SAC Capital: What now for hedge funds?

Categories: 
Legal
26 Jul, 2013

The on-going soap opera that is SAC Capital shows no sign of abating. In the last 10 days, the multi-billion dollar hedge fund has been indicted by the FBI and US Attorney’s office in Manhattan on charges of insider trading, while the Securities and Exchange Commission (SEC) filed civil charges against the firm's eponymous founder Steve Cohen for failing to properly supervise his employees.

One prime broker, speaking anonymously, said US authorities were hell-bent on making an example of SAC Capital, a hedge fund whose success has sparked envy (and indeed suspicion) among its competitors. Some in the industry complain the US government’s case against SAC Capital is akin to a witch-hunt, although nearly all experts concur the firm suffered from serious compliance shortcomings in the run-up to 2010. The fate of SAC Capital remains unknown although redemptions have been substantial, and there is debate whether the hedge fund will convert into a family office managing just internal cash. 

Fortunately for managers, investors will probably view this case as a one-off and their appetite for hedge funds will remain strong going forward - a recent Credit Suisse study revealed 88% of investors plan to increase their exposures to hedge funds throughout the rest of the year, for example. Despite this, investor support is not guaranteed and managers are going to have to brace themselves for more questions from regulators, particularly if their prosecution of SAC Capital is successful. 

The SEC, courtesy of Forms ADV 1 and ADV 2, not to mention the highly forensic Form PF, has huge swathes of information about hedge funds now. Whether or not they digest this data effectively is yet to be determined, although the SEC has made it no secret it has bolstered its technology infrastructure and staffing to cope with this additional workload, in what is likely to precipitate further intrusion into hedge funds' business practices.

Coinciding with regulatory reporting is the JOBS Act, a piece of legislation which will now enable hedge funds to market and advertise publicly. Permitting general solicitation among hedge funds has proved divisive at the SEC, and regulators are certain to take greater interest in any hedge fund putting their head above the parapet.

In light of this regulation, and the authorities’ actions pertaining to SAC Capital, managers will now have to redouble their efforts to ensure their operations are above board. The most obvious is by improving compliance, something SAC Capital, according to its detractors, achieved too late.

A zero tolerance policy of traders falling foul of the rules is not enough. Hedge funds will have to make sure compliance manuals are fully abided by, rather than gathering dust on a bookshelf, and force employees to attend compliance training and best practice workshops regularly.

Nevertheless, most hedge funds appear to have upped their ante on compliance over the last few years, and this is not only to appease regulators baying for blood, but their clients too. Institutional investors cannot afford to be exposed to a hedge fund where compliance is peripheral.

In fact, a survey of operational due diligence professionals at institutional investors by Deutsche Bank revealed unsatisfactory compliance policies and procedures at hedge funds was the second most common reason for failing managers, putting it marginally behind substandard operational infrastructure and technology.

Nearly three quarters of Deutsche Bank’s respondents confirmed regulatory compliance was their top priority over 2013, although given the influx of regulation, this should not be a surprise. The groundswell of regulation has also prompted operations teams to appoint more professionals with legal and compliance backgrounds, which again should serve as impetus to hedge funds that they take compliance seriously.

The bygone era of operational due diligence teams being subservient to their counterparts in investment due diligence is over. Seventy per-cent of operational due diligence teams now have explicit veto authority over any investments and this was exercised in 10% of manager reviews in 2012.

In this environment, compliance at hedge funds cannot be treated as an afterthought otherwise managers will find themselves with very little capital to manage. 

Tags: 
SAC CapitalSECFBIForm PFForm ADV 1Form ADV 2JOBS ActDeutsche Bank

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