Hedge Fund Fraud Case Study On PAAMCo

Feb. 20, 2013 2:12 PM ET
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How important is it to have an established infrastructure for a hedge fund start-up? A trading error or loss of important financial data may cause severe costs to an investment manager and investors, directly and indirectly, but such losses are not irreversible if a manager is truly talented. A hedge fund business, especially at the start-up stage, is quite simple as its administrative burdens can be outsourced to service providers, such as prime brokers and administrators. Therefore, until very recent, it was difficult to justify for a start-up hedge fund to hire COO or CFO to establish solid infrastructure beyond a trading platform, instead of hiring another skillful analyst or trader using the same amount of money.

However, the real value of having an independent back office professional from a portfolio manager is quite significant when it comes to prevent misconducts of the portfolio manager. A start-up hedge fund is a risky business because the manager takes big risks on his own wealth and future. If its performance deteriorates, even for a short-time, and investors start taking money out, turning around the business is like swimming against the current. The fear of losing everything often pushes the manager to go wild.

Verification of functional back office is an important process of due diligence and PAAMCo's fraud case in 2002 is a good case study how it could have been helpful for investors.

Case Profile

Fund Name

Philadelphia Alternative Asset Fund, LP

Philadelphia Alternative Feeder Fund LLC

Philadelphia Alternative Asset Fund, Ltd.

Option Capital Fund LP

Investment Manager

Philadelphia Alternative Asset Management Company, LLC

Portfolio Manager

Paul M. Eustace

Other Notable Parties

Thomas Gilmartin

Investment Strategy



Oct 2002

Estimated AUM

$278 million

Estimated Losses

$210 million

Major Misconducts

  1. Failure to disclose trading losses suffered in a subaccount hidden from service providers
  2. Misrepresentation of trading performance
  3. Artificially inflating net asset values


Paul Eustace ("Eustace") was a whiz-kid who gained fame at Trout Trading Management (now known as Tewksbury Capital Management, Ltd.), a prominent CTA firm established by his childhood friend Monroe Trout, where he served as president until 1998.

Eustace established Philadelphia Alternative Asset Management Company, LLC ("PAAMCo") with Thomas Gilmartin, his college roommate and Vice President of the prime brokerage department at Man Group ("Man"). Eustace's experiences at Trout helped to allure not only investors into the commodity trading funds, but also well-respected business magnets like Paul Wallace, vice-chairman of the Philadelphia Stock Exchange, as director of PAAMCo.

Eustace launched Option Capital Fund ("Option Capital") in spring 2001 and Philadelphia Alternative Asset Fund, LP ("LP Fund") in 2002. Although Eustace successfully raised about $35 million, PAAMCo's investment operations were not profitable. Both Option Capital and LP Fund were controlled and overseen only by Eustace, general partner of both funds, and investment performance was reported by Eustace to investors directly. Instead of telling investors that the funds were losing money, Eustace fabricated performance probably since March 2003.

Eustace also launched Philadelphia Alternative Asset Fund, Ltd. ("Offshore Fund") and Philadelphia Alternative Feeder Fund LLC ("Onshore Feeder") to solicit new investors without disclosing the losses in both Option Capital and LP Fund. Again, Eustace's capital raising effort was very successful and PAAMCo raised more than $250 million from at least 60 investors for the new funds. Unlike Option Capital and LP Fund, Offshore Fund and Onshore Feeder were both administered by UBS Fund Services in the Cayman Islands ("UBS") and the performance was reported to investors by UBS.

Despite the mounting losses in Option Capital and LP Fund, both Offshore Fund and Onshore Feeder generated steady returns until early 2005, when Eustace made a wrong call on U.S. interest rates and suffered from substantial losses. Eustace hid losses from investors and a fund administrator with a hope that he can turn things around by the summer. But, his hope was never materialized as CFTC filed an injunctive action against Paul Eustace on June 22, 2005 and shut down the funds immediately afterwards.


