Compliance – Hedging Your Bets?

The coming "war for talent" amongst compliance specialists as regulatory focus is stepped up

Greg McHugh, GRS Risk

As the deadline for hedge funds to have compliance officers in place looms ever nearer, what will be the likely impact on hiring practices? Although the FSA has not yet set up a mandatory system of regulation, the feelers are very much out, and market gossip is that a scandal may be brewing. Consequently, the accepted view seems to be that those who haven't got compliance arrangements of some sort would be well advised to get their houses in order sooner, rather than later.

The biggest concerns for the hedge funds sector are likely to be centred on costs – the costs of hiring, the costs of establishing all the policies and procedures and the costs of training. There'll also be the costs attached to the additional investment needed in IT. Software for order management systems will be needed as well as systems to record and retain e-mail – specifically those which document information about trades.

As Pradeep Yadav, Professor of Finance at Lancaster University Management School says: "Perhaps, only a small fraction of the costs to the hedge fund of having their own compliance officers will be the increased direct costs of these officers relative to compliance consultants. The major costs will arguably be in the form of the comprehensiveness of the internal restrictive control systems and procedures that will be introduced as a result, procedures that will potentially curb the freedom that is the hallmark of hedge funds. The difference is like the difference between the taxman conducting a random audit of 1 in 10000 cases to the internal tax manager auditing 100 percent of the time. It also depends on what freedom is being curbed. The regulation of the industry is from two perspectives. One is control of systemic risk, contagion, and market impact. The second is protection of retail investors. The costs to the hedge fund in the form of limiting upside potential due to the first factor are likely to be much greater than the costs associated with systems that protect retail investors."

There's no doubt that hedge funds are facing a huge task which is likely to lead to a flurry of recruitment activity. Asset management firms and investment banks may well become the main victims, as hedge funds offer big financial incentives for people who are familiar with the growing back-office burdens of control and compliance. The flip side to this is that the asset management firms and investment banks will focus very much on retention with an almost inevitable salary war ensuing. Consultancies, particularly the big four, have also been looking at strengthening their regulatory practices.

"The market is very tight for compliance specialists and we're seeing the start of a feeding frenzy in that end of the employment market," according to one head of compliance for an asset management firm.

"There's bound to be a bit of headhunting from other companies and I suspect there'll be a lot of business for lawyers as some of the smaller companies may look to the secondment route as an interim solution."

However, the headhunting could well lead to an overheated market. "When specialists with difficult to find skill sets start getting approached every five minutes it becomes difficult for them to commit to anything and so the jobs get harder and harder to fill – and salary expectations go into overdrive", according to an HR manager at one big investment bank.

Despite the well publicised troubles of a handful of hedge funds recently, it seems that money may well be no object when it comes to trying to attract the best compliance specialists. Recent surveys on financial industry pay have found that London's hedge fund managers are top of the league. Infact, the UK's top paid business woman is a hedge fund manager and is likely to enter the Sunday Times rich list next year. Elena Ambrosiadou, head of Ikos Partners earned £15.9m in 2004 – nearly double her 2003 pay of £7.9m. Additionally, the sector is seen as an exciting environment in which to work – hedge fund managers have a high risk, high octane and hard living reputation which is very attractive to many potential hires. And it seems that some very high profile investment bankers are still continuing to jump ship – a trend that has been growing for some time. Rod Barker, head of prime brokerage at CSFB, has moved to RAB Capital, the AIM-traded hedge fund investment manager, and Emmanuel Roman, former head of prime brokerage at Goldman Sachs, has joined GLG. The sector is also seen as one which is very quick to make recruitment decisions and not hampered by the layers of HR processes that many of the larger banks have to wade through.

Historically, the sector has used its own network of contacts to hire as a first step but once the company is up and running there are always specialist skills sets that are difficult to find – compliance being a prime example. Some may well turn to consultancy. Sturgeon Ventures, a company which specialises in putting start-up businesses who require venture capital in touch with those in a position to supply it, has developed what they call a unique 'compliance consultancy', helping companies register their businesses with the FSA, and continuing with compliance monitoring procedures. Sturgeon says that it developed the compliance division in 2003, when it was seen that the market place was approaching compliance from a legal standpoint, not from a best practice in the financial industry standpoint.

