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Schulte Roth & Zabel Navigating A Brave New World

This years Schulte Roth & Zabel’s  (SRZ) 19th Annual Private Investment Funds Seminar stuck a very different pose from last years event.  One year on from the global meltdown of financial markets, languishing institutional certainty and the  pervading crisis of industry confidence has been replaced with a cautious optimism.  The bold swagger of the industry however is gone, in its place a more certain sense of direction and expectation is emerging.  Though managers continue to labor under unachievable  high water marks due to the 2008 market devastation, 2009 marked a year of exceptional performance.   Investment portfolios rebounded in line with the upturn in the equity and bond markets.  Liquidity improved and net inflows into the industry has turned positive during the last quarter as large institutional investors and sovereign wealth funds returned to the sector with generous allocations.  These are taken as clear signs that the industry has stabilized and the path to recovery and the healing of economic and psychological wounds are underway.  Yes the industry will survive and ultimately thrive again but it will do so under vastly different conditions.  The new business landscape will require an industry with a guarded culture of  opaqueness to provide much greater transparency while operating under a regimen of greater regulatory scrutiny.

The 1,900 registered attendees heard a message about an industry at a cross road  still coming to terms with the market cataclysm brought on by unfettered, unregulated markets and excessive risk taking.  SRZ offered an honest assessment in examining the industries role in the market turmoil.  Speakers alerted attendees to an industry at a tipping point.  To survive the industry must adapt to a converging world that believes that uniform market rules and regulations are the surest safeguards against catastrophic systemic risk events.  A global political consensus is emerging  that expresses  support for industry regulation as an effective tool to mitigate the pervasiveness of fraud and market manipulation that undermines investor confidence and ultimately the functioning of a fair and efficient open free market.

Paul Roth, Founding Partner of SRZ,  noted in the events opening remarks that the market is beginning to recover as evidenced by industry AUM once again exceeding the $2 trillion mark;  but  he warned  that any exuberance needs to be tempered with the understanding that the new normal would not resemble the pre-crash world.  The days of  cowboy capitalism and radical laissez-faire investing are clearly over.   Indeed Mr. Roth wryly observed “the industry must develop a maturity about the need for change.  He concluded “that the industry must respond by playing a constructive role in forming that change.”

The conference subject matter, speakers and materials were all top shelf.  Break out presentations on risk management, regulatory compliance, distressed debt deal structuring, tax strategies and compensation issues all reinforced the overriding theme of an industry in flux.  The presenters passionately advocated the need to intentionally engage the issues  to confront accelerated changes in market conditions.  By doing so, fund complexes will be in a position to better manage the profound impact these changes will have on their business and operating culture.  Subject issues like insider trading, tax efficient structuring, hedge fund registration,  preparing for SEC examinations and the thrust of DOJ litigation initiatives and how to respond to subpoenas were some of the topics explored.

To highlight the emerging regulatory environment confronting the industry, a  presenter pointed to the Southerization of the SEC.  This is an allusion to the hiring of former criminal prosecutors from the Department of Justice, Southern District of New York to go after wayward fund managers.  The SEC is ramping up its organizational capability to effectively prosecute any violations of the new regulatory codes.   The growing specter of criminal prosecutions and the growing web of indictments concerning the high profile case of Mr. Raj Rajaratnam of the Galleon Group was presented as evidence of an emerging aggressive enforcement posture being pursued by regulators.  Managers beware!

Presenters made some excellent points about how institutional investors are demanding greater levels of TLC from their hedge fund managers.  This TLC stands for transparency, liquidity and control.  Creating an operational infrastructure and business culture that can accommodate these demands by institutional investors will strengthen the fund complex and help it to attract capital during the difficult market cycle.

The evening concluded with an interesting and honest conversation between Paul Roth and Thomas Steyer,  the Senior Managing Partner of Farallon Capital Management.  The conversation included increased regulatory oversight, compensation issues, industry direction and matching investor liquidity with fund strategy, capacity, structure and scale.   Mr. Steyer manages a multi-strategy fund complex with $20 billion AUM,  his insights are borne from a rich industry experience.  He made the startling admission that Farallon has been a registered hedge fund for many years and he believes that the regulatory oversight and preparation for examiners reviews helped his fund management company to develop operational discipline informed by sound practices.

