How to make sure you don’t invest in yet another Enron

8 September 2007

IT'S déjà vu all over again: this week, another hedge fund manager pleaded guilty to fraud. The activities of Keith Gilabert, the founder of a fund called GLT Venture Fund, cost investors about $14m (£7.8bn, E11.3bn). This was just a skirmish, however, compared to the spectacular collapse last August of Bayou Capital Management, which took with it $350m in investors' funds. In both cases, the losses were not due to anything like high-risk derivative investment structures: the cause was old-fashioned, outright fraud.

The truth is ?out there? in many investment situations. Risk can be mitigated by detecting and avoiding people and entities with discoverable negativities. Since one truly bad investment resulting in a total loss of capital can torpedo the cumulative return of many good investments, simply steering clear of such situations whenever possible can dramatically reduce overall portfolio risk and enhance return.

This can be done by exploiting the enormously expanding global information environment. Total information produced worldwide is increasing by about 30% per year: i.e., doubling every three years. Estimates vary, but a best guess is that somewhere over 90% of all information is now accessible somewhere through open source or restricted source data. ?Open source? is the technical term used in the intelligence community to denote data available without special access.

The inherent practical problem is that such data are not situated in one place, and thus the answer to a key business question like ?am I dealing with someone likely to defraud or misrepresent?? (or, for that matter, ?what are the new product strategies of my biggest competitor??) cannot simply be Googled. Such findings must be assembled analytically from many pieces of information gathered from many sources: some obvious, some obscure. Increasingly, the requisite pieces are simply not available on the ?open? internet, but are housed in the hundreds of proprietary subscription databases that capture and store full text data from tens of thousands of sources. Such data are ultimately legally accessible if you know where to find them and are willing to pay.

There is a set of protocols and approaches for collecting and analysing such data to produce actionable findings, and it has become known by an interrelated family of terms including competitive intelligence and investment intelligence. These techniques are closely related to methods long used by government intelligence agencies to derive meaningful findings from masses of data. This ?intelligence approach?, which is only productive with large arrays of data, has become relevant to the business world precisely because of the explosion of information (the private sector now has access to a level of data that not even national intelligence agencies possessed in the past).