Harsh Rules Yield October Surprise For Hedge Funds

Boston Skyscrapers

October was not a particularly good month for hedge-fund returns. While everything from a flip-flop on tax inversion benefits to adverse legal rulings have been blamed, the prime suspect it seems is the increasingly costly and complicated rules and regulations — not just in the United States but globally. From AIFMD (Alternative Investment Fund Managers Directive) angst in Europe to Dodd-Frank dread in America, hedge funds are experiencing regulatory perturbation as never before. Yet, at the same time, there are fund managers who welcome required registration and view it as a legitimizing “credential” in a highly competitive marketplace.

Expenses Eating Earnings

Until 2010, most hedge funds in the United States did not need to register with the SEC nor were they concerned about regulation in the EU. The qualifications necessary to be a player were high enough that market regulators generally took the attitude of  “they’re big enough to know what they’re doing.” But after 2008, came the realization that hedge funds pose a potential systemic risk if left to their own devices. Along with unprecedented rules came unprecedented compliance expenses to factor into return and growth equations. A KPMG survey that polled more than half of the hedge-fund industry disclosed that the average compliance cost for a small fund was $700,000, for a medium-sized fund, $6 million, and the largest funds were paying a whopping $14 million.

Regulation — A Resume Builder

Not all managers see mandatory SEC registration as a negative: “We were asking the SEC to register us in 2006. Being registered is a huge comfort to our investors?.?.?.?it shows we’re not crooks,” said an executive at one U.S. hedge fund. That sentiment was echoed by a fellow hedge-fund manager: “A big pension fund investor is not going to give $200m to some guy running a hedge fund from some office in Cayman any more. But if you’re regulated by the FCA or the SEC, if you meet all the requirements of AIFMD, then you’re much more likely to get that check.”

Only the Strong Survive

Absorbing the cost of regulatory compliance is viewed by some managers as an expense akin to infrastructure investment: “Fund managers around the world are working hard to deal with the challenges of compliance. But there is a sense that the investments they are making today will pay off in the future from a competitive standpoint,” according to a consultant in a global hedge-fund practice. While that may hold true for the largest funds, the smaller ones may find themselves “too small to succeed” as the cost of regulation continues to rise.