Hedge Funds Under Regulatory Scrutiny


The SEC has hired hedge fund industry professionals to assist in its investigation of problems and abuses in the hedge fund industry. Three SEC enforcement units are involved in the investigations: the Asset Management unit headed by Bruce Karpati, the Market Abuse unit, and the Structured and New Products unit. The SEC has brought over 100 enforcement actions against hedge funds since 2010, and sees this area of enforcement as a top priority in 2013 (“SEC Targeting 4 Hedge Fund Developments in 2013,” AdvisorOne).

As the article indicates, Mr. Karpati identified four areas of particular concern in the hedge fund industry. First, the retailization of hedge funds is big problem. Retail or individual investors generally lack the background and experience necessary to conduct due diligence on a hedge fund or evaluate the reliability of due diligence conducted by third parties. The lack of transparency of hedge fund investments makes due diligence critical. The involvement of retail investors is expected to increase thanks to the crowd funding provisions of the JOBS Act, which basically allows promoters to market unregistered offerings that previously could only be sold in limited private transactions, to a much wider audience via public offerings, which were previously required to be registered with the SEC, and were thus subject to at least some degree of regulatory scrutiny.

Second, individual investors (often unbeknownst to them) are being exposed to hedge funds through pension funds, endowments, foundations and other retirement plans. Pensions now have between 8% and 10% of their investments in hedge funds, and have also increased their investments in other alternative investments, such as private equity and real estate. All told, pensions with more than $1 billion in assets have almost 20% of their investments in alternatives ? nearly twice the percentage of 5 years ago.

Third, the SEC is concerned that the complexity and lack of transparency of hedge funds invites fraud and makes detection by regulators and investors very difficult. The SEC notes that even sophisticated investors can be and are defrauded through these opaque alternative investment vehicles.

Fourth, a disproportionate amount of fraud occurs at smaller hedge fund advisers, which are often unregistered, and therefore, fly below the radar, so to speak. The SEC is particularly concerned about unregistered advisers engaging in general solicitations to unaccredited investors.

Another area of concern is fraudulent valuations. Managers are compensated by management fees and performance fees. That creates an incentive to value the funds assets as high as possible to increase the fees. The assets are typically illiquid assets that have to be valued by models and guesswork, which provides an opportunity to overvalue them.

Page Perry is an Atlanta-based law firm with over 150 years of collective experience maintaining integrity in the investment markets and protecting investor rights.