Monday, May 28, 2012

KPMG-AIMA Study Finds Institutionalization of Global Hedge Fund Industry and Concern over the Severe Impact of FATCA

A joint study by a Big Four accounting firm and a global hedge fund association reveals that since the advent of the financial crisis, new capital coming into hedge funds has been largely from institutional investors, with the majority of assets under management now coming from pension fund and other institutions rather than from high net worth individuals and family offices. Because institutional investors are extremely demanding in terms of due diligence and require robust operational infrastructure in the fund managers they allocate to, said the study, hedge fund managers have strengthened their own infrastructure. And because these institutional investors seek increased transparency, hedge fund managers have increased their emphasis on transparency and due diligence. The study was a joint effort of KPMG and the Alternative Investment Management Industry.

All this has been happening in the context of a major wave of new post-crisis regulation impacting the industry. While the hedge fund industry accepts that increased regulation is here to stay, found the study, the industry would hope to see cross-border regulatory convergence and harmonization. Globally, regulators have been working toward a G20 agenda of introducing new registration and reporting rules for hedge fund managers, with the Alternative Investment Fund Managers Directive in the European Union and the Dodd-Frank Act in the United States, with both seeking to increase the flow of information from hedge fund managers to regulators. Changes to the regulations around short-selling and OTC derivatives clearing have also significantly impacted hedge fund managers.

But the study said that the wide-reaching Foreign Account Tax Compliance Act (FAT CA) is likely to severely impact the global hedge fund industry. FATCA is aimed at preventing offshore tax abuses by US persons. The legislation requires every foreign financial institution (FFI) to enter into an agreement with the Internal Revenue Service whereby the FFI commits to identifying US accounts and reporting them annually to the IRS. Hedge funds and managers will be captured by FATCA, said the study, since it impacts all domestic  and foreign financial institutions that make and/or receive withholdable payments or are in the same expanded affiliated group as an entity that makes and/or receives withholdable payments.

Non-compliance with FATCA will result in what the study called a ``penal withholding regime’’ (30 percent) on foreign entities that refuse to identify and report US persons. The study found that this regime would put severe commercial pressure on non-participating hedge fund managers, those not entering into agreement with the IRS, in terms of investing into the US for either themselves or their customers and investors; thereby damaging customer relationships and reducing business opportunities.

FATCA is expected to impact hedge funds in a number of ways. Counterparties are likely to demand all FFIs be compliant in order to guard against the contingent risk that a hedge fund’s control environment is not sufficiently robust to guarantee it will never have the slightest exposure to US assets or clients. Hedge funds will need to identify their US account holders and demonstrate the rest are not US taxpayers. In addition, withholding rules require that the hedge fund must have the systems and process capability to identify and withhold tax on payments to entities or people who are not in good standing in the regime. This may present significant technical challenges for hedge funds.