Don't let due diligence slip Bayou

For those who don't recall, Bayou Management's fraud used to be considered an "incredibly big" rip-off in the hedge fund world.  How far we've come in a few short years!

Few people outside a narrow range of experts are up to date on the litigation resulting from Bayou's liquidation.  However, this complex process has serious implications for those who suffered when someone else made off with their money, as well as anyone who invests in hedge funds today.

Here's the basic idea: Hedge funds are "partnerships" in a legal sense.  I'm no lawyer, so don't think I truly know what this means.  As a practical matter, however, this means investors are in it together, as partners. 
But, investors in hedge funds are never partners in any sense of the word, except that they are beholden to the same management company.  All hedge fund investors know the simple existence of other partners hurts them, even if only in the abstract.  (Example: another investor's ability to exercise redemption rights hurts you.  This is true of mutual funds too.  The smaller you are, the more likely you can free ride off the liquidity provided by others, etc.)

When does this matter most?  Liquidation!  When a fund goes BK, or into receivership, the well established legal system that applies assumes all the parties are really partners, and the goal is to keep the business together, and treat each other fairly.  Oh, and by the way, the same is true while the partnership functions.

So, if one partner determines the fund is a fraud, the Bayou litigation clarifies that the partner with the smoking gun cannot use it to his or her benefit.  If you are the limited partner invested with the next Madoff who "discovers" it is a fraud, you have a problem.  You have to tell all your partners.

If you happened to redeem from a fund before the news breaks, you have to prove you didn't know the hedge fund was a fraud.  Can you see the minutes of Big Institutional Money Manager? "We note that we have submitted redemption notices to BigScam LLC on 12/31/2009.  We have not spoken to the manager since we invested three years ago.  Performance continues to exceed expectations.  However, we've tired of our relationship.  To the best of our knowledge, the fund continues to do exactly as we thought when we invested."  Take that, Mr. Court Appointed Receiver!

So, given this state of play, why would any investor risk trying to figure out if their investments are frauds?

Seems to me the logical solution is to design a structure where all the "partners" consent to the idea that there are real incentives to figuring out if the fund is a fraud.  Maybe it's a winner take all bounty??  You can bet due diligence would get VERY good, VERY fast!