21/10/2009
By Joost Lobler
Post-Madoff, Joost Lobler explains the importance of employing a separate custodian when investing in funds of hedge funds for institutional investors
One important reason why Bernie Madoff could continue his $50 billion Ponzi scheme for such a long time was that his firm was both investment manager and custodian for its investors.
Madoff Securities took investments directly from its clients without placing them in a registered separate account held with a third party. Being a broker-dealer Madoff was able to keep the trading and 'safekeeping' of its investments under one roof. Any fictive holding could be reported back to investors without verification by an independent party.
Since then, investors have been looking for increased transparency and further segregation of duties. Funds are expected to have independent service providers: an administrator, custodian, broker, banker, auditor. Most funds that used to do their administration and Net Asset Value (NAV) calculations in-house have been forced by investors to outsource this to a third party administrator.
Among the investors that lost money to Madoff were funds of funds, which are often used by institutional investors such as pension funds to access the hedge fund market. Ironically, it is still possible for funds of funds to do exactly the same as Madoff did.
Funds of funds provide access for investors to a diversified portfolio of funds. Investors are issued shares of a parent fund, which in turn owns shares in the hedge funds they invest into. The assets of these hedge funds are generally easy to locate: they are electronically traded securities that are held by independent banks/custodians.
Hedge fund NAVs are calculated by independent administrators using data sent to them directly by the custodians, thus creating an independent confirmation of the actual existence of these assets. The independently produced NAVs are the components of the NAV of the fund of fund. The NAVs are consolidated, expenses and fees are deducted and the NAV for the fund of fund is born.
But who keeps the shares? Who can confirm that they exist in the form and shape that the manager tells them? There are no bank/custodians that hold shares for third parties, not even shares in hedge funds.
Often offshore jurisdictions which domicile funds of funds, such as the Cayman Islands, don't require a professional investment fund to have an independent administrator or custodian. This explains why there are still funds out there that do their own NAV calculations. Due to the nature of their assets, hedge funds automatically have an independent custodian (Madoff was not running a traditional hedge fund), but many funds of funds don't have, and aren't required to have an independent custodian. As a result there were quite a number of funds of funds that held their investments themselves, because it was cheaper, seemed more efficient and because investors did not seem to mind.
Investors in funds of funds nowadays know better, and demand an independent custodian. Of course a lot of them have been burned in the Madoff debacle, so from now on they want to be sure that their investments actually exist.
One of the consequences of the Madoff case is that investors now demand high transparency and segregation of operational duties. Independent custody for funds of funds should be high on that list of demands. In the past too many institutional investors have invested vast sums of money based on the blue eyes of the investment manager instead of on a thorough due diligence process.
