dodd_frank_hi resolution april 16 2012

8/2/2019 Dodd_Frank_hi Resolution April 16 2012

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THOUGHT LEADERSHIP PAPERIn Conjunction

with the

March 2012

DODD-FRANK BILLA YEAR AND A HALF LATER

VIEWS FROM THE HEDGE FUND INDUSTRY


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DODD-FRANK BILL A YEAR AND A HALF LATERVIEWS FROM THE HEDGE FUND INDUSTRY

TABLE OF CONTENTS

I. Introduction 2

II. Executive Summary 4

III. About the Research 5

IV. Results

i. Registration requirements 9

ii. Restrictions on investors 11

iii. Supervision 13

iv. Provisions aecting trading strategies 16

v. Creation o derivatives clearinghouse 18

vi. Impact o European legislation 19

vii. Heightened investor demands 21

viii. Changes in organizational management 25

V. Conclusion 28


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INTRODUCTION

The Dodd-Frank Wall Street Reorm and Consumer Protection Act

passed on July 21, 2010 has resulted in sweeping changes to the nancial

industry not seen since the nancial reorms enacted ater the Great

Depression. It is estimated that the bill will result in nearly 400 rules and

87 studies beore it is ully implemented.1 Although the bill will aect

all nancial institutions, its impact on hedge unds is notable because

these private unds have generally been able to claim exemptions to the

our major regulations imposed in the 1930s.

Hedge unds are not subject to the Securities Act o

1933 because they do not engage in public oerings.

Furthermore, these unds do not all under the perview

o the Securities and Exchange Act o 1934 because

they are not publicly traded companies.

Because hedge unds are not mutual unds that solicit

unds rom the public, they are not subject to the

Investment Company Act o 1940.

Finally, because they oer investment advice only to

private clients, they are not subject to the Investment

Advisers Act o 1940.

The sizable growth o hedge unds over the last two decades has

regulators wary o their potential to create systemic shocks to the whole

nancial system. Although the nancial crisis in 2008 was not the result

o hedge und activity, their potential to contribute to a similar crisis

prompted the new legislation. Hedge unds recognize the dilemma

without regulation a ew risky unds could jeopardize the whole nancialindustry. Yet, heavy-handed regulation can also stife the innovative and

entrepreneurial spirit that characterizes hedge unds. Their investors,

including pension and endowments unds, have become considerably

more cautious prompting increased demands or greater inormation

and transparency.

1 Dodd-Frank progress report, Davis Polk, 2011.


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Unquestionably, hedge und activity is benecial to the strength and

stability o global nancial markets. These institutions provide deep

market liquidity and, by taking on risks that are shunned by traditionalunds, are instrumental in pioneering new nancial instruments and

strategies. However, their contribution could be jeopardized i regulation

is not well crated or investor demands become too burdensome. This

thought paper seeks the opinions o hedge und managers on The

Dodd-Frank Wall Street Reorm and Consumer Protection Act, its impact

on their organization and the uture o the hedge und industry.


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EXECUTIVE SUMMARY

The key fndings include:

1. The registration requirements contained in the Dodd-FrankBill are not considered onerous, especially because largerunds have independently elected to become registered.

2. The increased threshold or accredited investors to invest inhedge unds was viewed avorably by most respondents.

3. Hedge und managers surveyed are not particularly con-cerned about the creation o the Federal Stability Oversight

Committee to monitor their industry, but they were notconvinced that providing trading and other inormation toregulators would necessarily help them detect uture system-ic risks.

4. The Volcker Rule, which prohibits banks rom engaging inproprietary trading, was generally viewed avorably.

5. A majority o the hedge unds surveyed agreed that thesettlement o swap contracts should be conducted by aclearinghouse.

6. Hedge unds are concerned about European legislation suchas a regulation being considered to limit nancial remunera-tion. However, they avored the single passport provisionthat would allow hedge unds to operate throughout theEuropean Union with one license.

7. Investor demands or inormation have increased consider-ably especially with regards to the due diligence process, riskmanagement procedures and reporting requirements.

