A Primer on Fund Compliance Management
Hedge funds and other alternative investment vehicles that provide investment exposure to risk factors not associated with traditional investing use a broad range of portfolio strategies and are open to a similarly broad range of compliance issues. Their investors demand strong disclosure, valuation, risk management, trading, and compliance practices. Further, government organizations globally including the SEC in the US are demanding more insight, information, and documentation concerning compliance requirements.
Hedge fund organizations are often young and small, use leverage to increase exposure and add risk to their portfolio. They often have an overconcentration of exposure to market and counterparty risks, and they are generally more lightly regulated than other asset management organizations. However, with the lack of governmental oversight comes with increased scrutiny from their investors, prospects, and even compliance and risk managers inside the organization.
In this blog post, we will discuss several of the top compliance management issues hedge funds and other alternative investment vehicles must manage in order to satisfy their stakeholders. We will define the issue and offer solutions to create transparency and automation in order to minimize unnecessary investment risk, maintain compliance, and reduce portfolio costs.
What is a Form PF?
Form PF (Private Fund) requires all registered investment advisers with more than $150 million in gross assets under management attributable to private funds to submit extensive financial data regarding their private fund investment activities to the SEC on a quarterly or annual basis. The purpose of this daunting, time-consuming data-gathering exercise is to enable the Financial Services Oversight Council (FSOC) to monitor risks to the U.S. financial system. Form PF affects SEC-registered managers of private equity funds, real estate funds, hedge funds, and liquidity funds with at least US$150 million in private fund assets.
To be clear, form PF or private fund is an SEC rule that requires private fund advisers to report regulatory assets under management, dubbed RAUM, to the Financial Stability Oversight Council (FSOC), an organization established under Dodd-Frank in order to monitor risks within the financial sector.
PF does involve significant data collection that requires a team effort across finance and legal functions. The SEC and the CFTC estimated that the initial Form PF filing would take 100-300 hours for larger advisers to complete and 40 hours for smaller advisers to complete.
We don’t want to deliver a commercial for Ryan Eyes solutions in this blog post, but we do want to help our customers reduce their time and energy investments in non-revenue generating activities.
Ryan Eyes provides an integrated operational and technological solution that assists in data identification, aggregation, calculation, verification, and storage to assist with completing a Form PF. Ryan Eyes gathers and consolidates the necessary data which is seamlessly populated into the Form PF template for review and validation by the manager prior to submission at least annually and often quarterly for larger fund managers. Specific capabilities include:
- Aggregating data to produce the required reporting for relevant sections of Form PF
- Performing risk calculations required for Form PF reports that are not available from data sources
- Ensuring data is accurate and consistent with all other regulatory filings and information
- Liaising with the manager to confirm mappings for new positions held in the portfolios and providing an interface for review, approval, and submission of Form PF
- Storing submissions, filings and provide an audit trail for future reference related to Form PF
Ryan Eyes automates the extraction of information from brokers, your fund administrator, and other parties to reduce the amount of time needed to gather information by 50%. Finally, it provides for a record of signoffs from internal users to ensure the quality of the data that you are filing.
What are 12-D Rules?
Section 12D-1, under the Investment Company Act of 1940, restricts investment companies from investing in one another. The rule was enacted to prevent fund of funds arrangements from one fund acquiring control of another fund to benefit its investors at the expense of the shareholders of the acquired fund. This use of control could come through exercising the controlling power of voting shares or under the threat of large-scale redemptions out of the acquired fund.
Congress has changed the fund of fund arrangements as they seemed overly cumbersome and served no real purpose from a regulation standpoint thus, the new regulations suggest:
Section 12D-1A’s restrictions limits state that a fund cannot:
- Acquire more than 3% of a registered investment company’s voting shares
- Invest more than 5% of its assets in a single registered company
- Invest more than 10% of its assets in registered investment companies.
Section 12D-1B applies to the selling of securities by a fund and prohibits the sale if it results in the acquiring company owning more than 3% of the acquired fund’s voting securities. Thus, funds must be vigilant about tracking these sales. Ryan Eyes seamlessly integrates with your trading system and allows firms to monitor and stop any trades that would violate the 12-D rules.
What are Shares Outstanding Limits?
As we suggested in our paragraph about Section 12d in general, one of the critical pieces of the legislation specifically Section 12(d)(1)(A) places the following limits on investments by investment funds in any registered investment company. In addition, funds have reasons for limiting its equity purchases in a company including:
- Becoming overexposed to a single equity investment
- Inadvertently owning a larger share of the float than was planned
Just like concentration limits in countries, industries, and other investments that tend to move in correlation, owning a certain portion of a single company may not be a compliance issue per se, however, the position will certainly impact the diversification metrics of the fund and needs to monitored closely.
What is a 13F?
If it is February 15, May 15, August 15, or November 15 of any given year, then it’s 13F day. The SEC as you likely know is responsible for regulating the trading of stocks and bonds. They require that all hedge funds submit a report of their long positions and other select investments each quarter. The reports need to be filed no more than 45 days after the end of the quarter and are commonly known as 13F filings. Besides long positions, funds are required to report their put and call options, American Depositary Receipts (ADRs), and convertible notes in each quarter’s 13F form as well.
