2017 is already shaping up to be an interesting year. With a new presidential administration taking office and the hedge fund industry coming off the heels of a challenging year, there’s a lot to keep an eye on. We recently hosted a panel with law firm Morgan Lewis to discuss these and many other topics as part of our “2017 Outlook for Hedge Funds: Risk, Regulation and Technology” event.
Read on for some of our panel’s key takeaways.
2017 Regulatory Outlook
While little is known about how a Trump presidency will operate, there could be potential tax savings for managers depending on how the administration chooses to regulate Wall Street.
Firms should expect to see reforms with the Dodd-Frank Act and the Volcker Rule, which could add more competition into the marketplace if limits on bank investments are adjusted.
SEC Focus Areas
Top six areas of focus for the Securities & Exchange Commission will likely be: (1) expenses and fees, (2) trade allocation, (3) material non-public personal information, (4) valuation processes, (5) operating partners and due diligence, and (6) security, privacy, insider trading and business continuity.
Cybersecurity is not necessarily part of every SEC examination, however, the bar will continue to be raised in terms of preparations firms will need to employ.
In 2016, the SEC provided additional guidance on business continuity and transition plan requirements, highlighting the need for hedge fund and financial firms to maintain their fiduciary responsibility to their clients and investors.
Categorized under: Security Cloud Computing Disaster Recovery Hedge Fund Due Diligence Hedge Fund Operations Hedge Fund Regulation Outsourcing Infrastructure Business Continuity Planning Trends We're Seeing
Operational due diligence meetings have become impactful moments for hedge funds to impress both current and potential investors. Firms have the ability to answer questions, alleviate fears and market themselves in a one-on-one setting that affords more opportunity than a completed due diligence questionnaire and an up-to-date performance sheet.
But how can today’s hedge funds truly set themselves apart and impress investors during these ODD meetings? Here are five ways:
1. Demonstrate your knowledge of and commitment to regulatory compliance.
Increasing regulatory oversight of investment firms has been a consistent trend over the course of the last few years, and it can be a challenge for hedge funds to keep abreast of changing legislation and regulator expectations. Disclosure and reporting requirements under the Investment Advisers Act of 1940, record-keeping requirements under the Dodd-Frank Act, and growing cybersecurity recommendations as part of the SEC’s ongoing inquiry are just a few of the initiatives to keep track of. But demonstrating to investors that your firm has knowledge of these regulations and takes them seriously will serve you well.
Whether your firm is compliant to the SEC, FINRA, NFA, CFTC, FCA – phew! – or another regulatory body, it’s imperative that you take the time to fully understand your firm’s legislative requirements and, in writing, show investors your level of preparedness. For example, if you’re a registered investment adviser with the SEC, are you aware of the proposed rule that would require firms to implement business continuity and transition plans? Have you compiled a document that outlines the SEC’s 28 points identified in its cybersecurity risk alert? Coming to your next investor due diligence meetings with this knowledge and the appropriate documentation will demonstrate that you take regulatory compliance seriously and are equipped to comply with the necessary requirements facing your organization.
To wrap up and round out our 6-week Risk Outlook Webinar Series, we spoke with John Cotronis, Executive Director at JP Morgan, about hedge fund risk management and governance. Specifically, he addressed the following questions:
What have you observed in recent years in terms of changes affecting hedge funds – particularly at the startup phase?
Have you noticed a marked shift in the importance managers are placing on risk?
Do the firms you typically engage with have staff on hand to manage risk – compliance officers, etc.?
In terms of corporate governance, where do you see investment firms excelling when it comes to implementing risk management controls and also fostering a culture of risk management across the firm?
Let’s talk a little bit about counterparty risk. What kind of criteria are you looking for that indicates to you a provider has the right risk management framework and best practice structure to support your clients?
A lot has gotten tougher for firms, particularly on the investment side with capital raising, also with regulatory reporting, etc. What areas of operations do you think have gotten easier for hedge funds over the years?
