Preparing for Alternative Asset Management Regulation

A roadmap to meeting the coming regulatory requirements

Originally published in the May/June 2009 issue

Public opinion alters the fate of alternative asset firms
It is undeniable that public opinion has turned on the “wizards of Wall Street” and that public outcry is growing for high levels of scrutiny and oversight of the now-maligned hedge funds. With proposals in place requiring hedge funds to register with the SEC, and the imminent establishment of a systemic regulator, it is clear that new, rigorous disclosure and reporting requirements for hedge funds and other alternative asset managers will become law in a matter of months.

Just as after Enron – when Sarbanes Oxley brought sweeping changes to public company disclosure rules – the financial crisis and fear of Ponzi schemes are pushing new legislation into the fast lane. Soon we will see similar sweeping changes to hedge funds and other alternative asset managers’ requirements.

In addition to a long list of requirements from regulators, managers will also face much higher standards for transparency and justification for performance and management fees from investors. Based on this industry evolution, it is critical to look back on what occurred in the years after Sarbanes Oxley took affect to help determine the best course of action for hedge funds and other alternative asset managers to reap maximum benefit for their businesses.

FinServ believes that this course of events presents a unique window of opportunity to those funds that are savvy enough to take advantage of it. We expect investor dollars to begin to flow back into alternative assets toward the end of this year. Forward-looking investment managers need to be positioned to adeptly handle regulation and other informational requests to attract new asset inflows.

In this paper we will outline the regulation that is likely to be implemented, and reflect on how, in the past, regulations have impacted on companies, and how those rules evolved over time. We will then discuss some of the unique challenges of the alternative asset management industry and discuss the readiness of the funds for the coming requirements. Finally, we will lay out lessons that have been learned from some of the larger organizations in the industry that have already put operational improvements in place, for business development as well as regulatory reasons, and draw lessons from those experiences.


Regulation is coming
Hedge funds, private equity firms and other alternative asset managers are now operating on the widespread belief that this time around, the push for regulation will not fail, as it has in the past.

In the post-Madoff world, the government and investors are going to be looking more closely at how hedge funds operate their businesses and report information. Gone are the days of hedge fund secrecy and limited information supplied to the outside world. Mr Torell went on to say, “it is likely that any new regulation will require enhanced financial disclosure. Improved transparency, in the form of increased information flow, it will need to be both well thought out and sufficiently targeted to help the regulators perform their responsibilities.” Investors will put increasing pressure on the government for more reporting and controls on the hedge fund industry.

Investors demand transparency
There has been a clear shift in power. The article below shows how investor expectations for information have changed and asset managers must be prepared to provide data in a timely fashion to keep their investors satisfied.

Just like regulatory demands, investor demands will mean most funds will have to improve their current reporting environments to provide information to their investors in a timelier manner than they have ever experienced. This requirement will also come from prospective investors as new money begins to flow back into the funds after the large scale redemptions of 2008 and early 2009.

  1. Excerpt from “Investors Turn the Table on Hedge Fund Fees”
    Not only are hedge funds losing clients and money, they are losing clout, too, as large investors turn the table on them and demand better terms. Stung by investment losses and vexed by so-called gates that limit redemptions, some of the largest pension funds and other large investors are demanding that fund managers trim fees, provide more information and increase access to cash. It is a far cry from the boom years, when hedge fund managers called the shots and managers could charge lofty fees and establish gates without fear. No more. “Clearly the 2008 experience evaporated the market’s euphoria and shifted the balance of power, at the margin, more toward the limited partner,” said Orin Kramer, Chairman of the New Jersey State Investment Council, which oversees $64 billion in state pension funds. Mr Kramer, who is also a general partner in hedge fund firm Boston Provident Partners LP, added: “There is a simple thing in life: when people make a lot of money, they end up with greater power. When they lose money, they end up with less power.” The hedge fund industry suffered a critical loss of power last year, when the average fund fell 18% and customers yanked out a record $185 billion in capital. The losses would have been even greater if not for redemption gates that blocked withdrawals. Yet rather than just grumble, some investors have used their new clout to demand changes. And now that institutions control some 80% of the money invested in hedge funds, managers take those demands seriously.

