Hedge Fund compliance Building a best-practice framework.

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Hedge funds have largely adapted to the regulations imposed on them after the financial crisis, but they are feeling the burden of compliance. This paper explores the current regulatory environment and explains how technology can help improve efficiency and potentially offset some costs in meeting the requirements.

This communication is provided by Advent Software, Inc. (“Advent”) for informational purposes only and should not be construed as or relied on in lieu of, and does not constitute, legal advice on any matter whatsoever discussed herein. Advent shall have no liability in connection with this communication or any reliance thereon.

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The Way It Is In just a few short years, the alternative investment market has had to adjust from being relatively unfettered to tightly regulated. Compliance is an everyday event.

Regulatory examinations and audits have become a way of life. Institutional investors now account for the majority of capital flowing into hedge funds, and are thus in a position to demand—and get— greater transparency from fund managers. The industry on the whole has adapted, though not without pain. By one estimate, funds that used to produce perhaps six reports a year may now be facing as many as 60 reports a year for investors and various regulatory bodies.1 Many firms report that the cost of compliance is a quantifiable drag on profitability.

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Honing Regulatory Reporting for Hedge Fund Managers, Hedge Fund Law Report, November 13, 2014 SEC Chair Mary Jo White Address, October 16, 2015 http://www.sec.gov/news/speech/white-regulation-ofprivate-fund-advisers-after-dodd-frank.html#_ftn2

Still, a “culture of compliance” appears to have taken root in many segments of the industry. Fund managers are making the necessary investments in technology and working with their service providers to help streamline compliance and build it into their everyday processes. Increasing efficiency through technology has the potential to offset some of the cost associated with compliance. And many managers are recognizing that compliance can be good business—the ability to demonstrate disciplined processes and a sound operational infrastructure can be a key differentiator in investor due diligence.

This white paper provides an update on the regulatory landscape that hedge funds must navigate. And it explores the technology and operational options firms should consider that can help ease the administrative burden and costs of compliance.

Key Regulations Affecting Hedge Funds SEC Registration (Dodd-Frank—US) A key component of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is the requirement for private funds, including hedge funds and private equity funds, to register with the SEC as investment advisors. The upshot is that hedge funds are now subject to the same reporting requirements as traditional advisors. They must also demonstrate compliance with business conduct rules, publish and maintain a code of ethics, file Form ADV describing their firms, have policies for managing potential conflicts of interest, and be prepared for visits by SEC examiners. As of October 2015, the SEC reported approximately 4,500 private fund advisors had registered, representing some 30,000 funds.2

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Many managers are recognizing that compliance can be good business—the ability to demonstrate disciplined processes and a sound operational infrastructure can be a key differentiator in investor due diligence.

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New requirements have motivated many firms to upgrade their reporting capabilities with more automation and integration, while other firms have decided to outsource much or all of the process to third-party solution providers.

Form PF The key corollary of the Dodd-Frank SEC registration requirement, Form PF is a reporting obligation designed to actively monitor and track systemic risk on the part of private funds. Also known as rule 204(b)-1, Form PF requires extensive information from three types of funds: hedge funds, liquidity funds and private equity funds. It requires SEC-registered investment advisors who manage private funds of $150 million or more to report risk exposure statistics on a consistent basis.

By now, most hedge funds should be familiar with Form PF requirements, though many may still be struggling with how to meet those requirements efficiently. The report entails aggregating data from multiple disparate sources and putting it into a standardized format following SEC guidelines. It can be a timeconsuming drain on staff resources and carries a high risk of errors when done manually. The requirement has motivated many firms to upgrade their reporting capabilities with more automation and integration, while other firms have decided to outsource much or all of the process to third-party solution providers.

AIFMD (The Alternative Investment Fund Managers Directive—EU) Implemented in 2013, AIFMD requires alternative investment fund managers in European Union countries, as well as US and other non-EU managers who market their funds to European investors, to obtain authorization, meet ongoing operating conditions and comply with transparency and reporting requirements. It essentially confers a “passport” that allows complying firms to market their funds to professional investors across the EU.

The primary reporting component of AIFMD—and by many accounts, the directive’s biggest challenge—is the Annex IV report. Effective for all funds as of January 31, 2015, Annex IV is a quarterly accounting to regulators of various fund characteristics such as holdings, strategies, leverage, exposure, investor information, and other variables. Comparable to the US Form PF, it is a comprehensive picture of the composition, management, and risk factors of a fund. And as with Form PF, the Annex IV reporting process is time consuming and complex. All of the data required does not reside in a single

platform, but usually must be aggregated from multiple sources, both internal and external, then formatted to the Annex IV template. FATCA (The Foreign Account Tax Compliance Act) Although FATCA is a US law administered by the Internal Revenue Service, non-US financial institutions are the ones who feel its impact. It requires financial institutions outside the US to report on deposits or assets owned by US citizens or residents. Its purpose is to curtail tax evasion by US investors attempting to conceal assets and income in foreign accounts, including offshore hedge funds. Firms have had to implement processes for the purpose of conducting ongoing investor due diligence, and many have had to revamp their fund reporting and documentation procedures substantially. The US has succeeded in generating a high level of compliance among countries and institutions—in part by levelling a 30% withholding tax on institutions that fail to comply.