What is your assessment of outsourcing risk – is it higher or lower than managing various functions in-house?
As our Risk Outlook Series continues, we recently spoke with John Araneo, Partner at Cole-Frieman & Mallon LLP in New York, about many of the regulatory risks facing hedge funds today, including compliance, expense allocations and cybersecurity. Continue reading for a brief synopsis or scroll down to watch our webinar replay below.
How would you describe the current regulatory climate for fund managers and investment advisers?
For hedge fund managers and investment advisers, the regulatory expectations have never been higher. Looking ahead to 2017, managers and advisers should expect the challenge of having to navigate potentially seismic regulatory changes - each of which has the potential to complicate business practices and add to the cost and complexity of compliance.
How should clients prepare to react to these changes?
It’s a top-down approach that all comes down to compliance. A culture of compliance is no longer a lofty goal or a cliché; it is now a regulatory expectation. There needs to be a robust compliance program, actual implementation, and accountability. Clients should be prepared and able to effectively manage the SEC examinations. Managers need to take time to understand regulatory priorities and expectations before an exam.
What is the current regulatory regime's appetite for outsourcing the compliance function?
There is no requirement for firms to employ a full-time person to service compliance. However, the worries about outsourcing certain functions, particularly the compliance officer function, may lead to weakened compliance culture. The opportunity of outsourcing creates a gap between the compliance function and the operations, decision makers and day-to-day activities. Outsourcing can be effective and sufficient, but management needs to resist setting it and forgetting it.
During Part 2 of our Risk Outlook Webinar Series we spoke with Eze Castle Integration Director Dan Long about how investment firms should address evolving cybersecurity risks, third party service provider oversight and employee training and education. Many of the points Dan addressed highlight questions hedge funds and private equity firms should be asking themselves.
Read on or scroll to the bottom to watch the full, 30-minute replay.
What is our commitment to cybersecurity and what is our outlook on the future?
Regulators and investors continue to ask more questions about cybersecurity because they want to know that firms are effectively mitigating risk. To meet these growing expectations, firms must demonstrate that you take cybersecurity risk seriously and have implemented sound systems, policies and procedures to combat those risks. As the threat landscape and technology continue to evolve, investment management firms need to evolve accordingly and develop better ways to counteract threats. Firms don’t necessarily need to implement every available security technology, but they should be keenly aware of their options and have a plan to effectively mitigate as much risk as possible.
How are we addressing third party risk and oversight?
Investment management firms often rely on third party vendors to obtain functionality or capabilities that they need, want or can’t afford to produce on their own. But moving functions out of the firm's control can present challenges. With any outsourced function, the firm inherently takes on additional risks at the hands of the third party. But it's critical for investment managers to limit those risks through sufficient due diligence. To combat vendor risk, financial firms need to maintain strict oversight of all third party relationships and investigate security practices and protocols, particularly for those vendors who have access to the firm's confidential information. An outsourced vendor should be providing the same level of security (or better!) as your firm would if the function was under in-house control.
Risk. Across the financial services industry, it’s a buzzword right now, and rightfully so. Perpetuated by mounting regulatory change, growing cybersecurity threats and a challenging market climate, the focus on risk is one that grows with each passing day.
As such, we are hosting a 6-week webinar series, Risk Outlook, wherein we’re interviewing industry experts on a host of risk-related topics. To kick off the series, last week we interviewed Mark Strachan, chief operating officer and compliance officer for BBL Commodities, a New York hedge fund. Read on for a recap of my conversation with Mark or scroll to the bottom to watch the webinar replay.
Question (Q): The last 5-10 years have been challenging for the investment management industry, looking back to the 2008 financial crisis as well as with increasing regulatory initiatives and changes across the investor due diligence process. How have your views on risk and the risk landscape evolved during this time? Or have they evolved?
Mark Strachan (MS): I think they’ve certainly evolved. The core features of non-investment risk – such as operational, counterparty, regulatory, security and business risk – have been constant, but they have evolved in terms of their complexity, our experiences with them, the tools available to help mitigate exposure and the focus by investors through their due diligence process.