The challenges ahead
The majority of hedge funds and private equity funds spent the latter part of 2008 and early 2009 shutting down projects that were deemed elective, meaning they were valuable but not mission critical and they could not be justified when budgets and resources were being drastically cut. US-based hedge funds were predicted to reduce total IT spending by 40% in 2009 to $882 million, according to a Tabb Group study released in December.

Many of these projects were compliance or financial-system related. These are just the sort of projects that would have facilitated the funds’ ability to react to upcoming regulations in an effective and efficient manner. With strict regulation imminent, many of these firms are now having to resurrect or are starting from scratch to plan the compliance, risk management and reporting processes that will be necessary to address the impending requirements.

This would be a difficult task even in prior years, when budgets were rising but over the past year the majority of funds have had to lay off a large amount of their key middle and back office personnel. This leaves the COO, CFO and CTOs in a very challenging position to now do more with fewer resources.

This challenge will require these CXOs to be smarter and more tactical about how they assign resources to key efforts that will be required. It will also require them to take a fresh look at their infrastructure to ensure that they have the right foundations on which to build.


Who will be regulated, and by whom?
The overriding evidence seems to point to the fact that regulation and scrutiny will be targeted at mid- to large-size firms with greater than $50 million in assets under management (AUM). This is based on these firms’ relative influence on the overall financial system, and their potential for placing the financial markets at risk, causing the severe systemic problems we saw during the financial crisis and following the Madoff fraud.

In US Treasury Secretary Timothy Geithner’s testimony to the House Financial Services Committee on 26 March 2009, he recommended that there be two main regulators: one central and independent regulator to oversee systemic risk, and a second Resolution Authority that would take over failing non-bank financial firms to avoid disastrous bankruptcies that could threaten financial stability. To date, there have been no specific recommendations as to which entities will provide hedge fund regulation. However, the current expectations are that the systemic risk regulator will be the Fed and / or the SEC, and the Resolution Authority would be a combination of the Treasury and the Federal Deposit Insurance Corp.

On the same day, SEC Chairman Mary Schapiro testified to the US Committee on Banking, Housing and Urban Affairs that the SEC is the right choice to regulate systemic risk. She focused on requiring “meaningful disclosure standards” to entities such as hedge funds. She made it clear that she is “asking for legislation that will require registration of investment advisers who advise hedge funds, and possibly hedge funds themselves.” Similar to certain aspects of Sarbanes Oxley, Ms. Schapiro pointed to a requirement that she expects the SEC to require that “a senior officer from each firm to attest to the sufficiency of controls they have in place to protect client assets.”

As the industry waits for the new regulatory infrastructure to take shape, many firms are trying to assess what impact new rules will have on their businesses To gain an understanding of what might be in store, it can be instructive to look at past regulation and how companies reacted and prepared for it. A case in point is The Sarbanes Oxley Act (SOX) of 2002.

Sarbanes Oxley: what happened after Enron, and how did those companies fare?
After the Enron collapse and the subsequent folding of Arthur Andersen, Sarbanes Oxley came to the forefront of the nation’s focus. The public wanted to understand how Enron, such a large company, could fool so many people for so long. The public also wanted to be assured that something of this nature could never happen again. At that time the rating agencies such as Moody’s, S&P and Fitch were questioned as to why, with all their inside information, they were not able to foresee these issues.

SOX regulation was meant to ensure that through proper documentation and implementation of controls in corporations, the events of Enron would never happen again. A key question is: how effective has Sarbanes Oxley really been in safeguarding us from another disaster like Enron? In addition, what have been the relative costs of becoming “SOX compliant” for those organizations that were required to comply? One estimate cited a total cost of more than $1 trillion thru December 2006 had been spent on SOX compliance alone. Did SOX compliance cost the shareholders of these companies, and the public, more than the benefits in the long run? For example, were the expenses associated with auditing firms and other third-party service providers of any benefit to firms that may have already had good risk management approaches in place?

