Mounting concern over regulation burden

Hedge fund managers are emphasising their commitment to compliance and operational best practices as regulators and investors step up their scrutiny of the industry.

The hedge fund industry is bracing itself for a regulatory crackdown. In the US a plan to force hedge fund managers to register with the Securities and Exchange Commission (SEC) is gathering momentum. Across the Atlantic the EU has tabled a controversial directive that will impose stringent regulatory restrictions on hedge funds if enacted in its current form.

These initiatives may be just the tip of the iceberg. Regulators are considering a range of actions aimed at hedge funds covering everything from disclosure requirements to rules on leverage and the use of derivatives.

Hedge fund managers are understandably concerned about the threat posed to their business by knee-jerk reactions to the financial crisis.

But in a reversal of traditional attitudes, hedge fund managers are also showing a willingness to accept regulatory oversight where it is reasonable and proportionate. The Managed Funds Association (MFA), which represents US hedge funds, recently joined the Alternative Investment Management Association (AIMA) in expressing its support for making SEC registration compulsory for hedge fund managers.

On one level the decision not to oppose SEC registration is a tactical move designed to stave off regulation that is more intrusive. But it also reflects a deeper change in attitudes towards regulation and compliance among hedge funds. The majority of hedge fund managers want to run their businesses with the best compliance practices, irrespective of whether they are regulated or not.

Adam Reback, chief compliance officer at J Goldman & Co, a New York hedge fund manager, says his firm has made "a significant investment" in compliance even though it is not registered with the SEC. The company uses computer software to screen all transactions for compliance violations and pre-approves and monitors personal trading by employees.

Emails and instant messages are reviewed and archived for future reference. This is in addition to implementing policies and procedures to address various business functions which could be open to abuse.

Rigid control
"The control environment here is fairly rigid," says Reback. "We monitor everything and have controls in place to deal with the full range of potential issues, from front-running and insider trading through to valuation and best execution."

For all intents and purposes, the company operates as if it were a registered investment advisor, Reback says. "We have all the controls and processes in place that you would find at any registered investment advisor."

He believes this is typical of many mid- to large-sized hedge funds in the US. He attributes this to the influence of institutional investors like pension funds, which now account for around 50% of assets invested in hedge funds.

"If you want to deal with institutional investors then you have to be prepared to meet a certain standard. The bare minimum is that you should operate in a manner consistent with the SEC guidelines," says Reback.

He says he is not opposed to compulsory registration but questions whether the SEC will be able to effectively regulate the industry. His main concern is that regulation should be well thought out and proportionate.

"In my opinion requiring hedge funds to register and giving the SEC the power to perform examinations is reasonable. However, there is a risk that we could see additional requirements introduced further down the line which would inhibit the ability of hedge funds to carry on their business. Regulators need to bear in mind that hedge funds were not responsible for the financial crisis and respond accordingly," Reback notes.

One of the issues that rankles with many hedge fund managers is the perception that the industry exists in a regulatory loophole and the inference that this in some way exacerbated the financial crisis. In reality the majority of hedge funds are already subject to some level of supervision by regulators.

Hedge fund managers in the UK are authorised by the Financial Services Authority (FSA). In Hong Kong they are licensed by the Securities and Futures Commission (SFC). The main exception to the rule is the US, where registration with the SEC is currently voluntary for hedge fund managers.

"To say the hedge fund industry is not regulated at all is somewhat misleading," says Ken Dursht, general counsel at GAM USA. GAM manages over $15 billion in assets in funds of hedge funds and around $2 billion in single-manager products.

Dursht says the company, which has offices in nine countries, is overseen by a multitude of different regulators. "As a global company, GAM has entities that are subject to regulatory supervision by the SEC and Commodities Futures Trading Commission in the US, the FSA in the UK and the SFC in Hong Kong, to name just a few," he says.

GAM has voluntarily registered its US investment advisors with the SEC. Dursht says the company places a strong emphasis on compliance and risk management. "It begins with senior management and flows through the entire organisation. We understand the net benefit to the company of having these controls and procedures in place."

