Editor's note: Firstlinks has never published an article anonymously before, but while we cannot reveal the source of this piece, it is known to us and we consider it impeccable.
In debating whether to publish, we felt encouraged by the decision by Peter Singer and colleagues as reported in The Conversation:
"Philosophers Peter Singer, Jeff McMahan, and Francesca Minerva have announced a new academic outlet, the Journal of Controversial Ideas, as an “open access, peer-reviewed, interdisciplinary journal specifically created to promote free inquiry on controversial topics,” it will give authors the option to publish their work under a pseudonym “in order to protect themselves from threats to their careers or physical safety.”"
In the same spirit, confident in the source, we are publishing this informative piece without implicating anyone.
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In 2007 Bernie Madoff’s fraudulent hedge fund came perilously close to being distributed by a major Australian wealth manager. Sensible minds (just) prevailed and the distribution deal was aborted. A year later the largest hedge fund fraud of all time, a US$65 billion Ponzi scheme, was exposed.
This article, which for obvious reasons must remain anonymous, is a reminder that financial institutions, just like retail investors, are vulnerable to fraud. Financial institutions have their own set of agency issues and behavioural biases which need to be managed.
Distribution of the funds of external managers
In the finance industry, distribution is king. The logic is that it doesn’t matter how good your product is, if it doesn’t sell, it's not worth having. Even if you argue that money will eventually find its way to quality investment products, there is a shorter-term imperative that demands businesses maximise their short-term return on equity.
Look at the CEOs of most wealth managers. Many come from a distribution rather than a specialist background such as investments. This is not a bad outcome by any measure: an all-round suite of skills is required for a CEO to succeed and a successful grounding in distribution provides many of those skills.
It is common for wealth managers to distribute externally managed funds. This practice has existed for decades and can take many forms. A simple contractual arrangement is known as a third-party distribution arrangement while a more integrated relationship could be described as a partnership model. Another model is the white label approach, commonly used for global sectors, whereby a wealth manager outsources the asset management of their own branded product to an external manager.
Third-party distribution decisions bring different payoff profiles to wealth managers compared with the outcomes realised by retail or institutional investors. Performance will impact the asset-raising prospects for the wealth manager while directly impacting performance outcomes for end investors. Non-success of a third-party distribution arrangement represents an opportunity cost more than any significant financial cost.
Fiduciary responsibility and fraud ... enter Madoff
It is only in the case of a fraud that both wealth managers and investors experience extreme pain. For wealth managers, their brand may be irreparably damaged and there is an issue of compensation. For investors, there is a performance write-off and reputational damage if the investor is an institution, such as a super fund.
There are many agency issues and behavioural biases which exist in wealth management. The agency issue centres on the degree to which staff view themselves as fiduciaries or renters of the company’s brand and scale. Some of the behavioural biases include confirmation bias (tendency to ignore contrary information to their view), herd mentality (blindly follow and copy others), and a framing bias (where the narrative may distract from the facts).
So how does Bernie Madoff come into this story?
One of many tactics used by Madoff was to allow other firms to distribute his hedge fund through select third-party relationships. This added further credibility to his name: investors take comfort from the assumed due diligence undertaken by the distributor.
A major Australian wealth manager came perilously close to entering a distribution arrangement with a respected US-based third-party distributor. The major attraction: access to Madoff’s hedge fund which had enviable performance, a legendary reputation and limited capacity, some of which this distributor had exclusively reserved.
What a coup to be able to partner with this group! It could really make someone’s career.
The business case was straightforward: exclusive access to a legendary hedge fund and an attractive distribution fee.
How to garner business case support?
Here's where big institution politics came into play. At the time there was an unofficial ideological power struggle between distribution and investments. The business case was selectively shared with ‘friendlies’ before being distributed to the broad executive group. There was significant momentum behind the business case by the time key questions were asked regarding the investment integrity of the underlying investment managers.
One investment executive engaged an independent consultant to provide an initial investment opinion on the suite of funds offered by the US third party distributor, including Madoff’s.
Madoff never cooperated with the due diligence processes of any investor but he had many established strategies to attract clients, including:
- access to exclusive IP (intellectual property) which couldn’t be shared
- his previous career successes, where Madoff had been heavily involved in broking and software
- connections and implicit endorsement from the sheer weight of investors and capital invested in the fund, and
- exclusive distribution rights, as others were ready to take your spot.
The consultant report raised concerns that something didn’t feel right, but without full due diligence access it would have been near impossible to claim that such a large and famous hedge fund manager was a fraud.
A fine balance tilted the right way
The decision was finely balanced, but it was decided to not proceed. I’ll never know to what degree the decision was political or objective. All I can say is that I am forever glad the right decision was made and that Madoff’s Ponzi scheme never managed to defraud Australian investors.
What’s fascinating is that no one did anything wrong. It is healthy for employees to propose new business ideas. The processes worked, and the agency issues and behavioural biases were managed.
Just.
This article is published anonymously but from an exemplary source as a warning that even when dealing with the biggest names in the industry for what looks like a sure profit, great care and due diligence are required.