Top 6 lessons learned from clients who have been through an SEC Audit

In line with our new tag line, “Don’t be a Target”, FinServ would like to provide some insight we have gained from our clients who have had the unfortunate experience to go through an SEC Audit. In many conversations we have had with our clients over the past year the concern of an audit has been on the top of many of their minds. Many have gone thru mock exams or SAS 70 Type II testing. Here is what we hope is a list of helpful hints if you have to go through this process.

1. Resist the Temptation to Educate the Audit Staff – The auditing staff just like any audit team will undoubtedly be staffed by a group of very junior inexperience yet intelligent team of staffers. However you should resist the maternal or paternal instinct to educate these individuals. Remember they have a job to do which is to uncover issues in your financials or trade history. You should answer specific questions that the staff has about the information you provide them but resist elaborating or providing lectures on various tangential topics.
2. Educate your Employees – A large part of the audit will focus on your policy and procedures and whether the team actually follows them. It is critical that in advance of the audit you ensure that your policy and procedures are up to date and that all employees have reviewed them and are familiar with the policies and procedures that apply to their area.
3. Accept the fact that they will be with you for a while – You should avoid trying to take steps to attempt to rush the auditors. You must remember first and foremost that these workers likely have no specific deadline for finishing your audit and they are not overly motivated to work extra hours so expect them to work 9 to 5 each day and be with you for a while. The best tact you can take to getting them out as quickly as possible is to provide the information they request in a quick and well organized manner. Again only providing exactly what they ask for. Having systems that can provide custom reports is critical so you are not spending hours on end attempting to modify excel files. Reports that come from a specific data source will appear much more reliable than you providing them with excel files as well.
4. Plan now for a major drain on your key staff members – If you don’t have a fully automated set of systems that can produce all the possible requests at a moment’s notice (and very few people do) you need to plan ahead so you can keep the lights on with your critical operations as the auditors drain your teams time.
5. Be Well Prepared – When you receive the notice that you will be audited you should be as prepared as possible for the team arrival. Hopefully you have the systems in place to produce the data they are most likely going to request (especially a strong portfolio management system). However if you don’t the best thing to do is start dedicating your internal team’s time to getting this data well organized and together as quickly as possible. No one ever said I wish I wasn’t so prepared, but plenty of people have said I wish I was more prepared.
6. Don’t give them a closet to work in – Avoid the temptation to try to place your auditors in the most uncomfortable location possible. While this may seem like a great idea and you may think this will motivate them to leave as soon as possible. The reality is as noted before they are with you for a specific purpose and cannot leave before that job is done. Providing them with

In addition we are linking a sample SEC Exam Documentation Request List to give you an idea of what they will be asking for some highlights our clients mentioned include:

http://www.finservconsulting.com/SECDocumentRequestList_Sample.pdf

1. Trade Data
2. Operational Data – Valuation & Supporting Workpapers
3. Reconciliations & Controls
4. Separation of Functions
5. Independence from your third party administrator (TPA)
6. Brokerage Data
7. Proof of Best Execution
8. Client Info (Value added, conflicts)
9. Corporate Record
10. List of Service Providers Paid
11. Confidential Agreement with Service providers
12. Political Donations

The Slippery Slope of Hedge Fund Regulation and Enforcement

In a recent Feb 26th Bloomberg article titled ‘Hedge-Fund Assets Offshore Exempt from Reporting Rule’, the Internal Revenue Service said “with respect to accounts for calendar year 2009 and earlier, U.S. investors don’t have to report large holdings (exceeding $10,000) in offshore hedge funds and private-equity firms this year under disclosure rules designed to detect offshore tax evasion and money laundering.”    

 This decision seems like a win for US Investors investing in Offshore Hedge Funds.  It allows the Investors to avoid the June 30th filing deadline that the Financial Crimes Enforcement Network (FinCEN) put forward and seems to allow the investors to completely avoid the penalties of having unreported Offshore accounts from 2009 and years prior.  

