The recent Madoff scandal once again has put private investments in the negative spotlight. Are unregulated investments such as hedge funds, private equity funds, and real estate partnerships just too risky anymore?
“Madoff is the exception rather than the norm,” says John T. Alfonsi, CPA/ABV/CFF, CVA, CFE, partner, Cendrowski Corporate Advisors LLC. “There are still good managers and funds out there. If you go in knowing what you are investing in, and doing your own ongoing due diligence, they can still be lucrative.”
Smart Business asked Alfonsi what types of warning signs investors should look for and how they can ensure their investments remain safe.
How important is diligence?
You won’t always be able to detect and prevent fraud in an investment, but you can take steps to minimize any potential damage. Due diligence is not something you do only in the beginning. You have to periodically review the investments and their people — what drew you to the investment in the first place? Is this the same reason you should be, or should not be, invested today?
Who should be involved with monitoring the investments?
Depending on the size or number of investments/time required, you might need a specialist to help review documents, study the investments, asses risk, etc. Not everyone is astute enough or ,even if they are, might not have the time. You may need to involve your CPA, an attorney, maybe even an experienced investigator. You can’t rely solely on your broker or investment adviser.
What are some of the preliminary considerations?
First, request information. Review their marketing materials for investment strategies, target returns and principal bios. If it’s an established fund, it should have prior audited financial statements. Audited is the key word. And it should be audited by a firm with well-known experience in that industry or that type of investment.
If it’s a hedge fund, look at its monthly performance track record. Madoff never had a ‘bad/down’ year — it consistently delivered 10 to 11 percent returns. So if it seems too good to be true, it probably is. While positive returns are possible every year, market factors will always impact those returns such that an even, steady return year after year would seem improbable.
What about private equity investments?
These are even less regulated than hedge funds. But like hedge funds, you are not investing in a particular stock or company, but in the investment strategy of a person or group of people. Make sure they can handle your investments appropriately and that their strategy doesn’t change without you knowing about it. It should be viewed as an investment in the people rather than their underlying portfolio.
With private equity, money is usually tied up longer; maybe five to 10 years. Background checks by a private investigator or forensic accounting firm are important with a hedge fund, but even more so with private equity investments. You need to find out if the people holding and investing your money are who they say they are, so to speak. Do they have any prior legal convictions? Lawsuits? Are they heavily laden with debt and as a result might be tempted to use the money for their own needs? What companies are they investing in and how do they monitor those companies?
What are other considerations?
Go visit the offices. Meet the people. If they told you they have six people on staff doing full-time research, go meet them. Ask them questions.
How much of their own money do the principals and employees have invested in their own funds? If they’re not willing to invest in their own funds, that’s not a good sign.
Know your withdrawal rights. Some hedge funds require a two-year lockup period with 30 to 90 days notice to process a withdrawal. They are not very liquid investments so you need other sources of liquidity. Private equity funds may have no or limited withdrawal rights because of the nature of their investments.
Understand the terms of the fund with respect to management fees. Are they in line with industry standards? 2/20 (two percent with a 20 percent incentive) arrangements are common.
How does the firm value non- or less-frequently traded investments? We’ve seen cases where values have been inflated to keep rates of return up. It created a house of cards until numerous requests for withdrawals brought it down.
Lack of an audited statement and investment pricing/valuation issues are big problems. This goes back to questioning who is managing the back office. A third party should be doing the accounting and handling administrative functions.
John T. Alfonsi, CPA/ABV/CFF, CVA, CFE
Cendrowski Corporate Advisors LLC