Regulatory scrutiny is limited in this rarefied world.

WHEN private investment firm Forstmann Little & Co. wasted more than $100 million in Connecticut pension money on two soon-to-be bankrupt telecom firms, the state didn't go to the SEC to complain.

Even though the investments were in public companies, they were made through a Forstman Little private equity fund. The state ended up suing in state court.

Like hedge funds and venture capital firms, private equity funds remain loosely regulated, even as they have attracted more interest from institutional investors and wealthy individuals.

All three are closely related to equity markets but they don't fall under the same stringent guidelines that have been set up for mutual funds or for stock trading in general.

At times, that's become a problem.

These types of funds are restricted to wealthy investors, but the funds aren't required to file regular paperwork with the Securities and Exchange Commission.

Private equity funds will, however, purchase stakes in public companies, as hedge funds also do. Or, like VCs, they will sell stakes in private companies to the public. These activities have drawn scrutiny when investments go sour, or when the private investment activity spills over into the public markets.

For example, pension funds, which have established a growing presence in the worlds of private equity, hedge funds and venture capital, are under pressure to disclose more of the profits and losses from these investments.

Private equity funds could also be inadvertent victims of recently enacted Sarbanes-Oxley legislation, although it doesn't apply to them directly. The law added new accounting requirements to public companies to curtail fraud. It could limit the ability of private equity firms to exit some of their investments with public offerings.

"They're going to start discovering that it may be harder to sell their portfolio companies or they have to get bigger before they go public," said Keith Bishop, an attorney at Buchalter Nemer Fields & Younger.

Hedge fund scrutiny

On the whole, it's been hedge funds that have attracted the most regulatory attention.

The spectacular collapse of Long-Term Capital Management, which required a bailout in 1998 so its failure wouldn't wreak havoc on the entire financial system, first brought hedge funds public notoriety. More recently, the failure of hedge fund Lancer Management has brought renewed calls for regulatory oversight.

In July, the SEC obtained a preliminary injunction against the New York-based fund, alleging that its managers had overstated the value of its holdings, which included stakes in small-cap firms allegedly tied to a con artist.

Among those caught up in the scandal: Bank of America Corp.'s securities unit, which managed the trading activities of Lancer, and pension funds such as the Connecticut State Pension Fund, which lost $19 million.

Hedge funds have also been a factor in the mutual fund scandal because some mutual funds allegedly allowed hedge fund clients to make late trades in their accounts at the expense of other investors.

In March, the SEC staff is expected to issue a series of proposed rules that would expand the agency's oversight of hedge funds. The proposals are based on recommendations in a staff report released in September.

One new rule would force hedge funds managers to register with the SEC. Currently, managers are not required to register if they have fewer than 15 clients--and a hedge fund qualifies as just one investor, no matter the number of individuals. Under the proposed rules, hedge fund managers would be subject to surprise audits by the SEC, and they would also have to disclose the performance of their funds.

The managers may also be required to pass the National Association of Securities Dealers Series 7 test before they can legally offer hedge fund interests and other securities.

Hedge fund managers argue that the new rules will merely add another layer of regulation without actually protecting investors from fraud--an element in the collapse of Lancer and another fund, Lipper Convertible Hedge Funds.

"The SEC is wasting resources on protecting wealthy investors when it needs to concentrate on less-sophisticated investors," said Tom Giovine, cofounder of hedge fund manager Giovine Capital Management in Los Angeles.

Like private equity funds, hedge funds are restricted to so-called qualified investors with more than $1 million in assets. They aren't required to register with the SEC unless more than 99 investors are in the pool.

For hedge fund managers the restrictions are looser. They don't have to register if they have less than 15 clients. Each fund is considered one client, regardless of the number of investors.

In practical terms, a fund that is required to register would include information about the fund manager. In California, hedge fund managers are required to register only if they manage portfolios of less than $25 million.