Compliance management is crucial for hedge funds, especially considering the strict regulatory requirements and addition of new rules that continually require industry professionals to pay close attention to their governance and compliance controls.
The topic of compliance can be somewhat overwhelming, but you can narrow it down to four key areas: Due Diligence; Risk Management; Conduct of Business and Governance; and Monitoring, Documentation, and Reporting. We’ll dive into each of these areas in a minute, but it’s equally important to consider the company’s culture. As important as each of the controls are, your organization must fully support compliance at all levels. Without an appropriate culture of compliance, supported by your senior management, even the best compliance program can’t meet your objective, which is to protect you from regulatory and reputational risk.
Creating a Due Diligence Questionnaire can help your investment team communicate with investors to understand your hedge fund’s approach. These Q&A responses can be helpful when answering an RFP (request for proposal), for ongoing manager monitoring, or in client meetings. Some sample questions to consider include:
- What training do you provide to staff?
- Do you have a responsible investment policy?
- How do you monitor your investment policies and data?
- What information and reporting do you provide to investors?
Now on to those four primary compliance topics mentioned previously:
The exact regulatory requirements may differ based on the country and type of fund, but
there are some general guidelines you should follow wherever you operate. Due Diligence sometimes takes a back seat for hedge funds because domestic hedge funds are exempt from anti-money laundering (AML) regulations. However, don’t overlook this step, because you may have a reputational risk if you do business with “dirty money” even without knowing it. Even if it’s not a requirement: Know your clients.
Due Diligence follows the principles of the Four Rs:
Investor Risk: Are you working with a bank or regulated public company? If so, your risks are lower than if you’re working with a trust, private investment vehicle, or foundation that can carry a higher risk of money laundering.
Condition Risk: This refers to the structure of your fund that might make it more or less appealing for money laundering, such as redemption times or investment sizes.
Country Risk: Some countries carry higher money laundering risks than others. High-risk countries carry additional regulations, and working across borders can increase your risks.
Value Risk: The payment method restrictions and investment amount requirements impact your value risk.
Any investment activities require a strong Risk Management program. These activities cover a wide range of risk topics, including Liquidity, Market, Operational, Compliance, and Legal Risk. Every hedge fund should create and follow a compliance manual that details your policies in key areas to help mitigate these risks. Your compliance manual should include key areas such as trading and brokerage policies, valuation, fees, disclosures, risk assessment, client assets, insider trading prevention, portfolio management, privacy, data protection, business continuity and disaster recovery, fees, disclosures, conflicts of interest, and more.
Conduct of Business and Governance
The phrase “conduct of business and governance” addresses the full spectrum from your company’s code of ethics and culture of compliance, to your specific business practices and dealings. Your compliance manual and its policies lie at the core, but just as important is your continual staff education. All staff must be trained on the policies, both an initial hire and periodically throughout their tenure, such as annually.
Your policies need to be wide-ranging and thorough, but at the same time, they can’t be so stringent that work doesn’t get done. From the start, make sure you have support and involvement from all key areas: Executives, Legal, Human Resources, Finance, IT and Security, Compliance and Records Managers, and End Users. Each area has a key role to play in developing and maintaining your compliance policies. For example, Executives help protect your company from compliance risks and bad press, and HR helps with employee training. End Users have to get the work done, so make sure you have their buy-in from the start.
Monitoring, documentation, and reporting
All measures that relate to business operations and trading need to be monitored, such as transparency, conflicts of interest, and insider trading. Without this ongoing task, the rest of your program can’t stand. Through this monitoring and documentation, you have proof that you trained your employees, that you provided oversight for your policies, and that you appropriately handled any lapses.
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