By James Williams - When the Dodd-Frank regulatory reform law was passed last July, there was probably a degree of denial amongst the hedge fund community as to precisely what the long-term implications would be.
Such sweeping changes - forcing hedge funds with USD150million or more to be registered with the SEC, and those with USD25million to USD150million in AUM to still require state-level registration - were hard to grasp initially. But the reality is sinking in fast.
The USA is home to the world’s biggest alternatives market (Bloomberg’s list of 2010’s top 100 hedge funds reveals that 13 of the 20 best performers last year were US-based), and US hedge fund managers must now embrace a new “culture of compliance” to meet SEC requirements.
It is undeniably good that transparency and greater due diligence are lifting hedge funds out of the dark esoteric investment space of times past, but how has this new era of regulation, post-Madoff, altered hedge funds’ relationships with their administrators, prime brokers, legal advisers etc?
One of the more noticeable trends in the last couple of years has been an increased willingness amongst US fund managers to use multiple prime brokers to mitigate risk – a direct response to the Lehman Bros collapse.
“More funds are using multiple prime brokers, especially those that reach USD250million in AUM,” says Glen Dailey of Jefferies (pictured), a New York-based prime brokerage. “Every one of the USD1billion funds is probably multi-prime because investors demand it; we’re happy to be a 2nd or 3rd broker.”
Understandably, it’s the bigger funds with excess cash sitting in brokerage accounts that are keen to ensure their assets are protected, with Dailey admitting that for the mid-sized hedge funds, which they typically service, there hadn’t necessarily been a large uptick in business: “I wouldn’t say things have changed dramatically post ’08.”
Increased investor due diligence has seen an upsurge in business for full service providers like BNY Mellon. “Managers have outsourced some or all of the accounting and asset validation/verification functions, as well as key areas such as prime custody, AAA-rated cash management and tri-party collateral management,” explains BNY Mellon Managing Director, David Aldrich.
To cope with Dodd-Frank and SEC demands, hedge fund managers are looking to outsource all non-investment functions: a trend that Aldrich believes is gathering force as regulatory pressures increase: “Demand for this holistic approach has increased the utilisation of a huge range of services beyond fund accounting, such as: risk analytics, performance attribution and OTC derivative management.”
Quite what the extent of SEC reporting will be is yet to be determined. Detailed, periodic filings and the collection/review of all employee brokerage trading accounts, will be expected. The logic being offered is that funds with over USD150million in assets can afford to hire a Chief Compliance Officer and develop a full-blown compliance program.
Nevertheless, such pervasive regulatory reform is far from easy to fully comprehend, and has increased the strain between fund managers and legal firms. According to Ron Geffner of New York law firm Sadis & Goldberg, due diligence demands have created complexity and price compression.
“With respect to complexity, Dodd-Frank is causing some firms to have to review their structure and regulatory needs,” explains Geffner. “Whilst many are having to register with the SEC, others are having to de-register due to lack of assets.” He adds that right now there’s expectation in the market place, people are looking for bargains – both investors and managers alike – and it’s causing price compression.
“Some funds that have fallen on hard times really can’t afford to do their own compliance,” says Geffner. “We’re seeing increased demand for services from managers whose existing law firms have had their own volatility – the cost structure of some law firms has become prohibitive.”
Whereas the original investors were typically high net worth individuals and family offices, the last few years have seen pension funds and insurance companies, funds of funds etc. increasing their allocations into hedge funds. The knock-on effect this has had on brokerage firms post ’08 is that they’re now having to field more calls than ever in response to increased due diligence. “I think by the time institutional investors invest in a particular fund they know the manager extremely well and some of that certainly involves being familiar with the brokers they use,” says Dailey, whose team is now handling significantly more institutional enquiries.
Increased transparency and risk reporting has meant that hedge fund administrators are now busier than ever, with Aldrich confirming that BNY Mellon’s assets under custody “have risen exponentially since the start of the financial crisis”.