8. Hedge unds expect their operational costs to rise as a resulto these new regulations and greater investor demands.

9. Future changes to the organizational structure o hedgeunds will ocus on the ability to more accurately monitorinvestment, liquidity and counterparty risks and providegreater transparency or investors.


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ABOUT THE RESEARCH

The survey was conducted by in-depth phone interviews o 12 senior

managers o hedge unds and asset management rms plus 29 detailed

email surveys also completed by senior hedge und executives. Those

at the asset management rms had either direct or indirect experience

with hedge unds. The in-depth interviews provided the opportunity to

ask ollow-up questions and gain clarity, considerably strengthening the

conclusions o this study. The graphs presented in this paper are based

on all 41 responses. For the most part, the results o the interviews and

mail-in surveys are consistent.

We begin with a breakdown o the sample which shows a heterogeneous

group o rms, ranging rom small to large unds engaged in both single

and multiple strategies.

Size:Twenty o the respondent rms (49%) had assets under management

(AUM) that exceeded $1 billion while the remaining 21 rms (51%) had

assets under management o less than $1 billion. O the latter group, ten

rms reported assets in the $5-50 million category and eight reported

assets above $250 million, providing a well-distributed range o rms by

size. Figure 1 shows the breakdown o sample rms by AUM.

Figure 1


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Strategy:Twenty-three o the rms specialized in a single asset class,

nine o which were rms with assets greater than $1 billion. The

remaining rms were engaged in multiple strategies. Figure 2 shows thebreakdown o respondents by their utilization o single versus multiple

strategies.

Figure 2

The investment strategies o the rms covered a wide range o activities

and included long-short unds, global-macro, xed-income, commodity,

arbitrage, event-driven and sector- specic strategies.

Figure 3


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As indicated in Figure 3, the largest group identied long-short as one

o their strategies (22 rms) ollowed by global-macro, event and equity

strategies (14 rms or each category).

Hedge unds accounted or the bulk o the rms (31 rms) while the rest

were asset management rms (7), two large banks and one commodity

trading advisor with assets under management. O the total sample,

our rms were located outside the United States (Bahamas, Switzerland,

Canada and the United Kingdom) although all had oces in the United

States. Twenty-seven o the unds were located within the New York/

New Jersey/Connecticut region and the rest were rom Caliornia, Texas

and Massachusetts. All the respondents were senior managers and

their designations ranged rom CEO, CFO, General Partner, Chie Risk

Ocer, Controller, Portolio Manager, Chie Compliance Ocer and

Director. More than two-thirds o the rms have been in existence or

over ve years with 41% over ten years. Figure 4 shows the breakdown

o sample rms by age.

Figure 4


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For both the in-depth interviews and email survey, the questions were

divided into two sections. The rst section ocused on the impact o the

Dodd-Frank Bill that was implemented as a response to the crisis bylawmakers and regulators. The second section examined the impact on

the industry as a result o heightened investor concerns ollowing the

nancial crisis o 2008 and amid reports o large risk-taking by nancial

institutions.

This report is authored by Anoop Rai, Proessor, and Gioia P. Bales,

Associate Dean o the Frank G. Zarb School o Business at Hostra

University. The survey, analysis and project was underwritten by

EisnerAmper LLP. Christian Bekmessian, Tax Partner and Co-Head,

Financial Services Group and Nicholas Tsaos, Audit Partner, Financial

Services Group, assisted in this project.


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RESULTS

The rst set o questions relate to the implementation o the Dodd-Frank

Bill and ocuses specically on the provisions aecting the hedge und

industry. Our report will use the term large unds to denote rms with

AUM o greater than $1 billion and small unds or rms with AUM

less than $1 billion. The respondents data displayed in the ollowing

graphs are categorized by size o AUM as indicated previously.

Registration requirements

The new provision requires unds with assets greater than $150 million

to register with the Securities and Exchange Commission (SEC). Figure

5 displays the reaction o respondents to the ollowing question: Will

your rm be aected by this provision?

Figure 5

Over 68% o the large rms surveyed reported that this provision would

not impact their rm. This result is expected as most o these large rms

are already registered with the SEC. In contrast, only 37% o the small

rms reported no impact.


