SEC’s Love Letter to Hedge Funds


This has been a hectic time for hedge fund compliance staff.  First there were the registrations with the SEC as mandated by Dodd Frank and then there were new reporting requirements. A few weeks ago, senior managers at hedge funds received a letter from the recently hired head of the SEC’s 450 person examinations team, alerting them that the next phase is now beginning: the dreaded on-site exams.

New Disclosures

For an industry that prizes its secrecy, the registration process has been painful for hedge funds.  First there is the Form ADV, which requires regular disclosure of general information about the firm such as fees, assets under management, number of clients and employees, soft dollar policies, among other things.

Then there is a new form, Form PF, created especially for managers of private funds, including hedge funds and private equity funds.   All registered funds with assets over $150 million have to file information about each fund, including gross and net asset values, investor concentration, borrowing and liquidity, performance, trading strategies, and various other information.

Hedge funds with over $1.5 billion in assets have to also disclose exposures by asset class, geographical concentration of investments held by funds and the monthly value of portfolio turnover by asset class.  They also have to disclose the fund exposures, portfolio liquidity, unencumbered cash holdings, identification of the fund’s base currency, collateral practices with significant counterparties, risk metrics, market risk, concentration of positions, and trading and financing for each fund with over $500 million in assets.

Large hedge funds started filing Form PF this past June, while smaller funds will start in December.  The information in the Form PF filings is used by the Financial Stability Oversight Council to monitor risks in the financial system, and by the SEC to help prioritize its exams and reviews.

On-site Exams

All the new disclosures pale in comparison with the invasiveness of on-site examinations.  Imagine then the emotions stirred by the recent letter sent by the newly appointed head of the examinations group.  The letter outlines the SEC’s examination process, which aims to conduct exams of all the newly registered hedge funds over the next two years.

The letter was written by Andrew Bowden, who was appointed last month as Deputy Director of the agency’s Office of Compliance Inspections and Examinations (OCIE).  Bowden spent most of his career at Legg Mason prior to joining the SEC last November.

Norm Champ, who preceded Bowden in the role of Deputy Director and is now the head of the Division of Investment Management, outlined the goals of exams in a speech earlier this year.  After notifying the industry (in Bowden’s recent letter), the SEC will launch a “coordinated series of examinations of a significant percentage of the new registrants that will focus on the highest risk areas of their business and help us to risk rate the new registrants.”

Portfolio Management Risks

Norm Champ provided a checklist for hedge funds of areas to prepare, including ensuring their compliance policies and procedures are in place, having a dedicated compliance officer, keeping compliance records, and reviewing the risks associated with their portfolio management process.

Specifically, he advised hedge funds to: “Review trades for unusual performance relative to peers and markets. Compare trades to restricted lists and determine if trades were made ahead of publicly available news or research reports.”

Bowden’s letter mentions portfolio management as a target area for the upcoming exams, along with marketing practices, conflicts of interest, safety of client funds and asset valuation.


It is easy to underestimate the scope of the new hedge fund registration.  According to the SEC, there are approximately 4,000 investment advisers that manage one or more private funds registered with the Commission, of which 34% (more than 1,350) registered since the effective date of the Dodd-Frank Act, July 21, 2011.  Based on the Form ADVs submitted so far, registered advisers manage approximately 30,000 private funds with total assets of $8 trillion.

We are entering a new phase of the regulatory process for hedge funds, the examination phase.  The exams are not a one-time phenomenon, but will be recurring, and will continue to reinforce the increased compliance focus of hedge funds.


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