Investors warming to outsourcing compliance but regulatory challenges remain, says KPMG

22 Oct, 2013

Institutional investors, historically wary of managers outsourcing their operations, are increasingly recognising the benefits of outsourcing regulatory compliance as the costs of these global rules continue to mount on small to mid-sized hedge funds, although managers need to be careful about how much work they externalise in light of the UK Financial Conduct Authority’s (FCA) “Dear CEO” letter, a senior executive at KPMG has said.

“Institutional investors are becoming increasingly sophisticated and allocating into smaller managers, which do not necessarily have the infrastructure to handle all of the regulatory reporting requirements internally. A number of these managers are therefore outsourcing reporting to technology vendors or fund administrators.  Investors, which traditionally would have been averse to outsourcing are tolerating it providing the managers are in control of the process,” said Robert Mirsky, global head of hedge funds at KPMG in London.

However, managers still need to be careful about the nature of their relationships with these providers. In 2012, the Financial Services Authority, the precursor to the FCA, warned asset managers in a letter to the top fund management houses in London about outsourcing activities, with a particular emphasis on regulated activities or activities deemed “critical and important” to regulated activities. It also advised managers have measures in place to safeguard their operations in the event of a service provider failure.

“I think we need to be aware though that the regulator through its “Dear CEO” letter is interested in how managers are outsourcing, so managers need to be very careful about how and to whom they outsource functions,” commented Mirsky.

A Deutsche Bank survey in July 2013 of 68 institutional investors globally with $2.13 in assets revealed 66% of allocators will tolerate managers outsourcing the compliance function. The study highlighted the emergence of specialist compliance consultancy firms and increased quality of these service provider offerings were the key drivers for this growth.

The cost of internalising regulatory reporting, particularly at smaller hedge funds, would be prohibitively expensive.  A study – The Cost of Compliance – conducted jointly by KPMG, AIMA and the Managed Fund Association (MFA) last week found more than a third of managers running less than $250 million in assets said their compliance spend alone accounted for over 10% of their total operating costs. 

“Investors recognise they are chasing returns, and they want managers to manage their money, and not spend all of their time building sophisticated reporting technology and infrastructure. This is why we are seeing more outsourcing and more investor tolerance of it. Investors are cognisant smaller managers thrive on efficiency and carrying out regulatory reporting in-house would hurt those managers, particularly given how high the barrier to entry has become,” commented Mirsky.

The costs are likely to increase for managers once AIFMD reporting comes into play. While the KPMG/AIMA/MFA study said US managers spent more on average on regulatory compliance, Mirsky said this was unlikely to be a long term trend.

“North American managers have been compiling Form PF and Form CPO-PQR which of course has eaten into their budgets. European managers have not yet started filling in their AIFMD reports, but once they do I expect expenditure on regulatory compliance will grow significantly for those fund managers. Furthermore, the cost is likely to be higher for European fund managers than US firms as European firms are often subject to US rules where US firms may not be subject to European rules as AIFMD only applies if a manager is actively marketing to EU investors through private placement,” said Mirsky.

The workload at hedge funds has increased exponentially since the onslaught of all of these global regulations. A Deutsche Bank Markets Prime Finance poll in September 2013 of 44 hedge fund chief operating officers (COOs) with a collective AuM of $325 billion in the US and Europe, said almost a quarter of US-based COOs and 13% of European COOs were devoting 75% more time dealing with regulatory issues. That same study said the average COO spent 50% more time handling compliance, legal and regulatory issues.