Madoff offers an extremely expensive lesson in due diligence

Date: Monday, December 22, 2008
Author: Hedgeweek.com

Jérôme de Lavenère Lussan, managing partner of investment management consultancy Laven Partners, says that the fraud apparently perpetrated by Bernard Madoff lays bare the inadequate nature and lazy implementation of the due diligence analysis conducted by many investors and their advisers.

We hope the Madoff failure will be the tipping point from which operational due diligence is taken seriously. Parts of the investment industry have been lax for years, and there were plenty of warning signs of weak operational due diligence, from the correlation issues that shook the investment world in 2007 to the Bear Stearns' hedge fund crisis, to the ultimate failure of banks and funds and the realisation that the liquidity issue in fund of funds would hit investors hard.

Madoff is the ultimate failure in that it involved a fraud which bypassed most due diligence efforts by living off, in some cases, a reputation that played to the personal relationships that link investors to managers.

Madoff's collapse warns against being lazy when it comes to due diligence. Too many investors have proven that their investment selection was based on either personal relationships with the manager, information received from 'friends' or historical performance.

The Madoff failure shows that a rigorous bottom-up due diligence analysis is the only solid basis on which to invest in a hedge fund. Many investors lacked the courage to reject such a highly recommended and popular investment. However some did, which gives us confidence that in the investment world investors who do their work thoroughly will reap the benefits.

Madoff's collapse is an expensive lesson in how investors and their advisors should have carried out more thorough due diligence. Investors have for years purported to carry out due diligence that is detailed and focused on risk.

However, it has become clear that many rely on word of mouth endorsement and the false premise that it necessitates only a cursory analysis of the fund concerned. This is despite many warnings from consultants and academics, and recent experiences such as Amaranth and Bayou, not to mention rules and regulations on best practice from regulators both in Europe and beyond.

Reviewing documents for any fund strategy and assessing the extent to which they create liability or diminish responsibility takes expertise and time and should show up weaknesses. This is often the case for contracts with service providers such as auditors and administrators who rarely propose to incur any liability for their work, or in the case of prime brokers, whose legal terms in relation to the segregation of assets are often very one-sided.

It is crucial that due diligence covers operational risks, valuation processes, investment strategy, offshore structures and independent risk monitoring processes if investors want to avoid falling into this trap again.