GAM follows a global standard for compliance which is set and co-ordinated by the global head of legal and compliance in London. Each office is responsible for implementing any additional procedures applicable to its jurisdiction. Dursht says GAM employs around 25-30 people in legal and compliance functions in its offices around the world.

Self-regulation
In recent years the hedge fund industry has sought to regulate itself through the adoption of best practice standards. After a slow start, the guidelines issued by the Hedge Fund Standards Board (HFSB) and the President's Working Group have been gaining traction among hedge fund managers.

At the end of March 2009, a total of 45 hedge fund managers had committed themselves to the HFSB standards, which deal with issues such as disclosure, valuation, risk management and governance.

Many managers are taking additional steps to meet the increased compliance and operational requirements being demanded by large investors in the wake of the Madoff fraud.

In January the $11 billion hedge fund Millennium Management said it was appointing an independent administrator after the Swiss private bank UBP threatened to pull investments from funds which valued their own assets. The California Public Employees' Retirement System, CalPERS, has said it is restructuring its relationships with hedge fund managers to achieve greater transparency and control over its assets.

Institutional investors have also redoubled their due diligence efforts in light of the discovery of the Madoff fraud and other similar Ponzi schemes. "They are taking a much closer look (at hedge funds) and seeking out any loopholes or weak points in the controls," says Reback.

Unlike SEC examinations, investor due diligence goes beyond compliance with rules and regulations and encompasses all the processes necessary to ensure the investment advisor can uphold its fiduciary duty to investors.

Reback describes the due diligence process as akin to self-regulation. "Institutional investors have a good eye for spotting operational issues. They see so many different funds and they have a good understanding of best practices. When investors make suggestions it carries a lot of weight, and more often than not, those suggestions are implemented."

GAM's operational due diligence team reviews around 100 hedge funds every year. They examine the internal policies, procedures and controls of every manager GAM considers for investment. The process includes a review of the fund documents, including the prospectus and any agreements with third-party service providers and checks on the service providers to the underlying hedge funds.

"The objective of the due diligence team is to assess and mitigate all non-investment risk, including administrative, legal and compliance risks," says Joe Gieger, managing director of GAM USA. The company wants to ensure the managers it invests with run their businesses along industry best practices.

However, the question of whether the manager is registered with the SEC or not is not a determining factor for GAM. "We review each manager based on their own merits. The fiduciary responsibilities we place on ourselves go beyond the simple question of whether the advisor is registered with the SEC or regulated by some other agency," says Gieger.

Like many in the hedge fund business, Dursht believes further regulation, particularly SEC registration, is inevitable. "I think the industry as a whole accepts that, more so than in the past."

He does not think compulsory SEC registration for hedge fund managers need be unduly burdensome and says it could even be beneficial. He says hedge funds should engage with lawmakers and provide input on how the regulatory framework could be strengthened and modernised to help restore greater confidence and stability in the marketplace.

"This industry may well benefit from the introduction of thoughtful, effective and rational regulation," Dursht says. The challenge is finding a balance between the demands for additional oversight and rules that achieve legitimate goals without imposing an undue constraint on the industry.

More to come
The consensus view among hedge fund managers is that SEC registration is only the appetiser. The main course may include restrictions on leverage, rules on the use of derivatives and the introduction of capital requirements for hedge funds.

Large US hedge funds may also be forced to disclose details of their positions to a systemic risk regulator. The expectation is that the EU will have to take its incoherent draft directive back to the drawing board, though few expect leaders in France and Germany to temper their calls for tougher regulation of the industry.

There are parallels between the political response to the current financial crisis and the reaction to the collapse of Enron in 2001, according to Howard Weinstein, managing partner at FinServ consulting.

The Sarbanes-Oxley Act, enacted in the aftermath of Enron, ushered in sweeping changes to public company disclosure rules. "The financial crisis and the fear of Ponzi schemes will lead to the introduction of equally rigorous disclosure and reporting requirements for the hedge fund industry," says Weinstein.

The parallels with Enron do not end there. Much as it had to do after Enron, the SEC is trying to rebuild its reputation after failing to spot the Madoff fraud. Under new SEC chairman Mary Schapiro, the agency is placing a higher emphasis on investigations and enforcement. In a recent speech Schapiro said the SEC was pursuing 150 cases involving hedge funds.