 Most Financial Institutions require all employees/consultants to undergo yearly Money Laundering courses; yet this IRS decision seems in direct violation of the Money Laundering courses designed to keep the Financial Industry honest and healthy. 

 Questions arise on this decision:  Is this decision just for this year as a means to extend the June 30th deadline? Or, is this a complete forgiveness for past Money Laundering transgressions?  Which is better?

 It would set a powerful precedence in the financial industry allowing other financial institutions to break loosely defined rules, like Money Laundering, and then not to pay any penalty and be forgiven one day, seemingly allowing dishonest financial practices without any penance. 

 Money Laundering does not usually hurt the Financial Institution that commits this act; instead it hurts other Financial Industries, US Interests, US Security and the Health of the overall US economy. Hopefully FinCEN will reassess this decision and will extend the deadline to a date past this year allowing individuals who have unknowingly committed Money Laundering to come forth and avoid the costly penalties and fees that may exceed their investments.  This will allow US Investors to follow a clearly defined set of rules put forth by the IRS and to have confidence in the Hedge Fund that they are investing in. 

 If FinCEN allows this decision to stand and by not extending the deadline to a date past this year, it will most likely have profoundly negative effects on the Hedge Fund Markets view of regulation and the regulatory authorities.  It would seem to weaken the Industry regulators by setting a precedent of allowing Financial Institutions to ignore loosely defined rules and endorse illegal investments, thereby weakening the IRS’s stand on enforcing/abiding by their own rules. Ultimately the cost may be that the US Investor will not be able to discern the important rules from the un-important rules causing them to possibly lose money or Assets in unsafe or illegal investments. 

It may seem counterintuitive, but we believe that the best regulatory environment for the hedge funds is one where the regulators are strong, well informed and work from a consistent set of rules, and level of enforcement. Without the presence of a strong group of well run regulators, the Hedge Fund Marketplace will continue to be dogged by the Madoff  effect. By that we mean that Hedge Funds will be devastated each time some scandal occurs in the industry, shaking Investor’s confidence in the Hedge Fund Market and seeing quick and large moves of money out of the industry.

At the end of the day, the Hedge Funds and the Investors rely on the markets and the regulators ability to determine a proper risk weighting on all Investments. For that reason we believe the IRS owes it to the Industry to ensure that this rule is defined clearly and proper time is allowed for members of the industry to receive forgiveness for unintentional violations.

 We look forward to the IRS final decision on this decision and the effects on the Hedge Fund Market Industry.

Tighter restrictions on Banks – Will Hedge Funds and Private Equity Funds Benefit?

Restrictions on big banks could boost possible benefits for hedge funds and private equity funds.  The Regulatory Reform package and other bills such as the “Volcker rule” could push investors from big banks towards their funds instead.  The Volcker rule is a plan to ban proprietary trading.  Another key element in the rule is to limit banks involvement with hedge funds and private equity funds.  The current Administration is not making sufficient efforts to limit the size and risk profiles of banks.  A goal is to stop Wall Street banks from gambling in markets with subsidized deposits.  This is good news for hedge funds and private equity funds.

Hedge Funds and Private Equity funds will definitely have a chance to absorb former bank investors when tighter restrictions are levied against the big banks.  Current bank investors will either get spooked from the new regulations or will be forced to seek other options because of new regulations.  This now gives hedge funds and private equity funds more potential investors and ultimately more power.  These investors will not hesitate to move to hedge funds and private equity shops outside of the big banks.  An investor’s main interest is to make money and are they willing to take the risks inherent with these types of firms.

The main impact will be proprietary trading.  Markets will become less liquid which in turn means wider spreads and higher costs for investors.  This may be something some investors feel is worth paying for – a safer banking system.  What will most likely happen are proprietary traders will move to hedge funds.

