Regulatory change is causing new patterns to emerge among alternatives, including increased automation, risk mitigation and reporting. Jay Nusblatt of RR Donnelley and Sean McKee of KPMG take a look
Jay Nusblatt: Regulations are changing quickly, and there’s been a lot of hard work around building and developing an infrastructure to support mutual funds through these changes. On the flip side, the unregistered, alternative funds are not as well positioned to cope. Would you agree?
Sean McKee: Absolutely. A maturation happened in the mutual fund space between the late 80s and the early 90s, to what we have today. We’re seeing a similar evolution, albeit slower, in the hedge fund space, but the pace is spurred on by the increasing regulation of investment advisors, coupled with increasing investor demands.
For a long time, especially in the hedge fund space, you had a supply and demand dynamic where there was a great deal of demand for alternative investment strategies with far less supply. That dynamic allowed hedge fund companies to basically dictate the terms for investors, which slowed what otherwise would have been an organic development and maturation in terms of administration and financial reporting. That equation has subsequently changed for a number of reasons. As alternative investments are becoming commonly accepted and more mainstream, the regulators have increased their scrutiny of investment managers, including managers of alternative investments.
As the number of investors interested in such strategies has increased, we’re seeing people pick up the pace in terms of developing their back- and mid-office functions, improving controls and processes, and using state-of-the-art technology to facilitate delivery to the multitude of stakeholders, whether that’s regulators in different jurisdictions or investors in different distribution channels.
Regulatory scrutiny has a couple of different aspects. One is an expansion in terms of what people need to report. Another is a clear articulation to the community of what is expected of investment managers—and what their roles and responsibilities should be with respect to financial and performance reporting to investors. As that becomes abundantly clear, there is greater scrutiny and greater penalties for those that don’t conform to the expectations. The investor community has picked up on those roles and responsibilities, and is becoming more demanding.
Nusblatt: In the fund space, and I assume in the alternative space, the investment manager is, in effect, the fiduciary over client assets. That fiduciary perspective has allowed the registered fund sponsors to accept and embrace their responsibilities for a multitude of matters, including financial reporting. Has this dynamic been evolving for alternative investments?
McKee: Historically, the efforts of the US Securities and Exchange Commission (SEC) have been highly correlated to where the assets have been, as well as to the type of investors involved. Mutual funds had larger assets with a significant retail base, and thus the SEC dedicated most of its efforts there. The SEC also dedicated more effort to registered products, because it receives far more data on them, and you naturally look at what you can see, feel, and touch every day.
Now, alternative investments have increased in popularity, and the regulators are beginning to realise that even institutional investors, such as the large pension funds and endowments, ultimately have retail investors as their base. So, the SEC has increased inspections of alternative investment managers, and that gives a depth of information that wasn’t previously available. That information has been shared to the alternative investment community by word of mouth through the attorney networks, through the accountant networks, through the administrator networks, and through all the other service provider networks.
Something that’s fascinating is the SEC’s role regarding gatekeepers. The SEC recently settled charges with a private fund administrator as a gatekeeper. The gatekeeper doesn’t have a fiduciary duty so much, but if you read the cease and desist orders, a key takeaway is that yes, they have a contract, but they can’t facilitate securities law violations and then claim that that wasn’t their responsibility under the contract.
Nusblatt: The SEC chair has been using the word ‘gatekeeper’ in various speeches over the past 24 months, referring to board members. The SEC has also taken that term and applied it to other participants in the fund industry. As a fund administrator, that is a somewhat controversial request because the administrator is generally not acting in a fiduciary role and does not have the power of the board or of the fund sponsor. This plays into the statement on why the hedge fund industry is beginning to embrace financial reporting, and taking on these new roles.
RR Donnelley’s ArcReporting solution is designed to fit into the evolving requirements of financial reporting and regulatory demands for alternative funds. How has the SEC come to increase oversight of all investment managers, including managers of hedge funds?
