August 30, 2011

Hedge Fund Regulation: A Clear Landscape

The regulatory landscape for hedge fund managers got a little bit clearer this summer.  With the Dodd-Frank ink (relatively) dry, we now have a much better sense of which hedge fund advisors will be subject to SEC or state regulation and what requirements will come with this additional oversight.

Here is a review of how Dodd-Frank extends regulatory oversight to the alternative investment industry:
  • For many hedge fund managers, registration as an Investment Adviser will be required by March 30, 2012.  To meet this deadline, registrants should file Form ADV by mid-February, 2012.
  • Certain hedge funds that are currently registered with the SEC will need to transition to State registration in early 2012.
  • Determining your firm’s regulatory requirements depends on whether you qualify as an “exempt reporting adviser” (ERA).  An ERA is an adviser that is exempt from SEC registration but must file a "truncated" Form ADV.  To be eligible for this exemption, an advisor must:
    • Act only as an advisor to private funds and have “regulatory AUM”* in the US of less than $150MM; or;
    • Advise solely to one or more “venture capital funds” (See Advisers Act Section 203(l) for specifics here).
  • “Regulatory AUM” is a new defined term that will be used going forward and includes leverage (i.e. gross assets) and uncalled capital commitments (which is typically limited to VC or private equity advisors).
  • Family offices that meet the specific criteria set forth in Release IA-3220 are also exempt from registration.
A little hard to follow, right?  Here is a grid that helps lay this out:

* Non-US Managers” that must either register with the SEC or seek ERA exemption are those who have a place of business in the US and have US clients (either directly or as investors in a private fund).

To avoid unnecessary switching between SEC and state registration, regulators have created a $20 million “buffer” around $100M (i.e. 90M to 110M), where advisors will not have to modify their registration status.

For hedge fund managers that fall into this new regime, adherence to regulatory requirements will certainly bring additional complexity and change to their day- to-day operations.  That said, with the appropriate resources, Investment Advisor compliance is certainly manageable by all but the most resource constrained hedge fund managers. And with the right partners, compliance will likely not be as expensive or time consuming as you may be expecting.

Here are a few “high priority” areas to think about.  We will be posting future blogs with additional details on a number of these topics.

1)  Conduct a thorough review your staff, including their specific roles and their access to information regarding clients or your investment process.  The Adviser Act requires that you identify a Chief Compliance Officer (CCO) to administer and enforce your compliance program. Requirements also include identifying “Supervised Persons”, “Access Persons” and “Investment Adviser Representatives”.  Each of your employees (and potentially others outside your firm) will likely be identified as one or more of these based on their access to information related to your clients and investment decisions.

2)  Prepare for data requirements. Dodd-Frank introduced a new reporting requirement which is intended to help the SEC and the newly formed Financial Stability Oversight Council (FSOC) monitor the stability of financial markets.  Form PF must be filed quarterly (for advisers with more than $1B in regulatory AUM) or annually (for advisors with less than $1B) by managers that are or are required to be registered with SEC and advise 3(C)1 or 3(c)7 funds.  Form PF has five Sections:Section One must be filed by all advisors.  Sections Two through Four are required by quarterly filers only.  (Section Five covers hardship exemptions in the event you cannot report on time.) There are a large number of new defined terms in Form PF and the required data is very detailed and, in some cases, may be open to interpretation.  The data includes regulatory AUM, leverage, counterparty risk, trading/holdings and performance.  We will be posting additional blogs that go through Form PF in more detail.

3)  Conduct a review of your firm’s processes and controls.  A key aspect of advisor regulation is the maintenance and monitoring of the processes that you follow to manage your fund and client relationships.  The objective of these processes should be to understand the flow and access of information related to clients or your investment process.  A review of information flow and access within your firm should focus on identifying risks or potential conflicts of interest.

4)  Identify resources or partners to guide you.  Reactions from industry participants and mainstream media have placed a lot of focus on the “increased compliance costs” that come with hedge fund oversight.  Depending on your firm’s specific circumstances, many of the estimates that we have seen look extremely high and most likely assume hiring a full time compliance professional or significant reliance on your attorneys.  Many of the federal and state regulations in existence today have been in place for over 50 years.  The regulatory knowledge base within our industry is very deep.  Highly experienced external resources are available to support your registration and compliance program without a six-figure outlay.

To cover this topic in adequate detail, we will post additional information on various aspects that specifically apply to hedge funds advisors.  If there is a topic that you are interested in learning more about, let us know and we will be happy to include in future posts.


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