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. According to Howard Weinstein, managing partner of FinServ Consulting — an independent provider of business consulting, systems development and integration services to alternative asset managers and their service providers — regulators will be looking at a firm’s size, capital-held and leverage ratios, asset class concentrations, off-balance sheet holdings, counterparty exposures and even executive compensation. Weinstein shares his views on the new rules, and how they will impact firm operations.
New regulatory requirements for OTC derivatives are on the horizon – what effect could they have on the trading and processing of OTC derivatives?
One of the main impetuses behind the current calls for new regulation relates to last year’s turmoil at AIG in connection with the credit default swaps (CDS) AIG sold in respect of various collateralized debt obligations (CDOs). AIG’s losses created considerable shockwaves that reverberated far beyond the firm. Few people recognized that a single firm’s missteps with respect to CDOs had the potential to create systemic risk. Consequently, regulators, creditors and investors alike are likely to demand greater reporting and monitoring of a firm’s derivatives activity and agreements, as well as potential firm exposures associated with derivative instruments.
To prepare for greater scrutiny and new rules and regulations, the industry has accelerated its move toward electronic confirmation and processing platforms as well as central clearing for certain credit derivatives. In addition, companies are taking steps to better organize and internally monitor the terms of the ISDA master agreements (as published by the International Swaps and Derivatives Association) governing their derivatives trading through the creation of central databases that track key agreement terms, including default and termination provisions that apply upon the insolvency or other economic deterioration of a party. This centralized tracking will ensure that firms are proactively and efficiently monitoring the default risk and exposures associated with their trading relationships.
What challenges do these new regulatory requirements impose on hedge funds, their operational departments and compliance teams? And what are the potential consequences if a firm stalls preparations for new regulatory requirements?
Because alternative asset managers have never been tightly regulated, there are no operational best practices for the industry, and every firm has its own way of doing things. To meet requirements, firms will need to make significant changes to their business processes, systems and organizational structures to facilitate disclosure and reporting that are aligned with the new rules.
Although most in the industry expect asset flows to resume later this year or early in 2010, recent redemptions, the lack of incentive fees due to high water marks, and firm layoffs have left many firms under-resourced to start new compliance projects, particularly in their middle and back offices. The biggest operational hurdle many firms will have to overcome is the need to provide consolidated reporting, to give investors an accurate picture of their holdings, and to address disclosure requirements for firm exposures and risk.
Managers should be prepared to identify, aggregate and report on counterparty risk exposures across the entire enterprise. The “Madoff Effect” has left investors deeply concerned, not only about the value of their investments, but also about the level of counterparty risk in their portfolios. Last year’s Lehman crisis – in which many fund managers took days or weeks, if not longer, to assess their exposures to that firm – revealed critical deficiencies in hedge funds’ counterparty risk management. This issue is complicated by the fact that most large alternative investment managers have multiple funds and prime brokers holding silos of their information.
Chief Compliance Officers will be looking to COOs, CFOs and CTOs to assist them in approaching compliance in a smart, efficient way – using a tactical approach that recognizes the evolutionary nature of compliance requirements. As new money flows back into alternative investments over the next 18 months, those firms that take action to enhance their infrastructures will be the ones best equipped to compete for assets. Those firms with weak infrastructures will not be viewed as an attractive investment allocation target, particularly by institutional investors.
What about the role of third-party fund administrators (TPAs) and auditors?
The administrator’s role is of particular interest to hedge funds, because 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 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, no one should be quick to assume these organizations are capable of the task they will be given. 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.
The biggest challenge 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 difficult 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 these platforms, 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.
What is the best strategy – or roadmap – that a hedge fund, or fund administrator, should adopt in order to prepare operations and compliance teams and infrastructure to comply with new regulatory requirements? What is the advantage of having a broader plan rather than approach compliance piecemeal?
Managers, and fund administrators, should approach new regulatory rules as an opportunity, not a burden. Implementing better controls can expose existing operational weaknesses and inefficiencies, which is ultimately good for business. Asset managers that can demonstrate strict compliance procedures and operational efficiency will be most likely to gain from the future asset inflows as the more diligent investors return their assets to the market.
There are three key points firms should focus on when approaching new compliance projects. First, compliance activities should be proactive, not reactive, led by project sponsors with an enterprise-wide understanding of key systems and a commitment to consolidating business processes. Second, in the interest of efficiency, an enterprise compliance plan should look for commonality in all regulatory requirements to reduce erroneous spending and remove complexity. And finally, firms should use the compliance requirements as a springboard to improve their systems and operational efficiency, creating seamless end-to-end systems that will not only better support compliance reporting, but management decision making as well.
What are the lessons learned from SOX, and how does this show firms how they can best change their business structures to comply with these new regulatory requirements?
Sarbanes-Oxley (SOX) legislation came in the wake of Enron, just as the current proposed legislation has come in large part in the wake of AIG. In complying with SOX, many corporations faced similar operational dilemmas. Notably, companies that lacked a proactive strategy, or road-map, to address compliance found themselves spending millions on products and services, including high-priced auditors, which in many cases were not well targeted to their needs. In other cases, firms chose to meet only the compliance minimum; but ironically, those who chose a bare bones approach ended up spending roughly the same amount as firms that approached compliance as an opportunity to improve their enterprise-wide processes and operations.
Alternative asset management firms are facing the unknown right now. Everyone knows regulation is coming, but what the exact requirements will be are still being crystallized. Because of this lack of clarity we see many fund managers not taking steps to plan for the soon-to-come requirements. The risk is, managers who don’t take action now to put the operational pieces in place could end up spending substantial amounts later for “reactive” compliance programs that are not well thought out.
With SOX, and with today’s regulation, the parallel we can draw is that when firms are preparing for a wave of new rules, they should view them as an opportunity to improve their operational profile and client reporting. Alternative asset managers have suffered a major blow to their public images. Improving client service, disclosure and transparency will go a long way toward attracting investment at a time when firms are actively seeking to raise assets.