Managers need more support as regulation heats up
Recently, the SEC proposed several amendments to Form ADV. Generally speaking, these amendments would require registered investment advisers to disclose information regarding their separately managed accounts, including assets under management and information related to the use of derivatives and borrowings.
Unlike the reporting requirements for private funds, the information reported on Form ADV would be available to the public. The SEC has stated that this information will assist them, and the public, in monitoring risk and advisor activities related to separately managed accounts.
"Managers have expressed concerns that the requirements of this proposed rule are burdensome, costly, and may potentially expose proprietary or client information," comments Mark Ruddy, an attorney and founder of Ruddy Law Office, PLLC in Washington DC. "No set timeline has been established for the adoption of the proposed rule, but it could be finalised as early as the first quarter of 2016. For a lot of managers, it does feel like they're hitting their head against a brick wall. The Fidelitys of this world have the means to cope with this amendment but for your average hedge fund with a small operations team, it becomes much more problematic."
The amendment, if it transpires, will indeed cause yet another headache to fund managers, many of whom have been grasping for the Paracetamol in recent years as they comply with one new regulatory amendment after another. Understandably, managers with SMAs are far from happy at the prospect of having to share information on these accounts. What benefit is this going to serve by divulging such information? It's not as if the end-investor needs protecting; they are the ones who own the SMA in the first place.
"The biggest concern for managers is that by having to report on SMAs, they'll be giving away sensitive information to their competitors," adds Ruddy. "It's always a crab shoot with our government so who knows if the rule is finalised early next year. Something gets proposed, it becomes a hot topic, and then it's gone."
Nick Tsafos, Audit Partner at EisnerAmper, notes that amendments to Form ADV in relation to SMAs will have no impact on a manager's financial statements as it is "the responsibility of the owner of that SMA to report their own figures".
"One of the trends I'm seeing among some of our clients is that their assets under management are decreasing because of managed accounts, not because the hedge fund manager is shrinking. These structures are gaining popularity as US mutual funds want to have liquid alternative products. They are hiring hedge fund managers to manage money in such a product, typically in a multi-manager arrangement. The mutual fund manager who owns the managed account needs to have look-through capabilities in order to report on all the various disclosures," explains Tsafos.
In order to help its clients make sense of the shifting regulatory sands, EisnerAmper established a regulatory compliance practice 18 months ago. From a reporting standpoint, one of the more challenging pieces of regulation to prepare for has been FATCA. Managers have now gone through the first iteration of filing and whilst it has gone smoothly, it has been a costly exercise, with Mike Laveman, Tax Partner & Co-Chair of EisnerAmper's New York Tax Practice, noting that some managers have spent USD50,000 to USD100,000 on compliance.
"Unfortunately, FATCA is a small dot on a much larger map when one considers Common Reporting Standards, which are coming," says Laveman. "There are some 50-plus countries that have already signed up to this and in theory these standards will become effective in 2017.
Another sobering thought. The Paracetamol bottle will be empty before long.
Over at Maples Fund Services, a comprehensive regulatory reporting solution has been created specifically to take this increasingly onerous compliance burden off of managers' shoulders. In a joint venture with New York-based ConceptONE LLC, which specialises in regulatory and risk reporting, MaplesFS rolled out a Regulatory Enterprise Risk Management (`RegERM') platform early last year. There are now 22 clients using the platform, with an aggregate AUM in the region of USD45-50 billion.
"We build the integration with all of a manager's data sources including the fund administrator, who holds a large proportion of the fund's data, the custodian, the prime broker, and any other key counterparties that the investment manager uses," explains Mark Weir, Maples Fund Services' Senior Vice President responsible for middle office operations. "Once the data is integrated we can aggregate data into our dedicated data warehouse, perform a series of reconciliations and data validation to ensure maximum data integrity and data consistency, and calculate all of the required metrics under the directive.
