One year earlier, Bishop (later joined by five current and former NFL players) had invested $20 million in several hedge funds managed by International Management Associates (IMA) of Atlanta. Before writing his checks, however, Bishop attempted to vet the fund’s managers. He visited IMA’s offices to meet the principals, and he and some of his fellow investors asked the NFL Players Association’s Registered Financial Advisor Program, a service that scrutinizes money managers, to run a background check. Its review gave the firm a clean bill of health.

Today, Bishop believes the NFL program’s incompetence cost him and his colleagues their capital. In June, they filed suit against the NFL and its players union. According to court documents, the plaintiffs claim the Players Association failed to unearth state and federal tax liens totaling $1.04 million against fund principals Kirk S. Wright and Nelson Keith Bond. (Bond has not been charged with any wrongdoing.) Bishop and his fellow investors also argue that the advisor program failed to discover that Wright had inadequate professional liability insurance.

TOP VIEW Most hedge funds are run conscientiously, but the ones that implode because of incompetence or outright fraud hog the headlines. Reacting to recent high-profile fund collapses, investors and wealth managers are turning to specialized agencies to perform background checks on prospective fund managers. By combing through public records and interviewing colleagues and acquaintances, investigators can ascertain if these individuals are above board. Careful review of their operations also highlights those at risk of loss from problems with logistics.

By the time Bishop and his colleagues invested, IMA was close to insolvency, according to SEC charges filed this past February. The SEC alleged that IMA had “largely dissipated” the $115 million to $185 million in capital it had raised from about 500 investors since 1997. The SEC also claimed that IMA fraudulently raised money by misrepresenting the assets in, and rates of return of, its funds.

“It’s shocking,” Bishop says, referring to the failure of the Players Association background check to unearth IMA’s problems. “We just feel like we were let down. If we had known about their background, nobody would have invested.” (The NFL denies the players’ allegations. “There were no requests for background checks,” says Richard Berthelsen, general counsel for the NFL Players Association.)

While fund manager fraud like that alleged in the IMA case often seems to be constant fodder for the business press, it actually accounts for only a microscopic percentage of hedge fund failures. Aside from IMA, two cases in the past year have captured the most attention. KL Group in Miami lost $213 million and Bayou Management in Greenwich, Conn., lost $450 million. But according to Hedge Fund Research, a Chicago consulting firm, 848 funds shut their doors in 2005 (a year that saw more than 2,000 new launches)—representing a record 11.4 percent attrition rate. All but a few funds closed because they did not meet their investment objectives—not because their managers were crooks.

Despite this, a growing number of private investors, spooked by high-profile meltdowns, are seeking to avoid being caught up in the next debacle by hiring investigative firms and making increasingly pointed inquiries of fund managers themselves. This may be prudent, in part because the government’s oversight regime is in flux. (One month after Wright’s arrest in May, a federal appeals court overturned an SEC rule that required most hedge funds to submit themselves to regulatory scrutiny.) Many fund managers argue the rule was the wrong solution—an expensive and time-consuming attempt to head off fraud, when the overwhelming danger to investors is really incompetence among managers. In any case, as the number of hedge funds nears 9,000 and assets under management top $1.2 trillion, these vehicles remain largely unregulated, so careful due diligence is crucial to minimize the risk of serious loss.

In each of the recent fraud-related incidents, it is alleged that the fund managers misled investors and engaged in deceptive business practices. As they found it increasingly difficult to cover mounting losses, the managers panicked, and in their increasingly frantic attempts to recoup their losses, they took ever-riskier bets, which led to greater losses. “The desperate hedge fund manager can turn a fund into a Ponzi scheme,” says John Coffee, a law professor at Columbia University and an expert in securities regulation. “We are going to have repetitions of the Bayou-type scandal,” he predicts.

“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.”

The scandals of the past few years have also made it good practice for investigators to interview a fund’s principals. On occasion, they present their findings to the managers and ask for their response. Their reactions can often say more about their character than details in the dossier. “You’re trying to gauge their reaction, and that is more important than what they’re saying,” Shain says. “How honest are they? Do you have to be Johnnie Cochran to get the answer, or will they just tell you?”

Do-it-Yourself Diligence
Some investors are conducting their own version of due diligence, but unless they have some experience in this field, their results may fall short, and can even provide a false sense of security. “For most people out there, it would be a daunting task,” says Ed Bowman, a partner with Newtown Square, Pa.-based Veritable, a multifamily office overseeing $8 billion in investments. “We have the advantage of 15 years of interviewing these managers.” Firms that offer
access to hedge funds and funds of funds can pressure funds for more information than would be available to all but the largest individual investors.

Even so, Bowman likens the do-it-yourself due diligence he conducts to the type of steps investors should take when acquiring a small, privately owned company; the capital commitments and lack of transparency are often similar in both types of transaction because of the funds’ substantive investment minimums and often lengthy lock-up periods. “Simple things like verifying with a university if the individual claims to have a degree—these things are not hard to do,” he says. Bowman also follows the same procedure that a professional investigator would take when creating a background profile. “We talk to people we know in the industry to create a complete picture,” he says. “Maybe they went to school with the person, or maybe they worked for the person in the past.”

Whether or not an investor decides to hire an investigator or go it alone, a number of issues should be top of mind. If a fund outperforms on an unusually consistent basis, this may be a warning sign, Bowman says. When choosing a hedge fund, financial advisors often use quantitative screens to bring strong performers to light, but these tools may also highlight funds with overly consistent records—such as those that have been manipulated.

Another important aspect to investigate is the prospective fund’s logistical professionalism. Hotshot traders decamping from investment banks to set up funds may know how to run a front office (the trading floor) but be clueless about middle-office operations (where risk and information management activities take place) and what goes on in the back office (where trades are valued and accounted for), all of which are crucial to a fund’s success. Small funds often outsource some of these activities to third parties; these entities should be recognized industry leaders.

Funds that manage their own back-office operations should put them under the watch of experienced chief financial officers or chief operating officers, according to a report by David Aldrich, a managing director with the Bank of New York. Aldrich outlined a series of additional recommendations in Hedge Fund Operational Risk: Meeting the Demand for Higher Transparency and Best Practice, a paper published for the firm’s clients in June. If a hedge fund outsources these duties to a third party, investors should make certain that an operational staff member oversees that work. Aldrich also recommends that investors review funds’ rules governing trading and how trading errors are managed. Funds should also have a process for valuing assets, especially illiquid ones, that are independent from their trading floor. Chris Dardaman, a partner with Brightworth, a wealth management firm in Norcross, Ga., also recommends scrutinizing a fund’s use of leverage and the competence of its auditors and legal counsel.

While no amount of research can completely immunize investors from the risk of losses due to a clever manager’s determination to defraud, it can help weed out those firms poised to collapse from simple incompetence—or indolence. “Go with your gut; go visit them on-site,” Turecek says. “There are horror stories in which people have gone to a fund manager’s office, and there was no activity there at all.”  

Elizabeth Harris is a staff writer for Worth.
Illustrations by C.J. Burton.

Additional Information 
The Bad and the Ugly

A Starting Point
Web resources for DIY DUE diligence.

LexisNexis mines news and legal cases for information on
individuals and companies. lexisnexis.com

Pretrieve is a searchable archive of public financial and court records pretrieve.com

The National Association of Securities Dealers provides background data on registered brokers, including employment and disciplinary histories. nasd.com/brokercheck, 800.289.9999

The Federal Judiciary’s Public Access to Court Electronic Records— PACER—system provides information on fund managers’ legal histories. pacer.psc.uscourts.gov, 800.676.6856