McKee: At the end of the day, what the SEC is realising is that even large institutional investors have expectations around the degree of oversight by the SEC. And if there’s not appropriate oversight, there are criticisms. When you’re working with pension investors who have individuals at the end of the chain, they can make very sound criticisms that they need to be protected, as well. Hedge fund investors are knowledgeable investors, and yes, they are held to a different standard, but by the same token investors still expect oversight, and this isn’t lost on the SEC staff.
Looking at the actions and the breadth of oversight that has occurred, the SEC was focusing on the explosion of the mutual fund industry. In the early days, it wasn’t that investment advisors and fund service providers didn’t try to do a good job, but you didn’t have the rigor and the processes and controls and systems. Now we’re seeing similar expectations and oversight coming from the SEC in the alternative funds space in terms of technology becoming prominent. Quite frankly, operating with low-quality processes, controls, and systems is not a sustainable proposition in the alternative investment space, whereas it was possible to operate in this manner in the past.
Nusblatt: We’re seeing exactly that. Hedge funds require an automated financial reporting system, and so spreadsheets and other homegrown in-house solutions are no longer an option. Furthermore, and more broadly speaking, our intelligence has told us that any servicer solution provided to the alternative investment fund space must have full automation, risk mitigation, audit trail, transparency, and compliance.
McKee: I agree. We’ve been involved with clients who have received routine inspections and where there isn’t a robust system that facilitates the books and records and all the compliance requirements. We’ve seen clients where the systems have been built in pieces and parts, and regulators are really questioning the advisors hard on how they fulfill their responsibilities with those types of processes and enabling tools.
I would add that the institutional investor community has got much better with respect to operational due diligence. It used to be that due diligence was focused around the investment process, but if you tell people that you’re using spreadsheets and databases to do your reporting, and not integrated systems solutions, it raises a red flag. As a result, firms are finding that if they do not have quality systems, it’s harder to raise capital. It’s not only a regulatory issue, it’s a core business issue.
Nusblatt: When we say that any service or solution must have full automation, risk mitigation, audit trail and compliance, it really requires sitting down and thinking through every aspect of your operational plan and how you provide service.
McKee: Absolutely. I’ve noticed that when people have processes and tools that were built in a modular fashion around particular problems and were never integrated, it takes them a long time to pull book and record requests. The ability to pull that data in a timely fashion, and to be able to explain it, provides that inspection staff with a degree of comfort. Inability to do that creates concerns as to whether you really can fulfill your roles and responsibilities in a way the SEC, and your investors, expect. The SEC is comparing statements you’ve made to your investor base to see whether they’re consistent or not. That audit trail is a real issue.
Also, as regulators expand on the data they want people to report, the ability to do regulatory reporting with manual solutions has changed. We’ve almost reached the point where, other than for the smallest shop, regulatory reporting with manual solutions isn’t possible.
Nusblatt: One reason investors have become more savvy, requiring a standard operating procedure for hedge funds, is probably because many investors are getting these items in other regulated investments. In order to attract capital, given the supply and demand issue, better financial reporting is now table stakes for the hedge fund to operate.
If you look in your crystal ball, where do you think we’re going to be in five years?
McKee: As I look to the next five years and think about systems, processes and controls, do I think the hedge fund industry will be at the same level as the mutual fund industry? No. Do I think they will be pretty darn close? I do.
Systems solutions are going to become important and I think you’ll see a continued evolution. The reality is that investment managers of all types are going to need to be able to mine their data for numerous purposes. For regulatory reporting purposes, the only way to do that well is through systems solutions.
These changes actually come at a very good time because systems solutions are far more prevalent. You can either use service providers or do things in house, and some funds are doing both, but there are far less infrastructure costs than in the past. The days of banks and in-house servers are diminishing. Some will have them, but it’s not requisite. If you want to have world-class systems, you can get cloud computing or software-as-a-service solutions.
The administrators and the service providers have upped their game around their technology offerings, and we’re going to see people move in this manner, starting to focus their internal operations around monitoring service providers.
