Graham Macdonald, MBE
MBMG International Ltd.
Nominated for the Lorenzo Natali Prize
Do not be conned, part 1
Recently, we have discussed Mark to Model schemes. Many people consider
these to be a new concept but they have been around for ages. Whilst it must
be said that many are above board and do exactly what they say, there are
more than a few that are less than honest with their clients. The most
famous of these was created by Charles Ponzi who was an Italian immigrant to
the US. Ponzi achieved notoriety there after World War I for spectacularly
defrauding thousands of investors, using a scheme similar to the one Bernie
Madoff got caught out using some 90 years later.
As most people will be aware, both Ponzi and Madoff attracted new investors
by promising higher-than-market rate returns, and then paying existing
investors these rates with the money entrusted to them by new investors,
rather than from any genuine business profits as, in both cases, any real
growth was insufficient to cover the promised returns.
Few investment professionals today would admit they could be taken in by a
modern-day Ponzi scheme, even though, as the Madoff case showed, a great
many people - including some of the supposedly brightest minds in the world
of financial services - were fooled as recently as five years ago.
This is why such professionals and the rest of the public ought to be wary.
The fact is that vigilance is absolutely necessary today - as much as it was
when Madoff was still spinning his story to potential new investors from his
offices on Third Avenue - if similarly toxic schemes are to be avoided.
That is because the DNA from “Pops Ponzi” is still out there, potentially
lurking in the models of some investment strategies currently being
marketed, if some troubling news stories in recent weeks are to be believed.
It seems that certain characteristics of Ponzi’s approach to investment have
a way of appearing in investment structures that many experts fail to
examine as closely as they perhaps ought to.
Often, as with the Ponzi and Madoff schemes, it is not entirely clear
whether some of the latest crop of troubled schemes are the result of
deliberate malfeasance, carelessness, or simple ignorance. In the end, of
course, it does not matter, as the damage caused to investors, in the form
of lost money, is the same.
Many of the schemes that we believe should be looked at with extra
attention, when they come striding down a runway towards would-be investors
and their advisers, are those based on “mark-to-model” (M2M) formulas. These
include some property investment schemes, which derive valuations purely by
reference to an assumed multiple of rental values, rather than by any
reference to the open market value that the property reasonably could be
M2M structures have even been known to be used in connection with investment
products based on off-plan properties that have not even been completed yet.
Although we hope we are wrong, it could be that in the same way “CDO cubeds”
- a super-leveraged variation of Collateralised Debt Obligations - became
symbolic of the folly behind the sub-prime bubble in 2008, hypothetical
investment models built on top of poorly designed mark-to-model assumptions
will come to be seen as a symbol of the 2013 - 2014 period that future
investment experts will shake their heads in disbelief over.
Readers of financial publications will have seen references to a number of
cases recently which have involved resort properties in popular vacation and
retirement hotspots. The reason they are in the news is because investors
have suffered when construction failed to take place within a projected time
frame, and/or the resale value of comparable properties in the local market
plummeted, causing the investment vehicle’s actual pricing to fall short of
the developers’ - and investors’ - expectations, based on the models.
Interestingly, Ponzi’s gimmick did not involve property at all, but what was
known, at the time, as “international reply postal coupons”.
Ponzi promised to give investors a 50% return on their investment every 45
days, purportedly by buying these coupons at a discounted rate in countries
where they were sold cheaply - such as his native Italy - and redeeming them
from the US Post Office for a significantly higher face value. Ponzi claimed
such transactions yielded returns in excess of 400%.
The main thing to note at this point, though, is this: artificial pricing
schemes work because, like Charles Ponzi’s original scheme, they sound
entirely plausible. The stories ring true, the assets are real and
recognisable, and very often, the people selling them believe they are real
and a genuine good deal for investors - and thus come across as trustworthy.
To sniff out the problem, an investor has to pick apart the valuation models
being used to explain current and future profits, and bear in mind the old
adage that if something seems too good to be true, it almost certainly is.
Unfortunately, this is, too frequently, easier said than done.
Another defining feature of Ponzi schemes - and another reason they can be
difficult to spot - is that their initial unconditional, high, fixed returns
typically encourage many of the original investors to re-invest their
capital and profits, rather than redeeming their holdings.
This feeds the illusion of an investment that others fear missing out on,
and thus are quick to pile into, while also preventing the model from being
tested by the usual market liquidity conditions - that is, normal periods of
Most of us can still remember the aura of success that the name Madoff
exuded in the months preceding the namesake company’s eventual collapse - as
well as the shock, subsequently, that so many well-respected financial
experts (not to mention regulators) had been taken in by the scam.
As stated last week, Charles Ponzi was an early American financial products
innovator who achieved notoriety in the years just after World War I, after
he came up with an investment scheme that spectacularly defrauded thousands
of investors - and in the process gave his name to future investment
entities of a similarly flawed nature.
In the case of Ponzi’s original scheme, one potential red flag that some
investors might have spotted, had they known 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 is
interesting to note that 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. Unfortunately,
no-one followed up on this.
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 do not get prizes for choosing
investments that are not 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
- 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 first-hand 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
respectable and robust and have well-known auditors, custodians and
To be continued…
The above data and
research was compiled from sources believed to be reliable.
However, neither MBMG International Ltd nor its officers can
accept any liability for any errors or omissions in the above
article nor bear any responsibility for any losses achieved as a
result of any actions taken or not taken as a consequence of
reading the above article. For more information please contact
Graham Macdonald on