It’s not volatility that is the biggest risk to investors; it’s losing capital as a result of fraud
Shinya Deguchi, founder of Shanghai-based multi-family office, Star Magnolia Capital, has been an investment professional for almost two decades – a job he is so passionate about that he sees himself doing it for the rest of his life. In his spare time, he has another passion: to help fellow investors identify and avoid investing in fraudulent investment schemes.
Investors have lost tens of billions of dollars in financial frauds over the years, with Bernie Madoff alone defrauding his investors of up to $65 billion. In Shinya’s early days in the investment industry, he, too, was the victim of fraud when his first employer, Melco Holdings, invested in a US hedge fund, and it turned out to be a fraudulent investment scheme.
Shinya’s brush with white-collar crime set him on an earnest mission, investigating financial frauds and sharing his insights on how they can be avoided in future. He publishes these fascinating case studies on his blog called: The Importance of Being Diligent
In an interview with AssetOwner, Shinya shares his findings after many years of doing this research. Primarily, he has found that even sophisticated frauds have red flags because it’s difficult, if not impossible, to design a perfect crime. So, if you dig deep enough, you can identify these.
But first, you need to overcome your human frailties. Shinya says that in his experience, it doesn’t matter how smart investors are; human weaknesses exist. He found this out close to home recently when his friends were caught up in the TCA Global fraud even though he had expressed various concerns about the fund, including its unusually stable - and steep increase - in returns.
They continued to ignore his concerns when he found that the auditor had qualified the financial statements of TCA because of concerns about the quality of the assets. As a result, the company was required to halve the previously stated return numbers to 6-7% from 15-20% but failed to do so in its marketing. In October this year, the SEC charged the principals with fraud.
So how can investors avoid falling prey to financial fraud? Shinya says if you’re a sensible business manager, you put checks and balances in place, and it’s the same in investing, where preparedness is essential. His mantra is: “Trust but verify”.
To help you do so, he has come up with the following framework to verify that you are doing good business with good people. This aspiration drives all his professional endeavours.
Straight-line performance is rare – be sceptical of it
Investors make the mistake of seeing volatility as a risk when the real risk is losing capital. Financial fraudsters take advantage of investors who are taken in by their strong, straight-line returns. However, it is almost impossible to run an investment fund for years without having some volatility in returns or, over 10 years, a substantial draw-down. All investors should know this simple fact and avoid investing in any investment scheme that reports straight-line performance.
Don’t rely on regulators to identify and prevent white-collar crime
Regulations are important safeguards, but they aren’t perfect. White-collar criminals are experts at finding loopholes in regulations and taking advantage of these. Then, when these are closed, they move on to find other opportunities in other market areas. For instance, loosely regulated hedge funds were fertile ground for fraudulent activities. But with the industry now subject to more regulatory oversight, white-collar criminals have moved on to the crypto space. With this in mind, you can’t rely on the regulators to protect you, and it’s crucial to do the legwork yourselves.
Conduct your own in-depth due diligences
Asset owners who conduct rigorous operational due diligence rule out most fraud cases. To do sufficiently rigorous due diligence, you need to:
Read all legal documents, including the Private Placement Memorandum and Limited Partnership Agreement
Verify the asset under management by speaking to the valuation agents
Understand where the performance is coming from
Confirm the standing of the auditor, administrator and legal counsel
Check for red flags, including an unexplained change in the auditor or a qualified audit, by speaking to previous and existing auditors
Review audited financial statements
Conduct background checks on all the key personnel at the firm
Do on-site visits and interview members of the firm
Create a circle of trust
Speak to other investors and share experiences and insights about investment schemes you’ve come across. Most investors don’t have inside information, so it’s challenging to uncover a fraud unless you do deep, time-consuming research on your own. With many minds on the job, however, the red flags will be easier to spot. Hearing other, independent viewpoints will also help you move past your blind spots when an investment proposition looks compelling is ultimately too good to be true.
Visit The Importance of Being Diligent - www.being-diligent.org
Read the original article