Reputation is a fragile asset that is as much about perception as fact. Reputational capital is built over a long period of time but it can disintegrate overnight. Even the mere allegation of wrongdoing can result in uncomfortable questions for institutional investors about their competence and moral fiber.
How Investors Try to Mitigate Risk
To mitigate risks associated with investment fund investing, institutional investors have adopted tools that help protect against financial loss. These include operational due diligence practices, separately managed account structures and financial audits.
But investing in investment funds involves risk beyond financial loss. Perhaps more significantly, institutional investors face serious reputational risk, the risk of damage to their reputation for being associated with an investment fund fraud. The highly opaque nature of many investment funds only exacerbates the problem.
Risk of Fraud
Since the financial crisis, the SEC has stepped up enforcement actions against investment fund infractions and levied more fines for non-compliance, but the risk of fraud still remains for institutional investors. And conventional tools such as diversification and separate account structures simply do not protect institutional investors from reputational damage due to fraud.
Diversification Doesn’t Work
The risk of financial loss to investors from investment fund fraud can be mitigated by a diversified investment portfolio, but reputational risk to institutional investors due to fraud cannot be reduced by diversification. In fact, the opposite is true; diversification increases the risk of reputational damage by increasing exposure to different investment managers.
Separate Accounts Don’t Work
While separate account structures are able to insulate institutional investors from financial loss in the particular accounts they establish, they do nothing to prevent reputational damage resulting from fraud elsewhere in an investment fund’s operation.
Reputational Damage Due to Fraud
Since the financial crisis, the SEC has stepped up enforcement actions against investment funds and levied more fines for non-compliance, but risk still remains for institutional investors.
Just last year, over 200 Chicago municipalities, pension funds, libraries and parks lost more than $50 million after the Illinois Metropolitan Investment Fund (IMET) invested in fraudulent loans now at the center of a federal criminal investigation.
The results were devastating for the cities and towns involved, and resulted in serious reputational damage to IMET. "This has completely shaken our trust," said Todd Hileman, the village of Glenview's manager. "I've seen other governments taken advantage of by some of these schemes, but I never thought I would be part of a scheme."
New Orleans Fraud
In another recent example, the New Orleans Firefighters’ Pension and Relief Fund and the Municipal Employees’ Retirement System invested a combined $100 million in a fund called FIA Leveraged. The fund was supposed to invest in liquid securities that could be sold in a matter of weeks. But when the Firefighters’ Retirement System tried to withdraw $17 million of its investment, the withdrawals were denied. Over the next few months, more reports began to surface that questioned the soundness of FIA Leveraged’s investments, and it turned out that virtually all of the $100 million had been lost in a Ponzi scheme perpetrated by the fund’s manager, Alphonse Fletcher.
Beyond the $100 million-dollar loss which hit New Orleans’ firefighters and city employees hard, perhaps the greater damage was the loss of confidence in the city's pension managers, the mayor of the city and the supposed safeguards put in place after Madoff. According to Richard Davis, trustee for the now bankrupt fund, “millions of dollars were lost, that much is certain. The explanation of how that happened and who is responsible is still emerging, but the cast, in addition to Mr. Fletcher, includes those we normally think of as creating a line of protection against such fraud.”