Bernard Madoff could have schooled Charles Ponzi on just how big and for how long a scheme built on deceit could go. The original huckster had no shortage of chutzpah, but Madoff, by all accounts, had it coming out of his ears.
To get at the answer to why investors acted like such sheep is to strike close to what must have been going on in Madoff’s head too. He was a Wall Street cognoscente, a former chairman of the Nasdaq Stock Market and a widely sought-after money manager believed to have found the secret to investment success, logging 10 percent annual returns year in and year out with almost nary a down month — or so he said. In the end there was no secret and there were no returns, it seems, but there was this: Madoff, a brilliant student of investment, had found three weaknesses in the system and had exploited them all.
First was the fact that many supposedly sophisticated funds of hedge funds and investment advisers whose job is to live and breathe the mantra of due diligence didn’t. Second was that simple greed struck investors not just blind but also dumb and made them forget that if something seems too good to be true, maybe it is. Third was that regulators failed to see someone like Madoff for what he was. They accepted him as a powerful investment adviser and broker who kept his books to himself in his 17th-floor office in the famous Lipstick Building in midtown Manhattan.
Madoff, in sum, got away with his alleged deception for so long because he seems to have known instinctively that investment advisers, investors and regulators would work together as unwitting accomplices by believing what they wanted to believe about Bernard L. Madoff Investment Securities. It worked for decades, ending only when the markets collapsed, the economy stagnated, credit seized up and Madoff could no longer sustain the illusion, admitting in December to a Federal Bureau of Investigation agent that he had been running a scam that was bankrupt and had vaporized perhaps $50 billion of investors’ money.
Quiz investors on what they were thinking — how could anybody go with a manager who was so famously guarded about what he was doing with their money? — and they will no doubt mirror how Madoff must have seen it. People with close knowledge of the fiasco say that those who put money with him also have a three-part answer to what motivated them: Fund-of-funds managers with a reputation for being in the know had signed off on Madoff; the proof was in the pudding (returns were steady and redemptions ready!); nobody with any regulatory authority had ever moved to shut Madoff down.
It was simply accepted as fact that Madoff was the real deal. What mere mortals would dare to question the conventional wisdom?
“The deep, underlying issue here is about trust and confidence, and even some of the most experienced investors had both trust and confidence in Bernie Madoff and the funds and subfunds invested with him,” says Gregory Curtis, chairman of Pittsburgh-based Greycourt & Co., an advisory firm that helps guide investment choices for 100 clients worth a collective $9 billion, two of whom were partially ensnared in the Madoff web through no fault of Greycourt.
Beyond the traits they had in common before the blowup, Madoff investors shared a new one after the fact: an understandable reluctance to discuss what happened.
“Why on Earth anyone would have 50 percent of their assets with one fund or manager is something I simply do not understand,” says Russell Kamp, CEO and head of quantitative strategies at Toronto-based Invesco, which manages some $26.5 billion in assets. “Most managers would not have more than 5 percent in any one stock; why would you do anything different with an allocation to a fund or manager?”
“A good portion of the investors were individuals who did not do their due diligence, or relied on second- or thirdhand due diligence, which unfortunately is just typical of this kind of phenomenon,” says Roxanne Martino, founder and co–portfolio manager of Chicago-based Harris Alternatives, which oversees $10 billion in funds of hedge funds. “There was also an impression given that it was difficult to get in, which put another level of pressure on people not to do due diligence — they didn’t want to rock the boat.
“I think there were a lot of signs,” adds Martino, whose firm invests with about 50 managers. “I just don’t think people were looking for them.”
Like most funds of funds, Harris Alternatives steered clear of Madoff, who was enabled chiefly by a handful of feeder funds set up by established fund-of-funds firms for the sole purpose of funneling money to him.
Among the more influential of these enablers was Walter Noel Jr.’s once $14 billion-in-assets Fairfield Greenwich Group, a New York–based firm that until December had an unimpeachable reputation. Fairfield topped the list of those that lost the most, and now it may have the most to answer for — its $7.5 billion Fairfield Sentry fund was entirely invested in Madoff Securities. (A Fairfield spokesman had little to say other than that the firm had been “defrauded by Madoff.”)
Rye, New York–based $3.1 billion-in-assets Tremont Group Holdings — which, like Fairfield, is registered with the Securities and Exchange Commission — had almost all of its assets with Madoff through a subsidiary, Rye Investment Management. No current or former Tremont officials would comment, though a spokesman said that information the firm had provided to investors made it clear that their money was going to Madoff. Tremont was in fact known as the best place in town through which to get to Madoff, according to individuals familiar with the situation. “People came to Tremont because they wanted to get access and could, and were charged only minimal fees for it,” says one source.
Sandra Manzke, the principal partner at Maxam Capital Management in Darien, Connecticut, and a former head of alternative investments at Tremont who helped set up some of the early Madoff feeder funds there, entrusted Madoff with practically all of her clients’ $280 million, even though in a November letter to investors she said that she was “appalled and disgusted” by what she said was a dearth of integrity in the hedge fund industry — this as she was collecting fees for routing investors to Madoff. “There are too many bad apples for my taste, and it only takes a few to bring the industry to its knees,” Manzke wrote. Maxam closed in December.
