The trials of two notorious figures in the hedge fund world, Allen Stanford and Rajat Gupta, made headlines this week with breaking news in both cases. Stanford, who was accused of running a $7 billion Ponzi scheme was sentenced to 110 years in prison, while New York continued its’ case against Gupta, and just this week convicted him of leaking insider trading information to Raj Rajaratnam.
Stanford, who conducted his Ponzi scheme over the last 20 years, led one of the largest financial frauds in history. Gupta, who was on the other side of the coin, fed material non-public information to Galleon Group, who acted on the insider information given to them.
Although each story is replete with its own unique intricacies, Gupta and Stanford’s cases recent reappearances in the news, continue to highlight the importance and need for operational due diligence. Operational due diligence allows investors to take a deep dive approach into evaluating a fund’s non-investment related risk. Operational due diligence evaluates a variety of subjects including front and back office practices, computer systems and a fund’s relationship with their service providers, etc. An operational due diligence review also allows investors to better gauge whether or not each part of a hedge fund is working together in a productive, ethical way.
It is best to think of operational due diligence as a safety precaution for assets, a seat belt, if you will. Operational due diligence will not prevent a fund from being exposed to situations such as Gupta and Stanford’s but, it takes the risk associated with key operational risks off of the table. By following a proactive approach towards operational due diligence, investors decrease the likelihood that they will be exposed to fraud and funds with poor operations. There is something to be said for following the correct procedures in trying to avert the worst. Operational yellow flags can alert investors about potential weaknesses which may cause future operational problems such as issues with trade procedures and cash management.
Although cases of illegal activity to the extent of Stanford and Gupta are rare, they are much more common than investors seem to think- after all, major developments in their fraud-based trials have made major news this week- and that is only talking about this week. Every day there are new frauds being exposed everywhere from Japan (AIJ scandal) to right in our own backyard (David Newmark, CEO of Short Hills, NJ based hedge fund fraud).
Investing is not something that should be taken lightly, no matter what the individual’s reputation is or the amounts of money involved. Investor’s that take charge of the responsibility to perform operational due diligence, are less likely to read about their funds in the headlines.