Success Brings Compliance Headaches for Small Hedge Funds

January 24, 2011

Even the “guppies” of the hedge fund industry may face compliance headaches and stifling expenses when new regulatory oversight goes into effect this July.

So says Frank LaGrange Johnson, who runs LaGrange Capital Partners out of New York. With total assets for his funds now around $150 million, Johnson will have to register with the Securities and Exchange Commission thanks to new rules designed to improve industry oversight, according to an article in the New York Times.

The new rules stipulated by the Dodd-Frank regulatory overhaul are set to take effect in July. They will force hedge funds of $150 million or more to maintain records of emails and investments, disclose details about their business such as their prime brokers and auditors, and set up compliance programs that include having an executive to oversee the whole process.

Big funds such as SAC Capital Advisors or Eton Park Capital Management have fully staffed compliance departments to handle this additional paperwork. But the requirement could put a serious dent in the bottom line of smaller funds.

For example, Johnson’s firm had to register in 2004 with the S.E.C. before the law was overturned in federal court two years later. At that time, Johnson says the additional regularly legwork cost his firm roughly $250,000. For a fund like his that charges below-average management expenses of 1 percent of assets, and has roughly $1.5 million a year for operational expenses, an extra quarter-million dollars in expenses take a serious bite out of his bottom line.

“We have four people,” he said. “So I’m going to hire a fifth person to do compliance? What will end up happening is that my treasurer will wear two hats,” Johnson said.

Johnson also wonders whether the new regulations will impede growth for smaller hedge funds. The Times article points out that many of today’s biggest funds, such as $6.8 billion Greenlight Capital founded by David Einhorn, or the $20 billion firm King Street Capital, began with just a few million dollars. If smaller funds are near the break-even point for their business, the new regulations are going to add a significant extra cost. It could become a barrier to entry for new funds or force smaller existing funds to merge and lose their independence.

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