Refco: When Smart Money Isn't So Smart

A special bankruptcy examiner faults TH Lee's bad due diligence for the downfall of the recently public brokerage. And he's got the e-mail trail

by Matthew Goldstein

Internal e-mail from Scott Schoen, TH Lee's co-president

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The titans of the private equity world fancy themselves smarter, shrewder, and more sophisticated than any one else on Wall Street. Investors have bought into the sentiment as they've scooped up the shares of the private equity firms that have gone public recently: Blackstone Group (BX) and Fortress Investment Group (FIG). But a recent report on the spectacular collapse of Refco—the once-dominant commodities broker that was laid waste by a massive accounting fraud—paints an unflattering portrait of the private equity firm that engineered Refco's August, 2004, leveraged buyout and its initial public offering a year later (see BusinessWeek.com, 7/11/07, "Kill the Private-Equity Tax Break").

The 416-page report from Joshua Hochberg, a special examiner appointed by a U.S. bankruptcy judge to investigate the Refco collapse, finds fault with some of the due diligence done by Thomas H. Lee Partners in the months leading up to its $1.9 billion LBO of Refco. In particular, the examiner takes issue with TH Lee's handling of a tip from a "deep throat" source that "all was not well with Refco." Four months before the buyout was completed, the informant tried to warn the Boston-based private equity firm that Refco was "sloughing off" trading losses and hiding them in a foreign subsidiary.

But the ominous warning was dismissed by TH Lee's top brass, following a June 1, 2004, meeting with Phillip Bennett, Refco's then-chief executive. Hochberg says TH Lee executives left the heart-to-heart meeting, feeling satisfied that all was O.K. with the brokerage. The examiner notes that Scott Schoen, TH Lee's co-president, sent an e-mail to his colleagues, saying the meeting "went very well" and that "Phil was very constructive."

Fraud Should Have Been Detected

Little more than a year later, the same Bennett was being charged by federal prosecutors with orchestrating a multi-year scheme to use a series of circular loans to hide up to $750 million in noncollectible customer-trading losses. The alleged scheme came to light in October, 2005, just two months after Refco went public in an IPO underwritten by Bank of America (BAC), Credit Suisse (CS), and Goldman Sachs (GS).

Within a matter of days, Refco's stock crashed, the 36-year-old brokerage firm filed for bankruptcy, and Bennett was charged with multiple counts of securities fraud. The examiner concludes if TH Lee Partners had done a more exhaustive investigation into the May, 2004, tip, it "Should have detected the fraud."

Worse, it appears Schoen and his cronies went into that meeting with their minds made up that the tip had no merit. In another internal e-mail unearthed by the examiner, Schoen refers to the "script" for setting up the meeting with Bennett. Schoen writes, "We want to sign the deal and go forward. This allegation has been brought to us by someone we have known on Wall Street for a long time and we trust, but it is brought second hand. We don't believe it, but we owe it to ourselves, our fiduciary role with our LP's, and to Phil as our prospective partner to discuss it openly and directly and try to address it together."