Stewart Eisenhart: Funds of Hedge Funds Under the Microscope

Casting a wider regulatory net over the hedge fund industry, the US Securities and Exchange Commission (SEC) has launched a “sweep exam” of funds of hedge funds to determine whether these firms are properly managing client assets and safeguarding against conflicts of interest.

Is this a sign of regulatory overreach that managers feared would come about once the SEC established hedge fund oversight via registration, or an extension of long-overdue accountability requirements to another subset of an opaque and secretive industry?

According to reports by The Wall Street Journal and Reuters, the SEC’s Office of Compliance Inspections and Examinations has honed in on roughly 12 firms; fund of fund managers under the microscope range in size from $100 million to $15 billion, and the investigation could expand to include managers active in private equity as well as registered investment advisers with pension fund clients.

Weakness Attracts Scrutiny
The SEC’s move comes as the fund of funds sector is struggling in the wake of losses over the past two years. Assets managed by funds of funds have fallen from $800 billion before the credit crisis to less than $600 billion as of the second quarter of 2010, according to data from Hedge Fund Research cited in the Journal article.

Interestingly, the SEC is requiring that fund of funds managers targeted by the investigation disclose which hedge funds those managers rejected for investments, and why managers decided not to allocate client assets to those hedge funds.

“Advisers typically reject more hedge funds than they hire, so the line of questioning could bolster the SEC’s knowledge of hundreds of hedge-fund firms that haven’t been subject to SEC examinations,” writes Jenny Strasburg in the Journal article. Indeed, the Commission may have found a back-door method of getting a better grip on those hedge fund managers that have so far avoided having to register under the Investment Advisers Act.

Stronger Infrastructures Needed
But regardless of the SEC’s intentions regarding those hedge funds, the ramifications for the fund of hedge funds sector itself may prove the most significant result of the investigation. While a great deal of US and European regulatory focus in recent years has targeted hedge funds, a stronger spotlight on how fund of hedge funds firms go about vetting managers to determine where to send their clients’ money is long overdue.

What kind of data and document management processes does a fund of funds typically have in place to support their fund due diligence and selection activities?

Hopefully, at least the 12 firms now under the SEC’s scrutiny have systems and policies in place to demonstrate their vetting methods, as well as established criteria for why they reject the managers that do not meet their requirements.

It would be foolish for the rest of the fund of funds community, however, to view the SEC investigation as having a direct impact only on those firms currently targeted—even if the Commission’s inquiry does not extend to the industry as a whole. There is no doubt the more sophisticated of these managers have robust, or at least adequate, infrastructures in place to handle allocation, risk management and other operations, but given the fund of funds sector’s lackluster performance since 2008, investors will—and should—show more interest in managers’ ability to demonstrate that they have appropriate policies and processes in place before allocating capital to them.

For those managers lacking adequate systems, perhaps relying more on qualitative factors in deciding which hedge funds to include in their investment offerings, now would be an opportune time to make the proper infrastructure upgrades—not only to ward off any future regulatory problems, but also to win back some of the investor confidence and assets they had proven so adept at attracting before the crash.