Who Pays for Hedge Fund Fiascos?

There is a fascinating article in today's WSJ pointing to a developing issue in hedge funds. When such funds fail over fraud it is increasingly common for current investors to sue to obtain monies distributed to earlier investors who, not knowing of the fraud, withdrew money when the fund was still liquid.

As you can imagine, early investors have a very hard time with this. To their way of thinking, they knew of no fraud, took their gains, and moved on. The idea that they should be punished ex post strikes them as indefensible and revisionist. On the other hand, current investors argue that excess payouts to early investors is central to the fraud perpetrated by such hedge funds, so the gains were never real in the first place, and therefore they should be paid back.

We lean slightly toward the latter view, but we’re happy to be convinced otherwise. Thoughts out there on this issue?

http://paul.kedrosky.com/archives/2006/08/22/who_pays_for_fa.html