Business Consulting Industry Report: November 2016

In this issue:

Industry Trends

Investor Sentiment

Legal & Regulatory Update

Industry Trends

Separately Managed Accounts

Wendy Beer, Head of Business Consulting, Wells Fargo Prime Services speaks with Mikael Johnson, Senior Partner – Alternative Investments and John Budzyna, Managing Director and National Head of Alternative Investments Market Development in the Asset Management Practice of KPMG LLP.

WB: Investors are increasingly utilizing separately managed accounts (SMAs) to access hedge fund managers. To what do you attribute the increase in SMAs?

KPMG: The 2015 KPMG/AIMA/MFA Global Hedge Fund Report included a survey of managers regarding sources of capital. A majority of respondents indicated that pension funds will be the primary source of capital by 2020. With this as a backdrop, it is not surprising that the increasing presence of institutional investors in hedge funds is driving significant change in the industry, including the ways in which investors access hedge funds. Key to this is a focus by institutional investors on transparency, liquidity and control issues with hedge fund investing that came to the forefront during the global financial crisis.

Investors require enhanced transparency to better understand investments made by hedge fund managers, and to better assess their liquidity. Customization, both in investment mandate and commercial terms, is increasingly sought to ensure hedge fund allocations better complement investors’ wider portfolios. Managed accounts, which allow for transparency and customization, play an important role in this evolution in the hedge fund industry.

The increase in managed accounts is also indicative of the ebb and flow relationship between the investor and manager. When capital is difficult to obtain or hedge fund performance is lagging, investors offering capital drive the relationship. When performance is outstanding and capital plentiful, investment managers dictate more of the terms. Hedge funds currently quite often find themselves in the former arrangement. Most managers would generally prefer to have a fund vehicle that they are able to market to those investors who don’t have the operational infrastructure necessary for managed accounts. A fund vehicle provides a readily determinable track record and also is easier and less expensive operationally for managers running multiple managed accounts and perhaps a fund vehicle as well.

WB: What are some of the main issues addressed by SMAs?

KMPG: Transparency and control. An SMA gives the investor transparency into the underlying hedge fund portfolio as accounts can typically be viewed on a live basis. Contrast this with a commingled fund where the level of transparency is limited (only aggregate exposures or top 10 positions are provided) and available on a weekly or monthly basis at best.

An SMA provides the owner with full ownership of the underlying assets and ultimate control, including the authority of when to invest or disinvest. The manager is typically only provided authority for trading on the account. This provides the manager with sufficient power to manage the portfolio on an ongoing basis, but limits wider authority such as the ability to move cash and securities.

The greater oversight this provides contrasts greatly with a commingled hedge fund whereby the manager has full control, typically with a more opaque structure. In addition, the investor has the ability to take immediate control of the portfolio should it be necessary (for example, when the manager repeatedly breaches risk guidelines).

Ultimately the investor has the authority to replace the manager in a manner that does not upset the managed account structure or the underlying portfolio. Finally, increased transparency and control enables the investor to manage hedge fund investments as a portfolio or as a component of a broader portfolio of investments. Utilizing commingled vehicles does not provide the access, transparency or control of the underlying portfolios necessary to facilitate an extension of the investment process in this manner.

Often managed account platforms are resident in investors who are institutions with highly regulated activities, e.g. banks. In order for those institutions to comply with their regulations, managed accounts can more readily address many of the prescriptive practices that the rules require.

However, in today’s environment, it should be noted that some of the popular quantitative trading strategies may not fit as well into a managed account platform due to the high degree of technology investment that it would entail for the investor.


The transparency provided by the SMA provides the investor with an improved understanding of the liquidity of the hedge fund investment through full transparency into the underlying portfolio. It also reduces the considerations of liquidity to the portfolio itself (for example, an SMA removes from consideration the liquidity risk impacted by other investors in a commingled vehicle). The SMA may still contain illiquid assets as permitted by the investment management agreement, and such assets will be unaffected by the underlying liquidity conditions. However, the investor is much better positioned to assess the actual liquidity of the investment positions.

