Fund managers have got over their anxiety about completing and submitting Form PF. Two years on from the first submissions it has become relatively routine. But the quiescent regulator may signify only that it has yet to work out what the contents of Form PF are actually saying about the state of the industry.
The introduction of Form PF (Private Fund) reporting in 2012, as mandated under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), requires private funds such as hedge fund managers to submit detailed information on their businesses to the Securities and Exchange Commission (SEC). The rationale behind this is that the SEC will subsequently pass this data to the Financial Stability Oversight Council (FSOC), the body charged with monitoring systemic risk in capital markets.
The idea of Form PF was greeted with indignation by hedge fund managers. They argued that they had nothing to do with the great financial crisis, and were already struggling with surging compliance and operational costs imposed by institutional investors, at a time when management fee income was being squeezed and performance fees were being reduced by lacklustre returns.
The Cost of Compliance, a study in October 2013 of 200 managers conducted by the Alternative Investment Management Association (AIMA), the Managed Funds Association (MFA) and KPMG reckoned the average spend on compliance had hit $700,000 at small managers; $6 million at mid-sized firms; and $14 million at large-scale houses.
Form PF is only one component of those costs. It resonates with managers because it marks a reversal of the defeat of earlier efforts by American regulators to increase the level of disclosure by hedge funds. A 2006 attempt by the SEC to force hedge funds to register as investment advisers was defeated in the courts by Phillip Goldstein, a hedge fund manager at Opportunity Partners.
Success for the SEC would have obliged managers to complete Form ADV Parts 1 (business, ownership, employees, and disciplinary events) and 2 (fees, personal backgrounds, conflicts of interest). Post-crisis, hedge funds with more than $100 million in assets under management (AuM) or ten United State-based investors, must register with the regulator as investment advisers, forcing them to complete Form ADV. Firms with less than $100 million fall under the remit of state regulators. Only sub-$25 million hedge funds are exempt from any reporting and registration obligations altogether.
Compiling and collating the necessary data for Forms ADV 1 and 2 has been a straightforward exercise. Registration with the SEC was even welcomed by AIMA, which acknowledged mandatory registration would provide an aura of legitimacy to an industry long criticised for being opaque and perceived to be unregulated. Form PF, introduced by Dodd-Frank, has presented managers with sterner challenges. Hedge funds managing in excess of $1.5 billion in AuM are required to submit the data requested in Form PF to the SEC no later than 60 days after the end of each quarter. Funds managing between $150 million and $1.5 billion must submit Form PF on an annual basis. Firms with less than $150 million in AuM are exempt.
These thresholds represent a marked improvement on what was originally envisaged by regulators. In October 2011, the SEC voted to increase the AuM threshold for quarterly reporting from $1 billion to $1.5 billion and from $100 million to $150 million for annual reporting. This reprieve for quarterly reporters fell short of the minimum $3 billion or even $5 billion threshold some industry participants asked for, but it was welcome nonetheless.
The SEC had also previously demanded data be submitted 15 days after the end of each quarter, a timescale deemed unworkable by managers and service providers at the time. Many argued – successfully – to the SEC that it would be nigh-on impossible to attain a rapid turnaround of complex, detailed information in such a tight time-frame. The regulator was warned that a rushed data collection process could result in the SEC being inundated with inaccurate filings.
“The original proposals for Form PF, which included fairly tight filing deadlines have been softened,” says Robert Mirsky, global head of hedge funds at KPMG in New York. “While Form PF is by no means a walk in the park, this concession from the SEC was much welcomed by the hedge fund industry.”
One reason it was welcome is that Form PF obliges managers to address some 3,000 data points, including exposures by asset class, counterparties, geographical concentrations, leverage, risk profiles, details of investors, liquidity terms, strategies, turnover by asset class, stress test results and Value at Risk (VaR). “There is a significant amount of data that needs to be collected and collated,” acknowledges Blair Henderson, head of business development at Mitsubishi UFJ Fund Services in London. “It was certainly a struggle for managers first-time round.”
The first firms obliged to file Form PF certainly did struggle. Calculating Regulatory AuM (RAuM) as required in Form PF did not conform with the methodologies employed to calculate standard AuM. The SEC interpreted RAuM as gross AuM, which incorporated leverage. A manager running $1.1 billion in AuM, for example, might have assumed they were exempt from quarterly findings, only to find the leverage in their portfolio pushed them over the $1.5 billion threshold.
This inconsistency was evident in data published by the SEC in the summer of 2013, which stated that SEC-registered hedge funds managed in excess of $4 trillion – a figure far in excess of the $2.7 trillion figure put out by Hedge Fund Research, the Chicago-based data provider. One chief compliance officer whose multi-billion dollar hedge fund internalised its entire Form PF compliance, speaking just after the first filing by the firm to the SEC, said the submission process took approximately 100 man-hours, or two and a half times a normal working week.
The SEC was, however, praised for offering financial institutions guidance through comprehensive Frequently asked Questions (FAQs) and responding in a timely fashion to industry comments and criticisms. The SEC was also commended in some quarters for permitting managers to adopt their own methodology in terms of calculating the required Form PF data, although this was contingent on managers providing explanations as to how and why they used their chosen methodologies.
