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Madoff Ponzi effect influences investor due diligence

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As a result of recent frauds and Ponzi schemes, a Madoff effect has developed, altering the nature and scope of investor due diligence, according to a study by Corgentum Consulting.

The data also shows that in anticipation of stricter hedge fund regulation fund of hedge funds are focusing the bulk of their due diligence efforts on legal, compliance and regulatory risks.

The study, The Madoff Effect – An Analysis of Operational Due Diligence Trends, is based on data from over 200 global hedge fund allocation organisations including fund of hedge funds, endowments, foundations, corporate pensions, family offices, large independent financial advisory practices, ultra high net worth investors and private banking organisations.

"The data shows that frauds such as Madoff are an important, but potentially misleading guiding light around which investors tend to focus their due diligence on hedge funds," says Jason Scharfman, managing partner.

Investors, influenced by recent hedge fund failures, have refocused their due diligence efforts on operational risk areas where leading operational red flags were present. In particular, since the Madoff scandal broke, this study shows that the number of fund of hedge funds reviewing hedge funds cash management policies and controls increased by almost 60 per cent.

Other operational risk areas covered in the Corgentum study that have realised double-digit increases in attention from investors include transparency in reporting and the role of service providers such as auditors and administrators.

Corgentum’s analysis also demonstrates that certain operational risk areas continue to be dangerously neglected during the investor due diligence process. Less than two per cent of the fund of hedge funds included in this study considered the independence of a hedge fund’s board of directors during the due diligence process.

Other frequently overlooked operational risk areas included information technology infrastructure, personnel turnover and the quality of overall operations management.

"Investor’s must not only understand historical red flags, but be prepared to anticipate new ones. By incorporating proprietary benchmark studies of hedge fund fraud and models of operational inefficiency into our evolving operational due diligence process, Corgentum’s approach ensures investors keep up with the changing nature of hedge fund operational risk," says Scharfman.

Corgentum provides hedge fund investors with operational due diligence reviews.

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