Ongoing monitoring and risk management

The transparency provided by an SMA provides the investor with an improved ability to monitor the ongoing performance of the hedge fund manager, typically on a ‘live’ basis with regular (e.g. daily) reporting. This allows the investor to understand exactly how returns are being generated and offers insight from a risk management perspective (such as early detection of style drift). This perspective enables the investor to challenge decisions made by the manager and understand periods of underperformance.

In addition to investment monitoring and risk management, SMAs offer the investor the ability to better manage operational risk. With operational weaknesses often the source of frauds where they occur in hedge funds, investors are keenly focused on the operational details of the hedge fund. In a commingled fund, key operational decisions such as the appointment of service providers and creation of internal controls are at the discretion of the manager. In an SMA, the investor makes these decisions and is responsible for setting up the operational structure. Investment managers often are encouraged to utilize service providers and finance arrangements that may not optimize their trading, execution and middle office clearing of transactions in their portfolio.

WB: You refer to operational aspects of SMAs. What are the important operational considerations of SMAs, and how do they impact the decision of whether or not to utilize SMAs?

KPMG: A key reason for managers to offer SMAs to investors is the potential commercial benefits to them – increased investor base and assets under management. However, offering managed accounts to investors will potentially increase costs to the manager (and the investor, for that matter) both from an investment and operations perspective with the management of more, potentially quite different portfolios.

With only one investor in a managed account, all accompanying costs are borne by that investor – these include, for example, the time required by the investor and the costs incurred through the employ of third party service providers. There are economies of scale that come with commingled funds by sharing such costs with other investors. The costs of SMAs include the costs to set up the structure along with the ongoing operating costs. These costs are typically a key impediment for small managers and small investors to use SMAs. Where the cost is not an obstacle, the investor has to be comfortable with the transfer of the operational responsibilities and costs from the manager/commingled fund to the investor itself.

This increased cost and complexity of SMAs is a key reason why an industry of infrastructure providers has arisen in the past several years. Such providers have made offering managed accounts more palatable for managers and investors because of their ability to handle most of the operations as an outsourced managed service. In addition, these providers have been able to focus on operational efficiency, thereby possibly making SMAs more affordable to a wider range of investors/managers.

Ironically, smaller managers who are most dependent on new capital infusions are the most constrained by their less robust operational infrastructures while larger managers who have the resources to accommodate managed accounts are often more inclined, absent a large mandate, to utilize their already established commingled funds for new capital flows.

WB: Can you get more specific as to how costs and fees for SMAs compare to those for commingled funds?

KPMG: The 2015 KPMG/AIMA/MFA Hedge Fund Survey found that two-thirds of the respondents expect that offering specialized fee structures will be a key growth strategy to attract investors in the next five years. An SMA gives the investor more ability to negotiate fees with the manager, specifically allowing for the negotiation of fee structures that are specific to the investment mandate (which is not available in commingled funds). This can include altering the split between the management and performance fees, a flat fee arrangement, or a performance fee only or management fee only arrangement. Other terms such as capital lock-ups and fees based on performance over periods longer than one year, as well as performance fee hurdles and claw backs, can also be incorporated to further negotiate fee terms. For these reasons, it is expected that SMAs will continue to contribute to the downward pressure on fee structures experienced in the industry during recent times.

It should be observed that even outside of the managed account platforms, there has been much progress made in the overall hedge fund industry regarding the alignment of interests between hedge fund managers and investors. The use of high water marks, hurdle rates, clawbacks of performance fees, longer lock ups, greater transparency and personal capital investments have all contributed to the lowering of fees and the continued relative acceptance of commingled investment vehicles in many cases.

The operational costs of SMAs include the third party service providers to the managed account: custody, administration, legal, etc. Operational costs of SMAs are much clearer than for commingled funds because the investor sees the exact costs incurred by each service provider. However, as the economies achieved in a commingled fund are not achieved in an SMA, overall operational costs of an SMA are expected to be higher. Cost savings can be achieved by using specialized providers of hedge fund services, where there is scope to bundle together the required services.

The existence of operational costs and risks are key considerations for investors and managers when contemplating SMAs. Sufficient size and scale or access to providers of hedge fund services is required to ensure that the approach is viable.

WB: Aside from the issues addressed above, what else should a manager be aware of when considering SMAs and managed accounts?

