From the November 01, 2005 issue of Futures Magazine • Subscribe!

How were so many fooled?

By late 2002, early 2003 the long-term bull equity market was more than dead and high net worth investors, if they did not have the foresight to be diversified from a long-only equity concentrated portfolio, were looking to do just that. That is where one investor of the Bayou Management LLC family of funds, we will call him Bill, comes in.

“The market was going nowhere, I just wanted to broaden my investments beyond what I had typically done. My investments were what you would expect, individual stocks, mutual funds, some bond funds. The most avante garde thing I ever did was sold covered calls,” Bill says.

Bill subscribed to online newsletter RealMoney.com. It is there he he first heard of the hedge fund Bayou. Columnist Gary Smith wrote about a long/short hedge fund that looked interesting and had a relatively low, $250,000, entry level. The article included a contact person for Bayou.

“I thought what the hell, I will e-mail Howard Kra [the contact] and see what I get. I got a sales pitch on [the] Bayou Fund,” Bill says. He learned the fund was managed by Sam Israel III, a third generation trader respected on Wall Street, it had been around since 1996, it didn’t shoot for home runs but produced steady returns [10% to 15%] by taking short term equity positions.

Kra sent him a PowerPoint presentation and a glowing article about the fund by hedge fund authority John Mauldin. Mauldin writes the Accredited Investor Newsletter and is president of Millennium Wave Investments, which creates research reports and recommends hedge funds. “I read it and in hindsight should have done a lot more ... I sent [Bayou] a check for $250,000,” Bill says.

Turns out that the report produced by Mauldin was for the exclusive use of clients of Altegris Investments and was being misappropriated. Mauldin had turned sour on Bayou by the summer of 2004 and recommended liquidation to all of the Altegris investors in Bayou. “We got in a situation were we were uncomfortable. We got all of our clients out,” Mauldin says. He did not have an inkling into the massive fraud that was going on but got out because of “a basic lack of transparency.” He says, “There were things that were making us a little uncomfortable so we asked for additional transparency. They wouldn’t give it [so] we were out.”

Bill says Mauldin’s report viewed it as a positive that Bayou executed trades through an in-house broker dealer, Bayou Securities LLC, because it added a layer of regulatory oversight, a view accepted by some in the industry though not universal. An October 2003 review by NASD of an investigation into risk disclosure, which resulted in Altegris being fined, states that in addition to a lack of disclosure some of the research reports used by Altegris contained unwarranted claims, some of which appear to refer directly to the Bayou report. John Sundt, president of Altegris, says the basis of the fine was the general nature of the disclosure and UBS and Citigroup faced similar fines during that time period.

NASD states the report falsely claimed the funds would be audited by NASD. Despite the nature of the language in the report, Mauldin and Altegris appear to have sensed a problem before most. “The key point is that our investors were not hurt by Bayou. The only people who had access to that report legally were our customers and those customers got out. There are plenty of investors who got into Bayou who didn’t get out,” Sundt says.

Unfortunately Bill only saw the initial report, which was not used after March 2003, according to Mauldin, and he did not see the subsequent recommendation to get out. But Bill was happy with the performance of Bayou. His account went from $250,000 to $336,000 in 30 months, according to Bayou. The monthly account report and weekly e-mails came like clockwork. “In all the months that I was in the funds there was only one or two months that showed a loss,” Bill says. In retrospect that may have been too good to be true but it was not as if Bayou was producing double digit monthly returns, it appeared to be what it purported to be, a conservative fund producing steady if unspectacular returns.

There were some red flags though. The weekly e-mails included commentary by Bayou founder and CEO Samuel Israel III. “It gave little thumbnails; Sam took a big position in gold this week, Sam is concerned that energy has gotten out of line so he is shorting a little energy. It was very detailed information,” Bill says. His understanding was that the Bayou strategy was short-term long/short equity. Most trades would be exited every day. The e-mails however indicated more of a global macro approach. The apparent style drift didn’t alarm Bill because all of the trades were short-term and he didn’t understand the various distinctions among hedge fund strategies.

“This was a strange world to me, I thought the hedge fund world is not like a mutual fund world. I figured you’re giving [an allocation] to this guy and if he thinks he needs to take a position for the moment in silver futures, fine, that is what the deal is if he thinks that is the place to be,” Bill says.

