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Episode 5: The Underlying Risks and Potential Criminal Activity Behind Hedge Fund Investments

April 12, 2023 The Investment Fraud Lawyer Speaks Podcast

Investment Fraud Lawyer Jake Zamansky Shares Intel on Hedge Fund Investments

Welcome to the Investment Fraud Lawyer Speaks a podcast by Zamansky Law Firm founded by Jake Zamansky, one of the top security lawyers in the country. Listen along as we shed light on investment scams, negligence, and share how you can recover your investment losses.

Welcome to the Investment Fraud Lawyer Speaks, a podcast produced by the Zamansky Law Firm. I’m Nancy Rapp from PaperStreet and I’m speaking with the founder of the firm Jake Zamasnky. Jake is one of the preeminent lawyers in the country for securities fraud matters and FINRA arbitration. The law firm represents individuals and institutional clients in cases against Wall Street firms for investment fraud losses. Today, we’ll be talking about hedge funds. We’ve briefly mentioned this topic in some of our past episodes, which covered complex products and things of that nature. But hedge funds have many risks that are decidedly worthy of their own show.

Hi, Jake. Thanks for joining us again today.

Jake, let’s get started by talking about hedge funds. To begin with, hedge funds are often seen as a top investment choice for extremely high-wealth individuals. What is the appeal to these investors?

Sure. Let’s talk about what a hedge fund is. It’s a partnership of private investors. The money is managed by a professional money manager who uses a wide range of strategies to try to earn above-average returns. A lot of hedge funds have superior research capabilities, research departments, superstar portfolio managers, and they employ complex strategies to generate high returns. For example, there are certain long-short hedge funds that use similar stocks. In one stock, they’ll be long, and in another stock, they’ll be short to try to generate a return and to hedge against risks. So, those are the type of hedge funds that a lot of these high net worth investors are interested in. As an example, there are also activist hedge funds like Bill Ackman of Pershing Square and Carl Icahn. What they do is invest in businesses and take an active role in the business to try to boost the stock price. They may help them cut costs and often try to get changes in the board of directors and in management to change a company and make it a more profitable one. These funds generally have high minimum investments, sometimes 250,000 is the minimum, sometimes it’s a million. They’re trying to get an exclusive group of investors who are experienced and have the money. In case there are losses, they won’t get nervous and pull out. They generally charge an interesting fee schedule. They charge 2% of the assets, so if I invest a million dollars, they get, say, $20,000, 2% off the top, and they get 20% of the profits. So, they’re different investments, and they’re for people who are willing to take the high risk and have a high net worth.

So, there’s an amount of prestige in the investments that may lead investors to that as well?

A lot of these hedge funds have pretty good track records; they’ve done well in the past. The managers have been at great places like Goldman Sachs or Blackstone, and they move over to a hedge fund. So, I guess you’re buying the quality of the people who run the place.

Now, that being said, obviously, there have been some risks associated with these hedge funds, and some of them have gone quite badly. You and I have discussed things like style drift, leverage, and liquidity issues as some of those top risks. Can we break those down for our audience?

Let’s talk about leverage. Hedge funds usually use borrowed money to boost returns. They may go to a prime broker or a bank and borrow money, sometimes three to five times leverage, by buying stocks on margin. If the stocks go up, you can make three to five times the return. Conversely, if the stocks go down, you can have large losses. Leverage magnifies gains and losses. Style drift is another issue for investors to be concerned about. You get reports from these hedge funds about what they’re investing in, and they promise you something up front. If they change the strategy and lose money, that’s a problem. Hedge fund managers are fiduciaries, and if they deviate substantially and go in a different direction, that’s a violation.

If there is a violation, it would be considered a misrepresentation or a breach of contract. These hedge fund managers are supposed to act in the best interest of the client and follow the strategy that they said they would. When we see these court cases, there have been substantial losses.

Sometimes managers argue that it was for the greater good, and they made money anyway. However, when we see these court cases, there have been substantial losses.

Liquidity is important for hedge fund investors to consider. There’s a lockup period, and most hedge funds won’t allow investors to take out any money for about a year. There are also liquidity windows where investors can take out some money. You’re basically locking up your money with a manager on a long-term basis. If you sell when the hedge fund is down, you’re going to take a loss on your investment. Sometimes when hedge funds are doing poorly, they put down a gate, which is a sign of problems. These are liquidity issues people need to consider.

Let’s talk about some of the biggest investment fraud cases we’ve seen with hedge funds.

Okay, I’m going to talk about some of the cases that we’ve handled. We were involved in a very high profile hedge fund blow up in 2008 by Bear Stearns. Bear Stearns, which was subsequently taken over by JP Morgan during the finance Intel crisis had won a $1.6 billion hedge fund that collapsed would happen there is, you know, we talk about style drift, they had a lot of exposure to subprime mortgage assets, which went bust in that financial crisis. So we got a lot of money back for investors, we went to arbitration cases and and got recovery for investors.

