SEC Registration of Hedge Fund Managers: How Bad is it Going to Be?
If youíre a hedge fund manager, you may be nervously wondering what, exactly, SEC registration will mean for your firm. According to Sadis and Goldberg partner Ron Geffner, "the media has helped incite snake-oil salesman who are spoonfeeding fear" to hedge fund managers. In his view, a well-run hedge fund manager may find that it already is making many of the disclosures that will be required under the Advisers Act. The biggest change, he said, is that the manager will become subject to SEC examinations.
Clearly, being put under the microscope will be a new experience for most hedge fund managers. But there are a number of other areas where hedge fund managers may find themselves pinched by SEC registration.
First, however, hereís an excellent tip provided by Geffner: before you begin any work on your registration, figure out what, exactly, you are going to be registering. The fact that you may have created multiple LLCs or partnerships for tax purposes does not necessarily mean that you will have to register multiple investment advisers. His advice: sit down with your lawyers and auditors to review your organizational structure. "Thereís no requirement for duplicate registration," he said. The goal "is for the manager to aggregate their advisory services into one entity that would be the hub to their business, and register that one entity."
Morgan Lewis & Bockius partner Thomas Harman agreed that hedge fund managers should spend time thinking about whether they really need to register multiple advisers. "If theyíre not really separate, it doesnít matter how many you register," he said. "The SEC has enough precedent to roll them all up into one anyway."
With that, letís turn to some areas where hedge fund managers are likely to feel the squeeze:
Compliance programs and CCOs. If you think this is going to be time-consuming and painful, youíre right.
But hereís something to consider: IM Insight recently talked to a portfolio manager at a two-man shop (already an SEC-registered adviser) who said he spent "pretty much all of September" working on his firmís compliance program (due for SEC-registered advisers last October 5). He noted that that month could have been spent researching investments. However, the portfolio manager (who also happened to be the president and founder of his firm), wasnít bitter: he described it as a good exercise in looking at his firmís operations, relationships, and disclosures to clients. "I learned a lot," he said. The SECís deadline, he added, ensured that the project got done.
Before you take those lemons and make lemonade, youíll need to find or grow a CCO. If youíre looking to hire someone from the outside, good luck. Hedge fund managers "that are looking for a real compliance officer are just having a nightmare of a time finding one," said a lawyer at a New York law firm that does a significant amount of hedge fund work. "Thereís just nobody out there." Assuming you can recruit someone with experience, keep in mind that the going salary for compliance officers starts at six figures and goes up from there.
Nominating an existing employee to be your firmís CCO also may be problematic, particularly for smaller shops. The New York lawyer pointed out that the "classic small hedge fund" consists of a portfolio manager, a trader, and a receptionist. In such a situation, he said, there might not be any one individual who lends himself to the role of CCO. "You donít want the portfolio manager to do it, you donít want the trader do to it, and you certainly donít want the receptionist to do it ó she might not even be able to work the phones."
Of course, thereís no SEC prohibition on having a dual CCO/portfolio manager or CCO/trader. It just presents certain challenges ó youíll need to ensure that someone is independently looking at the CCOís functional responsibilities as portfolio manager or trader.
Which brings us to cost. While the New York lawyer noted that larger hedge funds may be able to take the "I-donít-care-how-much-this-costs-just-fix-it" approach to compliance, start-up funds may find that the cost of compliance is a real business issue. He predicted that the hedge fund industry may see some compliance-driven mergers, as smaller hedge funds are acquired by larger hedge funds. Moreover, he said that going forward, Wall Street analysts with "good ideas" might be less inclined to leave and start their own hedge funds.
Past performance. Sure, the SEC has addressed the performance recordkeeping issue by grandfathering pre-February 10 performance from the Advisers Actís recordkeeping requirement. But you may or may not be aware that the SEC has certain rules about exactly how a manager can use performance accumulated while at another employer, or how one fund can use another fundís performance. In the past, said Harman, hedge fund managers might have been aggressive about their use of past performance, or might not have thought about the issue (of course, broker-sold funds already should be aware of the NASDís interest in this area). Once the manager is registered with the SEC, however, the firmís private placement memoranda and other documents will be scrutinized. "It will be one of those 85 things" that SEC examiners will look at, said Harman. If thereís past performance in the PPM, there is a "high likelihood" that the SEC will scrutinize it to determine whether it complies with their interpretations, he said.
Allocations. The New York lawyer predicted that some hedge fund managers could run into difficulties with SEC staff interpretations under the Advisers Act that require preallocation of trades. Certain hedge fund strategies, he explained, simply donít lend themselves to preallocation. He gave the example of a high yield bond manager who may receive a call from a dealer saying that they are aware of the managerís position and offering to buy half, "but they have got to do it on the phone." The pitch, he said, is "Are you guys interested in this? If so, youíve got do it right now." That leaves no time to go back to the system and do a preallocation. Moreover, some managers have an offshore fund, a domestic fund, and separate accounts, "yet still manage it as one pool" without preallocation. Not that thereís "anything wrong going on," he added.
Soft dollars. Some hedge fund managers take the position that they are not relying on 28(e). Keep in mind that SEC examiners may not be accustomed to that approach. "If you are going to contract out of the 28(e) safe harbor," cautioned Harman, "you better regularly review everything you soft dollar to make sure itís encompassed within what you say youíre going to soft dollar. If those things donít have enough flex in them, youíre just sort of daring the SEC to come after you."
Trade errors. This "is a huge one," said the New York lawyer, noting that many hedge funds indemnify their managers from errors caused by simple negligence (i.e., keystroke errors). But even when the fund manager has obtained board approval for the indemnification, itís possible that the SEC will take the position that indemnification for simple negligence isnít appropriate. "Is the SEC going to read indemnification provisions out of the agreement just because youíre an SEC-registered adviser?" asked the lawyer. "It remains to be seen." A lot of hedge fund managers "are losing sleep" over this issue, he added.
Whatís not going to be a big deal. The New York lawyer didnít think that performance fees would be "much of a problem," noting that most hedge fund managers have stopped launching 3(c)(1) funds. He also said that the ADV requirement shouldnít present many problems. Geffner agreed. "Properly-crafted offering documents already should be describing potential conflicts of interest, brokerage practices, soft dollars usage, and investment methodologies," he noted.
The real question, said the New York lawyer, is whether the SEC will look at their past precedent in context. Most of the guidance that has been issued deals with a long-only managers with private clients.
"Itís so basic," he said.