In the case of Ponzi’s original scheme, one potential red flag that some investors might have spotted, had they known at that point what to be on the look-out for, was Ponzi’s litigiousness.
Early on, Ponzi successfully sued a writer who had suggested that it was impossible to deliver as high fixed returns as Ponzi was promising.
This discouraged further investigative journalism that might have highlighted the problems with his scheme earlier. Instead, as history now tells us, the Boston Post was still giving Ponzi’s scheme favourable reviews until just two weeks before its collapse.
(It was at that point that Clarence Barron, one of America’s most important early financial journalists and a key figure in the development of Dow Jones & Co and the Wall Street Journal, observed that Ponzi wasn’t investing in his own company, and that the size of his scheme exceeded the total number of postal coupons in circulation – these were his investment category of choice – by a factor of almost 6,000.)
What, then, should an investor look out for today, in order to avoid Pop Ponzi’s genetically-flawed descendants?
The first warning sign, of course, is an investment that appears too good to be true. On the other hand, advisers don’t get prizes for choosing investments that aren’t any good – so by itself, this is a poor clue.
Therefore, every adviser kicking the tyres of an investment seemingly good enough to be worth considering needs to understand that his or her due diligence processes must be thorough. More thorough, indeed, than has been the norm until now for some, if recent media reports of investors having been put into less-than-ideal schemes are to be believed.
Indeed, many of the considerations that may have influenced advisers in the past might need to be revisited. In particular, advisers should be on the look-out for:
- Plausible stories, backed up by credible assets, but priced using artificial valuation models. Such investment stories abound across a wide range of seemingly attractive underlying asset classes, including property, resources and “financial contracts”, such as receivables, development mortgages, or litigation funding.
- Open-ended structures that (apparently) pay high fixed or consistent returns. The problems can arise when these are wrapped around illiquid or hard-to-price assets, such as highly-specialised properties or storage-unit container rentals. Being open-ended facilitates inflows, which repay redeeming early investors, and can give an impression of liquidity that may be false. As occurred during the financial crisis in 2008, open-ended funds can run into problems when too many investors head for the exits, at the same time that asset prices collapse.
- A vague affiliation is claimed with well-known auditors, administrators or custodians, but the nature and limitations of the affiliation is not made clear. For example, an auditor whose mandate is simply to confirm valuations that have been prepared in line with stated models may well give unqualified audit opinions, whatever the limitations of the subjective model itself actually might be.
- Schemes that have attached themselves to worthwhile causes, which a sceptical observer might dismiss as a cynical way to distract attention from the offering’s deficiencies through ‘reflected respectability’. An example of this might be the promotion of green credentials by forestry funds, exploiting investors’ understandable desires to “save the planet”, while racking up 15% a year in “fixed” returns.
- Schemes whose promoters are quick to threaten legal action, and make frequent use of the device to silence critics. (From firsthand experience, I know how quickly dubious schemes move to threaten litigation against any unfavourable analysis.) What you want to see is a well-argued, numerically-sound explanation of just why the critics are wrong.
- Unusually high incentives to introducers are also a typical feature of “mark to model” – if the underlying numbers are totally divorced from reality, then the hard cash in the pot can be spread around promoters and introducers very generously. Ponzi did the same thing, using a highly-paid team of distributors. The numbers say it all: if a 15% fixed return from 100% of the capital is unachievable, imagine how much more difficult it would be to realise if some 20% or more of invested capital is paid out to the parties responsible for devising and distributing the schemes, and never even reaches the investment assets.
Of course, there are exceptions to these warning signs. Most investment funds, for example, are open-ended, and the vast majority of these are respectiable and robust and have well-known auditors, custodians and administrators.
Many of the leading names in our industry, meanwhile, regularly and nobly attach themselves to responsible social causes; equally, many people with unimpeachable reputations – built up over many years – are keen to maintain and defend them.
The point is that due diligence on any investment, particularly in this day and age, needs to be undertaken much more precisely than, heretofore, has often been the case.
Which leaves us with the question: Just how does an adviser ensure that an investment is reliably free of any trace of Ponzi DNA? For that, see…
Part three, tomorrow: It’s the due diligence, stupid
Paul Gambles is managing partner of MBMG International, the Bangkok, Thailand-based advisory firm