KPMG: Managers should be cognizant of both regulatory and tax ramifications when considering SMAs since significantly different results can occur. Recent changes to the SEC regulatory regime for investment advisors now require Investment Advisers who advise SMAs or managed accounts to be registered when it reaches a $25 million AUM level. The level for registration required for advisers to commingled funds currently stands at $150 million. Accordingly, an adviser managing a commingled fund of less than $150 million and previously not registered as an Investment Adviser with the SEC might inadvertently be subject to that regime by virtue of taking on an SMA. The process of filing as an Investment Adviser and the approval of that filing need to be considered. In addition, all of the regulatory obligations (written compliance processes, procedures, Chief Compliance officer, etc.) need to be in place as well.

Secondly, managers of commingled funds typically enjoy the benefits of Carried Interest treatment of the incentive fee allocation for U.S. tax purposes. The tax advantaged treatment of carried interest is generally not available in a typical SMA unless structured as a Fund of One. So, in addition to fees potentially being lower in SMAs, the manager has to take into consideration the after-tax impact of the fee revenue.

WB: What should a manager consider with regards to most favored nation (“MFN”) provisions and how could this impact future investor negotiations with the flagship fund?

KPMG: Although this is fundamentally a legal question, there are business implications of this legal matter that should be explored. Managers should be attentive to negotiations with sponsors of managed account platforms and other investors requesting an SMA arrangement – not only on the merits of the terms but on the perspective of either an existing commingled fund or a future fund offering. First off, investors generally inquire about fee arrangements in other vehicles as a ceiling for any fee discussions. Hence, managers should be sensitive to any concessions provided. More importantly, assuming the manager is executing a particular trading strategy identical across both vehicles, often Investors in SMAs have superior liquidation rights that may create a disadvantage for investors in the commingled vehicle. This may be viewed as potentially having significant market impact for an investor and, thus, a potential conflict of interest for the manager.

WB: What investment advice would you give mangers when looking at the investment strategy consistency between the flagship fund and the potential SMA? When would the SMA process not make sense for the fund in terms of investment match?

KPMG: Similar to the liquidity issues discussed above, that impact becomes more dramatic when liquidating less liquid financial instruments or markets with less short term capacity, where liquidations in the SMA may drive down valuations that could impact redemption value of the commingled fund or restrict position liquidations in its entirety.

In addition, in today’s environment, as more creative fee arrangements are crafted, the manager may find itself having different benchmarks for the different vehicles. This in turn could incentivize the manager to trade differently and potentially could have a deleterious impact on the SMA or the commingled fund, depending on the circumstances. Managers should strive to limit the conflicts of interest created by the variety of structures.

At the same time, the investment management agreement for the SMA may be such that the investor expects differences in performance from the flagship fund, by design. It depends on the investor’s objectives for the SMA and the terms included in the investment management agreement. As a result, investment consistency between the SMA and the flagship fund would not necessarily be important to the investor.

Investor Sentiment

Capital Introduction Insights: Third Quarter Summary

Contributing Authors: Lauren Anderson, Capital Introduction, Wells Fargo Prime Service and Alison Arzac, Capital Introduction, Wells Fargo Prime Services

Many investors believe the equity markets are on the higher end of the valuation range and that a correction could occur sometime within the next few quarters. Given that, investors have turned their focus to credit strategies and continue to look opportunistically for funds performing well across all strategies.

For credit strategies, investors are willing to give up liquidity for return streams and favoring longer lock and drawdown structures such as private credit and direct lending strategies. In addition, investor interest has improved for systematic managers and macro strategies who have performed well for 2016. Lastly, esoteric and niche strategies have been increasingly popular as they are uncorrelated and outperforming Equity L/S this year. In a recent Preqin article, the largest proportion (21%) of fund manager participants believe that CTAs will be the best performing strategy in 2016 whereas 30% of fund participants believe that equities will be the worst performing strategy in 2016 .

Hedge fund fees have been a topic of focus over the summer months as hedge fund returns continue to disappoint. The fee discussion started with the SALT conference (most notably from Leon Cooperman of Omega) and the Milken conference (with comments made by Warren Buffet) and has continued throughout the past months. The allocators who continue to make new allocations are becoming more sensitive to fees and are more aggressive in negotiating for lower fees, especially from less established managers. The traditional “2 and 20” fee structure is becoming challenged throughout the entire industry given that hedge fund performance, on average, has lagged market indices for the past six years.

