Compliance fundamentals for Hedge Funds

Playing by the rules no longer is an option for hedge fund industry and is important to understand the compliance fundamentals for Hedge Funds to stay competitive. While Hedge Fund Compliance traditionally has been viewed as heavily related to the legal and regulatory side of the hedge fund business, it today has become increasingly integrated into all aspects of a hedge funds operations from investment research and trading through to investor relations and fund reporting.

Last year, around this time, I came across a number I found hard to believe: Apparently there were only 250 Compliance professionals on the books of Hedge Funds in London. Just to put this number in context, RBS, one of the biggest British banks, at the same time had about 2,000 staff running know-your-customer checks alone. While this number is likely to decrease thanks to the automation of KYC checks through RegTech solutions, the Hedge Fund compliance sector has been rising since and is likely to continue to do so as stricter regulatory framework and the continuing introduction of new rules will force the industry to pay more attention on controls and governance.

What are the key Compliance aspects for hedge funds though? The different areas can roughly be categorised in four sections.

1) Due Diligence

Funnily, the first point on our list has for a long time been kind of a non-issue for hedge funds as they have long been exempt from Anti-Money rules and the level of regulatory requirements varies between jurisdictions. It should be a fundamental part of the greater compliance function at hedge funds though if only for the purpose of reputational considerations. No one really wants to be associated with handling dirty money and it’s always good idea to know who you’re dealing with, right?

Considering the different regulatory frameworks, it is difficult to provide an exact overview of what is needed but there are some general guidelines that are applicable across the world. Client or Investor (depending of how you would think of the people putting their money in your fund, but let’s settle for investors) Due Diligence not only relevant for new investors but for existing ones as well as verification should be an ongoing process, especially since situations and the origins of investor’s funds can change dramatically.

So, while the requirements also depend on the kind of fund and subsequently differ, there are two key objectives of each due diligence exercise: a) the identification and verification of the identity of the investor and, in particular, the beneficial owner; and b) finding out of the purpose of the investment.

The appropriate level of drilling an investor for information is, in the absence of specific rules of a certain jurisdiction, guided by the 4 R’s:

  1. Investor Risk: what kind of investors are we dealing with? If we’re talking financial institutions or otherwise regulated or public companies, the investor risk generally is lower as opposed to complex and non-transparent organisations like trusts, foundations or other private investment vehicles that carry a higher risk of money laundering;
  2. Condition Risk – What does the structure of my own fund looks like, i.e. does it contain a higher risk of money laundering and terrorism financing? This depends on factors such as redemption times or the size of investments;
  3. Country Risk – Naturally, investors from high risk jurisdictions carry a higher risk and require stricter due diligence, but the origin of the fund also contributes to the transparency of the investment flow. If it is in the same jurisdiction as the investor, the risk of money laundering is normally lower as compared to cross-border dealings, especially in the case of multiple jurisdictions;
  4. Value Risk – The amount of any investment and any restrictions on methods of payment of subscriptions impacts the level of risk.

In any case, each of these aspects requires an analysis of the specific situation of a fund, but it serves as an overview of the general principles in terms of due diligence.

On the subject of anti-money laundering, an appropriate AML program needs to developed in accordance with the specifics of the respective hedge fund. Aspects of relevance include the nature and location of investors, relationships with third parties, and applicability of AML rules in jurisdictions the fund has dealings with. The basic requirements for a sound structure include a) a designated compliance officer; b) the development of internal policies, procedures and controls that support the structure effectively; c) an appropriate record keeping process; d) ongoing training of employee; and e) the independent auditing of programs and recordkeeping

2) Risk Management

Risk Management is essential for any investment activity and consists of a number of areas though the following list is not conclusive and depending on the respective structure needs to address other areas as well: Liquidity Risk, Market Risk, Credit Risk, Operational Risk, and Legal and Compliance Risk.

For the purposes of this article, it is the last of these areas that is relevant and any hedge fund should adopt a compliance manual consisting of compliance policies in key operational in key operational areas to seek as to seek to mitigate the risk of regulatory non-compliance. Such a manual can address all fields of relevance and the range of policies that it includes could cover the following non-conclusive list of subjects: portfolio management process, trading and brokerage, fees, valuation, disclosures and risk assessment, insider trading prevention, client assets, marketing, media relations, use of third party service providers, privacy and data protection, business continuity, record keeping, communications, conflict-of-interest, complaints, rumours, etc.

3) Conduct of Business and Governance

The area of conduct of business and governance covers the entire range from a firm’s culture of compliance and code of ethics, but specific dealings and business practices. At its core sits again the compliance manual and the policies it contains. Equally important to outlining the rules and guidelines for the management of the organisation is the constant education of all staff.

Any measures in terms and relating to trading and business operations need to address aspects such as conflicts of interest, transparency, best execution, and insider trading to name some factors.

4) Monitoring, documentation, and reporting

To an extent inherent to the first three sections are the main ongoing activities of a compliance function. This means that the compliance officer needs to continuously Monitor the operations of the fund and have effective controls in place that alert the officer of any breaches of set parameters. The compliance function needs to ensure the appropriate documentation of all relevant activities. And lastly report all relevant and required information to the authorities. Again the specifics will differ depending on the structure of the fund and the respective jurisdictions.

The culture

While these for sections form the backbone of any efficient compliance program, it is important to mention that to achieve the objective of any such program, i.e. the protection of an organisation with regards to reputational and regulatory risk, the full support of senior management is paramount to its success. While a compliance program can produce the best policies and controls, the right compliance culture often goes way further.