Those investigations have already resulted in a handful of enforcement actions. In April 2009 the SEC reached a settlement with Hennessee Group, a hedge fund advisory firm, over its failure to carry out adequate due diligence before recommending the Bayou hedge funds to its clients. Days later the SEC charged a former portfolio manager at Millennium Partners with insider trading.

"The SEC is investigating complaints from investors and whistleblowers more aggressively and carrying out more inspections of investment advisors than in the past," says Richard Horowitz, a partner at the law firm Clifford Chance.

Schapiro is lobbying the federal government for greater resources to beef up the SEC's enforcement division, which many believe was severely understaffed under her predecessor.

"In order to win the additional funding it needs, the SEC needs to show results, and quickly. That is part of the reason why they are pushing these high-profile cases against hedge funds," says Weinstein.

The regulator is also monitoring consultants and intermediaries such as funds of hedge funds to ensure they are conducting appropriate due diligence, says Sidney Wigfall, a compliance advisor at Barge Consulting and former SEC attorney. He sees the SEC's settlement with Hennessee Group as a "watershed event". Hennessee had to pay a $100,000 fine and return $714,644 in profits for failing to carry out portfolio analysis and perform checks on the auditor on the Bayou funds before recommending them to its clients. It also has to provide copies of the SEC settlement to existing and potential clients for the next two years.

"The SEC does not have the manpower to inspect and examine every hedge fund. I believe we will see an increasing number of SEC enforcement actions such as the one against Hennessee Group. The regulator wants intermediaries to have a robust due diligence programme in place partly because that can help ferret out problems the SEC may not be able to spot," says Wigfall.

Hedge fund managers must prepare for a new landscape of increased disclosure and reporting requirements from regulators and more aggressive enforcement by the SEC, according to FinServ's Weinstein.

He says many large and mid-size managers already have the core compliance systems and processes necessary to provide information on an individual fund level. These processes need to be integrated into an enterprise-wide compliance and reporting platform in preparation for new regulations, says Weinstein.

He points to the aftermath of the Lehman Brothers collapse as an example of deficiencies at many companies. "Many hedge funds took days to assess their exposure to Lehman. To meet the demands of regulators, hedge funds will have to be more organised about compliance and integrate their internal processes. They need to be in a position to provide quick and accurate information about their exposures and positions across all their funds and lines and business." he says.

This could be a costly exercise. Weinstein says hedge fund managers need to approach the problem intelligently. He advises firms to set up a steering committee to co-ordinate an enterprise-wide response to new regulations and leverage technology to capture and report information wherever possible.

Smaller funds to suffer
Small to mid-size firms managing between $100 million and $1 billion and start-up managers are likely to feel the biggest impact from regulations. Many of these firms lack an adequate compliance infrastructure and have not historically invested in the necessary systems to meet the demands of regulators, says Nolan Gesher, senior product manager of Fiserv Financial Control Solutions. He says this needs to change.

"They cannot simply throw bodies at this problem. Unless hedge funds invest in scalable technology the cost of compliance will become overly burdensome over time," he says. He argues that, from an infrastructure perspective, the hedge fund world is becoming more like the traditional mutual fund business. "Hedge funds need to factor in operational and compliance systems as part of the cost of doing business," says Gesher.

There are a number of consultancies and compliance firms that specialise in helping hedge funds to implement internal compliance procedures and meet regulatory requirements.

HedgeOp Compliance in New York has been engaged by a number of unregistered hedge fund managers to help them prepare for SEC registration, says Rinarisa Coronel De Fronze, executive vice president at the firm. The company works with managers to create an internal compliance infrastructure and assists with the preparation and filing of forms with the SEC.

Other firms like Kinetic Partners provide compliance outsourcing services for hedge funds. Kinetic's clients range from start-ups to established multi-billion dollar funds.

"We can perform most of the compliance function on an outsourced basis, from establishing the initial policies and controls through to the day-to-day monitoring," says Neil Morris, a member of the operational risk team at Kinetic Partners. The firm does not take on the official role of chief compliance officer (CCO), although other outsourcing firms will.