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Over 63% o the small rms state that the provision would moderately

to signicantly impact their operations.

Start up rms will need signicantly more capital

to launch. Smaller hedge unds will be at a

competitive disadvantage.

Fromtherespondents: CFo,

large new York-basedhedgeFund

Over 75% o all respondents indicated that rms with $100 million

or greater in assets should be subject to registration, with one-third

reporting a minimum o $500 million. Approximately 22% o the large

rms also recommended that rms with $25 million should register with

the SEC while only 5% o the small rms recommended registration or

these institutions (see Figure 6).

Figure 6

As shown in Figure 7, the majority o survey respondents preerred SEC

over state registration. The larger rms were particularly adamant with

close to 80% avoring SEC registration compared to 63% o the small

rms. Just over one-quarter o the smaller rms indicated a preerence

or state registration while none o the larger rms preerred registration

at the state level.


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Figure 7

However, with the exception o a ew smaller institutions, respondents

indicated that the dierence between SEC and state registration was

not expected to impact their rms.

The registration process is a big yawn. Our

und has been registered since its inception.

Registration with the Securities and ExchangeCommission makes investors more comortable

with hedge und investing. Registration with the

SEC is actually helpul and we see it as a cost o

doing business.

Fromtherespondents: senior ViCe president,

large new York-basedhedgeFund

Restrictions on Investors

The next set o questions ocused on the impact o the bill on hedge

und clients. The Dodd-Frank Bill requires accredited investors to own

assets o $1 million, excluding their primary residence. When asked what

should be the minimum amount required o investors, the responses

ranged rom $500,000 to greater than $5 million, with the average

around $1 million. Figure 8 displays the reaction o respondents to the

ollowing question: What should be the minimum amount o net worth

held by an accredited investor, excluding their primary residence?

Observation:

Hedge unds do

not appear to be

concerned about

the registration

provisions in the

Dodd-Frank Bill

except to indicate

a preerence or

registration with

the SEC rather

than the individual

states.


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Figure 8

Smaller unds were more consistent with over 77% recommending that

accredited investors hold at least $1-5 million in net worth. In contrast,

there was greater variation among the larger rms with the greatest

percentage o these respondents recommending a minimum o just

$500,000 in net worth. As Figure 9 indicates, most respondents elt that

the chie justication or raising this minimum threshold was the risk

posed to small investors. This was especially evident with larger rms

with 67% reporting this as the primary concern compared with just 44%o the smaller rms. Smaller rms also cited the diculties in investor

relations when servicing small clients.

Figure 9


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The majority o rms reported that this provision would have little

impact on their businesses, with the majority responding that less than

10% o their current clientele would be aected. The response wasconsistent or rms o all sizes with 83% o small rms and 87% o large

rms reporting little to no eect on their client base.

Supervision

A major change in the Dodd-Frank Bill is the authority granted to the

Secretary o the Treasury and the Federal Reserve Bank to supervise

hedge unds, a signicant change as these investment vehicles are

privately-held unds. The rationale or this provision was the tremendous

growth in assets held by hedge unds over the last two decades. As aresult, unidirectional trades by large hedge unds have the potential to

create systemic shocks to the overall nancial markets.

Figure 10 displays the reaction o respondents to this provision.

Clearly, there is a dichotomy o opinion between large and small rms.

Surprisingly, larger rms generally agreed that these provisions were

necessary in the current nancial environment. O these larger rms,

close to 53% agreed or strongly agreed while 11% remained neutral. In

contrast, nearly 58% o the smaller rms disagreed or strongly disagreed

with the necessity or this new provision.

Figure 10

Observation:

The increased

threshold orinvestments in

hedge unds by

the Dodd-Frank

Bill was considered

avorably by the

respondents

with risk or

the investors

considered a

primary reason or

their approval.


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In contrast, there was more uniormity o opinion on the question o

whether this new supervisory provision will harm the competitiveness

o the U.S. nancial industry. As Figure 11 shows, most respondents,including both large and small unds, were in agreement with

approximately 63% o small rms and 58% o large rms stating

that the new provision would somewhat or signicantly harm U.S.

competitiveness.

