Hedge fund matchmakers cannot escape scrutiny

Date: Friday, March 19, 2010
Author: Matthew Goldstein and Svea Herbst-Bayliss, Reuters

The specter of scandal never seems to fully lift from the business that plays matchmaker to hedge fund managers eager to connect with industry experts.

Now those firms are not only confronting the fallout from the Galleon Group insider-trading case, but a new problem: slumping revenue as the financial crisis has pruned the pool of potential clients.

The so-called expert networking industry was first thrown for a loop in 2007 when U.S. securities regulators began looking into allegations that some hired-gun consultants had improperly divulged confidential corporate information to traders looking to score a quick profit.

The investigation by the Securities and Exchange Commission and New York Attorney General Andrew Cuomo eventually ground to a halt and did not result in any enforcement action.

But lingering regulatory concerns about the potential for abuse in the rent-an-expert business never went away, according to legal sources.

Those sources said securities regulators are once again taking a look at the expert networking business, in part because the Galleon case revealed the lengths that traders can go to crack corporate secrets.

This latest inquiry by the SEC also may not result in any enforcement action and it is not clear if regulators are focused on any particular firm, the sources said.

Still, the chronic suspicion is enough to make some hedge funds steer clear of the industry, even though managers know that may put them at a competitive disadvantage.

Although it is the experts themselves that have been eyed for improper leaks, the networking firms could still potentially be held liable by regulators for their actions.

Robert Romero, who runs Connective Capital, a $65 million tech-focused Palo Alto-based hedge fund, said the trouble with experts who get paid to advise traders is they may tempted "to cross the line to provide inappropriate information."

DRAMATIC HALT

The industry is also feeling the fallout from the financial crisis.

Hundreds of hedge fund firms have been gone out of business in the last two years, meaning there are fewer potential clients for the estimated three-dozen expert networking firms. And even among those managers who survived the crisis, there is a desire to cut costs.

The result is a dramatic halt to the once rapid growth of the expert network industry - a business largely dominated by one big player, Gerson Lehrman Group.

Last year was the first time the roughly 10-year-old industry posted an overall decline in revenue.

Consulting firm Integrity Research Associates estimates that revenue for the matchmaking industry declined about 16 percent to $360 million in 2009. And it may take until 2013 before the industry tops the $430 million in revenues it tallied in 2008.

"Customers are getting very focused on trying to get price reductions," said Integrity Research Chairman Michael Mayhew. "The likely outcome will be fewer and bigger players."

Retrenchment and consolidation has already begun.

Last year, JPMorgan Chase (JPM.N) spun off Primary Insight, the expert network business it acquired by rescuing parts of Bear Stearns in 2008. Also, McGraw Hill (MHP.N) sold its Vista Research division to Guidepoint Global, absorbing a $10 million loss on the sale, said industry sources.

COMPLIANCE AS MARKETING TOOL

Meanwhile, Thomson Reuters (TRI.TO), which entered the expert networking business with high-expectations, is scaling back its operation, sources said. The company, which owns the Reuters news service, did not comment.

Mayhew predicts the firms that will prosper are ones that have spent heavily on compliance to guard against abuses.

Certainly Gerson Lehrman, which had been a focal point of the 2007 investigation, is trying to use the compliance measures it has put in place as a marketing tool.

"We expect competition in our industry but we believe only expert network firms that invest in compliance procedures and systems the way we have, will thrive," said Laurence Herman, Gerson Lehrman's general counsel.

Firm officials said it spent $10 million over the past five years to develop technology it uses to keep track of meetings it arranges between its consultants and customers.

Last year, Gerson Lehrman, which controls a little more than 60 percent of the market, earned more than $240 million in revenue, a person familiar the company said. By comparison, Coleman Research Group, a competitor, said it took in $22.2 million in revenue in 2009.

Many matchmaking firms charge clients a yearly retainer which can start around $60,000. Premium networking services can cost clients more than $1 million a year, sources said.

"It is a very expensive service, but something we use because it provides critical information," said Thomas Kamp, president of hedge fund Cornerstone Capital Management.

Going forward, managers said matchmaking firms will have to demonstrate that their experts are not simply making the hedge fund circuit, saying the same thing to one fund after another.

"The marginal value of anyone speaking goes down, if everyone is talking to the same guy," said one hedge fund manager.