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Donaldson Says Hedge Funds May Be `Accident Waiting to Happen'

Date: Friday, January 28, 2005

(Bloomberg) -- Hedge funds, with their newfound popularity and high fees, may be ``an accident waiting to happen,'' U.S. Securities and Exchange Commission Chairman William Donaldson said. The SEC, which voted last year to extend its oversight to the $973 billion industry, will use targeted inspections to police the investment pools designed for wealthy investors, Donaldson said. Hedge funds, which usually charge a 2 percent management fee and also take a 20 percent cut of investment gains, need high returns to justify their costs, he said. ``You have the potential for market manipulation and fraud,'' Donaldson said today in an interview at the World Economic Forum in Davos, Switzerland. A divided SEC in October ordered most hedge fund managers to register with the agency as investment advisers and undergo inspections and reviews of their bookkeeping. SEC officials have said they expect more than 1,000 hedge funds to sign up. Donaldson, 73, has championed the need for more oversight, saying the industry has grown too quickly to escape regulators' scrutiny. The agency's two Republican commissioners, Paul Atkins and Cynthia Glassman, dissented from the order and the rules are also being challenged by a fund manager who filed a lawsuit in U.S. federal court. Hedge funds, which typically require investors to have a net worth of at least $1 million, bet on falling as well as rising securities prices and often use leverage, or borrowed money, to boost returns. Registration Rules ``It's pretty hard to believe with the number of people flowing into this industry and attempting to achieve performance that would justify that fee structure, that this isn't an accident waiting to happen,'' Donaldson said, referring to the 2 percent fee and 20 percent cut of profits. Donaldson said the SEC's registration requirement, which takes effect in 2006, is ``a first step.'' The agency plans to conduct surprise inspections at the firms using risk-assessment models that seek to find out potential securities law violations, he said. ``We'll be sending out sweeps, gathering information to see if there are illegal activities going on,'' he said. ``We're not going to be going about regulating hedge funds, sort of sending somebody in every three years with a little checklist.'' While hedge fund managers have complained about the cost of complying with the SEC rules, Donaldson said he didn't think that would be a problem. ``With 2 percent fees and 20 percent profit, I don't think that is going to affect them very much,'' he said. To contact the reporter on this story: Robert Schmidt in Washington at rschmidt5@bloomberg.net. To contact the editor responsible for this story: Erik Schatzker in New York at eschatzker@bloomberg.net