SEC Probes Prime Brokers' Hedge Fund Matchmaking

February 2, 2004 ( - The US Securities and Exchange Commission has demanded information from prime brokers about a practice called "capital introduction" in which the brokers introduce existing hedge fund investors to managers of new funds.

According to a Wall Street Journal report, a new hedge fund picking up investors through this route typically will reward the firm by steering trading business to it.   Unnamed Journal sources said regulators are probing whether there is an inherent conflict in a firm’s recommending hedge fund investments because it will result in a good deal of commission revenue, rather than because they are the best funds for investors.

The people famliar with the matter say the process is in its early stages and is also part of a revival of interest by regulators into  soft-dollar arrangements , in which investors direct trading to certain brokers in exchange for stock research and other services. Regulators are looking for information on what firms get in return when they help a hedge fund lure new investors.

Wall Street prime brokers provide hedge funds with a one-stop shop of tools and services they need to conduct business, including technology and securities clearing. As more brokerage firms vie for hedge-fund business, they are seeking an edge by helping start-up funds meet investors at private gatherings.

Wall Street firms have powerful incentives not to advocate a hedge fund so aggressively that they become vulnerable if the fund should blow up, lawyers told the Journal.

Some lawyers representing hedge funds and institutional investors contend that, however implicit, Wall Street firms are recommending the funds as investments because they are putting their reputations behind them. Lawyers predict attention to the issue is likely to increase pressure on brokerage firms to disclose more about the benefits they get from capital-introduction arrangements.