"We then produce the regulatory filing for the manager in the format required for specific regulators, and internally review the filings to ensure the correct data is being used, that the answers in place are reasonable, and spot potential red flags. The manager then does a final review and we talk them through how to send the filing."
The new reality that fund managers operate in today is one where the costs of non-compliance far outweigh the costs of compliance. Nobody likes seeing their operating margins getting squeezed, and whilst some managers are looking at regulatory compliance from a purely cost perspective, others are looking at it from a knowledge perspective.
"A prominent multi-billion dollar hedge fund client of ours has the resources, both staff and financial, to build out their own platform. However, by opting for an outsourced solution, they gain access to a community of people who are working on this day-in day-out.
"This particular manager chose to work with us to do their Annex IV reporting because they found there was so much interpretation associated with the filings and they wanted a common sense approach based on what other people were doing; we are doing these filings for many different funds so we have a good sense of what needs to go into them.
"From a cost perspective, another prominent multi-billion dollar manager now using our RegERM platform, originally tried to build their own platform to comply with AIFMD. When it came close to doing the first filing, various internal stakeholders disagreed over the interpretation of how to respond to certain questions. The technology they built didn't provide the transparency into how all the Annex IV questions were being answered and it was ultimately a failed project," recalls Weir.
Outsourcing is really becoming a de facto choice for much of the alternative fund management community. At the end of the day, these are money managers. They are paid by investors to generate returns, not get bogged down in operational and compliance issues. Many are waking up the fact that this is best left to the experts.
"Regulation is making the barriers to entry for new managers that much higher," says Jason Brandt, Maples Fund Services' Regional Head of Fund Services – North America. "Something as simple as opening a bank account is much more challenging than it once was. It's therefore important when managers are setting up their hedge fund to spend the time up-front doing the necessary due diligence and understand the value-add of the service providers they choose."
To help US fund managers tackle the complexities of marketing their hedge funds, London-based Lawson Conner is able to offer an FCA-regulated AIFM solution. Although the third country passport under AIFMD is not yet available to US managers, it will be soon enough. As such, appointing an external AIFM to handle all the reporting and compliance issues of the Directive will be attractive to those US managers who do not wish to spend capital building an operations footprint in Europe.
"We bundle in to this AIFM service a regulatory concept that is unique to the FCA, known as an `Appointed Representative'," comments Daniel Maycock, Director, Investment Management Services with Lawson Conner. "What this means is that a US manager could have placement staff in Europe to conduct monthly, quarterly meetings with investors, without their needing to build any European infrastructure and apply for a direct FCA license. We could also help with our AR service in terms of capital raising on behalf of the US manager."
Lawson Conner recently teamed up with New-York based capital raising firm, Prime Allocation Group (PAG), headed up by veteran Andrew Gitlin. PAG have a specialist team operating out of Europe, allowing US managers the ability to get in front of European allocators.
As Maycock adds: "Whilst partnerships like that of Lawson Conner / PAG help make it easier for capital raising and distribution in Europe, what is particularly intriguing is the recent legislative changes regarding alternatives asset allocations amongst European institutional investors. The Netherlands and Germany just significantly increased the percentage of alternative assets that can be held in their portfolios with other countries expected to follow suit. The question US managers should be asking is, `Can your firm afford to miss out on Europe?'"
One aspect of regulation that is changing the way hedge funds operate is Basel 3 and the impact it is having on prime brokerage divisions; something that will affect all managers, not just those in the US.
Those strategies that rely on leverage, such as fixed income arbitrage, face the prospect of higher financing costs for the privilege of using a bank's balance sheet, or else moving their assets elsewhere.
"I would think that large custodial banks would potentially benefit from this upheaval taking place so that large hedge funds will be able to custody their unencumbered assets and still retain the ability to do their securities trading with the PB – basically to have the ability to move cash back and forth as they see fit. It would seem a logical step," suggests Frank Napolitani, Director, Financial Services at EisnerAmper LLP.
