Will new hedge funds lose their edge under Dodd-Frank?

Published by Reuters Complinet
June 1, 2011

The hedge fund industry is likely to lose some of the risk and entrepreneurial approach that has attracted investors with an appetite for high risk and reward scenarios as a result of new rules being formulated in the US and Europe.

The biggest impact of new rules under Dodd-Frank and the forthcoming Alternative Investment Fund Managers Directive (AIFMD) in Europe, AIFMD regulations will likely make it much more costly for new and smaller funds to operate because of the reporting and compliance infrastructure requirements.

There are also a number of concerns about conflicts between the two sets of rules when they come in to play, especially for offshore funds and those funds interested in marketing to investors in both Europe and the US.

The new rules could stifle the entrepreneurial environment in which hedge funds once operated, said Raul Garcia, a hedge fund audit manager in at Kaufman, Rossin & Co. in Miami.

Increased regulation could be eliminating the diversity (of investment options) that has been available in the market for the clients, adds Robert Q. Lee. The end result could be more limited choices for investors, fewer total funds and an industry dominated by larger funds and mega-firms. “And that’s never a good thing,” Lee said.

Increased reporting, coupled with the need for every fund to name a chief compliance officer and have detailed written policies and procedures, plus the technology required to meet the complex new reporting requirements, will make it much more costly for new funds to get started. Lee likens the changes to increased regulation of public companies enacted under the Sarbanes-Oxley Act, which significantly increased the cost and complexity of compliance for smaller publicly-traded companies. Consolidating or sharing the resources necessary to meet all these new requirements could result in the “institutionalization” of the industry, dulling the entrepreneurial edge and creativity for which small funds have been prized.

There are many unresolved issues as deadlines for the Dodd-Frank rules approach which are expected to be announced by July 21 with implementation slated by the end of first quarter 2012.
Attorney Jeff Blumberg, a partner at Drinker Biddle in Chicago, predicts the new rules will have little effect on larger funds since they are registered with the SEC or CFTC already. Smaller, existing firms that deal with institutional investors are likely prepared for the changes, as well, he believes. “Any firm that has been dealing with significant institutional investors probably already has most of the infrastructure that they need in place. If you’re dealing with sophisticated institutional investors, if they’re even going to talk to you as a non-registered investment adviser, they’re going to insist that you act like a registered adviser, that you have a compliance officer in place and that you have all the written policies and procedures that you are going to have to deal with as a registered investment adviser,” Blumberg said. “At the end of the day, I would say that for half, if not three-quarters of the industry, this is really a non-event.”

It is not clear yet, however, where some of the smaller unregistered funds (the threshold is expected to be $100m or less) will have to register. The default is registration with the SEC, but some may choose to register with the securities agencies of the states in which they have offices. There was an expectation that many states would change their de minimis exemptions, requiring smaller funds to register. But there has been no rush to do that so far, Blumberg said. Under de minimis rules in Illinois, for example, a firm with fewer than five clients is not required to register as an investment adviser.

Managers with state registrations and their compliance personnel will have to be aware of the rules and how they differ in every state where they have offices.
SEC registration might be the better option, notes Blumberg, because the regulator is prolific in its publication of rules and related information and makes it clear what its requirements are. Some state agencies may not be as communicative on those issues.
But not everyone agrees on where small funds should register. Garcia thinks many funds will elect to deregister with the SEC in favor of state registration, even though he worries the states don’t have the expertise or the manpower to police the industry adequately. He sees Dodd-Frank as a “knee-jerk reaction” to the financial meltdown, and worries that overregulation will hurt independent funds. Garcia audits about 130 hedge funds a year.

While the new requirements being placed on hedge funds may force some consolidation as part of an effort to share infrastructure and compliance-related costs, conflicting regulations across the globe may lead to some fragmentation. The rules that govern a hedge fund’s operation are based on where the manager of that fund is located, not where the fund itself is based. Hundreds of US managers operate Cayman or other offshore funds. Those funds will be subject to regulation and must register where the manager is based.

Europe’s new AIFMD rules, currently expected to go into effect in 2013, may have conflicts with the Dodd-Frank rules, according to a source close to the negotiations. One such issue that is as-yet unresolved is where transactions can be cleared. Will US fund managers be able to use European clearing processes and vice versa? That issue and others are only just beginning to be addressed. Groups are working to ensure compatibility in reports required by different authorities, but some countries within the EU are considering or enacting reporting requirements that may differ from the AIFMD rules.

Compliance officers will play a more visible and significant role in the newly regulated world, Blumberg said. The challenge for those who may continue to wear several hats within a small firm will be to ensure that the compliance role remains independent. Delegation of custody of funds to third-party sources will be under particular scrutiny in the wake of the Bernie Madoff affair and subsequent scandals. As one attorney who advised fund managers points out, the irony is that Madoff neither operated nor invested money in hedge funds.

Who will have access to information required by the various reporting agencies is another detail that needs to be ironed out.

The potential exists for even more regulatory regimes to step in. If information required of European managers under AIFMD is not made available, then agencies such as the Cayman Islands Monetary Authority, for example, might require that data through its own set of rules.

“Compliance becomes a greater role,” one that will permeate every aspect of a fund’s operation, notes Wesley Tellie of investment advisory services firm Duff & Phelps Corp. in New York. Tellie conducts due diligence on hedge funds for investors.

Hedge fund managers are taking a wait-and-see attitude on where the proposed new regulations are going before deciding how to proceed, said Lee. There are many issues to be resolved, even with the deadline for the Dodd-Frank rules looming.

In the meantime, the one thing compliance pros can count on is a source of new work – and a much higher profile – as hedge funds around the globe prepare for the wave of new regulations.

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