04/09/2014

Funds Weigh Outsourcing Compliance Tasks

Nearly one out of four fund operators rely on third-party contractors to perform key compliance functions, despite investor pressure to handle such tasks in-house.

Convergence, a New York firm that advises fund managers on operational issues, recently culled data it maintains on more than 2,100 hedge fund firms to see how they handle compliance at a time of increasingly complex regulatory mandates. The finding: about 500 firms, or 24%, outsource some or all of their compliance functions. And 300, or 14%, name an outside consultant as chief compliance officer.

Convergence co-founder John Phinney was surprised that so many managers feel comfortable outsourcing the work, given the traditional view among institutional investors that compliance is too important a task to leave to outsiders.

“I think there are people out there who have a view that any investor would consider the third-party model taboo,” Phinney said. “But clearly a number of investors are comfortable with this model.”

He said the compliance-consulting industry may have reached a tipping point comparable to what third-party fund administrators experienced a decade ago. At first, administrators had a tough time selling their services to hedge fund managers, in part because investors were indifferent. But the combination of the financial crisis and Bernard Madoff fraud convinced investors otherwise, and now the expectation is that any serious hedge fund operation will employ an outside administrator to help value assets and calculate net asset values.

The managers that outsource compliance tasks identified a total of 44 service providers in the field. The five busiest advisors, according to Convergence: Beacon Compliance of Kansas City, Mo.; Cipperman Compliance of Wayne, Pa.; Gery Sadzewicz Consulting of Plainfield, Ill.; Gordian Compliance of San Francisco; and Swayze of New York.

In addition, an increasing number of technology firms are offering software products that help managers automate a range of compliance functions, from developing policy manuals to reporting to regulators. Many fund operators that handle compliance in-house utilize software developed by third-party vendors.

Swayze founder Ashleigh Swayze acknowledged that institutional investors sometimes balk when fund operators want to outsource compliance functions. But they usually come around when they realize that compliance specialists often have more expertise than, say, a chief operating officer who also wears the hat of chief compliance officer.

“What I have observed in SEC exams is that a specific concern of the SEC is when the named chief compliance officer is a COO who knows nothing about compliance,” she said.

The recent growth of Swayze’s firm confirms the trend toward wider acceptance of compliance outsourcing. From 2012 to 2013, the firm’s client base expanded by 30%, with about half the new business coming from hedge fund and other alternative-investment managers.

For its study, Convergence relied on Form ADV disclosures by SEC-registered managers, as well as other sources. The consulting firm was founded last year to help fund managers reduce their operational expenses.

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