Two other funds ensnared were Kingate Management (run by London-based FIM Advisers), which had $2.8 billion invested with Madoff through two hedge funds, and London-based fund of funds Bramdean Alternatives. In a December filing, Bramdean said it had written off its investment in two Madoff feeder funds, Defender and Rye Select Broad Market XL Portfolio. Bramdean had about $31 million, roughly 9.5 percent of its assets, split between the two funds.
Geneva-based Union Bancaire Privée, one of the biggest Swiss private banks, had $700 million from half of its 22 funds of hedge funds with Madoff-related investment vehicles, including one run by J. Ezra Merkin, the well-known New York philanthropist and chairman of GMAC, the car finance company.
The UBP-Fairfield-Madoff tangle is especially interesting. The Swiss bank, which oversees about $56 billion in hedge fund investments, also provided loans and investment advice to a division of Fairfield Greenwich. Merkin funneled $1.8 billion of clients’ money, including that of UBP’s clients, into Ascot Partners, a hedge fund he ran that charged a 1.5 percent management fee and a 20 percent performance fee and invested almost entirely with Madoff, a longtime friend of Merkin’s. Ascot offering documents stated that Merkin would do something else: “engage in hedging and short sales.”
Ascot was also where Merkin placed money from New York philanthropies and endowments, including that of New York University, which has reportedly lost $10.5 million to Madoff. NYU is now suing Merkin, saying he never told the university that the money was going to Madoff (an Ascot offering memorandum states that “all decisions with respect to the management of the capital of the Partnership are made exclusively by J. Ezra Merkin”).
New stories of investors being burned — even wiped out — by Madoff continue to appear almost daily. They only add to the many questions about the integrity of an entire industry; funds of funds purportedly follow the principles of transparency, diversification and due diligence. What were they thinking, all these sophisticated managers who seem not to have followed their own rules?
“This had nothing to do with managing people’s money and everything to do with maximizing their own profits,” says Ted Seides, a principal with New York–based multimanager hedge fund firm Protégé Partners. If all a fund of funds had to do to collect a 1 or 2 percent fee was to divert client money to Madoff, what was the point of doing anything else?
One way to see into Madoff’s world is through the eyes of those who skirted it. Curtis, the Greycourt chairman, had several brushes with Madoff over more than 20 years, often at the behest of clients who were enchanted by the prospect of getting an “in” with the famed money manager. Greycourt ultimately warned clients away. “There were just too many unanswered questions — things we just didn’t get,” Curtis explains.
He says he was initially impressed, however, after his introduction to Madoff’s firm in 1987, when Greycourt heard what Curtis describes as Madoff’s trademark low-key pitch. He was “a smart, likable, rather modest fellow who even then had a very large reputation,” Curtis recounted in an early January letter to clients and friends. He and his colleagues liked what they heard and suggested another meeting. But no one from the Madoff camp ever followed up, so Greycourt didn’t send any clients their way.
In 2001 a Greycourt client bumped into Madoff at a resort hotel in the south of France, and was smitten. At his behest, Greycourt tried to contact Madoff. “We learned quickly that Madoff wouldn’t meet with us,” Curtis recalls, “and wouldn’t even take our call.” Greycourt’s advice: Any manager who will not deign to hold a due diligence meeting with an investor should get a pass. Twice in 2007 and once more in early 2008, the name Madoff popped up in Greycourt’s dealings with clients, most notably in a visit from Fairfield Greenwich, which came to Greycourt to say it had access to a roster of managers.
“But they only pitched us Madoff,” recalls Curtis. “We said we weren’t interested. They said they’d come back with more; they never did.”
Richard Bookbinder, founder of Bookbinder Capital Management, a small New York–based fund of hedge funds ($25 million in assets), says Madoff failed miserably to meet his firm’s due diligence requirements on several occasions. “We just didn’t understand the strategy, the source of returns or how the returns were generated,” he says. “We also understood we couldn’t meet the manager, which is just a big, flat-out no. Most important, they violated tenet No. 1 of our investment philosophy, which is, ‘Who is your auditor?’”
Madoff, it seemed, was his own auditor.
Stories like these appeared not to bother the legions of individuals and funds of hedge funds that poured money into Madoff. But they should have scared everyone away, argues Christopher Addy, president and CEO of due diligence firm Castle Hall Alternatives in Montreal. “It’s difficult to see how a Madoff feeder can avoid the responsibility to complete effective due diligence simply by including a bunch of risk disclaimers in its offering document,” he says. “Madoff was hardly an organization with an absence of operational red flags — one being his notorious secrecy and inaccessibility; two, the no-name audit firm; and three, the obvious absence of any third-party oversight from the broker-dealer level down.”
The glaring disparity between the amount of money Madoff said he had and what investors publicly stated they had invested with him should have been a red flag as well. SEC forms filed by Madoff’s firm last year said that it had approximately $17 billion in assets at the time, far short of the amount that had been sent his way, a huge tip-off to the deception that came to light a few months later.
“If you went down the list of the major feeder entities and asked how much they were running, it wouldn’t have taken very long at all, maybe six lines, to get well past that figure,” Addy notes. “It’s a big surprise that no one did this simple math.”
