Operational due diligence analysts find more red flags in hedge funds’ compliance and regulatory functions than any other area
Compliance and regulatory failures are the most common problems identified by operational due diligence (ODD) analysts when they conduct reviews of hedge funds.
A large majority – 76% – of ODD analysts, responding to a recent survey conducted by Corgentum Consulting, said they most often find problems related to compliance and regulatory issues at hedge funds. A further 11% said fund accounting and financial statement reviews threw up the most red flags. A smaller number said the most commonly identified failures related to legal issues (8%) and business continuity (5%).
Around 1,500 hedge fund managers registered with the Securities and Exchange Commission (SEC) for the first time in 2012 under the provisions of the Dodd-Frank Act.
The results indicate many of these managers are struggling to cope with the demands of SEC registration, including the Form PF disclosure requirements and surprise regulatory examinations.
The last-minute scramble to comply with the Form PF filing requirement was seen as a red flag by many ODD analysts, according to Jason Scharfman, managing partner of Corgentum Consulting, which performs due diligence reviews and background checks on hedge funds.
“Barebones compliance is not acceptable to sophisticated investors. If managers don’t plan ahead and prepare for regulations, they are seen as a risk,” he says.
The US Justice Department’s insider trading investigations also have investors on edge. Investors have redeemed billions from hedge funds that have been accused of trading on insider information over the past five years.
ODD analysts are looking closely at the compliance practices and culture of hedge funds in an effort to identify and preemptively avoid funds that may run into problems.
Assessing the risk of insider trading is a major challenge for the ODD community, says Scharfman. “Insider trading is a very complicated legal issue while most ODD analysts tend to have an accounting background. We have this paradigm where accounting professionals are trying to evaluate the law and spot potential problems and that’s not an ideal situation,” he says.
This need for legal expertise was reflected in the survey, with 76% of ODD professionals admitting they are not appropriately staffed to deal with the growing scope and breadth of ODD reviews.
The emphasis on compliance and regulatory issues will only increase following the implementation of the European Union’s alternative investment fund managers (AIFM) directive. Of the 68 ODD professionals surveyed by Corgentum, 59% said the directive presents the greatest compliance challenge for hedge funds compared with 23% who said SEC registration requirements and examinations were the biggest challenge.
Central clearing of over-the-counter derivatives was cited as the top operational challenge for hedge funds by 12% of respondents while only 6% said they were mainly concerned about the Foreign Account Tax Compliance Act (Fatca).
“The AIFM directive ranks so high because there are still so many uncertainties around the requirements and how they will impact non-EU funds,” says Scharfman. At the other end of the spectrum, “there is an expectation that fund administrators will handle the bulk of the work around Fatca”.
Looking ahead, 58% of those surveyed said compliance and regulatory issues would be their main area of focus when conducting ODD reviews in 2013 while 26% said fund accounting and financial statement reviews remained their top priority.
“If you did this survey five years ago, fund accounting and financial statements review would have been a much larger priority than compliance and regulations,” says Scharfman.
Although regulatory requirements have become more stringent in that time, he says investors could be placing too great an emphasis on this area. “People always have a tendency to focus on the most recent problem. The next big case may relate to counterparty risk or accounting problems. You have to focus equally on all areas or you risk putting the cart before the horse,” he says.