Figure 11

The respondents were skeptical whether eorts to prevent systemic risk

by the creation o the Federal Stability Oversight Committee (FSOC)

to collect trading data rom a range o nancial institutions, including

hedge unds, would prevent systemic risk. Figure 12 displays the

reaction o respondents to the question o whether the FSOC will be

able to succeed in its mission o detecting systemic risk.

Figure 12


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Similarly, opinions on the likelihood o the FSOC to achieve its goals

were generally consistent. Over 55% o small rms and 42% o large

rms disagreed or strongly disagreed on the ability o the FSOC tosucceed in detecting systemic risk in the uture. An additional 42.1% o

large rms and 33.3% o small rms were neutral on this issue.

Likewise, both large and small rms appear unconcerned with the

new supervisory landscape imposed by the Dodd-Frank Bill, with the

majority responding that they were either unconcerned or partially

concerned. Only 16% o all respondents were strongly concerned. This

data is presented in Figure 13.

Figure 13

The type o data that should be made available to the regulators

varied as indicated in Figure 14. However, there appeared to be a

consistency o opinion between larger and smaller institutions. The

greatest percentage o respondents, 28% o small rms and 29% o

large rms, indicated that rms use o leverage should be reported to

regulators. Reporting the amount o AUM was the second most cited

type o inormation that should be made available to the regulators,

with approximately one-quarter o large and small unds. Likewise, 20%

o large and small rms cited counterparty risk as important inormation

to disclose to regulators.


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Figure 14

Note: Respondents could select more than one type o inormation.The percentages reported are the number o responses per choice

divided by the total responses in the category.

We believe transparency is very important.

However, we do not eel that the regulators will

be able to detect systemic risk just through the

collection o inormation. Our rm understands

what the regulators are trying to do but questions

i they are as knowledgeable as they should be.

Fromtherespondents:

CFo, small new York-basedhedgeFund

Provisions aecting trading strategies

The survey addressed other provisions in the bill that were enacted

to prevent uture systemic risks. This included the Volcker Rule which

prohibits banks rom engaging in proprietary trading and limits their

investments in hedge unds and private equity unds to 3% de minimis

investment.


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Figure 15

Figures 15 and 16 display respondents reactions to the Volcker Rule.

More large rms than small rms indicated that it was likely that the

exclusion o banks would be benecial to the hedge und industry (42%

versus 32%, respectively). Over 47% o smaller rms disagreed with this

statement while a quarter o the respondents were neutral. Interestingly,

only 22% o the large rms and 44% o small rms disagreed that the

Volcker rule would provide opportunities to them.

Figure 16

Observation:

The results o

the survey imply

that both large

and small frms

expected to either

be neutral or

beneft rom the

Volcker Rule.


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Banks were getting carried away. The Volcker Rule will

denitely create more opportunities or hedge unds.

Fromtherespondents:CFo, large new York-basedhedgeFund

Creation o derivatives clearinghouse

The Dodd-Frank Bill also calls or the movement o trading and settlement

o many derivative contracts such as swaps, oreign exchange orwards

and utures rom over-the-counter to clearinghouses. Over 70% o

the respondents agreed that this would be benecial to the nancial

markets. It is important to note, however, that not all the respondentswere involved in derivative transactions, with roughly 30% o the large

rms and 47% o the small rms relying on derivatives as part o their

trading strategies. Figure 17 displays the reaction o respondents to

the question: All transactions should be cleared through a derivatives

clearing organization.

Figure 17

Opinions were mixed regarding whether this provision will reduce the

number o strategies involving swaps. In general, those rms not utilizing

swaps did not believe that the creation o a clearinghouse would reduce

derivative transactions. Opinions o hedge unds involved in derivatives

were evenly split.

Observation:

The concern with

counterparty risk

may be the result

o the recent

fnancial crisis

including the

bankruptcy o

Lehman Brothers

and near deault

o Merrill Lynch, all

once regarded as

AAA-counterparty

frms. Although

willing to share

counterparty

risk inormation,

respondents were

less enthusiastic

about reporting

their valuation

policies and

practices.