Like SOX, the alternative asset management industry will no doubt have to spend a large sum of money to become compliant with the regulations to come. Therefore, it is critical to learn from organizations that have already been through a similar exercise and to learn what worked, and what did not work, and ultimately how they achieved the biggest bang for their buck.

One consistent story that is told about Sarbanes Oxley compliance is that in the first year of complying with the most onerous section of SOX — Section 404, which dealt with the assessment of internal controls — very large amounts of money were spent. This was because the efforts were not well planned out, and the audit firms that were hired to conduct the work used outdated technologies to meet the demands. In subsequent years companies became more organized in their efforts, by establishing SOX project management offices and utilizing more sophisticated technologies to facilitate efficient compliance. In addition, the teams that were involved in the work became more familiar with what the legislation was really requiring. As a result, the effort to comply became much more efficient.

More importantly, what we have seen from anecdotal evidence is that those companies that simply chose to meet the bare minimum documentation rules recognized no real benefits beyond meeting the requirements. On the other hand, companies that used SOX as an opportunity to improve their basic internal controls — including enhancements to reconciliations and greater segregation of duties — have reaped much larger benefits. The parallel we can draw is that ultimately, the fund managers who take the time to not only comply with informational requests – but also use them as an opportunity to strengthen their systems and business processes – will be able to demonstrate strong internal controls and risk management procedures, attracting new investment as the money inevitably comes back into the market.

Companies that have undertaken SOX initiatives have also learned another critical lesson: in many cases, SOX information security checks exposed critical vulnerabilities to executives. The documentation required by Sarbanes–Oxley prompted companies to evaluate some of these procedures and determine that more standardized procedures should exist. Similarly, on today’s new regulatory environment, the assessment of existing risk management reviews and reassessment of compensation packages should lead to valuable improvements in the way the funds operate and reward their employees.

The role of independent third parties
Certainly the role of independent third parties such as public auditing firms and third-party administrators (TPAs) will become more prominent under a new regulatory regime. The public will take some level of comfort in having these separate organizations overseeing the proper accounting and reporting of a firm’s holdings and fees.

However the public should not be so quick to assume these organizations are capable of the task they will be given. Take the case of the collateralized debt obligations (CDOs) and credit default swaps (CDSs) that now surround hedge funds and the broader turmoil in our financial markets. Once again, questions have come to the rating agencies and other third-party overseers as to why the agencies had rated these market instruments so highly, and why the auditors did not recognize the risks and issues in the marketplace during the bursting of the housing market bubble and the subsequent implosion of many of the largest financial institutions in the world.

We learned from Enron, and more recently from AIG, that third-party entities are far from perfect, with only limited ability to uncover issues. In the alternative asset management world, a key third party is the TPA. The majority of the industry accepts the assumption that the public’s outcry for oversight will require all hedge funds to hire independent TPAs. The belief is that the TPAs provide an independent confirmation of ownership of assets as well as validity of the company’s operations.

What the public does not seem to appreciate is the immense complexity that is involved in the operations of hedge funds and other types of alternative asset managers. Over the past several years, many of the largest hedge funds had been taking steps to separate themselves from their administrators for a number of different reasons. Some funds felt as though the administrators were not able to provide critical information on a timely basis. Other funds became skeptical of the accuracy of their TPAs’ reports after finding discrepancies and errors in their reporting.

With substantial regulation on its way, large hedge funds will have to hire TPAs. The question is: will the TPAs simply function as window dressing to satisfy regulators, or will the administrators play a vital functional role for hedge funds? The biggest issue facing TPAs is how to handle the funds with products that do not have systems that can be readily supported. For instance, distressed debt funds that originate their own loans have been proven to be extremely problematic to support. Other funds with very high trade volumes and exotic product mixes have also proven challenging for the TPAs to service.