Mr. Steyer also spoke about scale and that additional regulatory oversight will add expense to the cost of doing business.  Mr. Steyer believes that it will become increasingly difficult for smaller hedge funds to operate and compete under these market conditions.

Another interesting topic Mr. Steyer addressed were issues surrounding investor redemption and fund liquidity.  During last years SRZ conference investor liquidity was the hot topic.  Fund preservation during a period of market illiquidity and a fair and orderly liquidation of an investment partnership were major themes that ran through  last years  presentations.  Mr. Steyer struck a more conciliatory tone of investor accommodation.  He confessed his dislike for the use of “gates” as a way to control the exit of capital from a fund.  In its place he offered a new fund structure he referred to as a “strip” to allocate portfolio positions to redeeming partners in proportion to the overall funds liquid and illiquid positions.  He stated he believed that strategy to be more investor friendly.

Schulte Roth & Zabel has once again demonstrated its market leadership and foresight to an industry clearly in flux, confronting multiple challenges.  These challenges will force fund managers to transform their operating culture in response to the sweeping demands of global market pressures, political impetus for regulatory reform and the heightened expectations of increasingly sophisticated investors.   The industry could not have a more capable hand at the helm to help it navigate through the jagged rocks and shifting shoals endemic to the alternative investment management marketplace.

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Risk: industry, market, regulatory, political

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January 15, 2010 Posted by | hedge funds, institutional, investments, operations, politics, private equity, regulatory, reputational risk, risk management, SEC, sovereign wealth funds | , , , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

IRS Audit Risk Survey: Final Results

tax-returnSum2 is please to report the final results of the IRS Audit Risk Survey for Fund Managers. Sum2 has commissioned the survey to determine financial services industry awareness and readiness for IRS audit risk factors. The survey sought to determine industry awareness and readiness to address IRS Industry Focus Issue (IFI) risk exposures for hedge funds, private equity firms, RIAs, CTAs and corporations using offshore structures.

Survey Background

Due to the pressing revenue requirements of the United States Treasury and the need to raise funds by recognizing new sources of taxable revenue; hedge funds, private equity firms, CTA’s and other corporations that utilize elaborate corporate structures, engage in sophisticated transactions and recognize uncommon forms of revenue, losses and tax credits will increasingly fall under the considered focus of the IRS.

Since 2007 the IRS began to transition its organizational posture from a benign customer service resource to a more activist posture that is intent on assuring compliance and enforcement of US tax laws. Specifically the IRS has invested in its Large and Mid-Size Business Division (LMSB) to enhance its expertise and resources to more effectively address the tax audit challenges that the complexity and sophistication of investment management complexes present. The IRS has developed its industry issue competencies within its LMSB Division. It has developed a focused organizational structure that assigns issue ownership to specific executives and issue management teams. This vertical expertise is further enhanced with issue specialists to deepen the agencies competency capital and industry issue coordinators that lends administrative and agency management efficiency by ranking and coordinating responses to specific industry issues. IRS is building up its portfolio of skills and industry expertise to address the sophisticated agility of hedge fund industry tax professionals.

To better focus the resources of the agency the IRS has developed a Three Tiered Industry Focus Issues (IFI). Tier I issues are deemed most worthy of in depth examinations and any fund management company with exposure in these areas need to exercise more diligence in its preparation and response. Tier I issues are ranked by the IRS as being of high strategic importance when opening an audit examination. This is followed by Tier II and Tier III focus issues that include examination issues ranked according to strategic tax compliance risk and significance to the market vertical. Clearly the IRS is investing significant organizational and human capital to address complex tax issues of the industry. The IRS is making a significant institutional investment to discover potentially lucrative tax revenue streams that will help to address the massive budget deficits of the federal government.

Survey Results

The survey was open to fund management executives, corporate treasury, tax managers and industry service providers. CPAs, tax attorneys, compliance professionals, administrators, custodians and prime brokers were also invited to participate in the study. The survey was viewed by 478 people. The survey was completed by 43% of participants who began the survey.

