What the Regulators have been saying

Investor Best Practices

The president’s working group on financial markets issued a white paper on “Principles and best Practices for Hedge fund investors”   This document supplies a potential investor with best practices in the selection and monitoring of their Hedge fund investments.  As forcefully stated in the document “The due diligence process should also include an evaluation of the business infrastructure, investment operations, and controls in place to support your decision”

What to expect from the SEC

Commissioner Luis A. Aguilar  of the SEC stated The reason for their (hedge fund) exclusion from regulation is on faulty ground; it seems certain regulation for hedge funds is coming," “Registration may not be enough to give regulators a complete picture. One solution is applying some provisions of the 1940 investment manager’s law to hedge funds”

We're now doing things like canvassing all hedge funds for aberrational performance," SEC enforcement director Robert Khuzami told a House Financial Services subcommittee. He said the focus was on "anybody who is beating market indexes by 3% and doing it on a steady basis."

How the SEC will conduct exams

“We simply show up, because if there are allegations of wrongdoing we don't want to give firms a good deal of lead time to clean up,” 

Gene Gohlke, associate director of the SEC's Office of Compliance, Inspections and Examination

 “We at the SEC are committed to pulling back the curtain on hedge fund operations and taking a close look at their activity. We are developing a variety of initiatives to do that involving greater specialization and expertise, improved technological tools to track and analyze trading, better coordination among regulators and law enforcement, new legislative initiatives, and other means to address these areas.”

“When we conduct a risk-focused examination, such as of fund advisers to large private equity funds, we will be looking for conflicts of interests, and for evidence that advisers have been vigilant in identifying such potential conflicts and putting in place effective plans or controls to address them.”

The Dodd-Frank financial-regulation law may require the federal government to spend almost $1 billion and hire or transfer more than 2,000 employees in the months ahead, according to the Government Accountability Office.

 Conclusion 

Even with looming budget cuts, the SEC will be doing more with less and they will be working smarter than ever before. They have hired individuals who know the capital market and hedge fund businesses.  The new methodology that the SEC employs will include a top down approach with an emphasis on an operational and business risk assessment.  In this way the SEC can quickly determine whether a hedge fund or private equity fund have a solid governance, internal control framework and reports that will measure those controls.  If the SEC determines that these controls are not sufficient to detect major issues, they will then perform a deep dive into the business practices of the hedge fund. 

How Your Organization can start to prepare for Dodd-Frank

Structure Considerations

• It starts at the Top of the house.  Senior management needs to embrace and own any new initiatives  or cultural changes of the oganization.

• The Organization should perform an assessment of its business  practices,   infrastructure processes, organization governance and how technology interplays with both.  This should then be bench marked against what is anticipated as an outcome of the Dodd-Frank bill.

• Tactical and Strategic initiatives should be prioritized, realistic time lines should be established and sufficient resources should be allocated.   Note:  these initiatives will distract senior management from every day business

What your priorities should be

• Consider a scalable infrastructure to efficiently retrieve granular data in any format for any audience.

• Build a formidable operational control framework.  Ensure that key risk indicators are created and reliably reported to senior management.

• The SEC will be reviewing front to back procedures, ensure you have proper documentation.

• Technology without the proper process or process without the support of effective technology will expose the firm to capacity and data integration issues. Though straight through processing is difficult to attain, data quality can be achieved through a front to back systemic reconciliation process.

• Manual processes may present an operational risk in the eyes of the SEC. Any manual process, therefore, should have solid controls supporting them and sufficient documentation that the controls are in place. 

• Regulators will be focusing on compliance and will be asking for the firm’s compliance manuals.  Ensure that the organizations compliance manual is tailored and inclusive of all your business practices. 

• Regulators will be searching for possible business conflicts with other firms or investors and conflicts within the enterprise.  As an example, the risk manager should not report to the business.   

• Ensure that your organization has a transparent allocation process. It should be properly documented and be able to be readily demonstrated.

Introduction to Dodd-Frank Bill

The Dodd-Frank financial reform bill has been in practice for almost a year but at this time we have not noticed any large changes in how hedge funds conduct their business.  However, during the next several months, we will see an increase in regulatory activity.   By July 2011, the regulators will be required to provide Congress and the industry the final roadmap/rules and regulations. Further, as established under the Dodd-Frank Act, the Financial Stability Oversight Council (“FSOC”) will provide comprehensive monitoring, studies and rule suggestions to the SEC and others
to ensure the stability of our nation's financial system. The FSOC is charged with identifying threats to the financial stability of the United States; promoting market discipline and responding to emerging risks to the stability of the United States financial system.

As one example, on January 18, 2011 the FSOC issued a study which suggests restricting a banking entities’ direct investment in “hedge funds and private equity funds”.  And for those investments that are allowed, the “banking entity” must comply with new governance rules and transparency rules: 

Investment and risk oversight: the Study recommendations for the banking entity’s board of directors and other employees, including but not limited to the written procedures regarding the objectives, strategies and policies governing permissible investments, as well as active compliance monitoring of those internal policies and procedures.

Management and public attestation: the Study suggests that the banking entity’s CEO be required to attest publicly to the ongoing effectiveness of the internal compliance framework with respect to permitted investments in hedge funds and private equity funds.

Transparency: The study also requires banking entities to publicly disclose certain information regarding hedge funds and private equity funds which they are permitted to invest in, including the type and amount of investments, portfolio concentrations, returns, and their contributions to reported earnings and capital.

The above study is now under consideration by the SEC.  Though the proposed rules do not directly affect hedge funds or private equity firms, the banking entities’ CEO will be publicly attesting to the internal controls surrounding their own hedge fund investments.  Most likely the Banks’ CEO will want to ensure the banks relationship with the hedge fund is transparent and that the banks senior managers are comfortable with the hedge fund’s internal controls.