Madoff and Outsourcing

A lot has gone wrong with the world economy in 2008 but the Madoff fraud will
stand out as one of its worst moments. The fraud has come to light just a few
weeks ago and the true impact will not be clear for some more months. It is,
however, safe to say that it is a financial 9/11 event that will leave many
things changed forever.

The Outsourcing Ecosystem for Hedge Fund

My company services nearly 1,000 funds. And knowing hedge fund operations
intimately, at first I couldnt believe that such a fraud could have continued
for so long without being discovered.

If you look at normal hedge fund operations, there is a large cast of service
providers. At a minimum it will include the investment manager who manages the
funds assets; the prime broker who executes the trades and provides credit
lines; the custodian who holds all securities; the bank who provides cash
management services; the administrator who maintains independent books of
account and reports to Investors; and the auditors who audit annual accounts.

Most of the time, you have large, established entities providing these
services (indeed, many of these are global banks) and while there is no
guarantee that any of them may not make an occasional mistake, they do take
their fiduciary duties quite seriously and are regularly audited by the
jurisdictions that regulate them.

What this also represents is an elaborate outsourcing structure that is not
only highly specialized but is delivered by a set of service providers who are
accustomed to handling very complex transactions, high transaction volumes,
working under very stringent time lines and dealing with aggressive, demanding
Investment Managers. While no one will pretend this is easy, these service
providers are no shrinking violets and will push back strongly if they see
something they dont like.

This is the system of checks and balances that creates the Hedge Fund
ecosystem that for the last two decades, has delivered superior investor
returns.

The Madoff Scenario

Bernie Madoff side-stepped the whole outsourced service provider structure
by simply choosing NOT to outsource. He did his own administration, his own cash
management and his own investor reporting. He chose an audit firm that was run
by one accountant in his 70s, and two other people, one of which was his
secretary.

It is important to remember that Madoff was not secretive and his entire web
of fraudulent record-keeping was aimed at one thing onlyto deceive. He staffed
key positions with his friends and relatives. His sons worked in the business.
His compliance officer was his brother. His chief attorney was his niece. His
nieces husband worked with SEC in-charge of compliance inspections. While it
does appear that they did not know the full extent of the fraud, even the most
charitable view possible suggests that they did not question his actions and
records too closely. But above all, Bernie Madoff outsourced nothing.

In an industry where outsourcing of certain functions is the norm, one has to
question why this did not raise huge red flags with institutional investors as
one has to question the regulatory framework of the SEC for domestic funds in
the US, that permits a fund to retain these functions in house.

In the Post Recession World

There are as many supporters of outsourcing as there are detractors. But
cost, politics and nationalistic sentiments apart, outsourcing is an essential
prerequisite that allows a system of checks and balances to operate effectively
in many industries. The world of hedge funds is one such.

Whether the current financial downturn is secular or cyclical is unimportant.
What is important is that the world learns from this experience and the
regulators and investors alike insist on the right level of transparency,
disclosure and oversight to ensure this does not happen again Intelligent
outsourcing must be a major component of the answer.