Geographical breakdown of the survey participants were as follows:

  • North America 73%
  • Europe 21%
  • Asia 6%

The survey asked nine questions. The questions asked participants about their awareness of IFI that pertain to their fund or fund management practice and potential mitigation actions that they are considering to address audit risk.

The survey posed the following questions:

  • Are you aware of the Industry Focus Issues (IFI) the IRS has developed to determine a fund managers audit risk profile?
  • Are you aware of the organizational changes the IRS has made and how it may effect your firms response during an audit?
  • Are you aware of the Three IFI Tiers the IRS has developed to assess a funds audit risk profile?
  • Are you aware of how the Three IFI Tiers may affect your audit risk exposures?
  • Have you conducted any special planning sessions with internal staff to prepare for IFI audit risk exposures?
  • Has your outside auditor or tax attorney notified you of the potential impact of IFI risk?
  • Have you held any special planning meetings with your outside auditors or tax attorneys to mitigate IFI risk?
  • Have you had meetings with your prime brokers, custodians and administrators to address the information requirements of IFI risk?
  • Have you or do you plan to communicate the potential impact of IFI risk exposures to fund partners and investors?

Survey highlights included:

  • 21% of survey participants were aware of IFI
  • 7% of survey respondents planned to implement specific strategies to address IFI audit risk
  • 6% of survey respondents have received action alerts from CPA’s and tax attorney’s concerning IFI audit risk
  • 26% of survey respondents plan to alert fund investors to potential impact of IFI audit risk

Recommendations

Sum2 believes that survey results indicate extremely low awareness of IFI audit risk. Considering the recent trauma of the credit crisis, sensational fraud events and the devastating impact of last years adverse market conditions; fund managers and industry service providers must remain vigilant to mitigate this emerging risk factor.

These market developments and the prevailing political climate surrounding the financial services sector will bring the industry under heightened scrutiny by tax authorities and regulatory agencies. Unregulated hedge funds may be immune from some regulatory issues but added compliance and disclosure discipline may be imposed by significant counter-parties, such as prime brokers and custodians that are regulated institutions.

Market and regulatory developments has clearly raised the tax compliance and regulatory risk factors for hedge funds and other fund managers. Issues concerning FAS 157 security valuation, partnership domiciles and structure, fund liquidation and restructuring and complex transactions has increased the audit risk profile for the industry. Significant tax liabilities, penalties and expenses can be incurred if this risk factor is not met with a well considered risk management program.

In response to this industry threat, Sum2 has developed an IRS Audit Risk Program (IARP) that prepares fund management CFOs and industry service tax professionals to ascertain, manage and mitigate its IRS risk exposures within the Three IFI Tiers. The IARP provides a threat scoring methodology to ascertain risk levels for each IFI risk factor and aggregates overall IFI Tier exposures. The IARP uses a scoring methodology to determine level of preparedness to meet each of the 36 audit risk factors.

The IARP helps managers to outline mitigation actions required to address audit risk factors and determine potential exposures of each risk. The IARP calculates expenses associated with mitigation initiatives and assigns mitigation responsibility to staff members or service providers. The IARP links users to issue specific IRS resources, forms and documentation that will help you determine an IFI risk relevancy and the resources you need to address it.

The IARP will prove a valuable resource to help you manage your response to a tax audit. It will also prove itself to be a critical tool to coordinate and align internal and external resources to expeditiously manage and close protracted audit engagements, arbitration or litigation events. The IARP product is a vertical application of Sum2’s Profit|Optimizer product series.

The Profit|Optimizer is a C Level risk management tool that assists managers to uncover and mitigate business threats and spot opportunities to maintain profitability and sustainable growth.

The IARP product is available for down load on Amazon.com.

The product can also be purchased with a PayPal account: Sum2 e-commerce

Sum2 wishes to thank all who anonymously took part in the survey.

If you have any questions or would like to order an IARP please contact Sum2, LLC at 973.287.7535 or by email at customer.service@sum2.com.

April 20, 2009 Posted by | compliance, CPA, CTA, FASB, hedge funds, IARP, IRS, legal, NP, private equity, regulatory, risk management, Tax, Treasury | , , , , , , , , , , , , , , , , , , , , , , , , , , , , , | 5 Comments