A couple others, we had a case involving the Millennium hedge fund. In this case, there was outright criminal activity. You had a manager who was buying what we’re, it’s an odd investment Nigerian oil warrants. And what he did was he did a false valuation of the of the oil warrants. He said that all these warrants, which are, you know, options to buy oil reserves, were worth, say $3,000 apiece, they had an outside valuation service say yeah, that’s the right number, that they were actually worth more like $30 a warrant. So it was just an outright fraud, there was a criminal conviction.

A lot of times you see hedge funds like that we got a substantial recovery for investments. For investors, we did the UBS Willo hedge fund, that was one where it was a distressed debt fund. And they they switch strategies and went the opposite way. What we just talked about a style drift, we were able to recover funds for investors, just one more there was a big blow up of a hedge fund called amarinth $6 billion blow up. They invested in natural gas futures and made just you know, outrageously risky bets and blow up the fund. So you see what these funds, they do something either there’s fraud, misrepresentation, or they do something much riskier than what they told investors. When they’re blow ups. We bring cases and we help investors recover.

Breaking it down to legally speaking for those who may not be familiar with the law firms, law lawsuits to begin with. If you are a person that suspects either style drift or something like that, with your hedge fund, do you need to try to find if it’s a class action or not? Or can you just try to file an individual claim?

Well, it’s a good question. A lot of these are our class actions where you can represent hundreds or even 1000s of investors. The reason it’s that way is it’s very expensive and time-consuming to bring one of these cases. If you had as a small loss, say 100 $200,000. In a hedge fund, you’re probably going to want to be in a class action because sometimes it costs millions of dollars in legal time and expenses to bring these cases, if you have a very large loss, if you’ve lost $10 million or more, well, then you might have, you know, an opportunity to bring your own case.

So usually, if you’re a smaller investor, you go in the class actions. If you’re a larger one, you can bring your own case, you also may have a claim against the firm that sold it to you. If UBS or Morgan Stanley sold you the hedge fund, you can go to arbitration against them for either misrepresentation, or not doing appropriate due diligence.

So either way, it’s safe to consult with a lawyer and just see what your best options are from there. Yep.

Yeah, so you talk to a lawyer and somebody like me can easily analyze it and say, you have a claim against the brokerage firm, you got a claim against the hedge fund. And, you know, you review the documents, you see the performance reports, and you can figure out, you know what went wrong?

Now, Jake, you said in one of the cases you handled there had actually been outright criminal activity. We’ve seen so hedge funds being connected to Ponzi schemes and insider trading as well. Also criminal acts. What happens in cases like that?

Okay, well, the most notorious one was Bernie Madoff. Bernie Madoff ran a Ponzi scheme. He raised billions of dollars from investors. He created the illusion of having an exclusive group you’re lucky to be able to invest with with Madoff. People would contact their friends and colleagues and say I got this great strategy. It always makes 10%. He’s got some great strategy going with Madoff as with others, you see that they target specific religious groups, sometimes ethnic groups, geographical locations, these hedge funds. In the case of Madoff, he was putting out false account statements showing a steady stream of profits. In fact, he never actually traded stocks. He was just making it all up. So there were numerous class actions. We were involved in some with Madoff. There was a civil trustee who sued all the banks and got recovery. Feeder funds that were sued. So it was a huge mess. But that’s an example of a hedge fund that ran a Ponzi scheme. We have also hedge funds that sometimes do illegal insider trading. A famous one was Steve Cohen, who’s now the owner of the Max Renet strategy called SAC Capital. And there were allegations by the government that they were using illegal insider information, knowing about events that would take place before it was publicly released, one of their traders went to jail. So it’s actually also in the show Billions, which a lot of people have seen. But we bring cases against hedge funds like that, if there’s fraud, misrepresentation or insider trading.

Is there any like warning triggers for something like that? I mean, obviously, the criminal activity is suspecting the person that you’re dealing with. But like, for example, if there’s like a low cost hedge fund to enter or something like that, are there any warning signs or something like that? Or does it really just run the gamut?

It’s, you know, they don’t really tell you a whole lot about what they’re doing. There’s somewhat of a black box. It’s It’s good to meet you to review the quarterly reports that are sent to you, sometimes you have an opportunity to talk or meet with the hedge fund manager, and, you know, the probe, how are they doing? What are they doing? If something sounds a little too good to be true? It usually is. So maybe if you do some due diligence, and you speak to the managers, or if your broker can get you on a call with them, sometimes, you know, people find out that there’s something foul going on. And then they alert either the regulators or speak to lawyers about it, that’s about the best you can do.

Now, what are the common aspects that are in hedge fund investments? Are those that involve REITs? What would you say to how are those regarded as safety wise? Are they a safe option for hedge funds or not?

Right, we’re talking about REITs, which is a real estate investment trust. And, you know, historically, a lot of real estate investment investments have done well. They invest in apartment buildings, shopping centers, commercial properties, and, you know, you as part of a read, you’re part of a partnership, you can, you know, realize returns if the rental market is good and and everybody’s paying their rent, you know, you may make 10% on a REIT.