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The systems you use and the way you use them can give examiners greater confidence that you are exercising due diligence and have the controls in place to properly monitor your activities for compliance.

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Planning for an SEC Exam Since obtaining the authority to examine and enforce regulations on hedge funds, the SEC has not been reticent about exercising its power. The SEC has brought sanctions and, in some cases, criminal charges for infractions ranging from insider trading to fraudulently inflating investment values. In the 2015 fiscal year, the commission reportedly filed 807 enforcement actions, the most ever in a single year, and assessed $4.2 billion in penalties.3 Private funds in particular have been a prime target. The SEC’s Office of Compliance Inspections and Examinations (OCIE) has signaled its intention to step up examinations of hedge funds, after an initial series of “presence exams” focused on newly registered alternative fund managers turned up a number of irregularities. SEC exam priorities may change every year, but in general, examiners concern themselves with five key areas, as outlined in an open letter from the OCIE to the industry:

1. Marketing—Examiners will study a firm’s marketing materials, ranging from emails to slide presentations, to determine whether it has published and distributed misleading information about its funds’ performance. 2. Portfolio Management—How are investment decisions made? Examiners will look at how assets are allocated to determine whether a firm’s actions are consistent with its strategy disclosures to investors. 3. Conflicts of Interest—The OCIE wants to know that firms have clear policies in place to manage or avoid conflicts of interest such as employee trading in personal accounts or improper allocations of revenues and fees. 4. Safety of Client Assets—Is the firm complying with regulations designed to prevent the loss or theft of investor assets? 5. Valuation—What is the firm’s method for valuing assets, particularly those that are illiquid or difficult to value? Inspectors want to know the firm is not inflating values, either intentionally or because of a flawed methodology.

Time magazine, Volume 186, No. 27-28, December 28, 2015

The OCIE has also added cybersecurity to its priorities, and announced a plan to examine firms’ policies and procedures to protect their data from loss or theft by hackers. These exams reportedly include a review of vendor selection and management practices. The best way to prepare for an exam is not to wait for the phone call or letter telling you examiners are on their way, but to maintain a constant state of preparedness. Experts recommend conducting at least an annual review of policies and procedures. Many firms engage compliance consultants to perform mock exams to identify vulnerabilities. Technology can help you reduce the labor and expense associated with an examination. It helps you confirm the accuracy of your data and maintain audit trails. It makes it easier to locate and retrieve the documentation the examiners are requesting, and to report it in a clear format. The systems you use and the way you use them can give examiners greater confidence that you are exercising due diligence and have the controls in place to properly monitor your activities for compliance.

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The best way to prepare for an exam is not to wait for the phone call or letter telling you examiners are on their way, but to maintain a constant state of preparedness.

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Technology allows firms to spend less time managing paper and people and more time actively managing risk, something the SEC likes to see.

The Role of Technology in Compliance

compliance readiness and creating a competitive advantage in the eyes of prospective clients.

Advanced technology that improves data quality and delivers real-time information has become both a competitive and a regulatory necessity. Investors are increasingly tech-savvy and cognizant of operational risk, and take a close look at hedge fund managers’ systems in the course of due diligence. A sound technology infrastructure is also virtually imperative in determining success in SEC examinations. Technology allows firms to spend less time managing paper and people and more time actively managing risk, something the SEC likes to see.

Transparency in Portfolio Management Systems Today’s state-of-the-art portfolio management systems play a critical role for hedge funds, delivering real-time information with a high degree of accuracy. A dynamic portfolio management system also demonstrates a strong culture of compliance. It shows clients and regulators alike that a firm has instituted best practices to price and value holdings accurately.

Creating a Compliance Infrastructure Of course, the core role of technology in hedge fund management is to streamline operations, systematize practices, improve productivity and accuracy, and reduce costs and risks. At a higher level, technology enables hedge fund managers to manage complex fund structures, make better informed decisions and implement sophisticated strategies. The systems that deliver these advantages, however, have the ancillary benefits of improving

Numbers used to demonstrate (and promote) a track record of performance must be supportable based on industry standard calculations. The CFA Institute’s Global Investment Performance Standards, or GIPS, are widely recognized as the standard in calculating performance. Using performance numbers that are compliant with and presented in accordance with GIPS demonstrates that a firm adheres to industry-standard measurement guidelines when measuring performance, affirming the integrity and the credibility of their numbers. That should further enhance the firm’s ability to attract institutional clients.