A big question was how Eustace hid the losses from the eyes of legitimate professional firms like UBS and Deloitte & Touche ("Deloitte"), an audit firm for both Offshore Fund and Onshore Feeder. UBS was hired as a fund administrator and responsible for calculating NAVs on behalf of the funds since inception of the funds. Deloitte duly executed audit for the fund's activities until Dec 2004 and found no illegitimate activities.

The answer was found at Man Financial ("Man"), prime broker of the funds. In March 2005, in order to hide losses in trading accounts, Eustace opened a new secret trading account ("50 account") where he allocated all loss making trades. Because Eustace had hidden the existence of the secret account from UBS, which did not have a direct access to the 50 account, UBS only received reports from Man only on the profitable trades, but not the losing trades in the "50 account." The total losses in the 50 account reached $179 million before it was seized by CFTC.

Thomas Gilmartin ("Gilmartin"), then-vice president of Man Financial and a college friend of Eustace helped Eustace to establish the 50 account and purportedly hid it from UBS and Deloitte, and even from the funds' offshore directors. Later investigation found that Gilmartin owned an economic interest in PAAMCo, the management company which collected both management and incentive fees. Were it known to investors, this could be a red flag, but the fact was never revealed until the official investigation was launched.

The Receiver of defunct funds managed by PAAMCo accused both Man and UBS of negligently allowing Eustace to hide $179 million in loss-making trades. Man initially denied the claim and counter-sued UBS, saying it should have spotted the problems, but later settled with the receiver and agreed to pay $69 million into a restoration fund and $6 million in legal fees and expenses. UBS also settled and agreed to pay $19 million.


This is one of rare cases where it was extremely difficult for investors to spot the misconducts of the investment manager even after fraud occurred in early 2005. Offshore Fund and Onshore Feeder Fund were legitimately managed until Dec 2004, when Deloitte conducted its audit. The operational review of UBS shall end up with no result as the administrator itself believed that it has established automatic feeds from all accounts held at the funds' prime brokers, including Man.

Does Check-and-Balance System Exist?

  1. PAAMCo, established in King of Prussia, PA and operated in Canada, was essentially a two-men shop, Eustace and his young trader, and had no operational professionals. Thanks to the recent technological advancement and electronic executions, a CTA fund can theoretically be managed by one trader with help from prime brokers. However, a potential investor could have pointed out the PAAMCo's business lacked adult-supervision, or check-and-balance system in its business. For the entire period of operations of PAAMCo, Eustace set up a wire and approved it by himself. This eventually allowed him to create a bogus trading account at Man without anyone but Eustace and Gilmartin knowing its existence. It is possible to find it out by interviewing Eustace's assistant trader about what role he is playing at the firm.
  2. It is still difficult to conclude the legitimacy of business by solely identifying the lack of check-and-balance system because it is not a fraud by itself. However, with over $250 mm AUM, the firm was able to spend money on the infrastructure and there must be a VERY good reason if a portfolio manager decides not to do so.

Check "Other" Funds Managed by the Investment Manager

  1. According to the court records and various media resources, Eustace marketed Offshore Fund and Onshore Feeder as successors for Option Capital and LP Fund, both of which were suffering substantial losses.
  2. A potential investor could have requested financial statements of both funds to verify Eustace's past track records.
  3. Both funds were also managed by Eustace himself, not by PAAMCo and not registered with NFA as commodity trading pools either (we can only find the trace for Offshore Fund and Onshore Feeder on the NFA's website). The reason why these two entities were not subject for the NFA registration was, as revealed later in the bankruptcy court, that they did not have any trading operations, but simply entered into various swap agreements called Collateralized Swap Agreements (between Offshore Fund and LP Fund and between LP Fund and Option Capital), so that both LP Fund and Option Capital can participate in the performance of Offshore Fund without actual trading activities. This set up was unfortunately beyond understanding of potential investors unless they obtain audited financial statements for LP Fund and Option Capital, but the lack of registration for the previous two entity could have been a good reason for a potential investor to cause a request for more information.

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