There are two types, one is private REITs and others are publicly traded the publicly traded ones, you have much more information required by the SEC to make fulsome disclosures, not as much with private REITs. There’s a very important case that just came out. Blackstone which is a top firm had a recalled br e it Blackstone REIT investors were trying to get money out recently, this is a $71 billion hedge fund, and they were getting you know, billions of dollars in, in redemption requests. And part of the problem is, you know, when you have everybody heading to the exits, like trying to get a couple billion dollars, they have to sell assets. And you know, it’s not like selling stocks or bonds. In this case, Blackstone had to sell to Las Vegas hotels they owned for about $6 billion to try and pay redemptions.

So one of the risks of being in a REIT is if there are a lot of redemptions, they could be forced to sell illiquid real estate to meet redemption requests. And you may you may get a very low price, because it’s a forced sale or a quick sale. So something else to keep in mind, if you’re a REIT investor.

And then another aspect that’s usually as one of the investment items that are in a hedge fund or private equity investments. They’re targeted among either in the hedge funds themselves or just similar investments to those who are already in a hedge fund. What are some of the concerns with those?

Okay, private equity firms own stakes in public and private companies. They’re always sold to high net worth investors. They’re designed to be long-term holds. So Bill Ackman, as I mentioned, is a good example that sometimes they’ll try and take over a company. They’ll try and kick out management, put in new management, maybe they’ll spin off the assets. A lot of times they’ll go after a company that they think is undervalued. And either, you know, try and pump the stock price up by improving the company. Or they may split it up. You know, they’re risky because you’re not dealing with publicly traded securities. Who really knows what these companies are worth? Who knows how well they’re doing or how well they’re managed? So that’s an issue. You’ve got to make sure that these are the private equity, and some of them are excellent at analyzing companies, and some of them are not. They may pick out a dog and pay a lot of money for it. Those are some of the risks there.

Once again, the private equity is a very illiquid situation. You’re supposed to stay in it for a long time. Hopefully, it generates returns. But if they start getting big redemption requests, you know, they’re going to need to sell a company or sell a stake in a company to pay off investors that want to redeem.

Interesting. Lastly, Jake, I think a lot of people who aren’t very familiar with investments hear of hedge funds, and then mutual funds. What are the distinctions between the two, and is one safer than the other?

Okay, mutual funds are generally much safer than hedge funds. Mutual funds, I mentioned Vanguard before, they do a lot of mutual funds. It’s a, they’ll buy a group of stocks, maybe a diversified portfolio, or they’ll still concentrate on the energy sector, or pharmaceutical sector. We’re bonds of different types of companies, bonds have ratings, it can be triple-A or B, and sometimes what we call high yield, or junk bonds. So mutual funds are fairly liquid. They’re traded on an exchange, you know, if the markets are going up, generally, these will go up in value. And, conversely, if the markets are going down, they can your your, your head mutual fund could go down in value, you could sell it pretty quickly, either that day or within a day and get your money out.

Hedge funds, as I mentioned, are not liquid. They don’t trade on an exchange. So you need to be careful. And you need to make sure that if you’re going to invest in a hedge fund, I’m willing to tie my money up for a substantial period of time, a year or more. And I could lose a lot of money, I could make a lot of money, but it’s probably at the higher end of the risk spectrum, investing in a hedge fund.

So realistically, a hedge fund would be as a secondary source of investments. In other words, you’re not going to lose your home or something like that, if you invest in a hedge fund, you need to just consider that you have assets coming in from elsewhere.

Right? They actually are called alternative investments, you know, so generally, you want to make sure that you have a low percentage of your assets and hedge funds, private equities or alternative investments. If you know, if I’ve got 40% in stocks, 40% in bonds, maybe I could do 10 or 20% in a hedge fund. Unless you’re, you know, really a risk taker. So it’s important, most people aren’t. And they don’t really realize how risky these things are. So you got to make sure that you’ve got, you know, a relatively modest amount of your net worth in one of these hedge funds or private equities.

And now, if an investor decided to do the somewhat safer option, a mutual fund instead, have you seen very big investment fraud cases with these are not as much?

Well, we see some. Yeah, we see some where managers, you know, deviate from a strategy or, or, you know, make huge, huge errors of judgment. So, we do see problems not as many in mutual funds.

I was involved in cases involving Puerto Rico bond mutual funds, from 2013 to 2021, that was put together by UBS, they package closed end funds. And when the Puerto Rico economy tanked, these were mostly Puerto Rico bonds, and people lost 50-60% of their of their money in Puerto Rico bond fund, which they weren’t expecting, you know, closed end funds mean that, you may not be able to get out of it so easily. There’s closed and there’s open ended funds. So there’s a whole variety of mutual funds. You gotta read the offering materials, the prospectus to see the type of risk and the type of investment you’re making.

All right, Jake, thank you very much today. I think we learned a lot about hedge funds and why they might not be the best option for you if you are not concerned about losing your money.

All right. Thanks for listening to us today. And we’ll be back next time. Have a great one everyone. Thank you.

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