Hedge fund investing: Beware of special relationships: The remorse of Beacon Hill Asset Management Investors

Abstract

Beacon Hill Asset Management (BHAM) is a hedge fund that specializes in investing and trading mortgage-backed securities (MBS). The fund exploits arbitrage opportunities in the MBS market and does not take interest rate risk. The background of the fund management team is excellent, and its performance is stellar. Assets under management exceed US$2.0 billion. The investors include the top financial institutions. What could go wrong? The pressure to honor the commitment in a symbiotic relationship with the major investor in the fund advisory firm coerces the fund managers into committing fraudulent activities that they may not have committed otherwise. Asset Alliance Corp., a New York-based investment firm, payed $40 million for a 50 per cent ownership stake in BHAM in 1998. The purchase agreement included a claw-back provision. The provision stipulated that should BHAM fail to deliver the performance, BHAM must return up to half of the prior earnout fees to Asset Alliance. The Securities Exchange Commission (SEC) complaint alleged that the BHAM misrepresented the valuation of the securities in order to show steady and positive returns. The partners concealed the magnitude of the actual losses in order to save the operation of BHAM. The absence of a compliance officer and/or independent board facilitated the fraudulent activities, and investors' losses exceeded $400 million. In late 2004 the SEC settled the case and expected the disgorgement, prejudgment interest and penalties to be distributed to the fund investors. Investors in hedge funds and industry stakeholders should demand some form of independent oversight and investigate any special relationship the fund has with a third party, through the due diligence process.