Additionally,

very ew were

willing to provide

inormation on

their trading

and investment

positions.


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Most o the respondents agreed that it was appropriate to exclude

oreign exchange swaps and oreign exchange orwards used or

hedging purposes rom the general denition o swaps, with only a ewsmall unds, not utilizing oreign exchange, indicating disagreement. A

majority o the rms used oreign exchange, at least occasionally, as

part o their trading strategies.

The creation o a central clearinghouse will

impact price and push market participants away

rom using derivatives. The structure that the

regulators are proposing does not t the product.

Futures are inherently dierent than credit deaultswaps.

Fromtherespondents:

direCtor, large new York-basedhedgeFund

Impact o European legislation

Because most hedge unds attract oreign capital and also engage in

transactions with other countries, oreign regulations will aect their

trading strategies. The survey addressed a ew major proposals beingconsidered by EU regulators. For example, the Alternative Investment

Fund Managers Directive approved in October 2010 will restrict the

remunerations paid by the nancial services sector.

As indicated in Figure 18, most o the respondents agreed that this

directive will ultimately reduce the number o hedge unds operating in

the EU (50% o small rms and 73.7% o large rms). Figure 18 displays

the reaction o respondents to the question: The Alternative Investment

Fund Managers Directive will restrict the remunerations paid by the

nancial services sector. Some predict that it will reduce the number o

hedge unds operating in the EU.


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Figure 18

However, the responses were mixed on the new regulation by the ESMA

that would issue pan-European passports or hedge unds to market

throughout the EU under one license. Figure 19 shows that just under

50% o the larger rms agreed or strongly agreed that this passport

will be benecial compared to just one-third o the smaller rms. The

greatest proportions o respondents were neutral.

Figure 19


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Observation:

Most respondents

agreed that the

new regulationsproposed by

the EU will be

burdensome and

may reduce the

number o hedge

unds operating

in Europe but

the prospect o a

single passport has

appeal, especiallyamong larger

hedge unds.

The Dodd-Frank Bill and new European

regulation is positive or the industry under the

assumption that implementation is fawless.Fromtherespondents:

Ceo, large ZuriCh-basedassetmanagementCompanY

Heightened investor demands

The second part o the survey examines the impact on hedge unds

o heightened investor awareness as a result o the recent nancial

crisis which exposed the lack o transparency o several major nancial

institutions.

Figure 20 displays the reaction o respondents to the question: Are

investors demanding more inormation and transparency o your

companys strategies and activities? Clearly, a majority o respondents

indicated that investors were demanding more inormation on their

companys strategies and activities. This was especially the case with

larger unds. Nearly 58% o large rms and 39% o small rms reported

that investors were demanding signicantly more inormation. Only

17% o small rms and 5% o large rms ound no change in the demand

or inormation.

Figure 20


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Large rms reported an increase in inquiries regarding their risk

management practices, reporting and due diligence procedures while

smaller rms reported due diligence and reporting as the most sought-ater inormation by their clients (see Figure 21). Clients o larger rms

appear less interested in obtaining inormation on administrative and

audit services (13% and 16%) while inormation on audit services and

risk management were the least demanded rom smaller rms clients

(12% and 17%).

Figure 21

Investors, especially those in larger unds, are increasingly interested

in inormation regarding the audit rm employed by their hedge

unds. Over 60% o the larger rms reported an increase in demandor inormation about their audit rms compared to 38% by the smaller

rms. Figure 22 displays the reaction o respondents to the statement:

Client inquiries regarding your audit rm and their practices have

increased signicantly.


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Figure 22

As demonstrated in Figure 23, demands by clients or separation o

custodial accounts and broker/dealer operations have also increased

more or larger rather than smaller rms (72.2% compared to 22.2%).

This is a signicant development and concern will probably increase

urther as a result o the MF Global crisis.

Figure 23

Likewise, larger hedge unds reported increased investor concerns

regarding counterparty risks. Over 84% o the large unds

acknowledged heightened concern compared to only 39% o the

small rms (see Figure 24).


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Figure 24

Just over hal o the larger rms claimed that their clients are demanding

more requent account reporting compared to 44% o the smaller rms

(see Figure 25).

