Hedge funds expect compliance costs to rise

Nearly one-half of hedge funds participating in a year-end study by Greenwich Associates expect their compliance costs to rise over the next 12 months.

And that is despite many having incurred sizeable expenses in 2005 associated with registering with the US Securities and Exchange Commission.

'The expectation of rising costs indicates that hedge fund managers as a whole recognize that, for better or worse, hedge funds are entering into a new era of regulation, and checking the box for registration might prove to be the easiest part,' says Greenwich Associates Hedge Fund Specialist Karan Sampson.

In order to assess the impact of the Securities and Exchange Commission (SEC) registration requirements going into effect this week and to establish some quantifiable compliance benchmarks for hedge fund managers, Greenwich Associates surveyed 34 compliance officers at prominent hedge funds operating in the United States and Europe. Slightly more than half of the participating funds had already registered with the SEC at the time of the study, and almost all the funds said their costs for regulatory compliance had increased in 2005. The compliance officers surveyed cited several serious concerns, including:

Creating effective record-keeping systems and practices, particularly for e-mail retention; monitoring and enforcing rules regarding personal trading by fund employees; and getting support from senior management for compliance-related efforts.

'There is a real question in the minds of many chief compliance officers about whether the independent-minded partners of hedge funds will fully listen to a CCO,' says Greenwich Associates consultant William Wechsler. 'This could pose a significant risk to hedge funds facing the increased compliance burden associated with registration. On the other hand, there is also the possibility that the dictates of SEC registration might grant new clout to CCOs within their own organizations.'

Hedge Fund Compliance Benchmarks

Once the new rules go into effect, the credibility gained through SEC registration may well become a necessary condition for the successful solicitation of funds from one increasingly important constituency: US institutional investors. However, it is unlikely that registration in itself will be sufficient. Hedge funds that hope to win institutional business will have to go well beyond the dictates of the current registration requirements in terms of defining their effective internal processes and risk controls.

With regard to costs, nearly 95 per cent of the hedge funds participating in the Greenwich Associates study saw their compliance costs rise in 2005. New compliance hires contributed significantly to this increase: about 90 per cent of funds said their compliance staffing levels rose last year, with most funds experiencing increases on the order of 10-25 per cent. Other significant drivers of increased compliance costs were IT expenditures and 'business costs' such as fees paid to outside consultants, and the expense of preparing registration documentation and planning for registration.

Additional compliance benchmarks presented in the report include:

Among the hedge funds participating in the Greenwich Associates compliance study, average compliance staff consisted of two full-time equivalents.

While most aspects of compliance are codified in hedge funds' written policies, nearly one-third of funds reported that they do not address the issue of employee personal e-mails in their written policies.
Fifty-five percent of hedge funds in the study said they review employees' personal trading activity on a monthly basis and about 40 per cent of the funds said they review this information quarterly.

Among hedge funds that actively monitor best execution, about 35 per cent use internally developed trade reporting systems to measure quantitative elements, while another 15 per cent use off-the-shelf systems.

About two-thirds of hedge funds reported using soft dollars, mostly to pay for financial market tools such as Bloomberg terminals and third-party independent research.

Nearly 60 per cent of hedge fund respondents said they limit acceptable gifts to less than USD 100 in value.

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