Coronel De Fronze says hedge funds should leverage technology to ease some of the burden of compliance. HedgeOp has developed software programs that can be used to streamline compliance monitoring and reporting.

The company's ComplianceTrak Advisor platform was designed to help registered investment advisors meet their compliance requirements. "Technology can make the compliance function more efficient and ensure that violations and conflicts are caught," says Coronel De Fronze. She also advises managers to engage an external consultant to carry out a compliance review on an annual basis.

In 2006 HedgeOp helped form the Alternative Investments Compliance Association (AICA), along with the chief compliance officers from a number of alternative investment groups, including J Goldman's Reback.

The association aims to stimulate dialogue between industry participants and encourage the sharing of best practices. Membership is open to CCOs and compliance professionals at alternative investment management firms and service providers.

Coronel de Fronze says AICA can be a good resource for compliance officers as they seek to make sense of the changing compliance landscape. The group also champions the streamlining of regulation and seeks to assist regulators to develop appropriate rules for the alternative investment industry.

Reback hopes regulators will be cognisant of the fact that compliance comes at a cost and ensure that the industry has adequate time to adapt to the new rules. Given their high trading volumes, many hedge funds will have to implement sophisticated systems to monitor and record trading activity if they have not already done so.

Hiring chief compliance officers is also likely to be a challenge if the experience of 2006 is anything to go by. "A lot of hedge funds will probably incur a large cost if new regulations are introduced. That is why it is important for the industry that the regulators get it right," says Reback.

Not put off
There is little evidence to suggest the threat of new regulations is putting off would-be hedge fund managers from entering the business. Over the past 12-24 months a steady stream of former traders and portfolio managers from the large hedge funds and banking groups have struck out on their own. Many of these managers are embracing compliance as a cornerstone of their business.

UK-headquartered Ebullio Capital Management, which launched its Commodities Fund in January 2008, is one such example. Paul Hudson, a partner at Ebullio, says the founding partners wanted to create a business that was institutional strength from day one.

"We placed a high emphasis on being transparent, compliant and operationally robust. This comes at a cost, but we took the view that putting a strong infrastructure in place at the outset can save us a lot of time and money in the long run," says Hudson.

For an emerging manager, finding the capital to invest in operations and compliance can require some sacrifices.

The partners at Ebullio chose to base the company in Southend-on-Sea, just outside London, rather than in the City of London or fashionable Mayfair. "We could have had a prestigious address in the City, but being based outside London meant we could put the money we saved into operations and compliance," says Hudson.

Ebullio has hired staff dedicated to operations and compliance and appointed GlobeOp as an external administrator. GlobeOp also acts as a compliance consultant to the firm. The CCO function has been outsourced to Complyport.

"It can be hard for a new fund to hire a compliance officer, so we outsourced this to a firm with a lot of experience in this area," says Hudson. Ebullio has also built its business to be highly transparent. Investors can get daily NAV estimates and reconciled position statements if they choose.

Hudson believes the investment in compliance and operations will pay dividends. Ebullio currently has around $50 million in assets but has ambitious plans to raise $500 million for its Commodity Fund.

"Having this infrastructure in place gives us the opportunity to attract the large investors. Performance is still the most important factor, but performance alone is no guarantee. It needs to be combined with strong risk management, operations and compliance controls in order to attract capital in the current environment," he says. "We think we can run $500 million without making any significant changes to our current levels of staffing and infrastructure."

SEC registration
After a false start in 2006, it appears almost certain that new rules requiring hedge funds to register with the SEC will be introduced in the near future. But while there is considerable momentum behind SEC registration, it remains unclear what form the final rule will take.

"The devil is in the detail. It is hard to predict the consequences of SEC registration until we know more about the precise requirements of any final law and any related implementing SEC rules," says Robert Kiggins, a US corporate attorney and counsel to the law firm, McCarthy Fingar.

There are currently two separate bills before the US Congress which if enacted would lead to the removal of regulatory exemptions that allow hedge funds and their advisors to remain unregistered.

The Hedge Fund Registration Act introduced in the House in January 2009 would remove the exemption from SEC registration for investment advisors. The Hedge Fund Transparency Act introduced in the Senate would require the fund vehicles themselves to be registered as investment companies under the Investment Company Act of 1940.

