Just as it takes money to make money, it took more than $700,000 in management fees for the Ohio Bureau of Workers' Compensation to lose $215 million in a Bermuda hedge fund, according to bureau records.
The fees were charged by Pittsburgh-based MDL Capital Management, which convinced former bureau chief financial officer Terrence Gasper in September, 2003, to transfer $100 million from an MDL long-bond investment fund into its offshore hedge fund, the active duration fund.
MDL's fees jumped by 50 percent during the next three quarters to $469,053 from $312,863 during the previous three quarters, and the bureau invested an additional $125 million in the fund. The fees only began to drop as the fund lost money because of an unsuccessful bet that interest rates for long-term U.S. Treasury bonds would increase.
During the course of eight years, MDL received a total of $1.97 million in fees from the state agency.
"It's stuff like this that gives hedge funds a bad reputation," said Charles Gradante, the chief investment officer at the Hennessee Group, a hedge fund consultant. "Any time an investor has an experience like this, it gives the industry a black eye."
Mr. Gradante said investors such as the workers' comp bureau regularly hire consultants such as the Hennessee Group or Tremont Advisers to examine any hedge fund contract.
"I don't know to which degree outside consultants were involved, if at all," said bureau spokesman Jeremy Jackson, adding that the investment was made without the bureau's complete knowledge.
State Sen. Marc Dann (D., Youngstown) said the billing process was another example of the lack of bureau oversight.
"This is exactly why we need to have an objective, bipartisan investigative committee with subpoena powers," he said yesterday. "There was absolutely no incentive for accountability."
While MDL has stated that the hedge fund existed to protect other outside bureau investments, the fund's payment structure would have rewarded MDL with record fees if its strategy had worked.
The contract stated that MDL would receive 1 percent of the hedge fund's assets each year, roughly $2.25 million. MDL would also be given 20 percent of any profits generated by the hedge fund, though profits failed to materialize.
A $225 million investment in a separate bureau fund managed by MDL would have paid MDL about $500,000 each year. However, there may be additional payments of which the bureau is unaware.
Like many hedge funds, MDL had an independent administrator, Olympia Capital, which calculates the net assets of 400 funds controlling $46 billion. Olympia Capital was paid directly from the hedge fund, said the firm's general counsel, Priscilla Murray Brown.
In addition to measuring the fund's returns, Olympia Capital also provided MDL's active duration fund with a Bermuda mailing address and two directors to its board. Both of these services allowed the hedge fund to incorporate in the British territory even though it was being managed from Pennsylvania.
Olympia Capital was responsible for sending monthly progress reports to investors, such as the bureau, Ms. Murray Brown said. Yesterday, Mr. Jackson said the bureau had yet to locate any of these reports.
Ohio Attorney General Jim Petro named Olympia Capital's principal, Oscar Lewnowski, as a defendant in its lawsuit to recover the lost $215 million.
"The fact that you're named in a lawsuit is no evidence of the truth of the allegations," Ms. Murray Brown said. "Many people don't understand what the role of an independent administrator is. We have no ability to impact whether the performance of a fund goes up or down."
Most hedge funds have similar payment structures but differ in how they manage an investor's money, said David Friedland, president of Magnum Investment, which invests $250 million in hedge funds. "Usually a manager is running a fund like it's an entire portfolio," he said.
Fund managers typically make a series of investments to balance the swings of the market, instead of committing an entire fund based on a hunch about the market's direction.
"If you're making directional bets, you're speculating. And if you're wrong, you're going to lose money," Mr. Friedland said.
There was evidence that MDL President Mark Lay made a shrewd investment. The Federal Reserve increased short-term interest rates four times in 2004, which commonly leads to higher long-term interest rates.
"It was mind-boggling," said Barry Slotnick, Mr. Lay's attorney, in an interview on Tuesday. "The Fed was pushing up its rates and long-term interest rates weren't going up. Hardly ever has that happened before."
Mr. Slotnick ventured to compare his client with Federal Reserve Chairman Alan Greenspan, whose careful words move markets across the globe. "Greenspan and Mark Lay have a lot in common," he said. "I think they thought that higher interest rates would cure all ills, and it hasn't."
After a period of growth, MDL, which manages $2.8 billion, appears to have struggled recently. While the firm maintains that Ohio's workers' compensation bureau is its only client to have lost money, several multibillion-dollar companies and state agencies in Illinois and Pennsylvania no longer work with MDL.
As part of the Rev. Jesse Jackson's drive to have Fortune 1000 companies partner with minority businesses, defense contractor Raytheon chose to invest part of its pension account with MDL in 2000. The company ended that relationship two years ago because MDL's returns were below Raytheon's preset benchmarks, Raytheon spokesman David Shea said.
Telephone company Sprint ended its relationship with MDL in February, but spokesman Susan Kristof declined to give a reason for the firm's decision.
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