May 27 (Bloomberg) -- Arthur Samberg, founder of Pequot Capital Management Inc., plans to liquidate his main hedge funds because a federal insider-trading investigation has “cast a cloud over the firm.”

“With the situation increasingly untenable for the firm and for me, I have concluded that Pequot can no longer stay in business as an investment adviser,” Samberg wrote today in a letter to clients. Pequot, started in 1986, managed $3.47 billion as of May 15, according to a regulatory filing, down from $4.3 billion in November.

The U.S. Securities and Exchange Commission in January reopened a probe into whether Samberg’s funds illegally profited by trading on inside information about Microsoft Corp., people familiar with the matter said at the time. Investigators learned of documents that show former Microsoft employee David Zilkha may have obtained confidential information in 2001 about the software maker, said one of the people. Zilkha left the Redmond, Washington-based company that year to join Pequot, where he worked for less than a year.

“Public disclosures about the continuing investigation have cast a cloud over the firm and have become a source of personal distraction,” Samberg, 68, wrote in the letter, a copy of which was obtained by Bloomberg News.

Jonathan Gasthalter, a spokesman for Wilton, Connecticut- based Pequot, declined to comment, as did Erik Hotmire, an SEC spokesman in Washington. Samberg’s plans were reported earlier by cable-television network CNBC.

Return Cash

Samberg’s firm will sell the holdings of the Pequot Partners, Pequot International and Pequot Endowment funds, according to the letter. The funds, with about $2 billion in assets, will return a “significant amount” of cash to investors by June. The rest will be paid out over the next several months, pending a year-end audit and liquidation of harder-to-sell assets.

The $493 million Pequot Partners returned an average of 16.8 percent since its inception 22 years ago, compared with the 8.5 percent gain by the Standard & Poor’s 500 Index, according to the letter. The fund rose 1.8 percent this year through April 30, compared with a decline of 2.5 percent by the S&P 500, including reinvested dividends.

The firm’s Special Opportunities and Matawin funds will be spun off into independent entities, Samberg said in the letter. Special Opportunities, with about $600 million in assets, will be led by Rob Webster and Paul Mellinger, while the $450 million Matawin will be run by Mike Corasaniti.

Once the Biggest

Pequot’s assets peaked at about $15 billion in 2001, making it the world’s largest hedge-fund manager at the time. The firm said in April 2001 that No. 2 executive Daniel Benton was leaving to start his own hedge fund, taking about half of Pequot’s assets. Benton ran Andor Capital Management LLC until deciding in August 2008 to shut.

Pequot also has offices in New York, California and London. Chief Investment Strategist Byron Wien joined in December 2005 after holding similar positions at Morgan Stanley.

Hedge funds are private, largely unregulated pools of capital whose managers can buy or sell any assets, bet on falling as well as rising asset prices and participate substantially in profits from money invested.

The SEC had closed an earlier investigation in 2006 that focused on communications between Samberg and Zilkha while Pequot was betting on Microsoft stock, yielding at least $2.1 million in profits in April and May 2001. Investigators found “insufficient evidence to bring a case,” SEC attorneys wrote in a report that ended that probe.

The agency resumed investigating Samberg after discovering documents on a hard drive Zilkha’s ex-wife copied from their shared computer during their divorce, her lawyer, Mark Sherman, said in January.

To contact the reporter on this story: Larry Edelman in Boston at ledelman3@bloomberg.net

Last Updated: May 27, 2009 19:52 EDT