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What Your ODD Failed to Identify: Red Flags for Allocators and Investors

Feb 14, 2017

Challenging markets, suboptimal returns, pressure to reduce management fees and performance fees, and increased operating costs are combining to make it tougher than ever for fund managers to stay in business. These challenges could create an environment in which there is an increased risk of fraud.  

Allocators and investors need to be aware of, and on the lookout for, the following three conditions that are generally present when fraud occurs:

  • Incentives/Pressures –A fund manager may be under pressure to achieve an expected investment result and therefore may have an incentive to falsify results to demonstrate a desired outcome and/or to earn performance-based compensation.
  • Opportunities – An opportunity to commit fraud may exist when a fund manager is able to easily access cash and/or securities.
  • Attitudes/Rationalizations – Fraud risk increases when the person(s) involved possess an attitude that allows them to rationalize committing the fraud (for example, thinking the losses will be made up in the future when performance improves or that the fraud is not significant to the investors or that they are ‘entitled’ to or have ‘earned’ the money based on past good performance).

What do allocators and investors do to identify pressure on fund managers that could lead to potential fraud? Due diligence focuses on a fund manager’s pedigree, track record, experience and expertise in managing investments. Background checks are used to identify bad actors or past anomalies. Tone at the top and a culture of compliance are always positive behaviors for a fund manager to exhibit. Other areas of focus include assets under management, fee structure, expense ratios, and the business plan of the fund manager.

Frauds perpetrated by fund managers when the three fraud risk conditions are present typically take one or both of the following forms:

Falsifying books and records – This type of fraud entails altering a fund’s books and records to cover losses or create performance that does not exist. This is often achieved by creating investments or performance that does not exist and may involve collusion with “related parties.”

Misappropriating assets – This type of fraud involves theft of the fund’s assets and is often accomplished by causing the fund to pay for a fictitious investment or diverting a payment to an investor (such as for a distribution). Accordingly, in a fund environment, a misappropriation of assets is often accompanied by falsified books and records in an attempt to cover up the fraud.    

Regulators, in recent litigation, have increasingly focused their attention on related parties. What can allocators and investors do to identify related party relationships and transactions? Allocators and investors spend significant time identifying and understanding related party relationships and transactions. This is done through a combination of inquiries with the fund manager, review of legal documents and filings with the SEC or other agencies (Form ADV and other regulatory filings). Allocators and investors could also ask the manager for an exhaustive organization chart that includes a complete listing of all related entities, related individuals and their cross-relationships to help better understand related parties and relationships. However, when fraud is perpetuated, it is not what has already been disclosed to investors but usually something that has been hidden or not disclosed to allocators and investors that is the cause of investor losses.

How does one identify something that has been hidden or has not been disclosed? The key is to know and interact frequently with the fund manager. In addition, allocators and investors should obtain and review a fund’s audited financial statements and pay special attention to the related party disclosures to assess if they are consistent with their understanding of the fund and its related party relationships.

Red flags that allocators and investors can look for include:

  • Is the fund manager trading investments outside his area of expertise or has the investment portfolio drifted from the fund manager’s traditional focus or the expected areas of focus described in the fund’s legal documents (for example, “style drift”)?
  • Do the fund’s legal documents properly explain all significant investment risks to the investors?
  • Does the fund manager fully understand the significant risks involved in making the investment?
  • Uncorrelated returns or exceptional returns defying market performance or logic.
  • Poor documentation relating to ownership or purchase of an investment followed by poor documentation of investment risks involved.
  • Unnecessarily complex investment products and or use of unnecessarily complex investment structures involving related parties.
  • The fund manager is unable to articulate the investment and significant risks clearly.
  • A sense of secrecy surrounding the investment either by citing confidentiality or competitive advantage.
  • Involvement of related parties: the investments are made in or through related entities. Look out for the fund borrowing money or loaning money. As well as being irregular, this can possibly be a fraud risk as it indicates that the fund or manager has exhausted its ability to find capital elsewhere and therefore could be loaning money to the manager or related parties.
  • Physical signs: aggressive behavior or unusually sugarcoated communications followed by aggressive behavior when confronted with tough questions.
  • Other physical attributes: Does the manager exhibit an overly and unhealthy competitive streak in work or home life? Does the manager have a dominant personality? Is he/she unwilling to submit to any sort of checks and balances or scrutiny?
  • Pressures at home: stagnant or lack of substantial growth in AUM. An office size/location and number of employees that is inconsistent with current AUM. A contraction of AUM without an appropriate level of downscaling. The use of high interest borrowing to sustain operations.
  • Personal challenges: Life altering events such as going through a separation/divorce or significant medical condition involving the manager or a loved one.
  • Using someone else’s money to either maintain an exorbitant and lavish lifestyle, or being very generous/holding big parties/paying for lavish social events.

Gatekeeper responsibilities: Several independent parties often act as gatekeepers to a private fund. Significant among those are the fund’s independent administrator and independent auditors. While investors and regulators have for a long time acknowledged the role of independent auditors, more recently fund administrators are being viewed as an important cog in the wheel for a private fund. Recent regulatory actions against administrators reinforce this view. It is an important step for allocators and investors to interact with the administrators and auditors or at least ask the fund for any significant written comments from gatekeepers impacting the fund operations.

Asset Management Intelligence – Q1 2017

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Gautham Deshpande wearing glasses

Gautham Deshpande

Mr. Deshpande practice focuses on financial services, including audits of hedge funds, private equity and venture capital funds, commodity pools, real estate partnerships and REITS, alternate investment vehicles, and investment advisors.

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