If Bernie Madoff had invested in Berkshire Hathaway, would the ponzi actually have succeeded?

Question

Bernie Madoff operated the largest known Ponzi scam in history, defrauding people of an estimated $20B for almost 3 decades. From Wikipedia:

Rather than offer high returns to all comers, Madoff offered modest but steady returns to an exclusive clientele. ... to deliver 12% annual returns to the investor, Madoff needed to earn 16% gross, so as to distribute a 4% fee to the feeder fund managers, who would secure new victims, be "willfully blind, and not get too intrusive".

If Bernie Madoff had simply invested everything into Berkshire Hathaway, and forged his 12% annual returns as he did, would the ponzi actually have succeeded?

Berkshire Hathaway averaged an annual growth in book value of 19.7% to its shareholders for the last 49 years (compared to 9.8% from the S&P 500 with dividends included for the same period), while employing large amounts of capital, and minimal debt.

You could say that Berkshire Hathaway was only a good investment in hindsight, but it had a 14-year track record of success at the time when Bernie was starting his ponzi (1980). Doesn't seem like a bad gamble. Of course it's still fraud, but I thought the idea was puzzling. If it makes sense, why didn't Bernie actually invest his clients' money... into anything at all? I understand that he was running a ponzi and trying to defraud people, but he could still do all that while having a reasonable chance of making everybody happy. Or am I missing something?

Answer 1

I could be wrong, but I doubt that Bernie started out with any intention of defrauding anyone, really. I suspect it began the first time he hit a quarter when his returns were lower than everyone else's, or at least not as high as he'd promised his investors they'd be, so he fudged the numbers and lied to get past the moment, thinking he'd just make up for it the next quarter. Only that never happened, and so the lie carried forward and maybe grew as things didn't improve as he expected.

It only turned into a ponzi because he wasn't as successful at investing as he was telling his investors he was, and telling the truth would have meant the probability that he would have lost most of his clients as they went elsewhere. Bernie couldn't admit the truth, so he had to keep up the fiction by actually paying out returns that didn't exist, which required constantly finding new money to cover what he was paying out. The source of that money turned out to be new investors who were lured in by people already investing with Bernie who told them how great he was as a financial wizard, and they had the checks to prove it.

I think this got so far out of hand, and it gradually dragged more and more people in because such things turn into black holes, swallowing up everything that gets close.

Had the 2008 financial crisis not hit then Bernie might still be at it. The rapid downturns in the markets hit many of Bernie's investors with margin calls in other investments they held, so they requested redemptions from him to cover their calls, expecting that all of the money he'd convinced to leave with him really existed. When he realized he couldn't meet the flood of redemptions, that was when he 'fessed up and the bubble burst.

Could he have succeeded by simple investing in Berkshire? Probably. But then how many people say that in hindsight about them or Amazon or Google, or any number of other stocks that turned out similarly? (grin) Taking people's money and parking it all in one stock doesn't make you a genius, and that's how Bernie wanted to be viewed. To accomplish that, he needed to find the opportunities nobody else saw and be the one to get there first. Unfortunately his personal crystal ball was wrong, and rather than taking his lumps by admitting it to his investors, his pride and ego led him down a path of deception that I'm sure he had every intention of making right if he could. The problem was, that moment never came.

Keep in mind one thing: The $64 billion figure everyone cites isn't money that really existed in the first place. That number is what Bernie claimed his fund was worth, and it is not the amount he actually defrauded people out of. His actual cash intake was probably somewhere in the $20 billion range over that time. Everything else beyond that was nothing more than the fictionalized returns he was claiming to get for his clients. It's what they thought they had in the bank with him, rather than what was really there.