According to Sturgeon: "In the interest of cost cutting, many of our existing clients find our service invaluable, without having to have a full time employee focusing on the role. Because our consultants all have experience gained from working in the capacity of brokers, fund managers and compliance officers as well as for exchanges and regulators, the advice ensures that regulatory requirements are balanced against commercial reality. We are able to provide a context for firms in terms of the compliance benchmarks they should seek to achieve in accordance with current regulatory expectations and what the industry is providing as a whole. This enables firms to satisfy themselves that the compliance effort made is wholly adequate and is up to FSA requirements. We also focus on areas of current regulatory interest which ensures firms maintain knowledge at the highest level in those areas which are likely to be under most scrutiny by regulators."

However, even consultancy may not be enough without more of a commitment by the hedge funds themselves. In its recent discussion paper, "Hedge Funds: A discussion of risk and regulatory engagement", the FSA says : "Generally speaking, overall awareness of the market abuse regime in hedge fund managers would appear to be mixed with, in some instances, considerable dependence placed on training received by staff in prior positions at other firms (usually investment banks). There also appears to be a significant degree of reliance in some hedge fund managers on outside consultants who draft compliance manuals and procedures, without clear evidence of significant firm buy-in to the results."

One view seems to be that internal auditors may well be used to fill the gap – particularly in areas such as monitoring and surveillance where firms may well have systems in place but need someone who can oversee those systems and ensure that everyone is doing what they are supposed to be doing. However, the traditional role of compliance as a sort of corporate policing system has changed beyond all recognition. Today's compliance professional has to be a relationship builder, commercially minded and able to implement rules, not just check that they are being followed. WorldCom and Enron changed the corporate world for ever – and changed the compliance role from one of tolerated interference to ethical stewardship.

With corporate ethics, anti-money laundering legislation and market abuse issues at the very top of the corporate agenda, the demand for this new breed of compliance professional is increasing all the time. No longer are we in a situation where, if the compliance team is ignored, there may be a fine – we are now in a situation where individuals can be facing prison sentences – that tends to focus the mind somewhat. As Enron whistleblower Sherron Watkins put it in a recent interview: "Monetary fines don't do it. If you've made $100 million and you're fined $25 million, you're still filthy rich. To go to jail scares these guys to death. Standing in a cafeteria line for food, communal showers? It will change them forever!"

So when is this major flurry of recruitment activity set to start? The feeling in the market seems to be that not much will happen before Q4 of this year as many will be sitting back to see what happens. It has not been unknown for the FSA to postpone deadlines and from an overhead point of view it is unlikely that many organisations will be in a tearing hurry until the deadline is set in stone. In the meantime it is likely that existing hedge fund staff may well be given an extra title – that of chief compliance officer!

However, the role of the compliance officer is a demanding one – and not one that can be easily bolted on. They will obviously need a detailed knowledge of the industry and all aspects of the business as well as a relevant legal background, experience of anti money laundering procedures, training and competence, policy and procedure, and financial promotion. Consequently, the contractor and interim market is likely to take up the slack in the medium term and this is likely to be a huge growth area – particularly as there may well not be enough compliance specialists in the permanent recruitment market.

Across the pond, our US friends seem to be no better prepared. According to a recent report by the Investment Adviser Association and the National Regulatory Services, barely half of registered investment advisers have identified a chief compliance officer on their registration forms despite having been required to designate a CCO as of October last year!

With financial regulators around the world stepping up their scrutiny of hedge funds amid rising concerns that the sector's recent dramatic growth could pose a risk to financial stability, the market for compliance specialists can only get tighter. Additionally the lack of recruitment at entry level for compliance officers could mean that we are storing up even more trouble for the future. The war for talent may well only just be beginning.

Greg McHugh is a consultant with GRS Risk, the specialist risk management recruiter. He is part of the compliance team with particular responsibility for the asset management and hedge fund sectors.