After more than two years of lobbying, the European hedge fund industry has now passed the point of no return – if you have too many American residents in your fund, you have had no choice since 1 February but to be SEC regulated. If a manager is "fortunate" enough to accommodate his US investors in an offshore (non-US) vehicle he has the sop of "adviser lite" to console him.

Anecdotally, stories circulate of those who have (deliberately) not registered, but those non-US advisers who have, will have learnt that forms designed for completion under a foreign law using terminology suited to the US market are a headache to complete. Others, who can afford to do it, have locked in their investors for two years, thereby avoiding the registration requirement by avoiding the private fund tag which brings SEC regulation in its wake.

Hedge fund managers outside the US with US investors (on a look through basis) now therefore fall into three camps: the lucky who can lock in their investors; the cautious who limit their US participants to 14 or fewer, but with the attendant commercial consequence of avoiding a rich seam of potential investors; the pragmatic with offshore funds who can benefit from adviser lite, and some of whom may seek that diluted form of SEC registration by moving onshore US funds offshore; and the vanguard, who are SEC registrants subject to full SEC regulation. In fact, it should not be forgotten that many UK and other European fund managers were already registered with the SEC under the US Investment Advisers Act of 1940 (the "Act") due to their involvement in the US market and with US customers.

One recent development which is to be welcomed is the SEC's acknowledgement that a sub-adviser to an SEC registered investment adviser need not itself be separately SEC registered, provided, among other things, that a fund's assets subject to the delegation are not more than 10% of total assets, the sub-adviser is not affiliated to the fund's primary adviser and full disclosure is made.

Speaking at a recent conference, Bob Plaze of the SEC's Division of Investment Management confirmed the following statistics:

• There are now around 2,150 hedge fund advisers registered with the SEC under the Act. They represent 21% of all registered money mangers.
• Just under 1000 advisers registered in the run up to the registration deadline of 1 February 2006.
• Of these, 320 are non-US advisers, of which 135 are from the UK.
• There are no separate figures for advisers who are subject to adviser lite.

Non-US SEC registered advisers are now grappling with the intricacies of SEC oversight and what that means for their businesses. The addition of SEC requirements to the expanding remit of local regulation gives impetus to the growth of hedge fund managers' middle offices. Managing operational risk, manifested by enhanced in house legal and compliance support, is a key element in the development of the hedge fund industry.

Whether subject to full SEC oversight or adviser lite, a hedge fund manager will now be subject to periodic SEC examination, that is the power of the SEC to inspect books and records and to exercise its anti-fraud powers. From time to time the SEC may carry out a sweep of registrants whereby it looks at particular aspects of practices in the hedge fund sector, but not necessarily at issues specific to a particular firm.

Coming to terms with their dual FSA/SEC regulatory status, affected firms have had to complete part II of Form ADV which provides information on the firm and its services (essentially its brochure) and which must be delivered to prospective clients and annually offered (as updated) to existing clients. Part II is not, however, required to be filed with the SEC, although this may change. Adapting the components of Form ADV to non-US registrants would be a helpful move on the part of the SEC to reflect the differences in fund structures and local legal and regulatory concepts and approaches.

One key consequence of dual registration has been the need to house two regulatory regimes in one compliance manual, an exercise which throws up some of the inconsistencies of marrying the requirements of two regulators, one (the FSA) principles-based, and the other (the SEC) rules based. For firms subject to full SEC registration policies and procedures should cover:

• Portfolio management processes, including:
  – allocation of investments among clients;
  – consistency with client investment objectives;
  – disclosures by investments adviser; and
  applicable regulatory restrictions.
• Trading practices, including:
  – best execution;
  – "soft dollar" arrangements; and
  – allocation of aggregate trades
• Proprietary trading of the investment adviser and personal trading activities of a supervised person.
• Accuracy of disclosures made to clients and regulators.

The procedures should be reviewed annually and take into account compliance issues that arose in the previous year, any change in business activities, an assessment of the effectiveness of existing compliance functions, and a gap analysis between existing compliance practices and relevant risks. As concepts (rather than in the detailed substance of the procedures) these are familiar to FSA regulated hedge fund managers.

At the end of the day, as non-US hedge fund advisers 'bed in' with the SEC, they recognise that the price of the extra administration is a price that has to be paid for effective access to US capital.

Simon Firth is a Partner with the Investment Management Group at Berwin Leighton Paisner