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7 Dec 2006

The Hedge Fund Hearings

The Senate Judiciary Committee conducted re-investigation hearings Dec. 5 on the hedge fund industry, looking into the handling of hedge fund giant Pequot Capital.

The Committee hearing focused on the regulation and enforcement issue. It is trying to determine whether the Securities & Exchange Commission might have been improperly influenced when it allowed Morgan Stanley Chief Executive John Mack to avoid questioning in an inquiry.

Although the SEC has cleared Pequot Capital and Morgan Stanley chief John Mack, questions still linger over allegations that the initial investigation was quashed when the lead investigator sought to subpoena Mack. Now two Senate investigations are underway to determine whether the SEC failed to thoroughly conduct the initial investigation and whether politics played a role in that failure.

The inquiry is focused on the trades that involved Morgan Stanley and Pequot, where Mack previously worked as chairman. As the hearings proceed industry observers will be looking for clues into just how much enthusiasm lawmakers have for imposing broader controls on the hedge fund industry.

Many hedge funds done tremendously well, attracting more capital and allowing them to pull off larger, higher-profile deals. But lawmakers and the media have focused on the blow up of a few funds, such as Amaranth Advisors.

Such problems have been relatively few in number, and the damage has largely been contained. Yet they have nonetheless led to calls for more regulation of hedge funds, which have been drawing more money from pension funds and even from some smaller, individual investors.

Earlier this year there was an effort to require hedge funds to register as investment companies, which would force them to disclose a certain amount of information about their strategy. The U.S. Court of Appeals in Washington overturned an SEC rule that would have required hedge fund registration. Some industry executives fear that would depress returns because funds would tip off their moves to rivals.

If the government were to impose leverage limits, the impact on the markets could be significant, industry observers say. Firms use debt to boost their return on investment. If deals become less profitable as a result of leverage limits, big pension funds may cut back on their allocations to alternative investments. Deals could become less competitive, and deal volume and price could decline as a result, weakening the investment market overall.

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