Hedge Fund Compliance: Essentials for Fund Managers in 2024

The world of hedge fund compliance is constantly evolving, with new regulations, enforcement actions, and best practices emerging every year. In June 2019, the SEC announced a $5 million penalty against a Colorado-based hedge fund manager, Deer Park Road Management Company LP, for compliance failures related to the valuation of fund assets. 

The firm’s chief investment officer (CIO) also agreed to pay a $250,000 penalty.

This case underscores the critical importance of robust compliance policies and procedures for hedge funds, particularly in areas like valuation and pricing. As we look ahead to 2024, it’s clear that the regulatory landscape will only continue to become more complex, with increased scrutiny from the SEC and other agencies.

In this guide, we’ll dive into the essentials of hedge fund compliance, including key regulations to be aware of, reporting requirements, administration considerations, and best practices for staying on the right side of the rules in the coming year.

Hedge fund compliance refers to the policies, procedures, and systems that funds must have in place to ensure adherence to applicable laws, regulations, and industry standards. Compliance professionals ensure that their firm is in compliance with U.S. federal laws such as the Investment Advisers Act of 1940, Securities Act of 1933, Securities Exchange Act of 1934, and the Dodd-Frank Act, as well as state and local regulations.

There are several key hedge fund regulations that managers must navigate in order to maintain compliance. Here are some of the most important ones:

Investment Advisers Act of 1940

The Investment Advisers Act requires hedge fund managers with over $100 million in assets under management to register with the SEC as investment advisers. Registered advisers are subject to periodic examinations and must maintain detailed records of their activities.

Dodd-Frank Wall Street Reform and Consumer Protection Act

Passed in the wake of the 2008 financial crisis, the Dodd-Frank Act imposed new registration and reporting requirements on hedge funds. It also introduced the “Volcker Rule,” which restricts banks from engaging in certain speculative investments, including hedge funds.

Foreign Account Tax Compliance Act (FATCA)

FATCA requires foreign financial institutions, including hedge funds, to report information about U.S. account holders to the IRS. Failure to comply can result in significant penalties and withholding taxes.

Alternative Investment Fund Managers Directive (AIFMD)

This E.U. directive seeks to harmonize the regulatory framework for alternative investment funds, including hedge funds. It imposes strict requirements regarding transparency, risk management, and depositary liability.

Hedge funds must develop robust compliance policies and procedures to stay compliant with these and other regulations. This includes implementing strong internal controls, conducting regular compliance training for employees, and maintaining meticulous records of all activities. 

Funds should also stay up-to-date on regulatory changes and guidance and seek the advice of experienced compliance professionals when needed.

In addition to adhering to broader regulations, hedge funds are subject to various reporting requirements. These include:

Form P.F.

Registered investment advisers with at least $150 million in private fund assets under management must file Form P.F. with the SEC. This form collects detailed information about the fund’s investment strategies, counterparty credit risk exposure, and other key metrics.

Form ADV

Registered investment advisers must file Form ADV annually, which discloses information about the firm’s business practices, ownership, clients, employees, affiliations, and any disciplinary events.

Form D

Hedge funds that are exempt from SEC registration under Regulation D of Section 3(c)1 must file Form D electronically to provide details about the offering and the securities being sold.

To streamline the reporting process, many hedge funds are turning to specialized compliance software solutions. These tools can automate data collection, flag potential issues, and generate the necessary reports for filing with regulators. However, ensuring that any software is properly configured and integrated with the fund’s other systems and processes is important.

Effective hedge fund compliance administration requires a combination of skilled personnel, robust processes, and cutting-edge technology. Here are some key considerations:

Hedge Fund Compliance Technology

Technology plays an increasingly important role in hedge fund compliance, from regulatory reporting software to cybersecurity tools. Funds should carefully evaluate their technology needs and invest in solutions that can help automate compliance tasks, monitor potential issues, and provide real-time visibility into the fund’s operations.

Cost of Compliance

The cost of compliance for hedge funds can be significant, with some estimates suggesting that funds spend anywhere from 5-10% of their operating budgets on compliance-related expenses. This includes salaries for compliance personnel, technology investments, legal fees, and other costs associated with maintaining a robust compliance program.

To manage these costs effectively, funds should look for ways to streamline their compliance processes and leverage technology to reduce manual effort. Outsourcing certain compliance functions to experienced third-party providers can also be a cost-effective option for some funds.

Are hedge funds required to be audited?

Yes, starting in 2024, hedge fund managers will need to conduct an annual audit. The audit will be performed by an independent public accountant who is registered with the company and subject to regular inspection by the PCAOB. There will need to be a separate audit for each individual fund.

Are hedge funds regulated by the SEC?

Unlike mutual funds, hedge funds are not required to register with the SEC. This means that hedge funds are subject to fewer regulatory controls than registered investment companies. However, hedge fund managers may still be subject to SEC oversight if they meet certain criteria, such as having over $100 million in assets under management.

Who else regulates hedge funds in the USA?

In addition to potential SEC oversight, many hedge funds operating in the U.S. are regulated by the Commodity Futures Trading Commission (CFTC), including advisers registered as Commodity Pool Operators (CPO) and Commodity Trading Advisors (CTA). Funds may also be subject to state-level regulations.

Do hedge fund managers need to be licensed?

A hedge fund manager does not necessarily need a specific license to operate a hedge fund, unlike any other type of investment fund. However, depending on the fund’s investment activities, a portfolio manager may find it necessary or helpful to obtain certain licenses, such as the Series 7 or Series 65.

To ensure that your fund is meeting all of its compliance obligations, it’s helpful to have a comprehensive compliance checklist. This should cover areas such as:

• Registration and reporting requirements
• Policies and procedures for trading, valuation, and risk management
• Employee training and oversight
• Cybersecurity and data protection measures
• Business continuity and disaster recovery planning
• Third-party service provider due diligence
• Recordkeeping and document retention

By regularly reviewing and updating your compliance checklist, you can identify potential gaps and ensure that your fund is meeting its obligations.

For many hedge funds, particularly those with limited in-house compliance resources, working with experienced compliance consultants can be a valuable investment. These firms can provide expert guidance on regulatory requirements, help develop and implement compliance programs, and offer ongoing support and training.

Some reputable hedge fund compliance consultants to consider include:

• ACA Group
• Aspect Advisors
• Cipperman Compliance Services
• Cordium
• Mitch Avnet Compliance
• Repool (offering fund formation and structuring support, KYC/AML compliance, and more)

When selecting a compliance consultant, look for firms with deep expertise in the hedge fund industry, a track record of success, and a proactive approach to staying ahead of regulatory changes.

In today’s complex and ever-evolving regulatory environment, compliance is not just a box to be checked but a critical component of any successful hedge fund’s operations. Non-compliance can result in severe consequences, from hefty fines and penalties to reputational damage and investor redemptions.

By investing in the right people, processes, and technology and staying vigilant in the face of new requirements and risks, hedge funds can build a culture of compliance that protects their interests and those of their investors. This includes budgeting adequately for compliance costs, staying abreast of regulatory developments, and being proactive in addressing potential issues before they escalate.

As we look ahead in 2024 and beyond, it’s clear that the focus on compliance will only continue to intensify. Hedge funds that prioritize compliance and make it a core part of their business strategy will be best positioned to navigate the challenges and opportunities of the future. Don’t wait until it’s too late – start building a robust compliance foundation today.