A Guide to the Hedge-Fund Maze

Dizzying growth and an absence of regulation have spawned a series of scandals. Here's why it happened -- and what's being done

By Amy Borrus

Hedge-fund scandals are piling up faster than autumn leaves on suburban lawns. In late September, the founders of Bayou Management, a $400 million Connecticut hedge-fund firm, pleaded guilty in federal court to criminal fraud. Two weeks later, the Securities & Exchange Commission filed fraud charges against the founder of the Wood River hedge funds (see BW, 10/13/05, "Another Fishy Hedge Fund").

About the same time, federal prosecutors charged the ousted CEO of derivatives broker Refco with hiding as much as $545 million of debt by shuffling it among the outfit's units, a separate company, and a hedge fund (see BW Online, 10/17/05, "Refco's Lessons for Investors"). So far this year, the SEC has logged 20 cases against hedge funds, compared with 19 in all of 2004 and just two in 2000 (see BW Online, 10/18/05, "The Hedge Fund and the Coffee Shop").

What's going on? Here are some explanations for all the funny business in these shadowy, unregulated investment pools for wealthy individuals and institutions -- and what's being done to clean up one of Wall Street's fastest-growing sectors.

Why does there suddenly seem to be so much hedge-fund fraud?

The industry's dizzying growth is a big factor. Over the past five years, the number of hedge funds has doubled, to more than 8,000, as have assets under management, to $1 trillion, according to Hedge Fund Research.

The more funds, the greater the likelihood that some fund managers will cheat. Stiffer competition is putting pressure on managers to take bigger risks. And big securities firms, eager to win trading business from hedge funds, may be more aggressive -- and less diligent -- in their dealings with hedge clients

Why have hedge funds escaped regulation?

For years, it was accepted wisdom that the wealthy investors who put their money into hedge funds didn't need the full protections of federal securities laws. Only "accredited investors" -- individuals with a minimum of $200,000 in annual income or minimum net assets of $1 million -- could buy into hedge funds.

But over time, inflation put that wealth threshold within reach of many unsophisticated investors. And indirectly, the retirement savings of teachers, firefighters, and millions more ordinary Americans have been funneled into hedge funds, as investment managers for pension plans hunt for higher returns than they can get in stock and bond markets.

Is anything changing?

Yes. Last year, the SEC approved a new rule that requires managers of hedge funds with assets of $30 million or more and at least 15 clients to register with the agency. Overseas hedge-fund advisers must register if they have more than 14 U.S. clients, regardless of the size of their assets.

The rule, which takes effect next February, exempts advisers who require investors to lock up their money in the fund for two or more years. The rule also raises the wealth threshold for investors in most hedge funds to a net worth of at least $1.5 million, or $750,000 in assets under management with that adviser.

Registration will give investors basic information about investment managers, their credentials, and resources. The SEC will gain a window on hedge funds -- and the right to knock on their door unannounced and demand to see books and records. But already, fear that such examinations might cause proprietary information about trading strategies to leak out prompted widespread opposition to the rule among many hedge-fund firms.

Will registration dent hedge-fund fraud?

It will help -- but how much isn't clear. The SEC estimates that more than 30% of hedge-fund managers are already registered with the agency. Forcing all to register could flush out the scam artists and make legitimate players more careful about how they manage client money.

But the SEC's ability to deter fraud in hedge funds ultimately will depend on the quality of its examinations. And critics contend the agency lacks the resources and expertise to do a thorough job. "No one believes that inspection of a hedge-fund adviser will be particularly effective at spotting either excessive risk or concealed problems," says Donald Langevoort, a Georgetown University law professor. "It's meant as a basic measure. It lets those on the marginal end of the business know the Commission is there and can walk in any time."

Can anything else be done?

Not much -- at least for now. SEC staffers are mulling whether to require more disclosure in the registration form. But tougher regulation of advisers or the funds they manage would be strenuously opposed by the hedge-fund industry, whose deep pockets open doors on Capitol Hill.

Still, no politician wants to be linked to a scandal-tarred industry. If the stream of hedge-fund fraud continues, debate in Washington about the need for stiffer rules could heat up fast.

Borrus covers the securities industry from the Washington bureau of BusinessWeek

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