Article by Jonathan Cohen, Source: Cayman Finance

In recent years, an avalanche of regulation has significantly increased the costs of compliance within the hedge fund industry, with looming change and uncertainty ever present.

It is widely known that hedge fund assets, originating from institutional investors, have grown significantly since the financial crisis. The compelling and persistent theme is the continued force and momentum with which the global hedge fund industry is becoming increasingly institutionalised

This trend brings due-diligence, risk-management and transparency- management processes of funds and their managers to the forefront, with the obvious result being an increase in hedge fund compliance costs.

In October 2013, KPMG, the Alternative Investment Management Association and the Managed Funds Association partnered to undertake a comprehensive survey titled The Cost of Compliance, which represents one of the largest global surveys of hedge fund managers. The survey included the views of 200 hedge fund managers representing more than US$910 billion in assets under management (AUM). It also included in-depth interviews with managers from North America, Europe and Asia. Total industry costs, related solely to compliance, are estimated to be in excess of US$3 billion and hedge fund managers are convinced the costs and resources associated with regulatory compliance will increase over the next five years. Additionally, fund managers are often subject to a mix of regulations, each of which will incur different costs and require various resources depending on the scope, geographic location and customers that the fund and manager serve.

In terms of ranking the cost of compliance across different regulatory regimes, it is quite apparent that certain regulations are exacting a higher toll than others. The Alternative Investment Fund Managers Directive (AIFMD) and the Foreign Account Tax Compliance Act (FATCA) have ranked highest in terms of cost, time and need for external support; this is due to their complex nature and global reach. Securities and Exchange Commission (SEC) registration and reporting ranked as a close runner up.

Key Survey Findings Include:

The use of outsourcing and third-party vendor support will increase significantly as managers seek to focus on their core business.

On average, the industry is spending more than 7 percent of their total operating costs on compliance technology, headcount or strategy. Smaller- fund managers are spending US$700,000 on compliance on average, medium-fund managers are spending approximately US$6 million, and large-fund managers are spending more than US$14 million. Additionally, survey participants responded that cost is not limited to capital investment with many regulations carrying high resource cost in terms of time or management attention.

North American firms report spending more as a percentage of their AUM than those in other regions. In part, this likely reflects the already-in-process compliance requirements in the US, which include Form PF reporting and SEC registration, versus the expected compliance requirements of AIFMD.

Overwhelmingly, managers are absorbing the cost of compliance rather than passing it on to their funds.

As a result of the increased cost of compliance and capital investments, new players are facing significant barriers to entry with larger players facing constraints on growth. The large pool of managers say they have not considered moving their fund domicile, management company or centre of main economic activity in response to the regulatory change.

The lack of a consistent regulatory approach across all markets is creating uncertainty and complexity for many managers and, as a result, is limiting investments.

Product and fund selection may reduce somewhat as a result of regulation; however, this gap may be filled by firms developing regulated products. Market participants are eager to work with regulators to reduce complexity and enhance investor protection.

Fund managers overwhelmingly support the aims and goals of much of the recent regulation and are dedicated to increasing transparency.

Managers appear to be focusing on creating a culture of compliance. As one UK manager noted, “We want to be robust in our compliance so we need to always strive to ensure we have an ethical culture that emphasises the importance of doing things the right way. That’s how you deliver longer-term value”.

The industry has limited financial resources to dedicate to compliance and smaller managers are already meeting significant barriers to entry as a result of the rising cost of regulation. On the other hand, managers who are adapting and leveraging their compliance capabilities, are ultimately creating a competitive advantage.

In this new paradigm for the hedge fund industry, managers that can demonstrate vigorous institutional-type operations in complying with headline regulations will not only survive, but also be well placed to become the large players of the future.

The Cayman Islands, as the premier hedge fund jurisdiction of choice, has remained nimble in adapting to the evolving global regulatory landscape. This has been due to ongoing and productive collaboration between the public and private sector. Cayman has modernised its legislation and has signed 33 TIEAs and 27 MOUs with respective AIFMD countries, as well as Model 1 IGAs with the United Kingdom and most recently the United States.

Niko Whittaker, Director of Business Development with KPMG in the Cayman Islands, stated, “As a jurisdiction, we have to be cognizant of the regulatory landscape we’re in, in addition to the increasing competitiveness of the offshore environment. We have to remain cost competitive without compromising our regulatory product”.

Cayman service providers are squarely focused on AIFMD and FATCA and are looking to seize opportunities in this area. From an AIFMD perspective, large Cayman administrators are supporting their clients by providing management- company services in Ireland and Luxembourg and, in addition, providing independent-depository services. On the FATCA side, and with the deadline looming, local administrators have geared up by adding FATCA-related products, such as ongoing reporting, or even offering FATCA Responsible Officer services.

The cost of compliance continues to plague the hedge fund industry, creating advantages for the large players and barriers to entry for small ones. Similarly, from a jurisdictional perspective, increased regulatory costs will act as a barrier to entry for smaller offshore centers; however, Cayman is a forerunner in this ever-evolving, regulatory environment. Service providers have continued to adapt by not only offering a range of complementary services, but also demonstrating the expertise needed to provide timely solutions. Ultimately, Cayman may have a competitive advantage, given the significant progress in complying with these regimes.

About the Author

Jonathan Cohen is an Audit Director with KPMG in the Cayman Islands. With over 10 years of experience in serving financial services clients, his portfolio includes some of the largest hedge fund groups in the world, private-equity funds and structured products.

Jonathan is a member of the Institute of Chartered Accountants in Australia and of the Cayman Islands Society of Professional Accountants.

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