The Making of a Ponzi Scheme

On February 4^th, the SEC charged three individuals and their investment firm, GPB Capital, with running a Ponzi scheme in the amount of $1.7 billion dollars. For scale, the Bernie Madoff Ponzi scheme was $64.8 billion, so while this scheme did not reach such a significant size, it is still the largest Ponzi scheme accusation made since Madoff’s conviction in 2009. While these are just charges and must still be proven in court, the enforcement action provides a great lens and impetus into how Ponzi schemes happen and how consumers can protect themselves from them.

The GPB Complaint

The core of the criminal complaint by the SEC is found here:

“The SEC’s complaint alleges that David Gentile, the owner and CEO of GPB Capital, and Jeffry Schneider, the owner of GPB Capital’s placement agent Ascendant Capital, lied to investors about the source of money used to make an 8% annualized distribution payment to investors.  According to the complaint, these defendants along with Ascendant Alternative Strategies, which marketed GPB Capital’s investments, told investors that the distribution payments were paid exclusively with monies generated by GPB Capital’s portfolio companies.  As alleged, GPB Capital actually used investor money to pay portions of the annualized 8% distribution payments.  GPB Capital and Gentile with assistance from Jeffrey Lash, a former managing partner at GPB Capital, also allegedly manipulated the financial statements of certain limited partnership funds managed by GPB Capital to perpetuate the deception by giving the false appearance that the funds’ income was closer to generating sufficient income to cover the distribution payments than it actually was. The SEC’s complaint further alleges that GPB Capital and Ascendant Capital made misrepresentations to investors about millions of dollars in fees and other compensation received by Gentile and Schneider.  As alleged, the fraudulent scheme continued for more than four years in part because GPB Capital kept investors in the dark about the limited partnership funds’ true financial condition, failing to deliver audited financial statements and register two of its funds with the SEC.”

Alternative and Private Investments

Alternative investments have been around a long time, and are generally defined as investments that are less well traded or securitized as common securities such as stocks and bonds. This includes investments such as private business ownership, limited partnerships, private equity ventures, and other high-risk low liquidity ventures. Alternatives are generally classed as having higher than average returns than common stocks and also having significantly greater risk (Blackrock’s 30-year return assumption is annualized at 14.8% compared to US equities at 6.8%, but has a standard deviation four times greater than that of US equities). As a result, they’re generally considered inappropriate for the average retail investor, and many are “gated” behind accredited investor requirements (high annual income or a minimum liquid net worth requirement), in order to protect investors from the risk of the investments. In the case of GPB, it’s alleged that they not only created fake private equity investments but that they reported to clients that their annual income payments of 8% of the balance of their accounts came from these investments. This alone is a fairly significant red flag, as alternative investments are often highly illiquid (meaning that the investment is locked up for a long time period) and that rate of yield is fairly high if not depleting the principal of the investment.* Succinctly, these investments were outperforming by heads and shoulders beyond that which they should do. However, in keeping with the tradition of being highly illiquid, the SEC’s attention was drawn to GPB largely in part due to customer complaints. Many investors assume they can get their money back from an investment easily and do not understand the illiquid nature of many alternatives; unsurprisingly, if GPB was running a Ponzi scheme, it was important that they keep the investments as illiquid as possible in order to keep customers from realizing losses or to help perpetuate the fraud of using customer’s money for income and calling it “returns”.

*Note that some alternative investments, such as oil and gas master limited partnerships (MLPs) are designed with the intent of creating large tax deductions while also creating a high amount of cash flow, but these are often an exception and not the rule.

Custodial Issues and Customer Statements

One of the biggest red flags for a consumer to identify for a potential Ponzi scheme is when the investment manager also acts as the custodian. This means that the investment manager is not only managing and investing the client’s money, but that they are also acting as the institution that holds the funds, and as a result, are responsible for generating client statements. Consequently, this means that as they provide the client with performance reports, they can also amend their custodial statements to say whatever they want, including reporting bogus balances and returns. This can be even further compounded if the company is also acting as the investment manager for the investment products the client is buying. In doing so, the fraudster can not only generate fake returns on the investment product, but also on the account statements, and finally on the performance reports provided to clients. Without any 3^rd parties involved, the client has no external resource to verify if what they’re being told is true. If the complaint against GPB Capital is true, this is exactly how they’ve been able to perpetrate a fraud on clients. So how does a consumer protect themselves?

Three Layers of Separation

Given the three layers of fraud perpetrated in the example we’re talking about today, I like to suggest that clients utilize three separate service providers as part of their portfolio.

• Utilize a fee-only investment manager that offers no proprietary products or custodial services. By doing so, you have an investment manager who has more than an arm’s length relationship with the investments they’re making on your behalf.
• Ensure that the fee-only investment manager is utilizing a 3^rd party custodian. By doing so, the investment manager now has an “auditor” for their performance reports. If their reports don’t match what the custodian is reporting, you now have evidence that they might be up to something (or that their reporting software has an issue!)
• Review the portfolio recommendations they make for proprietary offerings, either those of the investment manager or the custodian. This can be tricky, as some great service providers also create great investment products. However, it’s both a clear conflict of interest for any investment manager to recommend their own proprietary products, and by ensuring they only use third-party mutual funds, exchange-traded funds, and others- you can ensure they aren’t in a position to let that conflict of interest influence their investment recommendations, and more importantly, aren’t in a position to fake performance!