Others, however, rued the initial lack of guidance and clarity from regulators. “The SEC tacitly acknowledged no single hedge fund was the same so the regulator was ambiguous in what it asked for, leaving Form PF open to much interpretation,” says Jonathan White, head of business development at Viteos in New York. “This was a challenge. Managers were asking themselves, ‘How do we answer these questions?’ or ‘How far out of the box can we go when making an interpretation?’ A lot of managers at the time were in a vacuum wondering how the majority of their contemporaries were answering and interpreting Form PF. We just told our clients to be open and transparent. We told managers to compose Form PF in a way they saw fit from a methodological point of view, although we stressed they needed to highlight to the regulator how they reached the calculations they wrote into Form PF.”
Ian Shaw, managing director for the alternative investment services business at BNY Mellon, confirms this experience. “The biggest challenge has been trying to standardise the calculations and answers,” he says. “Each client wants to portray themselves slightly differently and has different interpretations as to what the answers should be.”
Others go further, with some managers reportedly struggling to identify the type of private fund they actually were in Form PF. “Some of the definitions used in Form PF, including the definitions of private fund types such as hedge funds and private equity funds, did not correspond with managers' views of their businesses or the marketing of their funds. Consequently, many firms were forced to classify certain private equity or real estate vehicles as hedge funds because of the funds' abilities to employ leverage or short securities, and therefore became subject to hedge fund style reporting,” says Grant Lee, director at PricewaterhouseCoopers (PwC) in London.
Subsequent filings have proven less onerous. A chief operating officer at one of the largest hedge funds in New York says he now devotes two thirds less time to Form PF than what he did when he first filed in June 2012. “Filing Form PF has become more streamlined as managers adapt to the entire process,” says Mirsky of KPMG. “Many managers tried to internalise the entire Form PF data collection process, which was expensive and time-consuming. However, a growing number of service providers – be they accounting firms, hedge fund administrators, technology vendors or regulatory compliance consultancies – are now offering outsourced services to help managers. We are seeing an increase in the use of outsourced services to help managers. Obviously managers must still keep a clear line of sight over what these providers are doing as they remain responsible for the information submitted to the SEC. However, it does help relieve significant pressure.”
At Mitsubishi UFJ, Blair Henderson agrees. “Like with many regulatory reports, Form PF filers have broadly gotten to grips with what the SEC expects of them,” he says. “Many hedge funds now have clearly thought-out and well-articulated business plans to deal with Form PF. A number of firms had previously completed the Form PF exercise in-house but are now electing to outsource to service providers, which can aggregate all of the necessary data from different service providers, and put it into a uniform format for the manager to submit to the SEC.”
Nevertheless, challenges remain. Collecting all of the data from multiple service providers continues to be awkward. Fund administrators do not possess all of the necessary data to complete Form PF, so managers cannot excuse themselves from the process any more than they can escape liability for its accuracy and timeliness.
The SEC is also conducting more on-site inspections at fund managers, and has warned firms they will be focusing on five key compliance areas: marketing, portfolio management, conflicts of interest, safety of client assets and valuation. Specifically, the SEC is assessing whether what it finds out tallies with what managers have told the regulator in Form PF.
“The SEC is putting a lot of its focus on comparing Form PF with marketing data published by hedge funds,” says one manager. “As was to be expected, the SEC is focusing a lot of its resources on the larger managers. The SEC wants to ensure there is consistency between what managers are reporting to the regulator and what they are reporting to their underlying investors.”
It is highly probable that the SEC will demand data not just from Form PF, but also from Form CPO-PQR, which is submitted to the National Futures Association (NFA), a self-regulatory body and then passed onto the Commodity Futures Trading Commission (CFTC), and from the Annex IV reports submitted to European regulators under the Alternative Investment Fund Managers Directive (AIFMD). This is despite rising anxiety in Europe about the security as well as the purposes to which American regulators apply European data. The SEC may even ask to look at data reported to investors via Open Protocol Enabling Risk Aggregation (“Open Protocol,” formerly known as OPERA), the risk reporting toolkit developed by Albourne Partners.
It follows that fund managers must ensure overlapping data points contained in these multi-jurisdictional and multi-agency reporting documents are consistent, or it will invite further scrutiny. That means checking RAuM numbers, notional values of derivatives, counterparty risks and portfolio exposures to ensure they are reported consistently to all regulators.
Actually achieving consistency could prove impossible. The SEC and CFTC, for example, give managers some discretion to use their own risk reporting methodologies whereas Annex IV and Open Protocol are more prescriptive in what they ask for. This could lead to data mismatches across the various reports.
Quite what the SEC will do with all of the data it receives is the subject of cynical speculation. By the time the SEC and the FSOC have digested the data, it will be many months out of date. However, the SEC is expanding. A study by Kinetic Partners in 2014 found the regulatory agency had increased its expenditure by 62 per cent and its headcount by 22 per cent since 2006. Despite the extra resources, there is serious doubt that the SEC can process the data in a useful and timely fashion, especially since its technology is somewhat antiquated.
Some observers reckon the SEC could alter certain aspects of Form PF. The precise nature of what will be altered remains unclear, and any reform of Form PF is unlikely to be prompt. “As Form PF and other global regulatory reports become bedded down, it is highly likely there will be an evolution in how the forms are filed,” says one expert. “It is essential therefore that managers future-proof their systems and ensure their service providers do so as well, because new regulation and reporting requirements will be implemented down the line.”
After some initial difficulties, American fund managers appear to be handling Form PF successfully. As one forward-thinking service provider prophesised back in 2012, when anger and anxiety about the implications of Form PF were at their peak, most managers will simply find it straightforward once they are familiar with the entire process.