Post ’08, hedge funds have had to cope with increased operational complexity; for example, the need to segregate unencumbered assets away from prime brokers to trust banks. “This has increased the burden on the back offices of alternative managers, part of which is mitigated in the use of outsourcing services from BNY Mellon and others in the area of share class hedging, for example,” adds Aldrich.
Dailey notes that brokerage firms including Jefferies have had to help clients adjust to greater due diligence demands, which he says “have been coming from investors”. “Capital raising has been tough – it’s better now than a couple of years ago but I wouldn’t call it robust.” Dailey, though, believes that hedge funds having to evolve in terms of operational structure will help attract more institutional tickets, particularly among mid-sized fund managers, as heavyweights begin to soft close and cause assets to trickle down: “Every day in the papers you’re reading about under-performing pension funds. It’s a trillion dollar problem. Hedge funds are a vehicle that can provide good returns – the industry will prosper because of that.”
Building out their compliance infrastructure has been another obvious trend post ’08, benefiting firms like US-based HedgeOp Compliance LLC. Patrick Shea, Managing Director and Partner at the firm, whose ComplianceTrak solution is designed to meet the compliance needs of alternatives managers, says that managers need to understand their compliance obligations and “develop internal processes” to meet obligations: “ComplianceTrak helps establish and maintain a workable compliance infrastructure – interest has never been higher,” confirms Shea.
Shea says that discussions with US alternatives managers have certainly increased, with the number one question asked being: what are the implications of becoming an SEC-registered investment adviser? “Since HedgeOp has been working clients through the Advisers Act compliance obligations since 2001, we have developed a very efficient process and given clients the tools they need to maintain their “audit-ready” compliance program.”
Everything from AUM, trading positions and amount of leverage (including off-balance sheet) through to counterparty credit risk exposure will need to be filed with the SEC this summer onwards. Whilst this will place added pressure on mid-sized fund managers, heavyweights that are already registered have solid enough internal infrastructures to cope with the demands. Leffman Professor of Commercial Law at University of Chicago’s Law School, Randal C. Picker, wrote on his blog last November, “I do not believe SEC registration will be significantly burdensome on hedge funds managers,” going on to say that a large number of funds have the “internal controls and human capital capacity” to make the transition process painless.
In Geffner’s recent experience, however, many managers feel that regulation has little value, adding that whilst they stay in the business there’s more of a disincentive for them not to. “While the rules that are being put in place exceed the purpose of protecting the public,” says Geffner, “the assets needed to maintain the necessary ‘police force’ – SEC – are not being spent by Congress.”
Geffner adds: “Certain securities filings are required by managers every year, or every quarter depending on their size.” In his view, regulations aimed at hedge fund managers have become too excessive: “We recently filed a lawsuit against the government in connection with 13f filings.”
In the land of the free where the American Dream still holds fast, introducing tough measures is perhaps squeezing the independence of hedge fund managers: after all, the very reason they became fund managers in the first place was to be autonomous and private.
As Dailey opines: “It’s getting more institutionalised because the industry is getting bigger. I think it’s good that the needs of the investment community are being met, but at the same time some of the entrepreneurial spirit is being lost.” Despite this, Geffner remains bullish on the fate of US hedge funds: “They’ve been around 50 years or more. The rhetoric concerning private funds causing systemic risk is, I believe, overstated. Private funds will continue to serve a purpose.”
One thing seems clear in all this: relationships between US fund managers and their service providers will continue to become deeper and inextricably entwined. With under-performing US pension funds likely to increase their allocations into alternatives, there’s perhaps never been a greater need for hedge funds to firm up their infrastructure and emerge from the shadows.
It won’t be long before the USD2trillion AUM mark is reached – everything from compliance and reliable administration to effective counterparty risk management will need to be established, the nuts and bolts of a fund’s operations clearly demonstrable to investors before assets are committed. The road ahead for service providers to US hedge funds could well be paved with gold.