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SEC Examines Funds of Hedge Funds

Date: Friday, September 10, 2010
Author: Jenny Strasburg, The Wall Street Journal

The Securities and Exchange Commission is examining whether firms that collect fees for funneling investors into hedge funds are properly overseeing client money and dealing with potential conflicts of interest, people familiar with the matter said.

The inquiry has identified about a dozen investment-advisory firms for questioning but could expand, according to people familiar with the matter, making it one of the SEC's broadest examinations ever of funds of hedge funds and advisers specializing in hedge funds.

According to documents reviewed by The Wall Street Journal, the inquiry is a "sweep exam" by the SEC's Office of Compliance Inspections and Examinations. That office's responsibilities include identifying fraud and other securities-law violations in investment firms, securities exchanges and Wall Street brokerage firms.

The sweep also could include alternative-investment advisers focused on private equity and other registered advisers catering to pension funds, people familiar with the situation said. The agency's initial scrutiny has involved firms overseeing $100 million to $15 billion in assets, according to one person with knowledge of the probe.

Funds of hedge funds collect fees from public pension funds, endowments, wealthy individuals and banks, which hand over money they want doled out to multiple hedge-fund managers. In return, the advisers typically collect fees of 1% to 2%, or as much as $2 million for every $100 million invested. Clients pay additional fees to the underlying hedge funds.



Before the financial crisis, funds of hedge funds and other niche advisers touted their firms as skilled finders and gatekeepers of the most talented hedge-fund managers. Investors piled in, eager to boost returns needed to fund everything from college scholarships and library books to retirement benefits for teachers and firefighters.

The boom ended in 2008. Hedge funds suffered steep losses along with the overall market, and numerous funds of hedge funds lost client money in the collapse of the Ponzi scheme led by Bernard Madoff. This year, some of the biggest funds of funds have attracted new client money, while many smaller firms are struggling.

Sweep exams don't necessarily mean the firms are suspected of wrongdoing. The SEC sometimes collects information that helps the agency develop and pursue leads to other firms and individuals. Evidence of illegal behavior can be referred to the SEC's enforcement division, which has the power to pursue civil charges. SEC spokesman John Heine declined to comment.

As part of the sweep exam, SEC officials also are demanding the names of hedge funds that advisers considered but then rejected, as well as the reasons why those funds were spurned.

Advisers typically reject more hedge funds than they hire, so the line of questioning could bolster the SEC's knowledge of hundreds of hedge-fund firms that haven't been subject to SEC examinations.

SEC officials also want to know the names of all consultants and outside advisers that helped choose or reject managers, and how much they got paid, according to the documents reviewed by the Journal.

Some advisory firms allow executives to invest in underlying hedge funds directly, apart from pooled accounts that hold clients' money, people familiar with the firms said. Some of those arrangements led to conflicts of interest during the crisis, as clients rushed to withdraw money, these people said. One question the SEC is pursuing: Did advisers gain an advantage from having better information than their clients?

People familiar with the matter said the SEC also is looking into the personal accounts of advisory-firm executives and other accounts not available to outside clients. The firms usually glean detailed information about the strategies and specific investments of hedge funds, and some firms allow employees to make side bets in the markets, the people said. That creates the potential for front-running, or trading ahead of client orders, or betting against them.

A letter sent recently by the SEC asked for the dates and amounts of all client withdrawals, details of any revenue-sharing agreements, and a "trade blotter" of asset purchases and sales for current and former clients, as well as for advisory-firm and executive accounts.

In the past year, the SEC's examinations unit has been reorganized as part of a wider shake-up of the agency in the wake of its failings in oversight of Mr. Madoff's business and other firms.

In January, the SEC named Carlo di Florio, formerly a regulatory-compliance partner with PricewaterhouseCoopers, to head the office.

Additional changes triggered by the financial-regulation overhaul passed by Congress this year will increase the number of investment firms required to register with the SEC, subjecting them to heightened scrutiny, including SEC examinations.

Write to Jenny Strasburg at jenny.strasburg@wsj.com