By Irwin Speizer
Hedge funds thought they already had plenty of hoops to jump through in late July when the U.S. Securities and Exchange Commission again revised its rules on short sales, adding another item to the industry’s growing checklist of compliance tasks. The SEC’s action makes permanent some restrictions to prevent naked short sales and, for the time being, has shifted short-sale reporting responsibilities from fund managers to the exchanges.
“Traders will need to be aware of the new restrictions, and hedge funds will need systems to monitor their activity and compliance with the regulations,” says Alex Viall, who heads up the New York City office of Complinet, a provider of compliance and risk solutions based in London.
The new SEC short-sale rules, along with other restrictions under consideration, make it increasingly difficult for managers without sophisticated software to demonstrate thorough compliance across a range of activities. Now, those software compliance service providers are promoting their ability to rapidly incorporate the latest SEC changes. A particularly promising target: hedge funds with less than $100 million under management that may have done much of their compliance work manually, sometimes using nothing more sophisticated than a paper checklist.
“Your ability to be compliant today is really dependent on your investment in technology and infrastructure,” says John Ferguson, chief executive of K2 Advisors, a $6 billion fund of funds in Stamford, Conn. “If you don’t have it, I don’t know how you can be compliant. It is kind of a barrier to entry.”
Hedge funds must comply—and be able to prove that they comply—with rules and requests from regulators, guidelines from financial and accounting standard boards and demands from investors. These standards apply to a range of hedge fund functions, from accounting and valuation procedures to portfolio concentration to reporting on execution, settlement and counterparty exposure. And each of these activities can entail separate compliance procedures and software systems.
Not surprisingly, spending on compliance is on the rise. In its 2009 cost of compliance survey published in January, Complinet reported that 43% of responding U.S. financial firms expected to spend more on compliance during the next 12 to 18 months. In addition, 70% of those firms indicated they would spend more time communicating with regulators.
The survey did not break out the results for hedge funds, but compliance service providers say they are receiving more interest from hedge funds worried about SEC regulation. “It used to be if you were a hedge fund and you were under a billion, you could get by relying on your broker and your fund administrator to do everything for you,” says Chris Monsen, a senior vice president and general manager of global accounts at Advent Software. “But now, due to the investment climate and the regulatory climate, those folks who have gotten by not doing much realize they need systems with a fairly sophisticated level of reporting.”
One of the hottest compliance topics this year centers on a proposal to require most funds to register with the SEC and file regular reports on their operations. Larger U.S. funds have a head start because about half—representing about 70% of all hedge fund assets—are already registered, says Viall. Thus, while the registration and filing requirements may change, those large funds should be able to tweak existing systems and methods to meet the new rules.
Citadel Investment Group in Chicago opted not to register with the SEC, but the $12 billion firm should have enough compliance processes and technologies in place to adjust to shifting demands. “It is very expensive; it takes real resources,” says John Nagel, deputy general counsel and head of global compliance for Citadel. “But big firms can absorb that.” Nagel wouldn’t provide details about how Citadel carries out its compliance tasks, but he did note that “technology is one of our main edges.”
The situation is more difficult for the thousands of smaller hedge funds, particularly those that have not registered with the SEC and now must, or those that avoided registration because they didn’t have the infrastructure in place to meet the new requirements. A compliance officer at a billion-dollar hedge fund, who also serves as its chief operating officer, points out that whatever requirements come out of Washington, D.C., will be in addition to increasing compliance demands from investors.
“Before, investors just wanted you to check a box on due diligence,” says the compliance officer, who asked not to be identified. “Now investors want some proof that you are doing what you say you do. Just being able to find the time and resources is a challenge.”
Hedge funds that start small typically don’t have the money to spend on compliance software and consulting services. Instead, a member of the management team (in most cases one who also runs other operation or finance functions) handles compliance inhouse. “A lot of times, when we start working with a client, what we find is that they are using spreadsheets and paper records,” says Patrick Shea, executive vice president of HedgeOp Compliance, a compliance consulting and software firm in New York City.
Viall notes that funds need to lay out their policies and procedures. He adds: “They are going to have to keep records, record any issues that arise and how they are resolved. They are going to have to train their staffs. They are going to have to stay on top of regulatory change and practices in the industry.”
Firms without a deep tech bench typically buy compliance software from vendors. Some compliance functions are built into other software systems. For example, order management systems, used to track order completion and clearance and perform accounting functions, as well as execution management systems, which execute trades, can be used to track and pre-clear trades for compliance purposes. Other stand-alone compliance software systems help track fund mandates such as style drift or screen trading for conflicts of interest or improper personal trades that play off inside information. Execution and portfolio management software can also be used to see that short sales comply with new rules.
The cost for organizing and computerizing compliance can vary widely. For example, HedgeOp’s package of services ranges from $15,000 to $30,000 per year, but that does not include compliance related to trading and portfolio management. The firm’s hedge fund clients typically have 10 to 25 employees and $500 million to $2 billion in assets under management.
Advent Software offers portfolio and accounting software that tracks and reports on market and counterparty exposure. Those features are part of a much broader accounting and management software service that costs anywhere between $100,000 and $200,000 a year.
One big question now is how much new reporting and disclosure the government will require of hedge funds. Any new hedge fund registration rule is likely to require that funds regularly report on their holdings and counterparties as well as submitting to regular SEC audits.
At the same time, the government is talking about setting up new rules governing derivatives, which could include additional reporting requirements and add another level of complexity for funds that deal in those instruments.
The SEC, reacting to the Madoff fraud, is increasing its oversight of financial firms by initiating more audits, says Shea. The focus appears to be on funds of funds, but it could expand to single-manager funds as well, he says. What examiners want to see is not just that a fund has a set of rules and guidelines for achieving compliance, but also evidence that the guidelines are being followed.
“It is no longer enough to have a robust process” says Meredith Jones, a managing director of Pertrac Financial Solutions, which offers software products for investment managers. “You have to prove it.”