According to a study of 120 alternative houses, three-quarters of hedge funds offer or are considering offering a sliding-scale fee, where management fees decline as the fund’s assets increase . A few investors told the Capital Introduction team they are no longer evaluating “2 and 20” managers because they are seeing plenty of talented managers with lower fees. HFR has reported that investors are now paying an average of 1.5% management fee and 17.7% performance fee.

Hedge Funds around the globe are willing to cut management fees to attract new capital in a tough capital raising year. Tudor, run by Paul Tudor Jones, in July trimmed fees for a share class that contains most of its biggest hedge fund’s money to 2.25% of assets and 25% of profits. The fees were 2.75% and 27% . In addition to outright reducing fees, some managers are considering hurdle rates and/or reducing management fees as firm AUM grows.

Legal & Regulatory Update

SEC proposed new rule for RIAs with regards to BCP and Transition Planning

Contributing Author: Kimberly Broder, Special Counsel, Katten Muchin Rosenman

The Securities and Exchange Commission (SEC) proposed a new rule under the Investment Advisers Act of 1940 (the Advisers Act) that would require an SEC-registered investment adviser (RIA) to, among other things: (i) adopt and implement business continuity and transition plans; (ii) conduct an annual review of those plans; and (iii) comply with corresponding recordkeeping requirements.

The proposed rule is designed to ensure that each RIA has a plan in place to address operational and other risks related to a significant disruption in the adviser’s operations in order to minimize client and investor harm. Although the proposed rule addresses requirements only for RIAs, all investment advisers, including those exempt from registration, are subject to the Advisers Act antifraud provisions and therefore should consider the SEC’s guidance when designing and implementing a business continuity and transition plan as a matter of best practice.

The proposed rule and rule amendments are intended to address a wide range of practices that advisers employ with respect to business continuity, succession planning and operational transition. While advisers may not always be able to prevent significant disruptions to its operations, advance planning and preparation can help mitigate the effects of such disruptions and in some cases, minimize the likelihood of their occurrence.

The proposed rule requires the business continuity and transition plan to be maintained in writing and to include a set of specific elements. While each business continuity and transition plan must address the specific elements, the SEC recognizes that operations vary significantly among RIAs and therefore, the proposed rule permits RIAs to tailor their business continuity and transition plans based on the complexity of their business and the risks related to each RIA’s particular business model and activities. The SEC has not issued any guidance as to how business continuity and transition plans may differ given an adviser’s regulatory assets under management other than that these plans should be tailored to the complexities and nuances of an adviser’s business. As a result, as a matter of best practice, utilizing outside counsel and/or a compliance consultant may be beneficial in assisting an adviser in preparing the most appropriate and comprehensive business continuity and transition plan.

Compliance Officer Liability

Wendy Beer, Head of Business Consulting, Wells Fargo Prime Services speaks with Rick Marshall, Partner at Katten Muchin Rosenman.

Rick specializes in investment management enforcement. Rick was a former SEC branch chief of the Division of Enforcement in Washington, D.C. and a former Senior Associate Regional Administrator in the SEC’s New York office. Rick also counsels investment companies and investment advisers on regulatory, compliance and risk management issues.

WB: When is a compliance officer treated as a supervisor?

RM: In 2013, the SEC stated that a compliance officer will not ordinarily be subject to supervisory liability. However, the SEC reaffirmed the test based upon “the requisite degree of responsibility, ability, or authority to affect [another] person’s conduct.”

There are two problems with this test. First, the test is vague. Unlike the clear standard of liability created by “line” supervision – the power to hire, fire, discipline, or set compensation – it is often hard to know whether a person can “affect” another person’s conduct. Second, the test is applied illogically. The test is applied when the compliance officer’s advice is ignored, which suggests that the compliance officer cannot affect the conduct of others.

WB: Compliance officers have also been found liable under a cause theory, which only requires a showing of negligence, “where the [compliance officer] has exhibited a wholesale failure to carry out his or her responsibilities.” What constitutes a “wholesale failure”? Is this judged with hindsight bias?

