Hedge Fund Audits Expected to Increase in Importance
The Madoff scandal has shown the hedge fund industry many things, not the least of which is the importance of hedge fund audits. While the details of Madoff’s audits are still a little unclear, it has been widely reported that the audit firm he used was a little known shop which is tightlipped. This article investigates reaction of hedge fund investors with regard to hedge fund audits going forward. (Please note, the Maddoff investment firm was not a hedge fund; however, the scandal will likely have a great influence on hedge fund due diligence and audit standards.)
Likely Hedge Fund Audit Fallout
There are two likely fallouts from the Madoff scandal with relation to hedge fund audits. First, it is likely that hedge fund audits will become necessary before most investors invest with a hedge fund manager. Second, investors may start to demand that hedge funds have name brand auditors or at least auditors with a significant hedge fund experience.
Audits may become mandatory
While it remains to be seen whether hedge fund audits would be required under any new hedge fund legislation at the federal or state level, it does seem clear that investors will require hedge funds to audit their track records every year. The current best practice is for hedge funds to have a yearly audit and a vast majority of hedge funds do in fact audit their returns every year. However, there are many funds which do not currently go through yearly audits, mostly for cost reasons. It is unlikely that going forward these funds, and new start up hedge funds, will be able to simply skip an annual audit – it is likely that investors will shun those funds without audits.
Name Brand Auditors
Another likely result of the Madoff scandal is that hedge funds will need to retain name brand auditors, or at least auditors which have a significant hedge fund practice. The big four audit firms may in fact see a larger amount of business from hedge funds who want to show investors that they are completely above board. Retaining a big four law firm will make some investors feel easier about investing in the hedge fund, however, it comes at a cost. Big four law firms will charge $25,000 to $35,000 depending on the nature of the hedge fund’s business and its valuation practices.
Smaller hedge funds which cannot shoulder such costs without the costs digging into the investor’s returns usually try to go with boutique audit firms which have significant experience with hedge funds. This is unlikely to change much and investors should feel comfortable with the level of expertise that these boutique audit firms offer.
There are some hedge funds, however, who do use smaller audit firms which do not have a regular hedge fund practice. It is likely that the use of such neighborhood audit firms will decrease over the next couple of years if investors demand more audit expertise to ensure their investment is safe.
How to handle other issues
It is unclear yet whether there will be significant changes to the manner in which audit firms evaluate valuation practices. In an earlier article about the SEC’s views on asset valuation the SEC may be seeking different methods of valuation in certain circumstances. Any changes to the current FAS 157 would come from the Financial Accounting Standard Board (FASB) and would be well reported on this website and other financial publications. If there were material changes to this and other FASB pronouncements then hedge fund audits could potentially increase in price (depending of course on the nature of a fund’s individual investment program and asset holdings).
Please contact us if you have any questions on this article or if you would like a recommendation for a hedge fund auditor. Other related hedge fund law articles include: