Hedge-fund implosions have become somewhat routine. Suddenly, the upbeat financial reports and bullish calls promoting stellar returns disappear...
NEW YORK — Hedge-fund implosions have become somewhat routine. Suddenly, the upbeat financial reports and bullish calls promoting stellar returns disappear, all correspondence stops, and the money is gone from investors’ reach.
The latest example of this comes with the collapse of Bayou Group, once a high-flying Connecticut hedge fund with $400 million under management that went belly up last month. Now, the company and its founders are under investigation for fraud by state and federal authorities.
It’s not that Bayou’s situation is so unique; neither are the lessons that should be learned from its demise. Yet, it still serves as a timely reminder for investors about the dangers of hedge funds and how potential trouble can be sniffed out.
While bad behavior presumably isn’t endemic to the largely unregulated hedge-fund business, it can’t be forgotten that many funds strive for superior returns than the broader market by employing risky trading strategies, such as arbitrage, shorting stocks and betting on the movement of commodities futures.
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For those investors willing to take the risk, there can be big rewards — or big losses.
Clearly, those making such bets appear to be on the rise. In 1990, there were 610 hedge funds with about $39 billion in assets. Today, that has grown to nearly 8,000 funds with a total asset base topping $1 trillion, according to the Chicago-based research firm Hedge Fund Research.
That growth has been largely fueled by increased interest from groups such as corporate- and public-pension funds as well as endowments and charities. Millions of Americans now have a stake in the game, not just the wealthy individual investors who had long served as the backbone to the hedge-fund business.
By putting money into hedge funds, this new crop of investors hopes to juice up their investment returns, which have been hit hard by low interest rates and what many consider a mediocre performance in the stock markets since the dot-com boom ended five years ago.
From afar, Stamford, Conn.-based Bayou appeared like a respectable place to invest. It claimed to have $411 million under management at the end of the past year. Bayou officials touted their solid trading and portfolio-management experience, were accessible to investors big and small and provided regular updates on the fund’s stellar performance.
A much different reality is now emerging. The company’s founder, Samuel Israel, and other top executives went into hiding this summer as accusations of massive fund fraud mounted against them. Israel could not be reached for comment, and his lawyers in an Arizona case withdrew their representation of him.
Federal prosecutors allege that from 1998 through August 2005, Bayou “overstated gains, understated losses, and reported gains where there were losses.”
They are trying to freeze all Bayou assets, including $100 million that authorities in Arizona have seized.
That has left its investors scrambling to get their money back.
Too bad that some of the red flags are a lot more visible in hindsight.
For one, the company claimed that it used an independent auditor, yet the firm was founded by Bayou’s chief financial officer.
In addition, prosecutors allege that it was really a “sham” accounting firm that conducted “no audits, independent or otherwise.”
Bayou used its own brokerage unit to execute its trades, meaning that it profited on all the trading that the hedge fund did and had control over how securities were priced. Using a third party to handle such transactions is considered safer.