Bernie 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.
Madoff has 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.
Our first 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 operational structure. The 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.
Having said 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.
The first 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 reasonable viewpoint.
Secondly, 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?
Thirdly, Madoff was subject to the full gamut of US regulatory oversight at both the broker dealer and (more recently) asset management levels.
Fourthly, 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.)
Finally, despite many, many criticisms and innuendo, no-one came up with any evidence that there actually was fraud taking place.
These 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 assets.
We can’t 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.
There’s also 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.)
There’s also 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?
Firstly, as 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.
The second 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.
The final 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.
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