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Bloomberg Hedge Fund Start-up Conference – Understanding Compliance

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The focus on industry best practices within the hedge fund industry, driven largely by regulation, has meant that today’s manager has to focus on the compliance function more than ever.

Industry regulators, and indeed institutional investors who now dominate the hedge fund market, expect to see proper internal controls and processes in place when assessing a manager. It’s no longer acceptable for any manager to focus purely on fund performance and raising capital; compliance is just as important.

Towards the end of 2012 Bloomberg hosted its highly successful Hedge Fund Start-up Conference in London. One of those panels focused on the compliance issue. Entitled Compliance: Navigating Murky Waters, the panellists included Matthew Hazell, Associate Director at Signet Capital Management Ltd; Nancy King, Director, Robert Quinn Consulting, and Andy Wood, Managing Partner at Hedgestart Partners LLP. 

The following interview between Hedgeweek and Nancy King details some of the key elements for a start-up manager to think about before embarking on establishing a hedge fund management business. To clarify, at the time of the interview, end January 2013, Nancy had become Partner at Portman Compliance Consulting LLP.

HW: Where should a new manager start from a compliance perspective?

NK: Initially, they need to commence the registration process with the FSA. The application is by far the longest element to getting established as a hedge fund manager. Depending on how complex your FSA application is you’re looking at a timeframe of anything between three to six months. The more moving parts you’ve got in the business, the longer it’s going to take. I would say that it is the most important thing that a fund manager needs to think about when starting up because it is the most time consuming!.
For example You must have an idea of what service providers you’re going to use, what offices you’re going to use, you must have a draft Offering Memorandum and LLP agreement in place. The manager has to demonstrate to the regulator that they are ready to go.
HW: Presumably there’s a lot of emphasis on getting a viable business plan in place?
NK: Yes, you need to have a clear understanding of your business plan. A manager will need to have a regulatory business plan and an investor business plan the two are not the same. In the former, you’ve got to include a lot of details: for example, what level of returns the strategy expects to generate, how much AUM the fund will have after year one,
Also, what kind of investors are you going to approach – HNW individuals, institutions? – what type of instruments are you going to be trading, who will be the key individuals in the firm? Is it going to be a one-man band and if so who will be able to take over if you’re indisposed. These are all key issues that managers need to thrash out before they can embark on the FSA application process.
HW: What are the costs involved?
NK: The FSA application cost is a flat fee of GBP5,000 for an investment manager application regardless of the size of the fund.
HW: The more detailed the application the better it seems. Can this help speed up the approval process?
NK: The FSA do not like uncertainty, the more questions you do not have answers to the longer your application will take to be processed. It’s an incentive for managers to make sure they put as much information in the application as possible. Once the application is sent a case officer at the FSA is assigned. They will get in touch with the manager who, in tandem with the compliance consultant (if they are using one), would then answer any follow-up questions that the case officer may have on the application.
HW: This is a huge task for, say, a former proprietary trader who has decided to spin out of a bank and go it alone. Do you tend to work with small managers who perhaps don’t have a COO?
NK: It is fair to say that for smaller start-up teams of say two or three people, they need more hand holding through the set-up phase. We would help them think about which service providers to use, get the business plan in shape. But managers who have a COO on board are better placed. They might well be inexperienced at running their own business and might not have the time to be collating all this information. If you have a COO, managers tend to be a lot better organised and understand the process.
HW: We should also mention a critical factor in managers getting their applications approved this year, which relates to the AIFM Directive. Could you explain?
NK: The provisions come into force on 23 July 2013. They are quite onerous for some managers but if you get your authorisation from the FSA before that date you will benefit from a year of “grandfathering”: meaning it may be possible to delay full compliance with the AIFMD until July 2014. So there’s an incentive to getting your application finished and approved early.
HW: What, in your experience, are some of the typical stumbling blocks that catch managers out when getting compliant?
NK: The first one, as mentioned, is being disorganised and not having a clear enough business plan. The FSA are now scrutinising business plans a lot more thoroughly. Secondly, individuals who’ve had sanctions against them previously and not disclosed this on their FSA application. If you don’t reveal such a thing not only will the application be rejected but you could be sanctioned by the FSA.
The key point is disclosure. Be transparent.
Another issue relates to the source of assets. The FSA will look closely at where the fund’s assets are expected to come from. If they are from potentially difficult jurisdictions like the Middle East, for example, that can potentially be a stumbling block and prolong the process.
Finally, they need to be aware that they need to have at least EUR50,000 in reserve assets in a segregated account. Sometimes managers don’t realise that.
To summarise, you’ve got to be up-front and as transparent as possible. Don’t sweep anything under the carpet and be organised.
HW: The FSA is starting to mete out more fines. Compliance is something they take very seriously now.
NK: Yes. Five or six years ago there wasn’t as much importance placed on the compliance function and having a compliance infrastructure but the FSA are taking a very dim view of systemic management failures within firms. It’s vital when you’re at the small, start-up stage to get your infrastructure in place. We hear from some managers that in order of importance, investors want to see the CEO, the COO and then the compliance officer: that shows how important compliance has become.
HW: Even if the manager doesn’t have a COO, they need to have a clear organisational chart in place right?
NK: Absolutely. Clear segregation of duties is vital, within reason. Of course, the FSA won’t expect a two-man outfit to have clear separation of front and back office responsibilities, but they will expect that in, say, a 10-man operation. It’s not acceptable for the portfolio manager to be the compliance officer if there’s a COO in the firm that is best placed and most competent to perform the role. You have to demonstrate that you’ve thought about all possible issues.
HW: What about ongoing training for staff and following internal procedures? Every person in a start-up fund has to be aware of their responsibilities because they are on the hook for any breach of compliance.
NK: It’s well worth any new start-up manager investing in some outside help from a compliance consultant just for their own piece of mind to ensure the right internal compliance controls are established. They might be in place but not written down so there’s no evidential provisions.
For example, board meetings take place but they aren’t minuted so there’s no evidence to show the FSA that such a meeting took place. You have to ensure that you’ve got your compliance monitoring program in place and that it’s properly implemented.
The second key thing is training, particularly because a lot of start-ups are spinouts from large institutions where they are used to having standard online training systems. Having your own hedge fund requires you to think a lot differently. Knowing what’s wrong and what’s right: for example when inside information is inside information. If the compliance officer is not a trained compliance officer but maybe a COO they need to clearly understand their duties.
HW: Not only do investors increasingly want to see that this compliance infrastructure is in place, but the FSA might pay a manager a visit as well.
NK: That’s right. It’s more important to have everything in place now because investors will increasingly ask if you have a compliance infrastructure and will want to see evidence of it. It’s no good dusting a manual down that’s been in the back of a cupboard for seven years. It’s got to look like you’ve given compliance the appropriate level of attention.
HW: There are alternative solutions to managers who feel overwhelmed by compliance. For example, they could join an umbrella company which takes care of everything. Do you anticipate such solutions becoming more popular?
NK: Yes I do. If you have two prop traders who either can’t afford a COO or don’t have the time to be stressing about all these compliance issues, then they can choose to join a platform and focus solely on running the fund and building a track record while the rest is taken care of.
Some providers will literally do everything from selecting the prime brokers to providing office space; a complete turnkey solution. All the manager has to do is come in turn on his computer and trade. I think for a small start-up, this represents an ideal solution. It enables you to develop a couple of years of fully audited performance in the fund and will help investors take you more seriously. 


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