After the fight for the right to remain unregistered, only about 10% of those hedge fund advisors that signed up with the Securities and Exchange Commission before last year's Feb.1 deadline have opted to withdraw, according to data from the federal regulator.

The remaining 2,200 or so are readying for examinations.

The reason, industry watchers suggest, is that what was once characterized as the "Wild West" of investment management has learned that registration has its advantages, not the least of which is credibility, especially with deep-pocketed institutional investors.

With the $1.2 billion industry expected to top $6 billion by 2015, many advisors have focused on transforming their industry's image from bad-boy to model corporate citizen. Achieving that, though, means making some sometimes uncomfortable adjustments for this heretofore lightly regulated group.

"Of those that are registered, the SEC is likely to take a close look at their operations, and especially their compliance programs," said Michael Chung, a senior manager in the investment management regulatory consulting practice at Deloitte & Touche during a webcast last week. "The key is managing the process," he said.

Last year at this time, managers complained that the rule, which required those advisors that managed more than $25 million, promoted themselves and had 15 clients or more-with each fund counting as a client-register with regulators. With registration came requirements, including development of compliance programs and submitting to examinations.

At first many advisors cried foul, complaining that registration was too burdensome, too expensive or, in the case of Phillip Goldstein, who runs Opportunity Partners, downright illegal. Opponents argued that foisting registration requirements on advisors would do nothing to achieve the SEC's stated goal of protecting the investing public from unscrupulous fund managers.

The U.S. District Court in Washington agreed with Goldstein that the rule was ill planned, and therefore invalid. The SEC lost again in appeal, and those advisors that had registered were free to withdraw. But through Jan. 4, only 335 hedge fund advisors have withdrawn their registrations, and of those, only 241 have included the Goldstein decisions among the reasons.

"Some may say, Hey, you know what? What's the big deal?'" said Thomas R. Westle, an attorney with BlankRome in New York. When no one was registered, it wasn't an issue, but now institutional investors with a fiduciary responsibility to uphold are getting pickier, he said.

"Now you're out there beating the bushes for new money, and if three funds are registered and two are not, the pension fund might just check off those that are as options," Westle said.

Other fund advisors found that the process of registering and developing compliance programs helped strengthen their own businesses, said Janaya Moscony, president of SEC Compliance Consultants in Philadelphia. "I've heard a lot of positive feedback about how it's helped heighten the level of internal controls and put more infrastructure in place," she said.

Many states also require advisors to register anyway, and it makes little sense for advisors to withdraw registration with federal watchdogs, if they must remain registered with another jurisdiction anyway, she added.

Those that are registered especially are working hard to assure their investors of their transparency, in some cases ending practices still protected by law, such as side letters.

The SEC allows hedge funds to enter into special arrangements with certain investors, say, for example, high-volume institutions, provided the fund advisor notifies all shareholders that side letters exist or may exist-without specifying the terms-and these arrangements do not jeopardize other investors or conflict with other documents or the terms of the initial offering.

"Side letters per se are not a problem," Chung said. "But be prepared to demonstrate to the SEC why the letters are appropriate," he said. That means having parameters for such arrangements and a documented policy in place, he said. Examiners will be especially concerned about arrangements that offer more liquidity to one investor than to others, for example.

But an on-the-spot survey of advisors participating in the webcast showed that 68% chose not to use side letters at all. "The bottom line is this: A lot of hedge fund managers realize that if they offer a greater amount of transparency, they will attract more clients," said Paul Doherty, a principal with Deloitte.

But valuation presents more challenges, as the process is sometimes subjective and based on complex arrangements or investment structures, Chung said.

Examiners have focused on managers' attempts to use so-called side pockets to hide losses, or otherwise mislead investors.

Again, Chung noted that the SEC will want to know what the advisor's process is, who is responsible for what operations and that the entire valuation process is documented. The most common violation among hedge funds is the inability to readily produce requested records, Doherty added.

Advisors also must adapt to being forthright with any problems testing may have uncovered, and what steps the fund has undertaken to correct them. A hedge fund that reports no errors is likely to invite regulators to conduct their own forensic review, Chung said.

Developing compliance programs can represent a daunting cultural shift for employees, and Doherty advocates adopting software programs to help maintain a calendar and coordinate record management.

About 28.4% of advisors polled during the presentation said they used an automated system, and 12.7% said they rely solely on a third-party administrator.

"These program-managing tools are underleveraged in the market. They can be quite useful," Doherty said. They can also be as inexpensive as $5,000 with $600 monthly maintenance fees, he noted, but invaluable when it comes time for an examination.

But software programs are no panacea, Moscony said.

"Automation a lot of times takes out human error, but in the process of evaluating the compliance program, [finding an] error can help identify problem areas," she said.

The SEC wants to see that advisors have thoroughly vetted their processes and developed an internal system catered specifically to their methods, she said. Extensive forensic testing is critical, added Moscony, herself a former SEC examiner.

And while all of this could be pricey for smaller funds, it's hardly as costly as missing out on new money in the rapidly growing industry. In the long term, even small funds might consider remaining registered if their business plan calls for them to grow, thus forcing them to re-register later.

(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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