A key issue will be how much money and effort it will take for any administrator to be able to create a platform to support multi-strategy or multi-fund asset managers – in a timely enough manner for regulators, and for the funds themselves. If the TPAs are unable to provide this information, funds will be facing exponential costs by not only having to pay for a new TPA to pacify the public, but by also increasing internal spending to meet the reporting requirements of the regulators.

This is a serious issue. TPAs and external auditors will find it difficult to provide multi-strategy and multi-fund asset managers with proper reporting and oversight. However, these are precisely the same funds that pose the largest potential systemic risk to world financial markets.

What the regulations are likely to include and how they will continue to evolve
While Congress and regulatory agencies are still trying to determine the disclosure requirements for hedge funds, key government leaders have stated some consistent themes. It is important to realize that these regulations will evolve over time so the approach taken today should recognize the following factors:

• After the initial publication of a regulation as complex as SOX, it takes a minimum of five years before anyone can confidently state the majority of the specific practices that are considered necessary for compliance. The frustrations associated with attempting to meet regulatory requirements are reduced when an organization recognizes that “full compliance” is an impossible goal. If the specifics of the rules are not written down, then the actions that must be taken to meet the law are a matter of professional judgment. Interpretations are often quite different yet still acceptable to the regulatory authorities.

• Initial attempts to comply with a new regulation both undershoot and overshoot what eventually emerges as appropriate or expected practices.

It is likely that at this point you are asking yourself, given that regulations take years to evolve, what actions should I really be taking now in regards to the coming requirements? The answer is that you should anticipate the future; you cannot wait for regulatory requirements to stabilize before you start preparing or getting involved in key industry organizations. Kevin Treacy, CFO of Fortress Investment Group’s Drawbridge Liquid Market Funds made a key point which is resonating with many executives in the industry: “Regulation without representation must be avoided at all costs. We need to take the lead by taking responsible steps in the direction of self regulation and thereby influence the legislative options. If the members of our industry do not get actively involved we risk being placed under the jurisdiction of an uninformed regulator, which could set the industry back a number of years, and hurt our ability to recover from the financial crisis.”

What we recommend is that all alternative asset managers need to be conscious of impending new legislation and evolving patterns of enforcement to build the systems and processes that will not only let you comply but allow your firm to thrive in the new more regulated environment to come.



How ready are most funds for the coming requirements?
The alternative asset management industry is a very mixed bag in terms of sophistication and level of built out infrastructures. Traditionally most of the IT money spent in hedge funds is spent almost exclusively on the front office, with the middle and back offices usually being an afterthought. Some of the larger players out of necessity and comments from their auditors have much more mature and sophisticated operational processes and technologies to support the middle and back office but even they will struggle with the regulatory requirements.

As many in the industry have predicted, the onslaught of investor redemptions is likely to provide a large degree of consolidation of the marketplace for hedge funds and private equity funds. Many of the smaller players will either be acquired by a larger player or will simply close up shop. This will likely leave a smaller but much stronger group of mid- to large-size funds, with most having a multi-strategy and multi-fund type setup.

Along with size and multi-strategy platforms comes complexity, as well as difficulty in providing consolidated information that the regulators – and investors – will require. Even the largest players in the industry are first trying to create systems that will allow them to look acrosstheir entire portfolios. Lessons can be drawn from many of the larger players in the industry, which have grown very quickly and have experienced the pains that the remaining surviving funds will soon experience as they begin to consolidate.

Going back to the lessons on SOX, as complexity is introduced the costs of meeting compliance go up quickly. To counter those costs best practices are required to drive down costs and increase efficiency. The challenge is to balance the level of compliance with the costs of meeting the requirements in order to create an efficient and compliant organization. One of the first questions that must be determined is: what is your risk appetite for not meeting or maintaining compliance?

