Madoff has, over a period of more than 20 years, apparently conducted the largest
fraud in the history of the financial services industry, anywhere in the world,
ever.Moreover, he managed to
conceal the fraud from a roster of clients that include many of the world’s
most sophisticated investors.John
Grisham could not have come up with a story of such magnitude, colossal impact
and brazen audacity.
claimed that the total amount lost was $50 billion (more than enough to save
the US car industry a couple of times over, let’s not forget).This is significantly above the $17
billion that the firm is thought to have managed at the beginning of the year,
but, as press reports identify ever more investors with billion dollar plus
allocations, it is alarmingly plausible that the $50 billion could be true.
Before we go
further, we want to be clear that Castle Hall has never conducted due diligence
on the Madoff organization.Our
knowledge is limited to conversations we have had with industry practitioners
over the years.
point – and the only saving grace in this catastrophe – is that Madoff is an
incredibly unusual organization with what we understand to be a unique
difference, and the fatal flaw which allowed this fraud to be executed, is that
Madoff custodied investors’ assets in its own broker dealer entity.Absolutely every piece of paper which showed
that investors’ money existed was, therefore, produced by the Madoff organization
itself.They were - so it would seem - all fake.
We should be
very clear that other hedge funds do not follow this structure.There’s a good reason why, as this creates
a blatant conflict of interest and an absolutely basic control deficiency. What this does mean though – thankfully
– is that there are no more “mini Madoffs” waiting in the wings.
this, though, we still have an obvious question – why would anyone ever go
along with such a crazy structure?This is the real question from this debacle, and where the real lessons
can be learned.
argument for the defense is the length of the fraud.Even Madoff skeptics had to admit that the firm had operated
for years and years and had always paid investors back.There was, therefore, a common sense
that if Madoff was a fraud, then surely it would have been uncovered by now.This is a very powerful and entirely
there is the veneer of respectability offered by the multiple Madoff feeder
entities.Many of these were run
by highly reputable organizations, from dedicated asset management firms,
through private banks, to global financial institutions.The feeders had Big 4 auditors and,
often, well known administrators. Surely,
the argument went, how could it conceivably be possible to fool all of the
people all the time?
Madoff was subject to the full gamut of US regulatory oversight at both the
broker dealer and (more recently) asset management levels.
Madoff allowed managed accounts which showed full transparency (albeit, and
this is the crucial point, with all the paper “proving” trades and holdings
coming from Madoff himself, not a third party.)
despite many, many criticisms and innuendo, no-one came up with any evidence
that there actually was fraud taking place.
factors combined enabled some of the world’s smartest people to suspend their
disbelief.And there was plenty to
disbelieve, beyond the core problem of no independent third party holding fund
imagine how we can write this given the allocators involved, but pretty much
all Madoff’s investors would admit that they never really understood how the
firm made its money.Press reports
suggest that no-one else who has ever tried a split-strike conversion strategy
has ever been remotely as successful.Indeed, it’s probably fair to say that no-one following any investment
strategy whatsoever has been able to generate the same returns with so little
volatility over so long a period.
the slight snag that the firm auditing a $20 billion asset management
organization was a three person shop (full credit to the institutional
consulting firm Aksia who took the time to investigate the auditor and found
that it operated from a tiny, one room office.)
the paradox that, for all the supposed portfolio transparency, Madoff is
notorious for their refusal to provide operational transparency: it was
apparently impossible for investors to get in to actually kick the tires at the
Madoff organization itself.Indeed, there seems to have been a threat that if you asked too many
questions you would be ejected from the club.Various reports indicate that the asset management firm ran
from a separate floor of the infamous lipstick building, with only a handful of
individuals – mostly family members – able to access the inner sanctum.
So, what are
the lessons from these almost inconceivable events?
we said above, Madoff is unique in that the firm custodied its own assets.As such, this is an isolated set of
circumstances which actually has very little relevance for the rest of the
hedge fund industry.You could
argue that a Goldman Sachs hedge fund using Goldman as a PB creates the same
conflict, but we’re much more prepared to give Goldman the benefit of the
doubt.Investors should not, however,
have accepted this custody arrangement for Madoff.Neither should the auditors of the Madoff feeders.
lesson is that, irrespective of the manager involved, investors must apply a
consistent and thorough due diligence process.It’s a sad fact that people universally have less appetite
to ask tough questions when they are making money.Due diligence, though, is counter-intuitive: the highest priority
is always managers who are doing – or appear to be doing - too well.
lesson, though, is that complex financial instruments can be a fertile ground
for fraud, especially when combined with the toxic mix of an opaque hedge fund
structure and an arrogant but convincing manager. A necessary outcome from this debacle is a change in
attitudes: managers who have unusual structures, refuse to provide adequate
operational transparency and treat due diligence as an inconvenient intrusion should
find it considerably more difficult to raise money in the years to come.