A day before he and his hedge-fund consulting firm were stung by the Securities and Exchange Commission with $815,000 in fines and penalties, a major figure in the hedge fund world started his own effort to change hedge fund audits.
Charles Gradante, co-founder of the Hennessee Group LLC of New York, received an order from the SEC on April 22 alleging that he and his firm had come up short in performing due diligence and evaluating certain hedge funds. A day earlier, he posted comments about hedge fund audits on his firm's website, though he didn't respond directly to the SEC's allegations.
Mr. Gradante said that his goal was to reduce fraud and systemic risk in the hedge fund industry. He advocated outsourcing hedge fund audits to third parties, such as Kroll Inc. of New York, a risk consulting company.
“The Hennessee Group believes they have the forensic skill and "street smarts,'” Mr. Gradante's statement read.
Outsourcing such audits “is an inexpensive way of controlling fraud and systemic risk,” he said in an interview last week.
Hedge funds typically have 100 or 200 investors, Mr. Gradante said, so if each investor contributes $1,000, an effective audit can be done for a reasonable price.
He also said that history shows that investment advisers, funds of funds and securities regulators at the SEC have had extreme difficulty in catching fraudsters.
One attorney noted that the SEC has a history of outsourcing audits, citing the commission's ceding oversight of broker-dealers to what has become the Financial Industry Regulatory Authority Inc. of New York and Washington.
But there is a big difference be-tween Finra and an third party's being responsible for hedge fund audits, said Bill Kelly, partner with Nixon Peabody LLP of New York.
“The enforcement powers of the SEC and Finra could go a long way” toward ensuring that hedge funds are toeing the line with audits, he said.
A forensic accounting firm and consultant such as Kroll may be better suited to work on behalf of large investors, Mr. Kelly said. He added that there is a movement to have Finra take over the supervision of investment advisers from the SEC, and said that the biggest hedge funds are already managed by advisers.
Mr. Gradante had other suggestions to reduce systemic risk and pushed for regulation he called “proactive” rather than “reactive.”
For example, the Hennessee Group recommends assigning the equivalent of a CUSIP number to each hedge fund, especially the 100 largest, he said.
Using a unique identifier like a CUSIP, which all North American securities carry for the purpose of clearing and settling trades, would allow regulators to monitor leverage extended by commercial banks and prime brokers, Mr. Gradante said.
Hedge funds could take other steps to guard against performance fraud, such as sending investors annual financial audits so they could check performance accuracy against the prime broker's report on realized and unrealized gains and losses, he added.
To guard against document fraud, limited partners of hedge funds would receive their annual financial audit reports directly from an accountant and not from the manager, Mr. Gradante said.
Hennessee Group is a registered investment adviser that consults for direct investors in hedge funds.
E-mail Bruce Kelly at firstname.lastname@example.org.