Surprise! Hedge Fund Fraud

Say it ain’t so! There are allegations of fraud today against a hedge fund. Dynamic Decisions Capital Management, founded by Alberto Micalizzi, has had it’s main fund, worth an alleged $500 million taken over. The fund is based in the Cayman Islands and is being liquidated by the firm Grant Thornton. The primary allegation is that the fund purchased bonds outside the scope of the fund parameters and that the bonds were of questionable value.

These stories are a dime a dozen. I meet with people every day-smart people- who do really stupid stuff with their money. Many invest in private equity and hedge funds. These investment vehicles are largely unregulated. Based on my experience and observation very few investors make money in hedge funds or in private equity. Typically the only people who make money are the fund managers. Managers make money regardless of whether the funds make money. These deals are usually structured where the managers take a 2% management fee and then take 20% of any profits. That means that if a fund manages $100 million (very small by today’s standards) management makes $2 million per year in management fees alone.

The funds that are especially troublesome are the ones where the managers do not invest any of their own money alongside investors. These folks use leverage that is often called “OPM” – other peoples money.

The problem for many of these funds now is that there are fewer opportunities for investment. There is so much money “on the sidelines” right now, it is very difficult for these funds to find worthy investment vehicles. Another problem is that these funds typically look at highly leveraged deals. And lenders who used to invest in a debt portion are very leery of these private fund deals. Finally a manager doesn’t make his management fee unless he has put the investment money to use. This can cause a manager to stretch on deals that are marginal just to make certain he has deployed the capital. This often leads to lousy investment decisions.

If you are thinking about investing in private equity or hedge funds there are a number of questions you need to ask before taking that leap. Call me before you invest. It will be a much more pleasant call than the call you make to me after you have already invested. Here an ounce of prevention really is worth a pound of cure.

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