If hedge funds do not already have proprietary trading strategies, it would be wise for them to start getting into that business or increase their current proprietary trading desks.  Fund subscriptions are likely to increase.  Private Equity funds will also be able to take advantage if big banks are forced to dissolve or separate their private equity arms.  Private equity funds will most likely see an increase of investors to their funds.  Therefore, more money will start to flow into these funds that are leaving the banks.  The larger funds will get bigger and other small to medium sized funds will start to adapt and create new strategies in order to accommodate new investors and new positions.

During President Obama’s State of the Union address, he made a remark of how the bank bail-out was “as popular as a root canal”.  He vowed to take on lobbyists who are trying to stifle financial reform and that it is a fight he is willing to have.  For President Obama, bank bashing is good politics for him now especially after the bruising he has taken on Health Care reform. 

Previous financial reforms have had some unintended results.  Regulation Q was a reform that restricted the interest rate that banks could pay on deposits.  Many investors ended up in the Euromarket and with money-market funds where dollars were then accumulating outside of the US.  Enforcement of the Basel Rules was another example.  This was an incentive for banks to hold AAA rated securities which required less capital to be held against them.  Eventually, there was a shortage of AAA rated bonds.  The financial gurus then devised complex securities called collateralized debt obligations (CDO’s) based on sub-prime mortgages.  CDO’s did not have a happy ending. 

In conclusion, big bank reform will have benefits for hedge funds and private equity funds.  When investors move away from big banks, hedge funds and private equity funds will be sure to grow.  Investors will invest more in these funds where regulation is not as stringent yet.  This leaves one final question for the readers.  Will the unregulated hedge funds and private equity funds pose a financial systemic risk in the future that will cause regulatory authorities to second guess themselves if another financial crisis occurs in the future?  Only time will tell.   For the near term, hedge funds and private equity funds will be sure to capitalize on bank reform.

The Age of “Hedge Fund” Enlightenment – The Resurgence of Hedge Fund Operations (Part 1)

The hedge fund industry from 2004 to the middle of 2008 went through a huge boom period and as the funds became larger and larger; during this boom time the smarter funds began to realize that with size came complexity, and with complexity came risk. However, in often secretive and private world of hedge funds there was little regulation, and less general belief that investors would demand transparency.

In 2008, about half way through the year, all hell broke loose with the financial crisis. It seemed like in an instant, the hedge funds secret world had been destroyed as CDS’s and the hedge funds became the evil empire that had brought the world’s economy to the brink of collapse. It was unclear at that time, or even just a few months ago, how long the financial crisis would last? In addition, coming out of the crisis, it was unclear, how long the hedge funds would want to stay under the radar, and how soon it would be before they returned to profitability (able to reach their high water marks).

Fortunately, for most of the medium and large players it appears that time is at hand. Many of the smaller funds have either closed their doors or been folded into larger funds. With pending regulations, the price of entry for new funds will be much higher than in the past, creating a barrier to entry for smaller players.

It appears we are starting to come out of the financial crisis, and rightly so, the general public no longer believes hedge funds were the sole creators of the financial crisis (they only believe that the people that work in the funds make too much money). The savvy investors have come back to hedge funds, knowing that these are still where the smartest people on Wall Street are, and where their best chance for healthy returns on their investments continues to be. However, the power has shifted from the funds, who used to pick and choose investors, to the investors who can now make more demands of the funds.

After experiences like Bear Sterns, Lehman Brothers, Madoff, Galleon, fund managers have come to an Age of “Hedge Fund” Enlightenment, realizing that their need for systems and stronger governance and better policies and procedures that support their business in real time are critical to their continued success. The future requirements from the Fed, SEC, and Investorswill require that funds are able to quickly provide their positions as well as linking their financials to their Assets Under Management.

There is no doubt, that as this Age of Enlightenment comes to the hedge funds there will be many approaches to building out infrastructures. Some funds will attempt to build everything, other will try to find that magic piece of software that promises the “hedge fund in a box”, while others will choose a mixture of all approaches. No matter what approach you pick the first thing a fund needs to do is understand itself. Any of these approaches could work (with the exception of the hedge fund in the box, that software is sitting right next to the Easter Bunny and Santa Claus) but none of them will work if they do not match your organization.