Charles Gradante, managing principal of Hennessee Group, which had investors in Bayou didn’t see a problem. Gradante says that Bayou was investing in gold and energy related exchange traded funds using the same momentum based methodology it used to select other securities. “There was no style drift as long as he stayed in equities. If he had gone to futures, then there was style drift,” Gradante says.

However it turns out Bayou, a registered commodity pool operator since 1998, had traded futures. On Sept. 29 the Commodity Futures Trading Commission (CFTC) charged Bayou and its principals with misappropriation and fraud. There were other red flags though. “I started in the Bayou fund and within a week or two after I invested my money I got a letter from the fund saying they were going to divide up the money into some other funds and I got moved into the Bayou accredited investor fund,” Bill says.

“That should have given me a little pause. But it didn’t seem [that strange that] they were going to create five funds. There was an overseas fund, a leveraged fund, a fund you could only get into for $1 million. But what was suspicious in hindsight was when I [asked] are they going to trade

differently. They said ‘no we just average the investments across all funds.’ Which probably should have suggested to me, why would you have [different funds?].”A master feeder fund structure is common, but multiple funds are usually created for specific legal or tax purposes, not just for a whim. A leveraged fund would indicate a higher risk level with higher returns and

drawdowns. “In hindsight I probably should have said, wait a minute, why do you have a leveraged fund if they don’t get any advantage from leverage? But I didn’t.

“What I wanted to know was could I get into a situation where one fund is doing well and my fund is not because one fund got lucky. They said ‘oh no, we invest money in the aggregate and then we take net earnings and allocate to the funds.’ In hindsight I should have thought, huh?” Bill says.

Gradante says the shifting of funds is common in the industry. “It is easy to Monday morning quarterback. The point is we have a due diligence process that has worked for 18 years, obviously it didn’t work on Bayou. We are rethinking the process but we avoided all of the big fraud and blowups,” Gradante says, noting that Hennessee did not invest client money in any of the major hedge fund frauds of the last decade.

Despite some of the oddities, returns were solid and there was no cause for concern until Bayou investors received a letter from Israel dated July 27, 2005 stating he was closing the fund for personal reasons and would return all investor money. Initially Bayou indicated that it would take a couple of months to complete the audits but after some investors complained, Israel indicated that 90% of investor money would be returned by Aug. 15.

“It was kind of a tear jerker. I have talked to other investors who were going to write him and say ‘we understand, you’re making the right decision, your family comes first.’ Of course, it all was a big lie,” Bill says. “And then the check never came. I called and the phone rang off of the hook and the mailboxes were full and the next thing I know I am looking at Gretchen Morgenson’s article in the New York Times. I completely freaked out,” Bill says.

“What was bizarre about it was if you are running a fraud and you knew it was a fraud, why on earth when you have people saying it is going to take two months and you had bought yourself two months to disappear, would you then say the checks will be in the mail next week knowing it was utterly impossible. The guy is not playing with a full deck,” Bill concluded.

Like all frauds, this has its unique aspects. Was Israel, like Barings’ Nick Leeson, utterly incapable of accepting bad trades and continuing to double up, while hiding losses, until he was eventually right or caught? Did he really expect to make $7.1 billion on his $100 million investment in another fund, Majestic, or was he a part of that secondary fraud (see “A fraud within a fraud” below).

It stresses the need for due diligence. Not only of a manager but of auditors, brokers, analysts and marketers. How much of your due diligence depends on you trusting the due diligence of others? “Given the fact that it appears to have been a total and complete lie, it was a very elaborate lie,” Bill says.

In 2003 Mauldin put together a due diligence document based on a survey of institutional investors, hedge fund analysts and hedge funds themselves. He compiled a list of more than 100 questions. “That document is the result of a lot of time and effort and lessons. If I wrote it again today it would be more extensive,” Mauldin says, adding, “Every time there is a fraud you add that to your due diligence.”

The questions aren’t designed simply to find fraud as much as determine overall competence, though Mauldin notes that in examining particular questions he suspects they are the results of tough lessons learned.

“You can sit and read them and say ah, these people got burned here and they have a set of questions to make sure they get never burned that way again,” Mauldin says.

If every fraud is unique, they have unique lessons as will the Bayou case. “The Bayou matter will create a whole new set of due diligence questions for everybody. Bayou won’t happen again in exactly the same way, but will there be other Bayou’s? Yes, because somebody will figure out how to defraud again,” Mauldin says.

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