hedges says, "there was one red flag after another."

For starters, he couldn't grasp Madoff's investing strategy. "I kept saying, 'you've got to explain it to me like I'm in first grade,' " he says. To no avail.

Then there was the fact that Madoff was charging no fees other than trading commissions: "The notion that something is fee-less -- which is what they largely proferred -- is too good to be true."

The fact that Madoff's operation was audited by a microscopic accounting firm also worried him. "He was also so secretive about his asset base -- that was another red flag."

In the end, Hedges was uncomfortable and Bessemer decided not to let Madoff manage any of its money.

It remains to be seen if this is just one extremely astute investment manager, or perhaps a very lucky manager.

Or maybe he was just a diligent manager. My firm is in the process of investigating exactly what information was available to investors and managers in connection with their recommendation of Madoff as a place to invest.

The results will be that this was either an extremely sophisticated investment scam that fooled most professionals, or a series of due diligence failures.

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