Form 13F’s have become popular for investors and financial reporters to scour and discuss because the reports provide many of the funds trades over the previous quarter and are thought to be good resources to follow investors like Warren Buffet, Ray Dalio, and other well-known investors. However, the forms are filed up to 45 days after the end of a quarter so they may in some cases reflect investment decisions made more than four months prior to the filing. Those considering investment decisions based on 13F results are best served by remembering that 13Fs are glimpses into past trends and strategies. These may not be useful any longer at the time the 13F is filed.
As you can imagine, many of these firms execute hundreds of trades in a quarter; fund administrators are often at the mercy of an excel pivotable in order to organize and categorize trades for reporting. What our clients have told us about Ryan Eyes’ software is that ensures them that data is accurate and only extracts only the most relevant information. Ryan Eyes also automates a simple, straightforward sign-off process.
What is Side Letter Compliance Tracking?
Most offering documents allow the management team to negotiate special terms (known as side letters) that are not applicable to other investors. Often the special arrangement involves better economic terms, such as reduced management fee or performance compensation.
Some of the more common terms that may be found in a side letter include:
- reduced minimum contribution amounts
- more lenient terms for transfers to an affiliate of an investor
- membership on, or the ability to nominate a member to, the fund’s advisory board or committee.
Care must be taken, however, not to allow side letters to create conflicts of interest. For example, side letters that provide additional information rights or preferential liquidity treatment can potentially present significant liability.
The SEC has expressed concern with the conflicts of interest arising from preferential terms granted to some investors in side letters, such as those dealing with expenses, fees, and preferential access to co-investments. A fund sponsor must work closely with its attorney in creating any side letter agreement and should only do so if proper disclosures were made in the original organizational and offering documents.
Side letters and MFN (Most-Favored-Nation) clauses play a key role in the commercial negotiations of an investment in a modern private equity fund. If an investor can negotiate a side letter with the fund’s sponsor, such a side letter entitles that specific investor to preferential terms for their investment in the fund (e.g. a reduced management fee or co-investment rights).
The MFN clause entitles an investor to have visibility of side letter entitlements of other investors in the fund and, in certain circumstances, allows such investors to elect to benefit from those entitlements.
The MFN clause and its interaction with investor side letters and the fund documentation can result in the disclosure of investors’ side letter entitlements to other investors and even the right to take the benefit of preferential terms negotiated by other investors. However, MFN clauses can also lead to a range of issues surrounding a lack of transparency for investors.
A major issue is MFN clauses can lead to increased bureaucracy, administration, and legal costs for the sponsor.
Ryan Eyes eliminates painstaking, manual side-letter monitoring and tracking is eliminated with Ryan Eyes Side Letter Monitoring as a Service; or clients can handle side letters internally with the ability to have visibility to conflicts to investor requirements, exposure and investor limits, and notifications when side letter obligations do not occur.
Ryan Eyes reduces the time spent poring manually through side letter documents by automating the search for incompatible clauses. It reduces the risk of sanctions from the SEC so that you can have confidence that you are fully in compliance.
What are Concentration Limits – Portfolio, Index, and Country?
A starting point in measuring internal compliance risk is measuring the degree to which the portfolio meets the unique strategies and standards of each fund. Position limits serve to limit exposure to a given position and industry concentration limits serve to limit exposure to a given industry with most firms using these limits to track and ensure diversification. There have been a number of large hedge funds that were forced into liquidation due, in part, to large investments in a single position or industry.
One model that does attempt to take account of such correlations is value at risk (VaR). It can be a good starting point for measuring market risk and credit risk embedded in a firm’s investments and is used to create compliance components for funds.
Most financial institutions have policies to identify and limit concentration risk. This typically involves setting certain thresholds for various types of risk. Once these thresholds are set, they are managed by frequent and diligent reporting to assess concentration areas and identify elevated thresholds.
Ryan Eyes reduces the risk that you will breach your concentration limits and automates the maintenance of gathering various third-party data points to ensure accurate checks. Index, country, and portfolio concentration limits are not only monitored by Ryan Eyes’ software, but also reported on through e-mail, text, and visual alerts so that responsible parties are notified in real-time.
What are Hard and Soft Triggers?
Hedge fund managers should have procedures in place for taking appropriate responsive action if hard or soft risk limits or guidelines are exceeded. Compliance reporting should be sufficiently robust to allow senior management to evaluate positions as frequently as necessary to prevent breaches of the triggers and to address them in a timely manner if they do occur.
Tracking the management of soft triggers including the action taken through an audit trail is critical for funds to maintain internal compliance. Ignored triggers or triggers that did not initiate a response by the owner would be out of internal compliance and needs to be handled before a hard trigger is activated.
Ryan Eyes has an unlimited level of soft triggers that can be escalated up a chain. Fine-tune your soft triggers to a degree not possible with other systems so that you are not flooded with notices that are not relevant to you.
Hedge fund managers and other fund administrators have become overwhelmed by compliance mandates for the firm whether they are internal in order to limit behaviors and risk or external, created by legislation like Form 12d, 13F, or PF. Further, tracking investments in terms of concentration in country, industry or simply outstanding shares has been a manual task that is conducted periodically by many fund managers.
The result is that funds may be out of compliance until a report is generated or an analysis of the positions is conducted. Often, funds pay a price for being out of compliance for a short time including investment losses from diversification issues, penalties for being out of compliance or making a mistake in reporting, or most critically the brand damage that funds suffer from errors resulting from not monitoring investments and compliance criteria accurately and in a timely manner.
To Learn More About How to Handle Compliance Issues in Your Asset Management Firm – Contact Us, We Are Happy to Help – 1 (347) 759 0105.
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