This month, the DePauw University Foundation revealed that, based on the advice of a high-paid consultant, it had invested $3.25 million in the Bayou Management hedge fund, which has collapsed amid allegations of fraud. As IBJ Daily reported Oct. 17, DePauw has filed a federal lawsuit against the consultant.
Bayou, formed in 1996, had over time amassed more than $400 million from about 100 investors. The list of other investors caught in the debacle include the Massachusetts Bay Transit Authority Retirement Fund, J.P. Morgan and the Jewish Federation of Metropolitan Chicago.
In addition, a number of well-known hedge "fund-of-fund" managers advised investors to place tens of millions of dollars into Bayou. One of the firms making that recommendation was the Hennessee Group, DePauw's consultant.
A hedge fund-of-funds is a firm that raises money from investors and allocates it to individual hedge funds after conducting due diligence. Such firms collect substantial fees for their efforts, at least 1 percent a year in Hennessee's case. Thus, for advising DePauw, Hennessee collected at least $32,500 annually.
As it turns out, the consultants and other investors missed numerous red flags that an extensive due diligence should have uncovered. Bayou owned the broker-dealer that executed its stock trades, and thus was receiving commissions on its own trading.
A 2003 regulatory filing showed the Bayou-owned broker generated $29 million in commissions-a figure that amounted to a whopping 9.6 percent of the fund's total capital. Another fact that should have been a warning: A Bayou partner was a principal of the firm that conducted the audit of Bayou's investment performance.
According to a fraud lawsuit the U.S. Securities and Exchange Commission filed against Bayou Sept. 29, the hedge fund claimed to its investors that it earned a $43 million profit in 2003, when in fact it had lost $49 million.
But amid the allegations of outright fabrications, another key point is receiving scant attention in the financial press. Consultants and investors were committing money to Bayou even though its publicly disclosed investment strategy was "day trading." That is what we find truly mind-blowing about the entire saga.
In presentations to potential investors, the manager of Bayou stated he would rarely keep an investment position more than three days, and his aim was to make 1 percent to 3 percent a month. Folks, this is all anyone should have needed to hear. Day trading is hardly a viable investment strategy and is akin to hoping the roulette wheel comes up red.
In defense of DePauw, it followed the institutional investor rulebook on investing in "alternative assets" like hedge funds. Hennessee, by all accounts, was considered an "expert" in the field. The university's lawsuit should serve as a wake-up call to investors in hedge funds.
One lesson is that investors could have sidestepped an investment in Bayou simply by digesting a one-sentence description of its investment philosophy. It is truly disturbing that there are supposedly wellregarded people in the investment industry advising fiduciaries to commit funds to an investing scheme like Bayou's, which was just slightly more advanced than a game of rock-paper-scissors.
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or email@example.com.