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Hedge Funds Face Massive Transformation

As they prepare to comply with new and more stringent rules, hedge funds must align their technology and processes to provide the transparency demanded by regulators and investors alike.

Since the Madoff scandal and the unraveling of the credit markets, few financial players have been more publicly vilified than hedge funds. With the general outcry against hedge funds' often-secretive practices ringing in their ears, regulators have been scrutinizing the industry that, at its peak in 2007, had more than $2.1 trillion in assets under management but has since shed $700 billion in assets and seen multiple funds close shop as fearful investors have fled for seemingly safer vehicles, according to research from TABB Group.

Today, however, the hedge fund industry is making a comeback. Fund managers once again seem bullish. Despite all of the headlines purporting hedge funds' greed and evil intentions, investors are returning, and assets are expected to climb back to nearly $2 trillion by the end of the year, says TABB's Matt Simon, who recently authored a report on the state of the industry.

Still, hedge funds face a massive transformation as regulators prepare to slap new and more stringent rules on fund managers. Hedge fund managers should anticipate that they will need to register with either the SEC or at the state level in the near future, says Lance L. Friedler, a partner at New York-based law firm Sadis & Goldberg.

"The general consensus is that hedge fund managers with assets under management of greater than $150 million will likely have to register at the SEC level, and those with less may have to register at the state level," Friedler reports. "If registration is required, hedge fund managers would need to build out a compliance infrastructure that is SEC- or state-compliant, which would include having written compliance policies and procedures and personnel to carry out such policies and procedures."

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A Transparent Future

While much uncertainty remains around the specifics of new regulations, their intentions are certain: to create greater transparency for both regulators and investors. "Hedge funds will need to disclose more about their trading practices, and will have to record trades and have a system in place to reasonably tell them what funds did the day before, what and how much they traded, and that they carefully examined risk," says TABB's Simon.

Even small hedge funds, which likely will not be required to register with the SEC, may want to consider the benefits that would come with registering and complying with new transparency rules, Sadis & Goldberg's Friedler suggests. "The benefits for smaller managers being SEC-registered would be, first, the potentially greater ability to raise assets from institutional investors; second, the ability to publicly market their advisory services -- although the private funds they manage still must be privately placed; and third, potentially more flexibility in managing assets, ... such as corporate pension and 401(k) assets to the extent the manager also qualifies as a qualified professional asset manager," he explains.

John Wolfe, managing director at Harmonic Fund Services, a specialized global hedge fund administrator, points out that investors are already pushing hedge funds to upgrade their technology and better define systems and business processes. "Since the credit crunch, the hedge fund space has become much more investor-driven," he relates. "Excel is no longer acceptable as an institutional technology platform. Investors want better reporting and transparency."

A Chief Concern

According to the chief compliance officer of a $9 billion hedge fund, who was speaking in an off-the-record forum at the Financial Technologies Forum's 3rd Annual Hedge Fund Operations & Technology conference in New York in April, hedge funds should prepare for this transparent future by first hiring their own CCOs. "Some may be tempted to attach this role to the CFO, but that's not a good idea, as it's a heck of a lot of work," she said, explaining that funds no longer can rely on standard templates for compliance manuals.

Instead, companies need to put in place solid policies and procedures that can withstand an examination from the SEC, whose tolerance for wrongdoings or lax procedures is widely deemed to be at an all-time low. And it is not enough to just outline these policies. Hedge funds must make sure they review their policies at least annually and update them in order to make sure they remain relevant to their business, experts say.

But compliance programs are expensive -- and on the heels of broad budget cuts, many smaller funds are shying away from buying technology before they know exactly what regulations are forthcoming, according to TABB's Simon. One New York-based hedge fund manager speaking at the Financial Technologies Forum notes that total compliance costs for his firm can easily reach $1 million to $2 million annually.

Melanie Rodier has worked as a print and broadcast journalist for over 10 years, covering business and finance, general news, and film trade news. Prior to joining Wall Street & Technology in April 2007, Melanie lived in Paris, where she worked for the International Herald ... View Full Bio

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