"The sense we are getting is that there's going to be a further period of downsizing of the exposure by global primes to hedge funds," says Jack Seibald, one of the founders and managing members of Concept Capital Markets, LLC.
"We expect to see further retrenchment of prime brokerage in some of the big names and that will have a tangible impact on the hedge fund business. What might have been considered an acceptable client to these primes until recently, are no longer being viewed as such; maybe due to the construction of the portfolio, the asset classes being traded, amount of leverage, and amount of revenues being generated for the prime. As a result, some large managers are perhaps starting to feel unloved.
"There are going to be a smaller number of larger, more lucrative prime brokers in future," suggests Seibald.
Aside from bank regulation, hedge fund managers who decide to broaden their product offering by moving in the liquid alternative space can expect to come under increased scrutiny from the SEC to ensure that the strict rules and restrictions of the 1940 Investment Company Act are being adhered to. Since 2008, AUM in alternative mutual funds has grown from USD46 billion to more than USD311 billion at the end of 2014.
Speaking at the Brookings Institution, Washington DC, SEC Commissioner Kara M. Stein said: "We continue to see more investment firms pressing to move into this area. An official at the Commission had an interesting description for alternative mutual funds. He called them `bright, new, shiny objects in the marketplace that are also very sharp and fraught with risk.'"
Ruddy says that with increased usage there's going to be increased supply "and with that there's going to be increased scrutiny. Everyone wants to try and differentiate themselves, they get close to the line and that's when it becomes problematic in the eyes of the regulator. That's just history repeating itself.
"Our government tends to be reactive when something reaches a certain tipping point. When something gets so big – as we are seeing with alternative mutual funds – it becomes a target issue, almost overnight," comments Ruddy.
Seibald is adamant that the basic premise is "flawed".
"You've got an alternative strategy that is designed to generate alpha and to do that you need to assume some additional risk; in other words, volatility. For that to make sense in a retail wrapper is questionable; it's a mismatch. And whenever there's a mismatch between the objectives of the manager and those of the end investor, it's an accident waiting to happen," comments Seibald.
He adds that he is perplexed at the ease with which the regulators have approved '40 Act alternatives. "Of course, '40 Act funds are a great, low-cost vehicle compared to investing directly in a hedge fund but the risks, to a certain extent, are the same; if not greater. And what I mean by that is, in a liquid alternative an investor can make a decision every day.
"In a hedge fund, you're locked up for 60, 90 days. The retail investor, historically, has panicked at the wrong time and got excited at the wrong time, generally speaking. If something happens mid-month, and the markets crash, how many people do you think will try and redeem their '40 Act investment? A lot.
"I'm not saying a hedge fund is any better or worse a vehicle but the investment objectives – regardless of the fund structure – have to be aligned between manager and investor. And for me, that just isn't the case with these liquid alternatives."
To support US hedge fund managers who move into the liquid alternatives space, US Bancorp Fund Services is able to provide a strong custody and compliance programme to provide daily collateral management.
"Derivatives such as swaps that are used in a liquid alternative compounds the complexity with respect to maintaining compliance with the '40 Act rules and we have a strong custody and accounting heritage to be able to handle these complexities for our clients as their administrator," says Bob Kern, Executive Vice President at U.S. Bancorp Fund Services.
To handle multi-manager liquid alternatives, Kern says that they have had to make some changes to the onboarding process by setting up trade communication, collateral management and cash communications. "We have a dedicated team to provide the same level of service and reporting, regardless of whether these are portfolios of 5, 10, or 15 sub-advisors. The complications arise in that we are doing that trade communication not once, but multiple times depending on the number of sub-advisors, so we've worked to refine and automate the reporting process.
"The same thing applies to collateral management on a daily basis, ensuring that the portfolio remains compliant as well as the manager and each sub-advisor. We use various compliance testings on the fund's assets and have built them to specifically handle either '40 Act multi-manager liquid alternative strategies, or pure play alternative fund strategies. Ongoing compliance is a key service offering," concludes Kern.