The SEC has recently adopted amendments to its Form ADV. Included are provisions that attempt to get a clearer handle on the extent to which Advisers are using outsourced chief compliance officers, placing even greater scrutiny on smaller managers who are more inclined to outsource the CCO function.
Whereas previously Form ADV only required the identity of the CCO to be listed, item 1J on the newly updated Form ADV stipulates that fund managers must confirm whether or not they are using an outsourced CCO, and if so what their name is, the name of the firm they work for, and their IRS number.
"The amendments place an increased burden on the manager. They need to provide more information on the CCO and maintain additional records and support with respect to the calculations of rates of returns and written communications provided to any person. The burden and cost of compliance just keeps on increasing. That's not what fund managers need in an environment where they are struggling to generate performance," says Jeffrey Rosenthal (pictured), CPA, Partner- in-Charge of Anchin, Block & Anchin LLP's Financial Services Group.
"There's a whole generation of fund managers that we might never hear of because the costs of running hedge funds are skyrocketing with all the compliance demands," says Rosenthal, adding that when advising start-up managers, one of the first things he makes clear is the need to have two or three years' capital to fund operations.
"They need to be able to survive that period without potentially making any money. A start-up will typically be funded by HNW individuals who may not be as committed to the fund when it incurs drawdowns."
Anchin, Block Anchin helps managers avoid common pitfalls of setting up a business. It advises on structuring, hiring, budgeting and establishing best practices that include preparing to register with the SEC as an investment adviser.
"Adopting best practices early on is not only beneficial from a compliance standpoint, but also helps with investor relations. Something we always preach to our start-up clients is, `Don't act like a USD20 million fund on day one, act like a USD200 million fund'," says Rosenthal.
He says that whilst some start-up managers are "ready to go to battle" and have the right mindset to run a hedge fund, others can be tentative. With amendments to Form ADV and further regulatory and compliance demands coming down the pipe, wannabe hedge fund managers cannot be under any illusion as to how hard it is to grow a successful business.
One option Rosenthal discusses with clients is to create a single member LLC with just their own capital. Perhaps they trade it for a year and generate a solid return, proving that their investment strategy works.
"At that point, the manager might decide they want to convert the single member LLC into a limited partnership and open it up to other investors when they feel confident and ready to commit to running a fund. We can perform a full audit for that year at a later date and the manager will preserve his track record.
"On the other hand, if, after a year or two, performance is flat (or negative), the manager might decide to shut down the single member LLC. Whilst not ideal, at least they would have avoided the compliance and regulatory costs of running a partnership," concludes Rosenthal.