RM: This second theory of compliance officer liability is also vague. While “a wholesale failure to carry out his or her responsibilities” sounds like a high standard, the cases applying this test suggest a very low standard. Indeed, some commentators have suggested that the test is unfairly applied with hindsight bias – since there was illegal conduct, the compliance officer must have been somehow derelict.

For example, in In the Matter of SFX Financial Advisory Management Enterprises, Inc., a Chief Compliance Officer was charged with causing a misappropriation despite, upon learning of the violation, “promptly [conducting] an internal investigation” resulting in the offender’s termination, and reporting the matter to law enforcement.

The SEC charged him with causing the violation he reported on the theory that the CCO “was responsible for implementation of the policies and procedures,” and that those procedures allegedly were not reasonably designed to prevent the misappropriation of client funds.

WB: In the matter of Judy Wolf, a compliance officer, was sued by the SEC for modifying a memo memorializing a compliance review she had conducted simultaneous with her investigation of the conduct at issue, but after the SEC started to investigate her review. What message does this send to compliance officers about documenting their work?

RM: There are benefits to documenting a compliance officer’s work. Such documentation provides after-the-fact proof that work was done. However, a few notes of caution are: (i) any notes created should be written simultaneous with an internal investigation conducted by the compliance officer; (ii) with increased scrutiny of the adequacy of compliance policies and procedures to detect and respond to potential wrongdoing, the compliance officer’s documentation must be prepared with care. Documenting inadequate work, or improperly documenting adequate work, may be worse than preparing no documentation at all. In the SEC’s eyes, if the investigation was not properly documented it is hard to argue that it ever occurred. Consulting outside counsel to help determine what to document and how, has a twofold purpose: first, it may help the manager to claim attorney-client privilege for certain documents. Second, external counsel can advise on best practice for documenting the investigation.

WB: What are the obligations of a compliance officer when he or she receives notice of possible misconduct?

RM: A compliance officer is expected to act with reasonable diligence to cause an adequate investigation to be conducted of possible misconduct. That investigation must do more than ask the alleged wrongdoer to confirm that everything is OK. The compliance officer does not have to conduct the investigation personally; the task can be delegated to competent subordinates or assigned to outside counsel. If wrongdoing is established, it must be stopped. If the firm will not conduct a reasonable investigation, or will not stop wrongdoing, the compliance officer must report to the highest level of the organization, then if the response remains inadequate, must either resign or report to the SEC.

WB: How can a compliance officer reduce the risk of personal liability?


  • Develop a clear job description and a clear mission statement for the compliance group.
  • Document clear lines of supervision within the firm.
  • Review the firm’s policies and procedures. Repeal any that are not being followed.
  • Continue all required compliance testing and reviews, even during emergencies.
  • Respond to all red flags of possible misconduct. Pay particular attention to whistleblower reports.
  • Address the “two hats” problem – acting in both a compliance and business capacity.
  • Escalate all material issues to senior management.
  • Keep informed about business practices.
  • Request permission to obtain advice from independent legal counsel if there is a disagreement with senior management.
  • Consider resignation or report to the SEC if management will not address serious concerns.
  • Obtain adequate indemnification and insurance protection.

WB: What type of insurance should a compliance officer obtain to insure that he is covered for personal liability?

RM: At a minimum the compliance officer would want to ensure there is adequate directors and officers (“D&O”) liability insurance in place. The compliance officer should liaise with an expert to conduct a thoughtful review of the adequacy and design of his firm’s D&O insurance focusing on understanding the persons covered by the insurance, including whether the compliance officer comes within the definition of an ‘insured person’ or whether the compliance officer needs to be specifically named on the policy; what acts or occurrences trigger coverage; the available limit for various insured parties; and whether the limit is shared with other types of coverage such as errors and omission insurance.

In addition, a compliance officer should review or have reviewed the firm’s bylaws and corporate documents to better understand what remedies are available to the compliance officer if he or she personally becomes named as a co-defendant in a suit against his or her employer, or pursued directly by a regulatory agency, including determining whether the compliance officer should obtain a personal indemnification agreement related to any such suits.