Each fund will have to consider their value of good governance. A holistic view of compliance should include business process simplification, and a consistent technology and business architecture. To further reduce compliance costs, businesses should consolidate their compliance requirements, appoint key project sponsors, and allocate adequate resources along with a detailed project plan. Compromise on any of these elements, and you will likely waste money, miss deadlines and increase risks.

One of the requirements Mr Geithner outlined was imposing stricter liquidity, counterparty and credit risk management requirements that are more stringent than for other financial firms. For instance, supervisors should apply more demanding liquidity constraints, and require that these firms are able to aggregate counter-party risk exposures on an enterprise-wide basis within a matter of hours.

During the Lehman crisis, we now know that many hedge funds took days, if not longer, to assess their exposures to Lehman. Ultimately, the inability to understand their exposures uncovered critical operational issues to the hedge funds. This is a crucial point, since one of the main aspects of regulation that is being considered is a requirement for each fund to report its counterparty exposures. Large funds such as GLG, Harbinger, Amber Capital and Elliott Associates had varying degrees of exposure to Lehman Brothers. Funds that used Lehman as a prime broker no longer had access to their money, but hedge fund exposure to Lehman came in many forms, and was not limited to its prime broker unit.

Harbinger, the $13 billion fund that gained recognition for its successful bet against subprime mortgages, had exposure through complex swap agreements made with an obscure Lehman subsidiary. As Lehman’s troubles grew last year, many funds began to withdraw assets, switching to larger banks such as Credit Suisse. But the speed with which it fell surprised many, and assets — complex derivatives, futures, options, stocks and bonds — were immediately frozen. It is important to understand why this was a difficult exercise and to determine what actions would be required to meet these coming requirements. Since many of these firms treat each strategy as a separate silo (and this is the way the heads of those funds prefer it), there has been very little effort or focus on trying to consolidate positions across funds and prime brokers.

To add to the challenges, the recent upheaval caused the majority of funds to move away from the single prime broker model, not wanting to be exposed to excessive counterparty risk that was highlighted as Lehman Brothers collapsed. While the move to diversify from a single prime broker was positive from a risk perspective, this added much greater complexity to the work required to consolidate positions which will be required in the regulations to come. Another challenge that the larger hedge funds have experienced relates to their investors. It has not just been the front office that has had a strong desire to work independently. In addition, many investor relations teams have worked separately by fund, and are not readily able to identify investors in multiple funds or provide a consolidated statement to any investor for all their interests in the firm. Without one consolidated system that tracks all current investors or prospects, managers must undertake a high degree of manual work and reconciliation in order to meet their investor regulatory requirements.

In the past, without any official body requiring consolidated reporting, this model was able to continue. However, as some of these larger players decided their next step was to go public, we were offered a glimpse into what happens when larger funds are required to report their assets in a consolidated fashion. The painful process that each of them had to go through presented clear evidence about why the exercise was so valuable. Being able to finally have a consolidated picture of their holdings allowed them to truly capitalize on the strength of their position in the marketplaces that they chose.

As we said at the outset, it is common knowledge that regulation is coming to the industry – the only real question is, in what form, and who will provide the oversight. As we have seen from recent history with SOX, the effort to comply will be costly and will drain already limited resources from alternative asset management organizations. With limited choices in the industry for administration and software, each fund manager must plan its own path to compliance and expansion in the new marketplace that takes shape over the next several years. Industry players predict that the lull in alternative investments will not last indefinitely, and investor dollars will begin to flow back into the funds toward the end of 2009. However, the investors who come back will be a much more wary and savvy group, with significantly higher standards and requirements. In addition, a new set of regulators will be put into place to oversee the industry and the requirements will begin to pile up for the firms that remain. The largest players in the industry are viewing the shakeup in the economy in a positive vein.

Firms that take action now to strengthen the core of the businesses will be the ones that are best equipped to thrive, and not be hemmed in by the limitations of their platforms and infrastructure.