From the New York Times, September 4, 2005

Connect the Dots. Find the Fees.
Gretchen Morgensen

TO many investors, the collapse of the Bayou Group - a hedge fund company and brokerage firm run by Samuel Israel III - may seem like just another financial mishap, and a calamity only for those who had the bad luck to invest with Mr. Israel or to be steered his way by advisers they were wrong to trust.

But actually, the mess at Bayou, which federal prosecutors are now calling a $300 million fraud, should be a clarion call for caution among the many investors who have been throwing money at hedge funds recently. This is especially true for institutions - endowments and public pension plans - that have flocked to hedge funds with the hope of increasing their returns. Because many of these institutions are having financial difficulties - low interest rates are cutting deeply into their returns - they are too often captivated by investments that seem to promise outsized gains with little risk.

"Our unique multifactor risk model acts as a road map for navigating risk and provides investors with alternative routes to reach their investment summit," Steve Henderlite, a co-founder and principal of Trail Ridge Capital L.L.C., said in a press release from October 2003. Trail Ridge Capital is a hedge fund and fund-of-funds company that had clients in Bayou. Mr. Henderlite did not return a phone call seeking comment.

Trail Ridge is also an adviser to a new investment fund, the Undiscovered Managers Spinnaker Fund, offered to wealthy individuals by the investment unit of J. P. Morgan Chase. The fund, which started last November and had $7.3 million in assets as of March 31, held $662,602 in Bayou. J. P. Morgan says it has written that investment down to zero.

Central to the Bayou story, and to almost every other financial disaster of recent years, are conflicts of interest. At Bayou, these conflicts began in its brokerage unit, which executed trades for the hedge funds. Because the brokerage unit, Bayou Securities, was wholly owned by Mr. Israel, he was able to profit personally from the rapid-fire trading conducted by the funds he oversaw.

But some Bayou investors who got into the funds on the recommendation of investment consultants were confronted with another layer of conflicts. That is, the consultants who recommended the hedge funds to their clients and the funds of funds that bought Bayou shares for their investors often received compensation from Bayou for sending assets its way.

While some investors may not find fault with such an arrangement, institutional investors who have a fiduciary duty to their beneficiaries should definitely steer clear of the deals.

"In my view, if a hedge fund manager wants to pay a particular level of fees to a marketing agent, that's their business," said Orin Kramer, chairman of the New Jersey Investment Council, the oversight board for the state's pension system. "But as a fiduciary, I would be very uncomfortable dealing with a gatekeeper who is being paid on both sides of the trade."

Unfortunately, not all fiduciaries know where these conflicts lie. They are often well hidden.

"Pension consultants frequently have undisclosed financial arrangements with hedge fund managers that create a conflict of interest," said Edward A. H. Siedle, president of Benchmark Financial Services, in Ocean Ridge, Fla., a company that works for pension funds to investigate possible wrongdoing among outside money managers.

Mr. Siedle says the nature of these deals varies. Sometimes the payments come in the form of commissions on trades steered by a hedge fund to a brokerage firm that is affiliated with the consultant; in other cases the payments are fees paid by the fund based on the assets the consultant brings in. In one case, Mr. Siedle said, he found that a pension consultant received a partnership interest in the hedge fund to which it was steering clients.

SUCH payments were a part of the picture at Bayou. According to materials provided by the fund to a prospective investor in 2003, Bayou had several outside marketers that it paid either as a percentage of assets raised or through commissions to the promoters' "designated broker/dealer."

One of the firms that Bayou listed as an external promoter at that time was the Consulting Services Group of Memphis. Bayou also gave prospective investors the name of E. Lee Giovannetti, chief executive of Consulting Services, as a reference and as an institutional investor in Bayou.

Joe Meals, a spokesman for Consulting Services, said that the firm did act as a reference for Bayou in 2003 and that it had recommended Bayou funds to clients. But, he said, "We became uncomfortable with the operations at Bayou and made recommendations to all our clients that they redeem their accounts, and they did so long before any of these issues came to light." He added that Bayou "may have executed commissions through our affiliated broker dealer at one time, but not recently."

Consulting Services did the right thing in advising its clients to exit Bayou before the debacle. Others weren't so lucky.

In coming weeks, federal and state investigators will try to sort out what happened to the money that investors entrusted to Bayou. Because Bayou's minimum-investment requirement of $250,000 was smaller than that of most hedge funds, the firm unfortunately attracted a lot of individual investors. The United States attorney in New York is seeking the forfeiture of all of Bayou's assets, including $100 million seized by authorities in Arizona last May. How much Bayou's investors ultimately get back is anybody's guess.

Larger investors, especially those who are fiduciaries, should take a lesson from the losses at Bayou. Conflicts of interest in the financial world are often hard to uncover. But refusing to do the necessary digging is downright irresponsible.


Copyright 2005 The New York Times Company