What I mean by that is, know yourself first, and don’t try to be what you are not, or what you don’t wish to be. If you do not have an IT department, or you do not wish to have one, don’t have some development firm custom build you a set of systems. All you would be doing, is making that development firm rich, and creating a money pit for yourself.

Don’t just pick pieces of software because your friend at Fund X or Y uses it and loves it. Hedge funds are like strands of DNA and no two are the same. It is a guarantee that what works great for your buddy at Fund Y will not work the same for you.

There is a lot more to this story, and I will continue to write more about this in the coming months. Treat this post as a cautionary tale. I have been in the consulting industry for close to 20 years now, and one thing I can say for sure is there is always someone who is willing to take your money. Be careful on how you pick a consulting partner / integrator. Treat this choice like the second most important relationship in your life (I will refrain from any Tiger references).

Third Party Admins – Where do They Fit in the A Newly Regulated Hedge Fund Industry?

It seems evident that Third Party Administrators (TPA’s) will hold a prominent role in the newly regulated alternative asset management industry. However, there are certainly key concerns about the TPA’s ability to provide the services that they will be asked to perform. As a firm that spends all its time at our hedge fund and private equity fund client’s sites we gain a very rare perspective of understanding what our client’s are thinking and experiencing but unlike our client’s we are able to see this at many funds in many different scenarios. This provides us with a truly unique perspective that very few firms can claim. I recently had the opportunity to talk with one of the heads of a “Tier 1” TPA to get his view on their side of the story to better understand not only what the issues are but from the TPA’s perspective what they bring to the table.

 Valuations

One of the key points the TPA’s make is that when they get to a certain critical mass in terms of the number of clients they service this will especially support FAS 157 and other valuation needs since as a company that is responsible for marking of so many assets they are a natural place to become an expert on this topic. This argument certainly seems logical, and on the surface it would seem that the largest of the TPA’s should have enough resources to hire the talent to perform effective valuations. Where this argument breaks down is in the world of exotic assets or with smaller TPA’s who do not have the large client bases and therefore the number of assets to do a thorough comparison.

 Books & Records

For portfolio and partnership accounting the arguments for the TPA’s becomes a little less clear since these systems like Advent Geneva, SunGard’s VPM, Investier, Investran or Markit’s Wall Street Office are all very complex systems that require a large degree of customization in order to operate properly for a fund. It would be very difficult and extremely costly for any TPA to try to purchase and customize all these applications for their client’s. Therefore, what usually occurs is that a TPA will select a few of these systems and then all client’s will be placed on the TPA’s version of the Portfolio or Partnership accounting system. It will then be up to the TPA how often they make changes or upgrade their systems. Upgrades will likely not occur very often because that would mean changes for all their client’s which would be painful for any systems the client has built in house to work with the TPA’s systems.

 Outsourced vs. In House Administration

In discussions with the TPA head the one point we could agree on is, if an organization is at a certain level of complexity, meaning they are a multi strategy fund and money is not a concern the fund will always be best served by creating their own administration infrastructure. This is simply because by picking, building and integrating the specific systems that the funds require they will always be able to create the exact information and support that their funds require. When a TPA tries to do the same they will have to take their existing systems which may or may not best fit the client and they may or may not try to customize their systems to meet the client’s specific needs. Of course setting up these systems is a very costly exercise so funds need to go into the effort with this very important understanding. In addition funds who choose this option must be prepared to hire a small full time dedicated IT team to support the systems after an integrator like FinServ Consulting has completed their work.

 Should TPA’s be Regulated?

One point that the head of the TPA made was that he believes that their organization should be regulated in the U.S. He pointed out that their entity in Dublin is regulated. This was a very interesting point and seems to make quite a bit of sense. Certainly as the TPA’s become a required player in the industry there has to be certain standard levels of service that the TPA’s should be held to.

