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Private equity firms brace for ‘mafia’ style scrutiny

Madison Marriage
Bloomberg/Contributor | Bloomberg

US financial regulators are turning their sights on private equity firms after winning a string of legal cases against hedge funds, according to law firms working with the buyout industry.

The Securities and Exchange Commission's clampdown on the hedge fund sector, which culminated in a record $1.8bn fine for insider dealing slapped on SAC Capital in November, is expected to lead to closer scrutiny of other corners of the alternative investment industry, particularly private equity firms, lawyers said.

(Read more: Private equity needs to act 'maturely': Report)

"Private equity investigations are at the stage where hedge funds were five years ago," said Timothy Spangler, a partner at law firm Sidley Austin.

John Carney, a former securities fraud chief at the SEC and currently co-head of corporate investigations at BakerHostetler, another law firm, said there was growing "scrutiny" of the private equity industry as "fraud follows money".

Mr Carney said Mary Jo White, who became chair of the SEC in April, "has filled her enforcement ranks with a number of her former lieutenants" from her time as attorney for the Southern District of New York who have a "native comfort" using aggressive tactics such as undercover agents, paying bounties to whistleblowers or setting up offshore funds to "attract the mice to the trap" and uncover white-collar crime.

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Mr Spangler said there had been few prosecutions of private equity firms in the past five years, but this was likely to change.

"These proven investigatory techniques and the young generation of prosecutors looking to make a name for themselves look like a volatile combination," he said. He added that US prosecutors are making greater use of techniques such as wiretapping, informants and "witness flipping" – turning junior employees into co-operative witnesses and getting them to draw senior staff into an investigation.

Hedge funds moving into non-traditional spheres

"These tools were hallmarks of mafia investigations, and they have proven very effective in hedge fund investigations. There is no limit to how these investigations could be replicated across other areas of financial services," he added.

John Nestor, a spokesman for the SEC, said it now uses "sophisticated pattern recognition technology" to trace information flows and detect employees who are trading in concert.

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Although private equity firms rarely trade in publicly listed stocks, which is where insider dealing typically takes place, there could be failings around fraud, competition, antitrust, bid rigging and collusion, says Mr Spangler.

"Private equity is probably wise to be worrying about [increased scrutiny] because they may well be [exposed to] market-sensitive information,"said Rajiv Jaitly, a fund governance adviser.

Tim Green, managing partner of GMT Communications, a UK-based private equity firm, said that compliance requirements in the US and Europe had risen significantly, prompting higher levels of scrutiny. "No doubt this will lead to more oversight and visits [from regulators]," he said.

However, he said regulators' mafia-style investigative techniques "are not relevant for the private equity industry". "I understand investors need to be protected, but frankly [regulators] have gone too far."

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