Open Up. It's the FBI.

From aiCIO Magazine: Between stepped-up enforcement and the host of new regulations promised by the new financial reform law, is it time for large asset owners to start rethinking the way they invest in alternatives?

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Last November 22, the FBI raided the headquarters of three major hedge funds: Level Global Investors, Diamondback Capital, and Loch Capital Management. It was the first real action by the Feds after a days-old whisper campaign from regulators and reporters (and even one would-be snitch) about a massive insider trading investigation, part of the Justice Department’s much-self-heralded campaign against securities fraud, Operation Broken Trust.

Since the raids, eight consultants and employees from Primary Global Research, a so-called investing “expert network,” have been charged, with half of them pleading guilty so far. A handful of traders and analysts also have been charged, and more indictments are likely on the way. Since being raided, Diamondback has had nearly a quarter of its funds withdrawn by investors, Level Global has announced it is shutting its doors, and another raided fund, Barai Capital, will close as well.

The raids and arrests show a greater willingness on the part of federal regulators to chase white-collar crime on Wall Street, putting many institutional investors in a tough spot. Between stepped-up enforcement and the host of new regulations promised by the new financial reform law, is it time for large asset owners to start rethinking the way they invest in alternatives?

Insider trading has always been difficult to define—not even the intuitive “I know it when I see it” definition that Supreme Court Justice Potter Stewart used to identify pornography really applies—but nowhere is the definition murkier than in what’s known as the “Mosaic Theory” of stock research. Mosaic analysts spend their days hitting the phone and pounding the pavement for little scraps of information about companies, then repackage the shards of info into useful portraits.

In this case, the Securities and Exchange Commission (SEC) is accusing defendants of breaking its Regulation Fair Disclosure, which compels companies to release important information to all potential investors at the same time. Prior to the 2000 law, it was common practice for companies to engage in “selective disclosure,” parceling out information to big investors before it was made public. With this disclosure law came a new breed of consultants, eager to fill the informational void. For a fee, investors can sign up to expert networks, like Primary Global Research, that pair them with wellpaid insiders from various industries. Within these networks, the line between good mosaic research and insider trading has always been blurry but, in the wake of the financial crisis, federal regulators and prosecutors are giving that distinction a sharper edge.

Since the financial crisis, white-collar crime has joined terrorism and political corruption as the most coveted cases on a federal prosecutor’s docket. In 2009, federal investigators used the first ever wiretap in an insider trading investigation to help nab Galleon Fund founder Raj Rajaratnam. (How the Feds—after more than a half-century of using wiretaps to bring down numbers-runners, low-level drug pushers, and mafia loan sharks— are just getting around to using them to investigate savvy financial insiders who live their professional lives on the phone, is another issue entirely.) Those wiretapped conversations among about 550 people led directly to the recent expert network investigations and hedge fund raids, the indictment of a former Goldman Sachs board member, and the arrest of numerous others. There are even rumblings that Steven A. Cohen’s SAC Capital Advisors could be caught up in the case after two of its former employees were indicted. With that kind of success rate, don’t be surprised to see the Feds make wiretaps a trademark of future financial investigations.

All of this has left institutional investors wary. “We don’t invest with any of the players that have been named” in the investigations, says Clark McKinley, a spokesman for the California Public Employees Retirement System (CalPERS). In part, says McKinley, that’s because, in the wake of the financial crisis, CalPERS stepped up an already extensive due diligence process and, in 2009, started demanding more transparency in its dealings with hedge funds. However, that doesn’t mean they’re completely out of the woods. “As the investigations go forward,” says McKinley, “we’re paying very close attention to what happens.”

The state of Massachusetts hasn’t fared as well as CalPERS. The state’s pension fund, Massachusetts Pension Reserve Investment Management (MassPRIM), has a $3.5 billion hedge fund portfolio, invested through funds of funds—five of which had invested more than $60 million with two of the three firms raided in November.

This wasn’t the first crisis, either: MassPRIM previously had lost $12 million invested with Bernie Madoff $30 million in the collapse of Sowood Capital Management, and $50 million when Amaranth Advisers went under, all through funds-of-funds exposure. Those losses have helped limit the state’s hedge fund returns to just 3.7% over the last five years, after fees. Partially as a result, MassPRIM recently decided to execute its own due diligence and invest directly in hedge funds.

So, what’s an asset owner to do? Since the financial crisis, most of the focus on alternative investing has been on lowering fees and creating more long-term performance incentives, but that’s not the only way for investors to get more for their money. The Alaska Permanent Fund’s “external CIO” program is finding new ways of partnering with hedge funds and asset managers, using them almost as external think tanks and research departments. Other large funds, like CalPERS, have not only reduced fees, but also gained greater transparency and made the process of de-vesting much simpler, should things go wrong. “Because of the downturn, it meant that we had a little more leverage than we had before the recession,” says CalPERS’ McKinley. “No one can just swagger in and demand things, but certainly the crisis gave us more clout and gave investors more power.”

Post FBI-raids, protection from scandal is increasingly important— both for capital pools and for the CIOs and boards who run them. If CalPERS’ and MassPRIM’s recent moves are any indication, investing in hedge funds now means more than analyzing rates of return and fee structure, as well as more directly controlling allocations. Also, don’t forget: Keep your ears open for a knock on the door. —Joe Flood