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One size regulation doesn’t fit all hedge funds

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A survey by Hedgeweek in June shows that 50% of larger hedge funds (>$1bn) are looking to expand their internal legal and compliance teams, with 44% of smaller hedge funds (<250m) planning to increase their outsourcing of compliance functions.

A survey by Hedgeweek in June shows that 50% of larger hedge funds (>$1bn) are looking to expand their internal legal and compliance teams, with 44% of smaller hedge funds (<250m) planning to increase their outsourcing of compliance functions.

Regulation has historically been perceived as a burden to hedge funds due to the difficulty for firms of varying sizes to implement the same legislation into their funds.

The burden can be immense for smaller firms who might need to outsource all their compliance requirements, but must still ensure the accuracy of the information.

Previously, regulatory concerns were often driven by larger institutional clients, such as pension funds, who were concerned with fee disclosure, expenses, and performance. But over time there has been a transition.

While the industry may have previously held a reputation for not always doing things by the book, consistency has improved over the past few years, especially with regards to transparency.

“I’ve certainly seen an increase in transparency, which has really been driven by investors and people like myself, on the operational due diligence front, who have asked and received a positive response. While this hasn’t necessarily generated new regulation, it has forced managers to provide investors with more transparent information,” notes Louis Rodriguez, head of operational due diligence at Meketa Investment Group.

But is the blanket approach to hedge fund regulation always fair to smaller funds?

Regulatory landscape 

US vs UK legislation

The Securities and Exchange Commision’s new proposed rules has incited the most concern by far across the hedge fund industry, with 50% of hedge funds <$250m, 41% of hedge funds $250m-$999m and 43% of hedge funds >$1bn all citing the SEC’s upcoming regulation as their most prevalent concern.

The consensus among managers is that the SEC is viewed as an organisation which tries to catch funds out, whereas the Financial Conduct Authority works in a much more collaborative way.

“The SEC has a very different mindset to the FCA because the FCA tries to work with you. The FCA will try and assess what the hedge fund industry needs to protect investors, whereas the SEC takes the approach that all hedge funds are trying to cheat the system in some way,” observes one manager.

“They want you to follow things within the letter of the law.”

New EU legislation (AIFMD II and MiFID/R III)

Towards the end of 2021, the EU announced updates on two pieces of legislation, the Alternative Investment Fund Managers Directive and the Markets in Financial Instruments Directive.

The long-awaited MiFID III looks to empower smaller investors by giving them more security in their investments in shares or bonds. Transparency, fairness and ensuring that EU market infrastructures remain competitive at the international level are its three main priorities.

On average, the same proportion of hedge funds of all sizes are concerned about new EU regulation, with 25% of smaller funds expressing concern related to AIMFD II, and 28% regarding MIFID/R II, and 29% of mid-sized and larger hedge funds noting their concern about both initiatives.

Phillip Chapple, Monterone Partners’ COO, notes how, in the past, managers may have been more willing to set up a fund or product based in the EU to access those investors, but that increasingly complex legislation may now discourage people from doing so.

“Previously, managers were more or less able to tick a box for legislation requirements. But now, managers require a lot of additional documentation and structure. They have to look at each jurisdiction as it becomes more divergent and ensure that they’re complying with the correct version of MiFID and other legislation. It could mean that you have to double your reporting and compliance efforts, and of course that can get expensive,” notes Chapple.

Investors

Research from SEI’s latest hedge fund report shows that managers underestimate how much investors value regulation, with 22% of investors citing limited regulation as a ‘major concern’ compared to only 4% of managers taking note of this.

“Prospective investors are really keen to see managers’ compliance presence,” says Kavita Devani, head of compliance operations, Coremont. “Whether you outsource it or keep it internal, investors want to understand how you are doing it, who’s doing it, and exactly what controls you have in place.”

The volatility and high inflation rates experienced so far in 2022 have made it difficult for investors to specify certain regulation demands.

“Historically, public and private pension plans have been most attentive to regulatory oversight; however today there is no overwhelming consensus to increase the current level of regulation,” notes Adrian Sales, head of operational due diligence and partner at Albourne.

There may be reason for investors to be concerned about just how much regulatory-themed paperwork fund managers deal with, especially if it stops them focusing on the portfolio and returns.

Some regulators are finding that as soon as new regulation is brought in to answer investor demands, the same requests are being repeated and risk obscuring other legislation.

“There’s some frustration and confusion across the industry which has arisen from the repetition of existing regulation or minor tweaks and add-ons, which are presented to managers as entirely new regulation which needs examining and a compliance team’s full attention,” says Rodriguez.

Genna Garver, investment management partner at law firm Troutman Pepper, notes how not all regulation needs to be framed in the same way, and that compliance reminders and risk alerts serve a purpose.

“I’m a little worried about the recent onslaught of proposed rules. Managers need to allocate sufficient resources to compliance, but also to managing their portfolios. Investors and regulators need to ask themselves how fund managers can cope with the increased compliance burden while also continuing to produce good returns on fund investments – distracting attention and resources with duplicative regulation will likely result in unintended consequences.”

Adapting

Due to increasing regulation and legislation from the SEC, FCA and the EU, hedge funds have found themselves having to adapt in different ways in order to deal with reporting and compliance requirements.

As the Hedgeweek survey demonstrates, larger firms have been building internal legal and compliance teams to deal with this new wave of regulation, while smaller firms have chosen to outsource their compliance to service providers.

“I’ve seen a rise in smaller boutique compliance consulting firms. We’re all used to seeing the likes of ACA and the larger firms. But I think over the last few years there’s been a proliferation of smaller boutique shops that have seen an opportunity to branch out and start their own businesses,” says Rodriguez.

Firms of all sizes have also been seeking advice from external legal experts on compliance costs, with 36% of smaller (<$250m) and larger (>$1bn) hedge funds and 41% of mid-sized ($250m-$999m) hedge funds seeking guidance.

“For emerging managers, although funding is always going to be an issue, they do want to outsource a lot of the procedural day-to-day tasks. Of course they keep the regulatory obligation, and therefore need to be in control of what is being done, how it’s being monitored, who is looking at it, to ensure they have oversight at all times,” says Devani.

Gary Pitts, founder and managing partner at Tetractys Partners, acknowledges the ongoing challenges faced by hedge funds’ compliance functions and points to the need for compliance staff to have ongoing discussions with senior management over risk appetite, risk assessments, three- and four-year projections, and stress tests, among other things.

“A lot of firms are too busy, and don’t have the bandwidth to do the basics. It’s costly to get people who are bright and experienced enough to engage with some of the things that need to be engaged with in a proportionate manner,” he notes.

“It’s taking up a lot of time for senior managers. The senior managers who aren’t engaging are going to get a substandard outcome – a box half-ticked – and, while there may be a document in place, whether it’s actually doing what the FCA envisages it to do is another matter. That’s one of the biggest issues for managers right now,” Pitts adds.

As regulation demands continue to increase, managers must learn to perform a balancing act between compliance and performance.

“Hedge funds are now having to really think about what they outsource, and how, because burdens are increasing. There is a lot more compliance oversight required – striking the right balance between outsourcing, yet maintaining control is key,” concludes Devani.


Key Takeaways

  • For Managers | Current trends point to increasing regulation and legislation as the industry professionalises requiring managers to look for solutions to meet these new compliance needs
     
  • For Investors | Investors must learn to balance their demands for more regulation and security and their demands for good portfolio returns as hedge funds come under increasing capacity pressure
     
  • For Service Providers | As regulation demands increase and smaller managers look for solutions, the need for compliance boutiques is growing

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