Hedge Fund Best Practices Checklist - Beta Testers Needed
We have developed an industry-leading online self-assessment questionnaire reflecting the President Working Group Asset Manager’s Best Practices Guidelines. The questionnaire asks a series of yes/no questions based on the guidelines presented in the report, and tabulates your own, as well as comparative, results at the end in a pdf output. It allows for comments as well.
Of course, the report is still in draft form, so this is not the final product version, however beta testing may still be useful to fund groups performing compliance reviews. We currently have several testers and are looking for more.
Please contact us via the website if you are interested or need more info.
When hedge funds put up their gates… compliance issues start coming down
When hedge funds put up their “gates” on redemptions, limiting the amount or timing of investor redemptions from a fund, compliance professionals need to get their antennae up for potential issues. With gates going up more frequently throughout the industry, it is interesting to see why some managers actually succeed in doing so, and others wind up putting up the gate, but also bringing the business to an untimely close.
The implementation of the gate needs to be invoked perfectly, lest any one individual or group of investors is disadvantaged. This translates generally into three areas of focus:
- communication: all investors need to be hearing the same message at the same time — no telegraphing information in advance to favorite investors and no selective dissemination of information
- valuation: since gates are frequently invoked in situations where the manager has illiquid investments, keep in mind that once the gate is raised, there will be intense scrutiny on the valuations assigned to portfolio securities
- client servicing: while managers frequently delegate this entire area to an administrator, now is not the time to be completely hands off. Follow closely how clients are being serviced by the administrator and what messages they are receiving from them. Also, review client statements carefully to make sure there have been no administrative errors in the calculation of redemption amounts.
Gates were largely theoretical in the hedge fund industry for a long time. Now that their implementation is being tested in real life, there are certain to be many lessons to be learned.
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Hedge Fund Email Review: Compliance Dream or Nightmare?
Emails and IMs can be dangerous — litigators, regulators and compliance professionals all know this well — yet their use at hedge funds, sometimes in the most casual of ways, continues to expand exponentially.
Most recently, we have seen the emails on display in The Children’s Investment Fund litigation related to its CSX investment in which Christopher Hohn, the fund’s manager, appears to be grappling with rought markets and grasping for direction. “I am not sure what to do now… We have a real credit crisis” was reportedly written by Mr. Hohn to a colleague. Emails were also used to indict two Bear Stearns hedge fund managers. In these, we see that their internal discussion on the ability of their funds to weather the markets is far bleaker than that disclosed to investors during the same time period.
From a compliance point of view, the procedure of retaining and reviewing email has been a double-edged sword. On the one hand, email review allows a bird’s-eye view into what’s happening at a fund, allowing swift and effective intervention if anything has gone wrong. On the other hand, once the email is written, sent and retained by an archiving system… well, that particular email is here to stay, and the damage may well be irreversible, as we see from the two examples above.
As the use of emails and IM’s continue to increase, the oversight function needs to be particularly vigilant. There is no substitute for swift and effective intervention and we wonder if these two cases would be at the point they are at today if there had been.
CFTC and Futures Markets Oversight: truly light regulation
As the temperature has been going up in Washington, so has the heat on the CFTC as Congress continues to scrutinize the futures market’s role in driving up oil prices. From a compliance viewpoint, we have been analyzing what additional regulations might result from these hearings. And, some rather interesting tidbits about the CFTC itself have emerged from the hearings as well…
As for possible outcomes, the most likely seems to be some system of increased disclosure around trades in the swap market by those who are truly “speculators” (as opposed to true commercial traders, such as airlines or refiners). The hearings have highlighted the lack of in-depth data for this market. Other possible (but less likely) outcomes include an overhaul of the market to restrict speculators or a ban on pension fund participation in the market. A Congressional battle would be required for passage of these latter two options, so their likelihood is diminished.
Perhaps more interestingly, the hearings have brought out the spotlight on the CFTC, which is looking like the lightest of “light regulators” anyone could have imagined. While this is of course how the CFTC was envisioned by all concerned when it was created in the mid- 1970’s, we find it hard to believe that the CFTC has a staff of only 437 while being responsible for oversight of a $4.8 trillion market with generating over 3 billion trades per year. At the same time, its budget in 2007 was cut back from the amount that the President requested, and it is funded at about 1/10 of the SEC’s level. What is emerging is a picture of really slim regulator.
Update: Slow Start for EU Hedge Fund Best Practices
Antonio Borges, a former Goldman Sachs vice chairman and current chairman of the European Corporate Governance Institute, has been named the chairman of the Hedge Fund Standards Board (formerly the Hedge Fund Working Group). Mr. Borges will now play the role of persuader, attempting to get a significant number of hedge fund groups “sign on” to the Standards.
Let’s see if Mr. Borges can help this slow start gain a bit more traction, and help dampen the implied threat of additional regulation that is hanging over the industry in Europe.
(As a footnote regarding the US’s President’s Working Group draft report that was recently released — those standards do not require an affirmative “sign on”, as the European ones do. This difference may prove critical as both these initiatives move forward.)