Figure 25

In addition, the majority o the respondents agreed that the nancial

crisis has changed investors due diligence requests prior to investing in

the rm. Figure 26 displays the reaction o respondents to the question:

How has the nancial crisis changed investors due diligence requests

prior to investing in your rms product?


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Observation:

Investors are

demanding more

inormation

rom their und

managers,

especially on the

hedge unds

due diligence

procedures, riskmanagement

practices,

counterparty

risks and account

reporting. This

heightened

investor scrutiny

can be attributed

to the recent

fnancial crisis.

Figure 26

When everyone was making money, due

diligence was non-existent. Today, investors

are less willing to give away a dollar. We have

one client that asked or weekly perormance

numbers.

Fromtherespondents:

CFo, small new York-basedhedgeFund

Changes in organizational management

In the nal section o the survey, hedge und managers were queried

about changes in operational strategies, including the outsourcing, o

some or all o their back oce operations, necessitated by the increase

in regulatory oversight mandated by the Dodd-Frank Bill and the

substantial rise in client inquiries.

As illustrated in Figure 27, the costs associated with regulatory

compliance, and the consequent impact on protability, is a major

concern o hedge und managers. Without exception, all o the large

rms surveyed expect costs to increase, either moderately or signicantly,

as a result o heightened regulation and investor demands. A majority

o smaller rms also reported the same, with the exception o 11% o

these rms expecting no increase in costs.


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Figure 27

Opinions regarding the outsourcing o back oce operations are mixed,

with hal the respondents stating an outsourcing o some, i not all, o

their back-oce operations is expected. Smaller rms were more likely

to outsource some o their back oce unctions than larger companies.

Figure 28 displays the reaction o respondents to the question: Does

your rm intend to outsource some or all o their back-oce operations

as a result o increased regulatory and investor demands?

Figure 28


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Our rm outsources the compliance unction.

We nd this very benecial.

Fromtherespondents:CFo, large new York-basedhedgeFund

Clearly, as shown in Figure 29, hedge und managers anticipate changes

in the organizational structure o their rms in this new regulatory era.

Respondents cited changes in liquidity and transparency as the key ocus

areas within their organizations. Procedures involving the monitoring

o counterparty risk were also indicated as a potential area or change

in their organizations. Monitoring o investments received the lowest

response rate. Interestingly, none o the smaller rms and only 3% o thelarger rms indicated that no changes in their organizational structure

were anticipated.

Figure 29


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CONCLUSION

The ramications o the sweeping reorms called or in the Dodd-Frank

Wall Street Reorm and Consumer Protection Act are not yet clear one

and a hal years since its approval. The complexity o the act combined

with the diversity o impacted nancial institutions present staggering

challenging or regulators. In addition, political actors exacerbated

by the 2012 election will undoubtedly complicate implementation

urther. As the United States struggles with a historic decit, budgetary

constraints may also hamper regulators. As o December 2011, only

74 o the expected 400 rules have been nalized. This is reassuring,

however, as these are important rulings and should be made only aterthorough discussions and vetting with all the aected parties, according

to Anoop Rai, proessor o Finance at the Zarb School o Business at

Hostra University.

The survey conducted by the Center or International Financial Services

and Markets o the Zarb School o Business in conjunction with

EisnerAmper LLP highlights the importance o this historic legislation

on hedge unds, an industry once spared rom signicant regulatory

oversight. As most hedge unds, especially larger institutions, are

already registered, this aspect o the bill is not expected to present

diculties. However, most institutions expect operating costs to rise as

structural changes are implemented to eectively deal with increased

reporting requirements and client inquiries. The results o the survey are

consistent with our observations. As more nal rulings are announced,

hedge unds are beginning to recognize the value o reorganization

and outsourcing,comments Nicholas Tsaos, Audit Partner, Financial

Services, EisnerAmper LLP.

Indeed, 2012 will be an important year or hedge unds as theseinstitutions adapt to a new regulatory landscape. Although smaller

unds may be at a disadvantage as start-up costs increase, hedge unds

are expected to remain resilient and continue to innovate the hallmark

o this industry.


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