Order Management Systems for Accurate and Efficient Trading Improved trading also can strengthen a hedge fund’s compliance infrastructure. In today’s environment, trading is often seen as being at odds with compliance. For the trader, speed is of the essence. But from a compliance perspective, speed creates risk—the risk of error or violation of policy. Because trading is inherently risky, each firm needs to have a trading program that has at least three components:

> Risk identification > A process to manage risk > Periodic assessment of risk To manage trade-related risks, a hedge fund manager can implement an advanced trade order management system that can handle higher volume and instrument sophistication, while simultaneously addressing the demand for flawless accounting and reporting, error correction and efficiency of execution. Even with all the right tools in place, trading errors may still happen. The right way to fix errors is to document their cause. The ability to create a clear audit

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Today’s state-of-the-art portfolio management systems play a critical role for hedge funds, delivering realtime information with a high degree of accuracy.

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Regulation is the reality. It is here to stay and likely to become even more complex. That makes it incumbent on hedge fund firms to institute compliance practices and invest in the technology infrastructure that supports them. trail of a fund’s trading activity easily is of great importance from both an operational and a compliance perspective. If a firm can demonstrate that it had the policies and procedures in place to catch an error and then correct it before damage was done, it sends a powerful message. In evaluating trading systems, hedge funds should look for such important features as connectivity to prime brokers, fund administrators and trading partners, a FIX interface for order execution, and automated P&L reporting. Investor Accounting and Servicing A less understood yet no less critical area of hedge fund accountability is investor accounting. Due to the flexibility of fund partnership structures, investor accounting can be extremely complex, tedious and error-prone. A modern investor accounting system, however, can automatically perform book and tax allocations among investors through multitiered fund structures and generate IRSapproved Schedule K-1s. These systems automate rate of return calculations and NAV computations, and send account statements to investors.

Using a proven investor accounting system solution underscores a firm’s commitment to the utmost in data accuracy and integrity. It also ensures equitable distribution of assets and promotes transparency to fund partners. Research Management Systems: Documenting Due Diligence SEC regulations require firms to maintain all documents pertaining to specific investment decisions. A purpose-built investment research management solution (RMS) can help firms meet this requirement. The RMS provides a centralized repository for organizing external and internal research data around specific investment theses, as well as a firm’s own records of meetings and deliberations leading to each buy and sell decision. An RMS also helps demonstrate to investors that the fund manager follows a rigorous, disciplined, and repeatable due diligence process in decision making. The Outsourcing Option Outsourcing some or all components of the technology and operational infrastructure is increasingly viewed as a way to improve efficiency, control costs,

reduce risks, and achieve compliance goals. A firm may choose to outsource the hosting and maintenance of its core portfolio management system, reaping the advantages of the technology while reducing the need for in-house IT expertise. Specific operational functions—for instance, reconciliation, data management, or performance measurement—can also be outsourced to specialists. Fund managers can leverage the specialized expertise of providers that have developed best practices from working with a number of clients. It’s critical, however, to perform due diligence on technology and service providers to ensure that they are thoroughly knowledgeable on regulatory issues and that their processes meet current compliance standards.

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Putting it all together

The Compliance Opportunity Regulators have pointed out the positive role hedge funds play in the capital markets. Hedge funds can contribute substantially to capital formation, market efficiency, price discovery, and liquidity. Instead of a burden, compliance may in fact create an opportunity for hedge funds. The worlds of hedge fund management and mainstream asset management are converging. Institutional money managers increasingly incorporate hedge funds into their strategies. The ability to demonstrate compliance and best practices will only increase in importance in attracting institutional money or mutual funds.

Regulation is the reality. It is here to stay and likely to become even more complex. That makes it incumbent on hedge fund firms to institute compliance practices and invest in the technology infrastructure that supports them. As competition, volume and complexity accelerate, technology that makes a firm’s operations more transparent and its data more reliable will deliver a powerful competitive advantage. And a culture of compliance, ingrained in a firm’s everyday business, may well prove to be good business.

Who We Are Advent, a business unit of SS&C, is helping over 4,300 investment firms in more than 50 countries—from established global institutions to small start-up practices—to grow their business and thrive. Delivering unparalleled precision and ahead-of-the-curve solutions for more than 30 years, we help our clients minimize risk, work together seamlessly, and shape the future of investment management. For more information visit www.advent.com.

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