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SEC Poised for Massive Audit of Hedge Funds

The U.S. hedge fund industry will be deluged with on-site examinations over the next three years, as the Securities and Exchange Commission broadens its oversight of this sector with a focus on strategy, valuation processes and “side pockets,” a leading securities litigator said on Wednesday.

“Hedge funds are far more likely to get an audit in the next three years than ever before,” said Liam O’Brien, a partner at McCormick & O’Brien in New York. Speaking at a conference sponsored by the law firm Citrin Cooperman, O’Brien, who has faced off with the SEC across a range of issues facing fund managers, said the agency was poised for a “dramatic increase in onsite exams.”

Last month, Mary Jo White, Chairman of the SEC, noted in a speech to the Managed Funds Association, how the Dodd-Frank Act had required most advisers to hedge funds and other private funds to register with the agency and report basic information regarding business operations and conflicts of interest. In addition, White said one of the key requirements would be to collect information on the “risk-profiles” of their funds.

Echoing White’s speech, O’Brien said the examinations would likely be “risk-based presence” exams, but would include a focus on “side pockets.”

A “side pocket” is typically an account that is used to segregate certain assets from a hedge fund’s primary investment portfolio. In most instances side pockets are used to hold less liquid securities. A fund’s disclosure and documentation may specifically permit the use of side pockets, allowing managers to isolate investments until market conditions improve. By segregating the less liquid assets, the managers can protect the fund’s investors.

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