[original post] For an industry that has cried out for “self-regulation”, and investors who have cried out for “increased transparency”, it is hard to fathom how it is that no EU hedge funds (that’s none, as in zero) have actually signed on to comply with the best practices enumerated in the UK Hedge Fund Working Group Standards report published some five months ago. Actually, that is a slight exaggeration — the 14 original working group funds have signed on — but that is the extent of participation.
We see the self-regulatory movement having a tough time in Europe, and now we can only wonder what will occur here in the US once the President’s Working Group best practices guidelines are finalized. Will the participation rate (or lack thereof) be the same? And if so, what will be the reaction of regulators?
We continue to hear the drumbeat call for additional regulation in EU countries — will the echo reverberate to the US?
Update: The compliance shark in the “dark pool” for hedge fund traders
As an update to the original post (below), we note that the London Stock Exchange announced last week that it is creating its own “dark pool” Pan-European trading facility, to be called Baikal. Baikal was created in partnership with Lehman Brothers. As these pools grow in size and complexity, our compliance concerns, as noted below, continue.
[original post] “Dark Pools” are alternative liquidity pools that have been developed by broker/dealers to match buyers and sellers in non-public exchange transactions. The growth of these pools has increased exponentially recently — as much as 95% between 2004 - 2007, according to the Security Traders Association’s Special Report released on April 30, 2008. www.securitytraders.org
These pools have been typically utilized by hedge funds to trade large blocks of small or mid-cap securities that have limited liquidity so that the trade price will not be impacted by the size of the order and information leakage about the trade can be kept to a minimum. While the pools are in a sense more efficient because they avoid exchange fees, the lack of transparency that results from their use can be a concern from the compliance perspective. In particular, an investment adviser’s fiduciary duty to clients to provide “best execution” can be more difficult to document in a dark pool. From our perspective, this may be the “shark” in the dark pool that hedge funds must be wary of….
“Custody Rule” Reminder for Investment Advisers
As we head around toward the end of the second quarter — and thus the likely passing of 120 (or 180) days after fiscal year end — hedge fund compliance pros know that it is time to ensure that “custody rule” requirements have been met at their shop.
While the SEC’s Rule 206(4)-2 can be a tough read, simply put, registered investment advisers who hold “custody” of client assets generally need to ensure that either (a) they have met the distribution requirement for GAAP audited financial statements in the applicable time frame (either 120 days for hedge funds, 180 days for fund of funds, after fiscal year end), or (b) the custodian has delivered separate account statements to clients. A “surprise audit” may be required in certain circumstances as well.
Other requirements of the Rule apply, such as maintenance of assets with a “qualified custodian”, so at this time of year, be sure to check in on this important compliance area.
Alternative Minimum Tax/ Hedge Fund Managers/ Charles Rangel
Charlie Rangel (D-NY) has proposed, yet again, that relief to middle-class tax payers (in the form of a reduction of the alternative minimum tax) should be at least partially paid for by the elimination of the favorable tax treatment that fund managers have on the “carried interest” portion of their partnership interests. Under this bill, net income and loss from an investment services partnership would be treated as ordinary income and loss.
Simply put, the legislation seems to have a certain logic: rich fund managers lose, middle-class wins. While this may sound like an easy choice, the implications of “carried interest” across the investing world are enormous, since “carried interest” is utilized in the private equity, real estate and venture capital worlds, as well as the hedge fund world.
It is not clear at this time whether the bill will pass with the current Congress. The proposed legislation, HR 6275, can be viewed at: http://www.govtrack.us/congress/bill.xpd?bill=h110-6275
Click on the link to view a discussion that aired on CNBC with Congressman Rangel. http://www.cnbc.com/id/15840232?video=778009422
Slow Start for EU Hedge Fund Best Practices
For an industry that has cried out for “self-regulation”, and investors who have cried out for “increased transparency”, it is hard to fathom how it is that no EU hedge funds (that’s none, as in zero) have actually signed on to comply with the best practices enumerated in the UK Hedge Fund Working Group Standards report published some five months ago. Actually, that is a slight exaggeration — the 14 original working group funds have signed on — but that is the extent of participation.
We see the self-regulatory movement having a tough time in Europe, and now we can only wonder what will occur here in the US once the President’s Working Group best practices guidelines are finalized. Will the participation rate (or lack thereof) be the same? And if so, what will be the reaction of regulators?
We continue to hear the drumbeat call for additional regulation in EU countries — will the echo reverberate to the US?
Taking Your Firm’s Compliance Temperature - It’s Annual Review Time for Hedge Funds!
Many registered investment advisers of hedge funds start their annual review of compliance procedures and processes in June. But what exactly are the requirements for this review?
Rule 206(4) -7 under the Advisers Act requires registered investment advisers to annually assess the “adequacy and effectiveness” of the compliance program. This review may take place once per year in one comprehensive assessment, or be undertaken on an on-going basis throughout the year.
The assessment should look at all aspects of the program, whether there were any deficiencies during the year, and whether procedures are effective in their implementation. This latter aspect is often subject to “forensic testing” to evaluate effectiveness. For example, why not deliberately slip in a suspicious email — see if your email review system catches it! Special note to advisers of multiple hedge funds: the annual review should include some “forensic testing” of trade allocations, to determine that there is no hidden bias in allocating trades across multiple accounts.
Here’s hoping your compliance temperature turns out to be normal!