"The Hedge Fund Transparency Act is generally thought to be the more onerous of the two bills, since registration and compliance as a registered investment company has historically been much more complicated and expensive than registration and compliance as a registered investment advisor," says Kiggins.

Opinions differ on which of the bills, if either, will eventually become law. Richard Horowitz, a partner at the law firm Clifford Chance, believes the Hedge Fund Transparency Act is "very unlikely to be enacted". He says regulation of the hedge fund industry in the US will take the form of registration and supervision of investment advisors in the first instance, although he does not discount the possibility of Congress making changes to the Investment Advisors Act of 1940 to require more disclosure from registered investment advisors.

Howard Weinstein, managing partner at FinServ consulting, says his firm is taking the view that both bills currently before Congress will be enacted. "We are telling our clients to be prepared for that eventuality," he says.

SEC-registered hedge funds will have to comply with the Investment Advisor Act of 1940, which includes a requirement to make annual filings with the SEC and rules regarding compliance manuals and advertising. Registered investment advisors are also subject to routine examinations by the SEC.

The requirements of being a registered investment advisor are not hugely onerous. "SEC-registered investment advisors are not required to provide a regular flow of information to the regulator. Form ADV, which must be filed with the SEC annually, asks for simple facts and figures about the business. It is relatively straightforward," says Neil Morris, a member of the operational risk team at Kinetic Partners. Most hedge fund managers cite the cost of legal advice and the time spent filling out forms as the biggest drawbacks of being registered.

Hedge fund managers with bad memories of registering with the SEC in 2006 can take some comfort from the fact that the registration requirements are better understood now than in the past. Law firms have a wealth of practical experience in this area.

"The hedge fund advisors I have worked with have not had any difficulty complying with the requirements of the Investment Advisors Act. Many of them find that being registered with the SEC gives them added cache and inspires confidence on the part of investors," says Kiggins.

Challenging environment for evolving fund documentation
The extent of a hedge fund manager's power to impose gates or suspend redemptions from the fund was among the most hotly discussed topics of 2008. Faced with a potential catastrophic run on redemptions, a number of hedge fund managers sought to take advantage of the provisions in the legal documents of the fund to halt withdrawals and place illiquid assets in side pockets.

In a significant number of cases they discovered the legal documents were either silent or provided confusing guidance on how they could exercise their powers. For instance, one common clause in the legal documents meant funds had to suspend net asset value (NAV) before they could restrict redemptions, even when there were no specific problems valuing the portfolio. Others found their legal documents did not permit them to impose gates or create side pockets to hold illiquid assets in the conventional sense.

As the industry begins to stabilise, hedge fund managers are revisiting the terms of their legal documents with a view to clarifying their powers and responsibilities when faced with liquidity constraints or a run on redemptions.

"Those managers that found the legal documents did not give them the flexibility needed to effectively manage the fund during the crisis are looking to rewrite them. The main areas they are looking at include the liquidity terms of the fund and the clauses which govern gates, the suspension of redemptions and the creation of side pockets," says Bryan Hunter, a partner at Appleby in the Cayman Islands.

But the traffic is not all one way. Investors are flexing their muscles too, checking the fine print of the legal documents more closely and negotiating better terms. Fees are a big part of the conversation, but investors are also pushing for greater disclosure and a bigger say in actions like gating and the liquidation of the fund.

"There is undoubtedly a balance to be struck here. The manager's need for flexibility must be reconciled with the need for transparency and certainty on the part of the investor," says Hunter.

Lawyers say they do not expect to see widespread litigation by investors over issues like the temporary suspension of redemptions or the creation of side pockets. In the case of funds of funds, they fear that pursuing action against underlying managers could set a precedent that could be used against them by the own investors.

Ultimately, investors remain pragmatic and are seeking to leverage their current position to push for improvements in the way hedge funds are managed. Managers who approach the problem with an open mind are often able to find common ground with their long-term investors, according to legal experts involved in negotiations.

"The manager may be able to negotiate a longer lock-in for investors if they are prepared to collect performance fees only on realised gains. There has to be some quid pro quo," says one lawyer.