S.E.C. to Hedgies: Who are You Sleeping With?

Look out, hedge fund managers. The Securities and Exchange Commission is going on a fishing expedition in your waters.

The agency sent a 27-page letter to an undisclosed number of hedge funds that demands detailed information on their employees and clients, according to Bloomberg News. The objective is to find any possible links that may have led to insider trading activity.

It's an admirable ambition, but the probe is likely to lead to information overload for the already overworked agency. According to Bloomberg, the S.E.C. wants to know if any employees or clients of the hedge funds, or any of their relatives, serve as officers or directors of public companies. In addition, they want to know if any relatives work in brokerage firms. And they want detailed information on any deal that the funds passed on because it was "deemed inadvisable, inappropriate, unethical, or possibly illegal.''

Investors in hedge funds are mostly institutional investors like pension funds, endowments, and other investment funds. The only individual investors who put their money in hedge funds are the extremely wealthy. They're wealthy entrepreneurs, or corporate executives, or smart investment professionals. In other words, they're they kind of people you might find on corporate boards or at cocktail parties with friends and relatives in the brokerage industry.

The S.E.C. is asking for such a vast wealth of information, it's hard to imagine the hedge funds even have it. Do hedge funds ask these details of their clients before taking their money? Doubtful. Moreover, the hedge fund industry isn't likely to hand over the data without a fight.

Insider trading is certainly a problem, and one the S.E.C. should proactively pursue. Demanding information on hedge fund employees is certainly defensible, but asking for details on all of their clients is hardly going to prove fruitful.

Just take a look at the board of one of the biggest companies that had suspect trading activity around the time of an announced acquisition. Credit-default swaps in First Data's bonds rose sharply in the days after KKR approached it about a buyout late last year. Its board consists of the following: one managing director of Warburg Pincus, who was also formerly a vice chairman of J.P. Morgan; one managing partner of Belvedere Capital, a private equity firm, who was formerly an executive of Barclays Global Investors; a managing director of Bankers Trust, who was formerly an executive at Merrill Lynch; the head of investment banking of William Bair & Company; a general partner of a venture capital firm. The rest are retired or sitting C.E.O.s who more than likely have at least some of their investment portfolios tied up in hedge funds.

The bottom line is that hedge fund investors are all tied to public boards and people in the brokerage industry. People on boards are wealthy investors in hedge funds. People in the brokerage industry are sometimes related to (and often friends with) people in the hedge fund industry. And they all know people in the private equity industry.

No amount of regulatory paperwork is going to skim the surface of the incestuous nature of these industries. The S.E.C. might have better luck going undercover.

by Megan Barnett