“You’re trying to gauge their reaction, and that is more important than what they’re saying. Do you have to be Johnnie Cochran to get the answer, or will they just tell you?”

Engaging a Gumshoe
Firms that specialize in vetting fund managers, such as private detective agency Kroll and First Advantage Investigative Services, both with offices in New York, and Intelysis, based in Cherry Hill, N.J., are seeing their businesses boom. First Advantage says that it will investigate some 1,200 hedge funds in 2006, up from 100 in 2000. The company has scrutinized the backgrounds of more than 4,500 fund managers. The ranks of their traditional clients—fund of funds managers, family offices, wealth advisors representing affluent investors and pension funds—have swelled as individual investors have also requested their services.

These companies charge anywhere from a few thousand dollars to more than $30,000 per engagement, depending on the assignment’s complexity, which is based on factors such as the number of hedge fund principals being scrutinized and their location. The time required for background checks varies, but typically these agencies require two weeks to deliver an oral summary of their findings and four weeks for more thorough written reports.

Investigators begin by confirming elementary facts, such as a manager’s education and employment histories. They then delve into SEC and court records, as well as records from financial industry accreditation organizations like the National Association of Securities Dealers. These simple inquiries are often enough to set alarm bells ringing. In mid-2005, First Advantage investigators found one lawyer-turned-hedge fund manager who failed to reveal that not only had he been disbarred, but that his business partner faced an undisclosed seven-figure legal judgment, according to Randy Shain, a vice president at the firm.

The infamous Bayou scandal might have been avoided if investors had conducted a simple background check of Samuel Israel III, its founder, who pleaded guilty to fraud in 2005 after bilking investors out of $450 million. “Israel never graduated from college. He didn’t lie about that fact, but in this industry, pedigree matters,” Shain says. Israel did exaggerate his work experience by claiming he had been a head trader at another firm, when in fact he had not. “With hedge funds, this type of information is not a secret. You can identify these red flags if you just pay attention,” Shain adds. However, Peter Turecek, who examines hedge funds for Kroll’s business intelligence and investigations division, warns investors against excessive reliance on publicly available information. “It’s that other 15 to 20 percent that can be really eye-opening,” he says.

Investigators found one lawyer-turned-hedge fund manager who never revealed he was disbarred.

To unearth these subtleties, Turecek interviews fund managers’ acquaintances and colleagues. Many offer valuable details about the manager’s lifestyle and character. Turecek learned, for example, that one hedge fund principal was “great until 4:30 pm, after which time you find him at the bar.” In another interview, he learned that female assistants of another manager routinely quit soon after joining the company, reportedly because of inappropriate comments. While the manager was never dragged into court, the risk of a harassment suit was high and would have hurt investors’ interests.

The information gleaned from the interviews can help investors ascertain how a manager performs under stress—a crucial aspect of the job. The best fund managers thrive under pressure, says Jeffrey Brenner, a principal at Intelysis. The worst fall apart—and this may plant the seeds of fraudulent activity that can unravel a firm. “I don’t believe that many of these frauds occur with the intent of defrauding people, but they began with a manager conducting honest trading activity, only to find himself in trouble, and then having to cover it trying to get himself out with a spectacular play.”