Advisors to Hedge Funds Need to Start Preparing for Registration As Investment Advisors

June 05, 2005

Is your firm an advisor to a hedge fund? If so, your firm must register (if it hasn’t already done so) as an investment advisor by February 1, 2006.

Earlier this year, the SEC passed several rule amendments that require hedge fund advisors to register as investment advisors. In essence, the SEC is aiming to improve its knowledge and control of this growing segment of the financial industry. In its rule release, the SEC states in the last five years, hedge fund assets have grown 260%. Some have predicted that by the end of 2005 the amount of hedge fund assets will exceed $1 trillion. Hedge fund assets are growing faster than mutual fund assets and already equal just over one fifth of the assets of mutual funds that invest in equity securities.

However, more than just the recent boom in hedge fund activity, it is the number of fraud enforcement cases that is the driving force behind the registration requirements. In the last five years, the number of cases brought by the SEC against hedge fund advisors represented over 10% of its cases against investment advisors during the same period. The SEC also states that because hedge funds themselves are not registered, no governmental agency has any reliable data on even the number of hedge funds or the amount of their assets. By requiring the registration of hedge fund advisors, the SEC can begin to collect solid data on this industry.

So what does this all mean? It means that if your firm is an advisor to a hedge fund and not currently registered or cannot claim an exemption to registration, it will need to complete the Form ADV, implement written compliance controls, create a code of ethics, designate a chief compliance officer, and follow all of the other rules and regulations under the Investment Advisers Act of 1940.

The Act does exempt an advisor from registration if (1) it had less than 15 clients during the previous 12 months, (2) does not hold itself out to the public, and (3) is not an advisor to any registered investment company. Therefore, you may be asking, “Does my firm need to be registered since it is only an advisor to one hedge fund and does not hold itself out to the public?” In anticipation of that situation, the SEC specifically requires advisors to “look through” the hedge fund and include all investors within the fund when counting clients. For example, an advisor cannot evade registration by claiming that the limited partnership set up to run the hedge fund equals just one client. You need to “look through” the limited partnership and count the actual investors as your advisory clients. If that number is greater than 14 and your assets under management is greater than $25 million, your firm will need to register with the SEC. Firms will assets under management less than $25 million are required to register at the state level.

We suggest advisors to hedge funds begin implementing procedures to comply with the new rules now as opposed to waiting until the last minute. While the SEC can take up to 45 days to approve a registration, some firms have been approved in as little as two weeks. Keep in mind that once you are approved, you need to be in full compliance with the Investment Advisers Act of 1940. Therefore, filing the Form ADV should be the last step you take. Our recommendation is that you submit your Form ADV by no later than early December 2005.

If you need assistance with meeting these new requirements, please do not hesitate to give RIA Compliance Consultants a call today.

Posted by Bryan Hill
Labels: Hedge Funds