Involvement of Funds of Funds in Alleged Madoff Fraud Reemphasizes Importance of Due Diligence

As Warren Buffett famously said in his 2001 Chairman’s Letter, “you only find out who is swimming naked when the tide goes out.”  According to a criminal complaint and press reports, the tide has clearly gone out on Bernard L. Madoff Investment Securities LLC and its founder Bernard Madoff, and a number of prominent funds of hedge funds have been caught swimming sans bathing trunks.  Specifically, a significant part of the value proposition of funds of funds is the ostensibly rigorous due diligence they perform on underlying managers.  Yet some of the biggest names in the fund of funds world appear to have invested in Madoff investment vehicles without performing adequate due diligence.  The anticipated losses of such names from the Madoff scandal emphasize the central importance of due diligence, especially for funds of funds, and the inadequacy of exclusive or near-exclusive reliance on personal relationships in making investment decisions.  We explore the implications of the Madoff scandal on the rigor and content of due diligence that should be performed by funds of funds prior to and after investing in underlying funds.

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