KSM's run-in with Madoff spawns bevy of questions

January 12, 2009
KSM Capital Advisors didn't invest its clients' money directly with Bernard L. Madoff, but they're out millions of dollars just the same.

Does the fact clients' cash took a convoluted path—through financial middlemen—to Madoff's New York hedge fund reduce the culpability of KSM, the investment-advisory arm of the Carmel accounting firm Katz Sapper & Miller? Or does it leave KSM with even more egg on its face?

Those are among the questions looming in the wake of KSM's acknowledgment last month that clients had about $15 million invested with Madoff, the disgraced financier who told the FBI he oversaw a $50 billion Ponzi scheme.

Investigators say Madoff falsely told thousands of investors they were earning 10 percent to 17 percent a year—a ruse he kept up for years by using money from new investors to pay off old ones.

KSM said fewer than 50 of its clients have Madoff exposure. The clients ended up with Madoff after KSM placed client cash in funds run by Redmond, Wash.-based Future Select Portfolio Management Inc.

Future Select, in turn, invested in funds run by Rye, N.Y.-based Tremont Group. Tremont was one of the biggest operators of feeder funds for the now-defunct Bernard L. Madoff Investment Securities.

Why the labyrinth of layers? "A lot of times, that is the only way to get access to those types of investments," Peter Reist, a managing director of KSM, told IBJ. He noted that many managers would otherwise be beyond reach because they weren't open to new customers or required high minimum investments.

Indeed, the collapse of Madoff's investing empire has cast the spotlight on the prevalence of "fund of funds," which hold stakes in other funds instead of directly owning stocks or other securities.

Fund of funds sell themselves to firms like KSM on the basis that they offer diversification, access to sought-after managers, and thorough due diligence. Funds claim to have vigorously checked out all the managers to whom they committed capital.

Now, all the supposed advantages are in question. Though fund of funds outperformed the overall stock market in 2008, they still posted steep losses—a far cry from the profits many investors expected.

And many investors can't fathom how firms funneling money to Madoff overlooked a litany of red flags. Among them: His firm reported steady returns in drastically varying market conditions, and its outside auditor was Friehling & Horowitz, an obscure, three-person firm operating out of a 13-by-18-foot New York office.

Tremont—which funneled billions of dollars to Madoff—"did not act as a reasonably prudent investor would have," according to a class-action investor lawsuit filed in Manhattan last month.

That so many seemingly reputable funds were helping shovel money Madoff's way may have fostered a false sense of security.

"If everyone believes they are piggybacking off the due diligence of others, the risk is that no one does it," Paolo Cristofolini, a former hedge fund manager, told Reuters.

But even if everything about Madoff had been above board, investors wouldn't necessarily have been well-served, investment experts say, since fees pocketed by the financial middlemen erode returns.

"The underlying investments have to be that much more profitable just to cover all the layers of fees that are being taken out," said Mark Maddox, an Indianapolis securities attorney who represents clients in disputes with investment firms. "Everybody is taking some skin."

KSM's Reist acknowledged the higher fees but said that, before the scandal broke, the firm deemed the trade-off worthwhile "based on the returns and ability to access managers."

Reist also acknowledged that "any time you use a hedge fund, you run the risk there is not as much transparency as there would be if you have a separate account manager or mutual fund."

He wouldn't discuss details of KSM's due diligence, but said he'd been aware client money was invested with Madoff.

The discovery last month that Madoff was a sham triggered one of the worst stretches of his life, as he began contacting clients to tell them the bad news.

Now he's focusing on trying to recover as much of their money as possible. In a Dec. 31 note to clients, he wrote, "I will keep you apprised of any information we secure about this tragedy."

Smulyan takes tax loss

Emmis Communications Corp. CEO Jeff Smulyan closed 2008 by cashing in 17,707 shares for 40 cents apiece-transactions that yielded a mere $7,000.

Why bother selling the shares, a tiny fraction of the nearly 5 million he owns? The answer, according to a Securities and Exchange Commission filing, was to recognize a tax loss for the year.

Every little bit helps these days for Smulyan, who last year watched the value of shares in the company he founded tumble 90 percent.

He went to considerable lengths to lay the groundwork for the sales. Because Emmis soon will announce quarterly results, he requested and received an ethics waiver from the company's board giving him the right to sell shares during a period in which insider trades are normally barred. He also agreed to sell to people privy to the same information about Emmis' performance as he had.

General Counsel Gary Kaseff ended up buying half the shares, with Chief Operating Officer Patrick Walsh purchasing the other half. 
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