What issues and challenges may new regulations pose for auditors of hedge funds and funds of hedge funds?

As governments and regulators begin to introduce a raft of new rules and regulations aimed at increasing transparency and reducing risk, the industry is bracing itself for the many challenges compliance will bring.

An already complex industry is about to become even more complicated as concerns over possible systemic risks to the international financial system posed by the industry are addressed by new rules targeting the use of leverage and trying to diversify risk.

For the accounting industry these changes mean auditors will need to have a thorough understanding of regulations and how they impact the auditing and valuation processes as well as other aspects of the fund.

Julian Young at Ernst & Young in London believes the coming regulation will increase complexity in the industry as investment managers grapple with how to apply and interpret the new requirements.

“There is little precedent for some of the anticipated regulation and consequently the risk of non-compliance will increase. Some of the measures on registration, enhancing transparency to minimise systemic risk and enhancing cross-border marketing, are sensible,” he notes. 

“However, rules to limit leverage, to mandate how a fund must be managed or to limit choice for European investors, seem to be poorly aimed and unrelated to the financial crisis,” says Young.

These circumstances, together with increasing product and structure complexity, demand that auditors have a deep understanding of the industry and associated tax and regulatory requirements, believes Young. “Clients rely on their auditors for advice and insight. Auditors will therefore need to ensure that they have the requisite skills and understanding to respond to client demands,” he comments. “It is in these times that specialisation is critical and firms who have specialised in alternative investment management will be well placed.”

Stuart McLaren at Deloitte takes a different approach. “We do not expect the regulations to have a significant effect on fund audits,” he says. However, he does believe the US self-custody rules will require auditors to perform more work on clients who self-custody and to produce SAS70s.

“The new regulations will force fund managers to outsource more activities and thus, as managers and directors will still be held responsible, they will need to learn how to efficiently and effectively monitor these activities,” notes McLaren.

Deloitte also expects the EU regulations to have a significant impact on the way administrators and custodians do business. “Fund managers and directors will need to work carefully with their service providers as they respond to the regulations. This may include agreeing new service level agreements and fees for the service provider’s additional responsibilities per the regulations,” says McLaren.

KPMG believes there is going to be massive regulatory change over the next few years. The accounting profession, as an important service provider to the hedge fund industry, needs to engage with regulators to help try to ensure that this regulation is proportionate and will be effective, says KPMG.

Clients will need help to achieve compliance with new regulations and KPMG expects to be asked by fund directors and regulators for additional assurance on valuations, systems and controls.

Anthony Pace and Noel Mizzi at KPMG in Malta agrees the standards being proposed by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) should provide the industry with the necessary requirements and guidance to reduce the amount of subjectivity and make the valuation process more uniform and transparent across different jurisdictions.

This is also complemented by the fact that the FASB and the IASB seem to be converging in the valuation and disclosure requirements under new standards being issued, notes Pace and Mizzi.

Barry Winters and Garrett O’Neill at KPMG in Dublin raise concerns about the draft EU directive on alternative investment fund managers. They believe there are a number of issues and challenges for auditors posed by the draft regulations. As it now stands, the draft requires the alternative investment fund to have the annual report available to investors and competent authorities no later than four months following the end of the financial year. This requirement is less than the six-month current requirement for Cayman-domiciled funds and many other jurisdictions.

The reduction in the period for preparation of financial statements may give rise to significant practical difficulties, say Winters and O’Neill.

The draft directive’s devolution of powers and responsibilities with respect to an alternative investment fund directly to the fund manager without reference to the board of directors will prove problematic for governing bodies and auditors.

In the Cayman Islands, Colin Hanson at PricewaterhouseCoopers believes whatever the eventual outcome of legislative deliberations in Europe and the US, audit firms will “do whatever is required under any new regulations”. “Various regulatory initiatives are likely to lead to higher costs of compliance for managers and investors,” he concludes.