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Notes from the Greenwich Roundtable

Thanks to hedge fund guru Steve McMenamin for notes from his most recent Greenwich Roundtable, where I served as a panelist along with Jules Kroll, Jim Roth and Rusty Olsen. Ben Alimansky of Glenmede moderated the July 8th, 2010 session.

Erin Arvedlund, Barron’s Magazine

In May 2001 I wrote an article for Barron’s questioning Bernie Madoff’s strategy.  I didn’t out him.  I just raised some important questions.  Ken Nakayama, an equity derivatives strategist, called to alert me to a hedge fund that never loses money.  He tried to reverse engineer the Madoff trades but he was unsuccessful.  Madoff was running $6-10 billion in OEX options and they were a dying instrument.  His fees didn’t make sense.  The marketers were getting all the fees and Madoff just collected the brokerage commissions.  There were 2 types of investors, those who were ecstatic and those who were terrified about the strategy.  Madoff finally spoke with me just before the story went to press.  He claimed he was trading over the counter and in Europe.  He also claimed his secrecy was to guard his competitive edge.  The story ran and much to my shock, I didn’t get a single phone call.  Harry Markopolis was trying to blow the whistle too.  7 years passed.  On December 11th Madoff was arrested and I yelled ‘holy shit, they got him’.  Then I wrote the book “Too Good To Be True”.  I believe the fraud went on for 30-40 years. The $65 billion figure wasn’t real because they were all the inflated profits.  The moral of the story is to ask the dumb questions.  Sometimes they seem so dumb that they seem not worth asking.  Use stupidity as a stage prop.

Jules Kroll, Kroll Bond Ratings

Four years ago I warned that there will be more frauds popping up.  The incentives for alternative investment managers to cheat are too great.  The fees are too high and they are addicted to getting paid.  Today there is much excess.  When historians write about rewards in relation to work they will be writing an interesting chapter.  The reward to work ratio is out of whack.  It has been for a very long time.  Too many people are overpaid.  This business model will be harder and harder to sustain.  Beware.  The activities will get stranger and stranger.  People get accustomed to a lavish lifestyle.  It becomes an addiction.  The industry needs to engage in self-help.  The fish tank needs to be cleaned and kept clean.  I hope more of you have the guts to blow the whistle.  I don’t think you will.  The industry is in disrepute.  Millions of people are counting on you.  They’re hurting.  My effort will be to create a new rating agency that’s funded by investors.  This is a public sector problem that can be solved with a private sector solution.  Kroll Bond Ratings will be issuing ratings in the structured products sector.   Better ratings must rely on diligence and judgment.

I’m honored to address the Greenwich Roundtable again.  Anyone with Steve McMenamin’s perseverance deserves to have many candles lit for him.  What are you selfish S.O.Bs waiting for?  Make a donation to keep this forum going¹.

Jim Roth, The Langley Group

Four years ago I spoke about effective techniques in carrying out due diligence for investors, and tonight I’d like to expand on those methods.  Investors face the challenge of making decisions based extensively on input from the subjects of due diligence themselves, who are not disinterested observers.  It is a common error for investors to fall in love with management teams or allow themselves to be susceptible to the biases of interviewees.  Approach diligence with a healthy degree of skepticism, speak with people with no vested interest and corroborate the data.  Don’t accept anything at face value.  Red flags signal a need to dig deeper.  Don’t come to premature conclusions based on limited input.  Become a student of human behavior.  Understand the biases of those you speak with.  When interviewing management, focus not only on the substance but also on signs of deception, both verbal and non-verbal.  Take advantage of available training in detecting deception.  Be flexible in due diligence interviews:  while it is important that diligence be comprehensive in scope, it is also essential to be efficient in narrowing the focus to the most significant issues.  Above all, be objective, keep your ego in check, and recognize your own biases to avoid subconsciously cherry picking data that leads to a hoped-for outcome.  This requires constant practice and a lot of self-discipline.

Rusty Olsen, Former-Eastman Kodak Pension Fund

The study Best Practices encompasses all strategies. The study was performed by a diverse group of investors and managers and it’s a work in progress.  It also covers almost all investment and operational aspects of evaluating a fund manager.  But it’s not enough.  It’s only a starting point.  Most of the preparation must be done before the face to face meeting.  The track record has little predictive value in forming our judgment.  We should pay attention to our intuitive reactions.  Listen to that small voice within.  Understand the strategy.  What is the perfect storm?  What could sink the manager?  I like to write the strategy down and replay it to the manager for verification.  We need cat’s whiskers, a sensitivity to the unseen.  There is no sure-fire due diligence process.  It’s all based on judgments.  If we do our homework, we’ll avoid the common mistakes.   Pay attention to how questions are answered.  We’re investing in people.  Everything is founded on trust.  Our only protection is disciplined due diligence…to confirm not only skill but also integrity.

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