Trusting Audits!

[Parsad]

A boardmember messaged me the question below, and I thought it was actually a good one for the message board.  Here is his question and then my response.  Any other comments you guys would like to add, feel free to do so.  Cheers!

 

Hey

 

I'm still new to the hedge fund scene, and I'm wondering how one goes about confirming the legitimacy of these entities. Obviously the funds have auditors, but from what I can gather auditors won't show you much of anything, they'll just say, yes, we're the auditor.

 

Using the Pabrai funds as an example, how would you go about proving that the fund isnt a ponzi scheme?

 

 

Hi ???????,

 

Auditors, whether they audit corporations, trusts, mutual funds, or hedge funds, have both a fiduciary and legal liability for any audit they perform.  There is always risk with any audit, on whether it is conducted accurately or not.  It's why the audit standards should be (doesn't necessarily mean they are) as high as any oath a physician, attorney or police officer should take. 

 

Registered mutual funds and hedge funds not only have audits done, but the SEC does random site checks...doesn't necessarily mean that a fund has been checked, but that at some point it probably will be.  Non-registered funds do not have site checks done, but they are required to do state filings, as well as conduct an audit unless an audit waiver has been granted by the partners.  Those really are the only safeguards, other than the custodian or brokerage service provider doing their job.  To paraphrase Buffett and Munger, no safeguard protects someone in all circumstances, so dealing with ethical people is the best way to reduce risk.

 

I would look at the auditor and see if they are respectable...any outstanding issues?  The PCAOB has a list of all auditors in the U.S. and how many issues they've dealt with.  That being said, any auditor that conducts a lot of audits over their lifetime, will eventually run into one issue or another.  I would also look at the fund...are they doing really esoteric things that may create valuation issues that the auditors would face?  If so, how did the fund and auditor deal with that issue?  Finally, I would contact the auditor and talk to them.  Obviously they won't give too much in fund details, but would they describe their process...reconciliation of financial statements with client account statements, confirmations with clients, confirmation with the custodian/broker, proof of assets and valuation, internal controls testing, etc. 

 

Unfortunately, part of the risk of investing is having trust in the financials and that the audit was done accurately.  I would say in over 80% of cases they are.  But investors should still be careful about what they read or see in that other 20%!  Cheers!

[jay21]

That's a very good reply Parsad.

 

The only thing I would add is it is not the auditor's job to search for fraud.  You can have an auditor do a great job and give a clean audit opinion, but this does not provide any assurance that there is no fraud.

 

I do think that the risk for fraud in a fund with a clean audit opinion from a reputable auditor that has low turnover, is concentrated, and invests in all equities would be low.

[JEast]

The only way that a ponzi scheme works is if you have collusion among several players.  The third party players in the hedge fund or family office space may not realize it is a ponzi scheme, but they do not ask the tough questions because they are getting paid handsomely.  Nevertheless, in the hedge fund or family office space, it seems almost impossible to run a scam unless you are forging documents which Madoff (and others) end up doing.  Even then, if a fund is using a public broker, the broker has to confirm at least the asset value of funds held with them to the reputable auditor.

 

I guess the question is about the unknown, unknowns, but the normal fraud type of stuff that gets by the auditors are valuation items for hard to price holdings.  One always runs the risk somewhat, but the risk seems to run many zeros to the right of the decimal point based on my experience for somewhat prudent man investing.

 

[Parsad]

That's a very good reply Parsad.

 

The only thing I would add is it is not the auditor's job to search for fraud.  You can have an auditor do a great job and give a clean audit opinion, but this does not provide any assurance that there is no fraud.

 

I do think that the risk for fraud in a fund with a clean audit opinion from a reputable auditor that has low turnover, is concentrated, and invests in all equities would be low.

 

Yeah, I would say that an audit that relies on reconciling the monthly brokerage statement with the prepared financials, and almost all of the assets are Level 1, is highly unlikely to be a fraud.  It's when you have more complicated valuations or complex structures, combined with collusion between the financial statement preparation and audit, you tend to see fraudulent behavior.  More often than not, fraud isn't quite blatant but more obfuscation of conflicts of interest.  You see far more of that than outright Ponzi schemes, etc.  Cheers!

[Guest]

He (or she) may want to give this book a try as well. I haven't read it but I read a review a while ago. Seems like some decent information.

 

http://www.amazon.com/How-Smell-Rat-Financial-Investments/dp/0470631961