U.S. regulators are scrutinizing how hedge funds and other moneymanagers divvy up the stock they get from hot initial publicofferings due to concerns that highly lucrative trades areinappropriately enriching a select few, said three people familiarwith the matter.

Investment firms typically oversee multiple funds, and theSecurities and Exchange Commission is asking how they dole outshares of newly listed companies among those various portfolios,the people said. One worry is that stock is being moved tobadly performing funds to bolster returns. The SEC's examinationcomes after it found instances in which firms violated securitieslaws by directing winning trades to their own employees and favoredclients.

Hedge funds often buy into IPOs for a quick profit. The stock istypically priced at what's believed to be a discount to its actualmarket value to ensure a pop in shares on the first day of trading— an incentive for buyers to take a risk on a new company. Onaverage, newly listed shares gain 16% on the first day of trading,according to Bloomberg data on U.S. IPOs since 2015 that raisedmore than $50 million.

The demand for IPOs has increased in recent years as newlistings have been in relatively short supply. Now the SEC wants tomake sure that hedge funds are following their stated policies andprocedures in how they allocate those shares, rather thanmisleading investors by cherry picking profitable trades.

Money managers can run afoul of rules if they tell clients onething and then do something else, such as saying a particular fundwill invest in equities that can be easily bought and sold but thenloading up on illiquid corporate bonds.

The SEC wants to know whether firms are violating disclosurerequirements to place IPO shares in funds that manage money fortheir senior executives, instead of clients, said two of thepeople. Additional concerns: Firms are allowing only certaininvestors to benefit from IPOs or shares are being used to give animmediate pop to laggard funds to keep clients from pullingtheir money, the people said.

The review is being led out of Chicago by the SEC's Office ofCompliance Inspections and Examinations, said one of the people,who like others spoke on the condition of anonymity because theinquiry isn't public. If OCIE finds suspicious conduct, itwill often make referrals to the SEC's Enforcement Division, whichinvestigates wrongdoing and can sanction fund managers.

Judy Burns, an SEC spokeswoman, declined to comment.

IPO Abuses

Last year, the SEC brought an enforcement case against Londonhedge fund manager Tim Leslie for allegedly routing IPO shares to afund that he had a large personal investment in. Leslie's firm,James Caird Asset Management, oversaw about $2.1 billion, with allbut $100 million in a fund that primarily managed money for outsideinvestors.

Leslie's smaller fund was advertised as buying mostly thinlytraded distressed assets, not the dozens of IPOs he ended upinvesting in, the SEC said.

The firm also had given its clients the impression that therewould be little overlap between the larger fund they invested in,and the smaller one in which Leslie personally had a big stake. Butthe SEC said the funds often shared investments, and when they didabout one-third of the selected trades went to the smaller fund andtwo-thirds went to the bigger fund. The practice wasn't disclosedto Leslie's investors, according to the SEC.

Leslie, who had spent much of his career at Louis Bacon's MooreCapital Management, agreed along with his firm to pay more than$2.5 million to settle the SEC's claims without admitting ordenying any wrongdoing.

Hoarding Trades

Former SEC Chair Mary Jo White flagged the issue of fundmanagers rewarding themselves at the expense of their investors ina 2015 speech. She said the agency's examiners had found instancesin which hedge funds were running profitable trades through“proprietary funds rather than client accounts in contravention ofexisting policies and procedures.” She was speaking generally andmade no reference to any specific firm.

SEC concerns about IPO abuses aren't new. After the dot-com bustin the early 2000s, the regulator sued multiple money managers foralleged infractions, including stuffing new funds with IPO sharesto boost returns without disclosing that those gains were dependenton the newly listed companies.

The SEC examination of how hedge funds dole out stock comes asthe regulator's new chairman, Jay Clayton, tries to increase IPOs.He has repeatedly said he wants to make it more appealing forcompanies to raise money by going public, rather than relying onless-regulated private markets.

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