Money, Securities Law

Finance And Law: Compliance Is A Growing Problem At Hedge Funds for Managers & Investors

Compliance issues are a serious problem for hedge fund investors even if the investor can be guaranteed that no activities at the fund will ever rise to the level of fraud.

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iStock_000013298318SmallHedge funds generally only make the news for one reason; fraud. Now, that is not to say that most hedge funds are perpetrating a fraud. They are not. Nor is fraud exclusively the territory of hedge funds. But the mundane world of finance is not the type of riveting action that generally makes the nightly news.

Nonetheless, investors and attorneys representing them should be aware of the potential for problems at hedge funds that do not rise to the level of fraud, but which do still harm investors. Broadly speaking, these types of structural problems at a fund can be termed compliance issues. Across the hedge fund arena, regulatory scrutiny is increasing from the SEC and a major reason for this increased scrutiny is compliance failures by many hedge funds.

Compliance issues at funds can arise from many sources; cherry picking issues, side-by-side management, undisclosed compensation, incentive fee structure, and more. The US Securities and Exchange Commission is increasingly taking a closer look at these kinds of issues. I recently led a series of executive education training sessions related to these compliance problems and was surprised to find that many participants initially were not aware of the potential for these conflicts of interest.

Compliance issues are a serious problem for hedge fund investors even if the investor can be guaranteed that no activities at the fund will ever rise to the level of fraud. In particular, any conflict of interest at a hedge fund can often lead to underperformance of the fund because of distortions of incentives for management.

Hedge funds are often structured as limited partnerships wherein the general partner contributes some cash but mostly large amounts of sweat equity. The general partner also has substantial control over the assets of the limited partners as well as almost complete discretion over the investment decisions of the overall organization. In order for this type of situation to work effectively for the limited partners, incentives have to be carefully managed.

Hedge fund operators should receive very little salary and instead mostly be compensated through bonuses based on performance. Hedge fund managers also should be required to disclose any type of outside compensation they receive such as commissions for steering assets towards certain asset managers. In addition, hedge fund managers should be required to treat all investors on par with one another when it comes to redemptions or allocations to promising new investments.

Similarly, another major issue that is becoming increasingly common at many hedge funds is side-by-side management. This term simply refers to hedge funds managing funds in parallel with one another, especially 1940 Act compliant mutual funds and more free-wheeling non-40 Act funds. Managing these funds side by side can lead to muddled incentives and favorable treatment for the non-40 Act funds which often include performance incentives versus the traditional 40-Act compliant funds. Recent studies have shown that these types of arrangements significantly short-change investors in the mutual fund vehicles with consistent and significant underperformance over time. In some groups of funds, that underperformance averages as much as 5% annually.

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The new complications and scrutiny regarding compliance are a key reason why many hedge funds are now forming dedicated compliance teams. Sometimes these teams are internal to the fund, sometimes they are external, but they are a critical protection for investors either way. The same thing holds for auditors and valuation agents. These parties need to be truly independent of the hedge fund to be effective, and ideally they should be rotated every few years.

Failure to deal effectively with potential compliance issues hurts both investors and the hedge funds themselves. Investors are hurt by underperformance which saps their investments of expected appreciation. Hedge fund managers and the firms themselves are also hurt because these compliance problems expose them to the risk of lawsuits and potentially deters new investors in the fund. For attorneys dealing with hedge funds either representing the fund itself or investors in the fund, special attention to compliance issues is warranted and prudent for all involved.

Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at M.McDonald@MorningInvestmentsCT.com.

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