Are US hedge funds fudging information on documentation provided to regulators?

It's a pretty scary thought raised in passing in a study conducted by a Minneapolis law professor. Hidden in a lengthy report on how hedge funds view the challenge and costs of complying with the Dodd-Frank Wall Street Reform Act is one pretty provocative comment. "Anecdotal" evidence indicates that US hedge funds are "flattening out" the information provided on their Form PF, says a statement on page 59 of the report written by Associate Professor Wulf Kaal of the University of St. Thomas School of Law.

Form PF is the documentation used by the Securities and Exchange Commission and other regulators to understand the financial health of a hedge fund and the effects its potential collapse might have on the overall economy. The largest private fund managers were required to submit the form as of late August following their registration with the SEC mandated under the U.S. financial reform legislation. The largest alternative fund managers are required to update the information quarterly and have a lot more sections on the document to fill out than the smallest fund managers which must only provide the basics on annual updates.

Kaal, who teaches international finance, did not ask hedge fund managers specifically about their responses to Form PF so he offered no hard core numbers to back his stance. The information, he tells www.iss-mag.com was provided during discussions with attendees of conferences where the paper was presented. 

"No one wanted to clarify just what the phrase flatten out meant," explains Kaal. "It was the exact wording they used in discussing how they responded to PF which suggests that they took advantage of the SEC allowing them some leeway in how they would answer some of the questions."

A random survey of about a dozen hedge fund compliance executives conducted by www.iss-mag.com on Wednesday also provided little insight into how US hedge funds might have presented information on Form PF. None wanted to publicly elaborate, but privately gave credence to Kaal's "anecdotal evidence," saying they "hedged" their answers when necessary to provide as little information as possible which would expose their trading strategies to competitors if it fell in the wrong hands. Risk metrics -- counterparty, value at risk and liquidity risk were also key areas where the questions were subject to interpretation.

The "anecdotal" evidence begs the question as to whether Form PF will actually provide U.S. regulators -- the SEC and newly created Financial Stability Oversight Council--with any sense of systemic risk, one of the key reasons the documentation was mandated in the first place. Many hedge fund advisers have doubted its long-term efficacy, viewing competing the form as a tedious compliance exercise.

The consensus of the 94 advisers to hedge funds, private equity funds, venture capital funds and real-estate funds who responded to Kaal's questionnaire indicated that complying with Dodd-Frank Wall Street Reform Act was a bit surprising. Although the majority of respondents say they outsourced compliance work, hired additional counsel and staff; instituted new recordkeeping policies; changed marketing materials; and changed communications with investors, the pricetag and time spent complying with the legislation reflected Kaal's conclusion that it had only a "moderate" impact. Most of the respondents said they spent about $50,000 to $200,000 and did less than 500 hours worth of work.

Still, Kaal does offer one key caveat to his study. It is entitled "Hedge Fund Manager Registration Under the Dodd-Frank Act; An Empirical Study," but as Kaal notes, the results are "preliminary." He will be conducting further studies on the effects of Dodd-Frank on alternative funds, with an emphasis on smaller-sized funds. More often than not, their advisers cited cost as a challenge to complying with the new regulations.

Written by Chris Kentouris, Editor-in-chief (Chris can be contacted through Chris.Kentouris@hotmail.com)  

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