 Conclusions

This is certainly a topic that we will spend much time in our Blog discussing over the coming months and years. FinServ Consulting is very fortunate to be inside many hedge funds to be able to get this rare insiders view of so many of the top funds in the industry. From this unique perspective we can clearly see that there are many facets to this question and it certainly requires more than just a simple review and answer.

In the end, the decision to utilize a TPA will need to be based on the specific requirements and resources of the asset manager themselves. One thing we feel safe in assuming is that many funds will be forced to take on third party administrators for their public image even if they are still maintaining much of their operations in house. It will then become a question of how effectively they choose to utilize the assets of their TPA’s. Over time FinServ has developed an approach to working with TPA’s most effectively which we share with our client’s. For a full perspective on this approach contact me at hweinstein@finservconsulting.com.

Offshore Accounts Back on the Radar

It appeared based on President Obama’s and Tim Geithner’s comments today that they are taking a serious focus on tax havens like offshore accounts and other vehicles that could potentially be used to avoid taxes. This is certainly not surprising and most people have been expecting these moves for some time. It is all part of the new level of vigilence that the funds will have to provide increased data to the IRS when they request it on potential investor account information. Similar to other requirements that will come down with the coming hedge fund regulation this will require better and more efficient systems and processes to provide data to the regulatory agencies. We will provide more information on this topic as the specific requirements become clearer.

FinServ Consulting Launches New Web Site and Informational Portal for Clients

NEW YORK – April 17, 2009 – FinServ Consulting, an experienced provider of business consulting, systems development and integration services to the alternative asset management sector, today announced the launch of its new web site and informational portal for investment managers and service providers.

The website, www.finservconsulting.com, is a response to the changing dynamics in the alternative asset industry and the desire for informative, third-party information from experienced industry experts. The Web site will contain several innovative aspects within its architecture that will provide an informative user experience, including a blog that will impart regular updates to visitors regarding news and other topics within the alternative investment world.

FinServ Consulting will also be providing visitors with in-depth white papers on pressing industry topics and case studies on solutions provided to its clients.

About FinServ Consulting
Based in New York, FinServ Consulting is an independent experienced provider of business consulting, systems development and integration services to alternative asset managers and service providers to the sector. Founded in 2005, FinServ delivers customized world-class business and IT consulting services for the front, middle and back office, providing managers with optimal and first-class operating environments to support an opportunistic style and asset growth. The FinServ team brings a wealth of experience with the largest and most complex alternative asset management businesses and institutions. For more information, visit www.finservconsulting.com.

All is Quiet on the Regulation Front…..For Now

After a flurry of regulatory and legislative activity over the past few weeks the holidays  saw a slow down and presented some time to reflect and absorb on what we have heard from the Treasury and from the G20.  Based on history and the nature of our government, the rule changes and setup of a new systemic regulator is likely to be a slow moving process. However, it would be advisable to start thinking ahead to anticipate  the impact on your  organization.

We are already seeing money starting to flow back alternative assets after the redemption craze of last year, HSBC Global Asset Management reported last week it is finally seeing inflows into some of its hedge funds and believes it may have reached a “tipping point” after a tough period of client withdrawals. Funds that have their reporting act together will be the ones who will be able to take advantage of these inflows.  We expect these are likely to seriously ramp up by the end of 2009, into next year and beyond.

Introducing: An Alternative View – the FinServ Consulting Blog

Introducing: An Alternative View – the  FinServ Consulting Blog- . Focused on the  alternative asset management industry, our writers will bring insight and depth to the pressing business issues that impact complex alternative asset managers Never has expertise, knowledge and ability to act on critical business decisions become more vital to fund managers and service providers and we look forward to weighing in , and guiding, the conversations of the day from the discussions taking place on Capitol Hill on regulation to the role technology will play in the future of the industry.