What Investment Advisers Need to Know About the SEC Proposed Business Continuity and Transitions Plan Rule
The Securities and Exchange Commission (SEC) recently proposed Rule 206(4)-4, which would require investment advisors to enact business continuity plans (BCPs) and transition or succession plans. This rule would aid advisers in maintaining the continuity of services in the occurrence of a business disruption.
If you missed it, our recent webinar with featuring our Director of BCP Lisa Smith and speakers from Arthur Bell CPAs examines internal, external and transition-related risks to business continuity, mitigation strategy best practices and points highlighted by the SEC within the rule.
Rather watch a video? Scroll down and listen to the full webinar replay.
Potential Risks to Business Operations
The SEC stresses that investment advisers need to assess not only external threats, but also internal threats to accurately ascertain their own risk from a holistic standpoint. This evaluation is critical to identifying the risk impact to specific capabilities and operations, as well as, how they will affect the firm’s employees, clients and third parties. Advisers should take a proactive and organized approach to creating risk mitigation programs for employee activity, as well as, required systems (e.g. email and Internet). Risk mitigation programs should include documentation of processes, segregation of responsibilities, critical tools (think cross-training), etc.
The following article was written and contributed by James E. Grand, Esq. of The Securities Law Group, a specialized boutique law firm dedicated exclusively to representing investment advisers.
We are often asked by advisers who are switching firms whether they can use in their own performance presentation or the predecessor firm’s performance record at their new firm. There are two separate questions here: First; if Jill Doe moves from one firm to another, can Jill use her own performance record while she worked at the old firm in the new firm’s advertising? Second, can Jill use the old firm’s overall performance record in the new firm’s advertising?
A number of SEC staff no-action letters address these questions. These no-action letters generally take the position that an advertisement that includes prior performance of accounts managed by advisors at their prior place of employment will not, in and of itself, be deemed to be misleading so long as:
1. The advertisement is consistent with SEC staff interpretations with respect to the advertisement of performance results.
2. All accounts that were managed in a substantially similar manner are advertised unless the exclusion of any account would not result in materially higher performance. For example, in one case we know of the SEC allowed a newly registered adviser solely owned by an employee to use performance data of several accounts managed by the employee prior to registration. In other words, Jill could advertise the performance of some but not all of her prior client accounts so long as such performance is not materially higher than her accounts’ overall performance.
3. The accounts managed at the old firm are so similar to the accounts currently under management at the new firm that the performance record would provide relevant information to prospective clients.
4. The person(s) managing accounts at the new firm are also those primarily responsible for achieving the prior performance results at old firm. In other words, the individual(s) primarily responsible for achieving the prior performance results must also be the individual(s) primarily responsible for the accounts at the new firm. To put in another way, it would be misleading for an adviser to advertise the performance results of accounts managed at her prior place of employment when she was one of several persons responsible for selecting the securities for the adviser’s clients. The question is whether she was actually responsible for making investment decisions without the need for consensus from other advisers (e.g., an investment committee, etc.).
5. The advertisement includes all relevant disclosures, including that the performance results were from accounts managed at another firm.
It’s no surprise that starting a hedge fund is no easy feat. In an increasingly competitive landscape challenged with evolving investor and regulatory demands, progressive technology and mounting cyber threats, emerging managers can become overwhelmed at the winding path that lay before them. Still, hundreds of emerging managers attempt launching every year due to the prospective monetary and fundamental rewards.
What sets apart successful startups from those that fail? In today’s post we will cover a few essential areas startupreneurs should consider during their launch journey.
Invest in People
Your greatest assets walk out of the door every day: Your team. Every hedge fund startup is backed by people, and the more dynamic and versatile this team is, the greater chance the firm has of achieving and sustaining a successful future. Why? Since capital is limited during the development phase, selecting people with skill sets in multiple arears is essential. Additionally, employees are ambassadors for your firm, and thus, critical to attracting investors.