The following is a transcript of an interview with Rob Mirsky, global head of the hedge fund practice at KPMG. For the video, please click here.
Hamlin Lovell: We are privileged to have with us today, Rob Mirsky, who is global head of KPMG’s hedge fund practice. We are sitting in the London headquarters of AIMA, and we are going to be discussing the compliance survey jointly conducted by AIMA and KPMG which investigates how much hedge funds around the globe are spending on complying with all these new regulations. So, how much are hedge funds spending on compliance?
Rob Mirsky: A lot. If you look at the spend that hedge funds have had over the last several years, post-financial crisis, the number we came to is around $3 billion which has been spent trying to deal with all aspects of regulatory compliance.
HL: Right, that really is quite a lot. And what percentage of operating costs are hedge funds spending on compliance and how does the figure differ for smaller funds?
RM: It’s interesting that, if you look at percentage of operating costs, the average number was a bit less than 10%, but what’s really interesting is that for certain hedge funds, particularly smaller hedge funds, the cost was much higher.
So the way that we looked at it when we looked at what average costs are is that we broke it down into small, medium and large hedge funds. Small hedge funds were spending around $700,000 dollars a year on regulatory compliance costs. Mid-sized hedge funds, those hedge funds over $1 billion, were spending around $6 million a year, and larger hedge funds were spending around $14 million a year on regulatory compliance. I think you need to put that into context a little bit, and think about what $700,000 a year means to a small hedge fund. So if you’re a $100 million hedge fund manager, $700,000 a year spent on regulatory compliance alone is a huge percentage of your typical management fee, if you assume management fee at 1.5%.
We also took a look at what as a percentage of AUM those costs amounted to and somewhere up to half of management fees were being spent purely on regulatory compliance – that’s without keeping the lights on and paying for the office.
HL: It seems a huge overhead. So how can small hedge funds continue operating and how can smaller ones enter the market now?
RM: It’s tough – the barriers to entry have risen dramatically. It’s not just the regulatory compliance that we’ve been seeing, it’s also the general trend towards institutionalisation in the industry, so investors are expecting a lot more out of the fund managers with whom they do business. So it is just becoming a much more expensive place to do business as a fund manager. There are a few things you can do. One of them is outsourcing. We’re seeing an increased trend towards outsourcing certain aspects of the business that are non-core to the investment management side. What an investor looks for is that they want their fund manager to make them money – that’s what they’re really good at. Doing the grunt work, ticking certain things that aren’t core to the business, certain middle office activities, certain collateral management activities, those kinds of things – we’re seeing an increasing trend towards having those kinds of things outsourced. It’s helpful and it’s important, but I think that a fund manager needs to be aware that while they can outsource some of that grunt work, as I’m calling it, they can’t outsource the responsibility. The regulator doesn’t want that, and neither do the investors.
HL: So are these compliance costs being borne by funds or being passed on to investors?
RM: I think one of the really interesting findings from the survey is that the vast majority of managers were actually taking on, or “eating” – absorbing – somewhere between 75% and 100% of all these additional regulatory and compliance costs. I think that’s quite a strong message that the industry is sending that “Look, we take this compliance responsibility really seriously, and we’re not going to pass that on to investors.” I think that’s important, and I think that something like 75% of the managers said they were taking on most of the cost.
HL: Which regulations in particular are proving to be most expensive or onerous to comply with?
RM: We gave a list to chose from and there wasn’t a single regulation on there that managers didn’t respond to or say, “Well, that’s not so bad,” but those that posed the largest challenges were really AIFMD and SEC registration. Those are where managers were spending a huge amount of resources in trying to handle them. More than 20% of the managers with whom we spoke said they were spending more than 500 hours, or they had spent more than 500 hours trying to get Form PF done. Huge, absolutely huge.
HL: That’s incredible. And what is the most surprising story beyond Form PF that you have heard from the face-to-face interviews?
RM: We heard lots of stories from managers who had reconsidered where their fund was domiciled, and where the management company was domiciled. A few years back there was talk around redomiciliation, especially in Europe or to Europe. I don’t think there was that discussion so much, but certainly the thought occurred to a number of the larger managers, how do we most efficiently run our businesses, and is it onshore, is it offshore, is it in the UK or the US? One of the continental European managers that we spoke with said that if they had to do it all over again – this is one of the largest continental European managers – that “If we had to start over again, we would not start over here in continental Europe, we would be starting in London or New York,” because the regulatory regime is that much more friendly, and it’s a much more friendly place to do business – not that it’s an easy place, but that it’s more conducive to running a financial services firm.
HL: In which geographic regions is compliance most expensive?
RM: That was a really interesting finding in the study: what I would have expected is that compliance costs in Europe would have been the highest, compliance costs in North America would have been in the middle and compliance costs in Asia would have been the least expensive. What we found though was that North American compliance costs were actually, as a percentage of AUM, higher than in Europe. As expected, Asia was on the lower end. The reason, we think, that the North American costs were higher though isn’t because taken as a whole it’s more expensive to comply in the US, it’s because I think the US is a bit further ahead in the implementation of their rules – so for example theSEC registration, Form PF and those kinds of things, whereas in Europe AIFMD is still coming in. We’re looking at a January 2014 deadline to get authorisations in to the FCA. I think that’s why North America looked – at least in the time-frame of this study – like it was a more expensive place to comply with regulation. I think though if we looked at this again next year or one to two years out, we would see that Europe had eclipsed North America in terms of those compliance costs, and was continuing to accelerate at a faster rate of cost growth than North America.
HL: And looking at Asia Pacific, it seems that fewer managers there are using external help. Is that because they don’t need it, or is it because the average manager in Asia is much smaller and they can’t afford the services of consultants?
RM: Although when we asked the managers there how they were complying with local regulation most of them rated compliance difficult, taken in a global context, it is slightly easier to comply with local regulation there and to get through, compared with SEC and AIFMD and European regulation. So the total costs are probably slightly lower in Asia, although the complexity is still there.
HL: So looking on the bright side, do managers actually believe that these new regulations are bringing any benefits?
RM: A few managers we spoke with thought that there was some improvement to process and, I suppose, a bringing-up of the lowest common denominator of the industry, and that’s important, and providing some base level of investor protection is important.
And interestingly as well, we had some positive comments about how the regulators themselves were actually assisting managers in trying to deal with the legislative side of this, and for the legislation that had been put in place, particularly in the US, we had some comments that the regulators were trying to be as helpful as possible to help managers deal with this legislation. But for the most part managers were concerned that the lack of coordination amongst global regulators made this a challenging environment in which to operate and were concerned more broadly that if there is a continued lack of coordination the overlap in reporting requirements and the increased costs will eventually lead to less selection, less opportunity to invest in diversified managers, and could potentially reduce the innovation that this industry has thrived on for years. And ultimately it’s harmful to the end investor. Lack of selection and lack of innovation isn’t what you want, and that’s not what this industry was founded on.
HL: Indeed. Do you think compliance costs will carry on rising inexorably, or do you think at some stage we’ll find a steady state where costs just plateau off?
RM: I would like to think that that will happen but I don’t see how those costs would truly level off. Even as there is innovation in financial products there’s going to be regulation to deal with those financial products and I think as a simple inflationary cost, regulatory costs will rise year-on year. It will become an increasingly expensive business to run, which again, gets back to my point about barriers to entry, and making sure that if there is regulation coming in, as it is, we try to manage it as sensibly as possible, use technology, use outsourcing, to try to reduce the burden on managers to allow those small, niche, nimble guys to be able to continue to grow their businesses and that it doesn’t hamstring the mid-size and the larger funds either.