European Hedge Funds Less Susceptible To Fraud

by Phillip Morton, Investors Offshore.com

07 November 2005

The risk that hedge funds will defraud investors is lower in Europe than in the United States, because most European hedge funds turn to independent administrators to value their books, analysts have stated in a report by Reuters.

A lack of independent valuations contributed to the high-profile failure earlier this year of the US-based Bayou Group hedge fund.

Investigators believed that Bayou's deceptions went as far back as 1998, and the firm lured investors to commit some $300 million by overstating returns and concealing losses in the intervening years.

Crucially, however, Bayou was able to cover its tracks for so long because it used a phony accounting firm to audit its financial statements which was able to report assets of $192 million and trading gains of $27 million at the end of 2003 when, in reality, it had a value of $53 million and had lost $35 million.

However, in Europe, there have been no comparable hedge fund failures due to fraud in recent years because it has become industry practice for hedge funds there to use independent administrators, even though it is not a legal requirement.

"Hedge funds outside the United States without independent fund administrators are unlikely to have any serious investors," Joe Steet, senior partner at Sigma Partnership, a specialist hedge fund advisory firm, was quoted by Reuters as saying.

"Most hedge funds that collapse do not have fund administrators that are truly independent," he added.

In Europe, the reputation of administrators is also important. For example, in Dublin, analysts estimate there are close to 40 fund administrators, all of which are registered with Ireland's central bank.

The coming of hedge fund registration rules in the United States in 2006 will mean that many US hedge funds will have to change the way that their books are valued, and that will mean more independent oversight.

However, while most large US-based funds are becoming more sensitive to issues of accountability and corporate governance and have the necessary resources to put new system in place, many of the smaller funds may find themselves struggling to adapt to the new requirements.

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