Madoff's Fraud Ushered in Changes to Secretive Hedge Funds

(Bloomberg) -- Bernard Madoff’s sordid legacy remains the stuff of headlines. But his fraudulent scheme altered -- and transformed -- the hedge fund industry.

As fund lawyer Steven Nadel at Seward & Kissel LLP put it in a recent interview: “Madoff was a huge wake up call for the entire asset management industry.”

Here are some ways money managers have changed since Madoff was arrested by federal authorities in December 2008:

Middle Men Fade

Already bruised by losses in the wake of Lehman Brothers’ bankruptcy three months earlier, the middle men who help pick and vet hedge funds for investors fell further out of favor. Many of these so-called funds of funds did business with the conman by steering clients to his firm.

Leery of putting their money at risk, retirement plans, sovereign wealth funds and other investors began shunning these firms to invest in hedge funds directly.

The impact of that has been staggering: Investors have pulled their money from funds of funds for 10 straight years. The industry lost almost a fifth of the money it had pre-Madoff -- assets stand at $647 billion as of the third quarter, according to data compiled by Hedge Fund Research Inc. That caused many firms to merge or shrink their businesses.

Among the firms hit hard was Union Bancaire Privee of Geneva. The bank, which was once the world’s biggest investor in hedge funds -- and one of the oldest -- had invested about $700 million of client money with Madoff. In 2010, it agreed to pay as much as $500 million to settle claims by the trustee liquidating Madoff’s bankrupt investment firm.

Since 2007, UBP’s hedge fund investments have slumped more than 80 percent. It now has about $10 billion in the asset class, according to its website.

UBP’s loss has been Blackstone Group LP’s gain. The New York-based money manager didn’t park client cash with Madoff and that helped it lure customers in droves. Blackstone’s hedge fund investments have surged more than three-fold since 2008 to $80 billion, displacing UBP as the world’s biggest investor in the private pools.

The Madoff toll on the industry, however, goes beyond numbers. Twelve days after Madoff’s arrest, a fund of funds executive who had done business with Madoff took his own life.

Asking More Questions

The days of investors blindly entrusting their money to hedge fund managers with no questions asked ended.

The process of vetting managers was upended in its entirety -- investors started giving much greater scrutiny to the auditors, brokers and lawyers funds had hired. More attention was also paid to the procedures funds put in place in the course of carrying out their business, while manager background and other checks accelerated.

“Madoff’s fraud showed how some investors didn’t have the necessary procedures in place to detect Madoff,” said Nadel, whose clients include hedge funds.

Madoff’s crimes, together with the 2008 financial crisis, changed the culture of hedge funds.

Reeling from record losses after the implosion of Lehman, hedge funds either introduced, or fortified, rules and procedures on everything from trading to accounting to assure jittery investors.

Fewer Secrets

Almost since their inception in the 1960s, hedge funds have been shrouded in secrecy.

As private firms, hedge funds had little regulatory oversight. That worked out nicely for the industry since money managers wanted to keep their trades private, while their wealthy clients didn’t want others to know how they got rich.

Post-Madoff hedge funds became much more attuned to the demands of pension plans and other major clients who became a growing part of their investor base.

They increasingly shared details with clients about their trades and investing strategy. Now, managers give investors their view of the markets, industries, and even information about the inner workings of their operations.

As part of increased communications with investors, firms added more client meetings, conference calls and hosted investor days -- just like public companies have. Opening the doors even changed the way hedge fund managers dressed.

In the early 1990s, Renaissance Technologies, the quant fund founded by military code breaker Jim Simons, merely provided investors with a Manhattan phone number to dial so they could listen to a recording of how their investments were faring every month. These days, the hedge fund sends weekly and monthly updates on some funds. That often includes some analysis of its trades and even how they are managing risk.

--With assistance from Katherine Burton.

To contact the reporter on this story: Saijel Kishan in New York at skishan@bloomberg.net

To contact the editors responsible for this story: Margaret Collins at mcollins45@bloomberg.net, Alan Mirabella, Vincent Bielski

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