How the SEC May Be Changing the Way You Outsource

Outsourcing is a popular option for many hedge funds, as it comes with so many benefits. It allows funds to take advantage of unique skillsets and expertise they don’t have in-house, save funds spent on talent by condensing in-house teams, and focus their efforts where it matters most — on both the tasks a firm does best and those that boost its bottom line.   

However, firms may need to start approaching their outsourcing differently, thanks to newly proposed guidance from the Securities and Exchange Commission (SEC). 

Late in 2022, the SEC proposed a new rule and rule amendments that would prohibit investment advisers from outsourcing various services without proper due diligence and monitoring.  

SEC Chair Gary Gensler states, “Though investment advisers have used third-party service providers for decades, their increasing use has led staff to make several recommendations to ensure advisers that use them continue to meet their obligations to the investing public. When an investment adviser outsources work to third parties, it may lower the adviser’s costs, but it does not change an adviser’s core obligations to its clients. Thus, today’s proposal specifies requirements for investment advisers designed to ensure that advisers’ outsourcing is consistent with their obligations to clients.” 

The proposed rule underscores the importance of partnering with high-quality service providers with the proper hedge fund experience.

“As a hedge fund advisory service, our firm sees this as a huge benefit for those outsourced advisory firms that have a responsible process for due diligence and oversight capabilities,” says Arootah Founder and CEO Rich Bello, formerly COO of Blue Ridge Capital, “The proposed rule will allow firms to better work with their clients to ensure regulatory compliance, maintain the highest level of service quality, and continuously protect the interests of the investing public. It fosters a more accountable and trustworthy business environment, which is critical in our industry.”  

Here, we offer a breakdown of the proposed rule and share insights into what every firm must understand to adapt to this new landscape. 

Understanding the Newly Proposed Rule

While this newly proposed rule may seem like a burden that makes it more difficult for firms to outsource select responsibilities to various service providers, it is, in reality, a positive. The ultimate purpose of the proposed rule is to protect investors and ensure the integrity of the financial system — something every firm and service provider should want.  

As Global Private Equity Watch reported, and as Gensler mentioned above, the proposed rule comes in response to the increasing popularity of outsourcing among hedge funds. As such, the rule touches on a few critical considerations intended to protect clients.  

Before hiring a service provider to complete outsourced work, advisers, under the proposed rule, are required to prove that the services outsourced are necessary for the adviser to complete their work under the law and that, if those services are not performed or not performed well, the adviser’s clients will suffer as a result. These adhering services will then be considered “a covered function.”  

Other things the firm will potentially have to consider before outsourcing include: 

• “The nature and scope of the covered function” 
• The potential risks that come with outsourcing that covered function 
• The service provider’s ability to perform the function 
• Whether or not the service provider themselves outsources 
• The service provider’s federal law compliance  
• Whether or not “the service provider can provide a process for the orderly termination of the performance of the covered function”  

The “covered function” guidelines will not include “clerical, ministerial, utility, or general office functions or services,” according to Ropes & Gray.    

Beyond these requirements, the proposal also suggests advisers incorporate a few other tasks into their outsourcing processes, including: 

• Monitoring service providers’ performances 
• Regularly reassessing service providers’ suitability 
• Maintaining records regarding the adviser’s due diligence 
• Reporting the service providers’ information appropriately 

And beyond all of this, the proposal also requires advisers who outsource record keeping to ensure the record-keeping service provider meets the due diligence requirements as listed above and also that the service provider implements appropriate internal processes for that record-keeping, provides access to electronic records, and ensures the continued availability of those records. 

Benefits of the Proposed Rule

While it may initially seem like it’s giving firms additional work, the proposed rule’s benefits are myriad. This heightened level of due diligence will bolster trust, oversight, and accountability within the industry, a move set to benefit advisers and clients alike. 

Outsourcing and the Importance of Quality Third-Party Providers

While only some third-party service providers may remain a good fit for advisers operating under the newly-proposed rule, third-party service providers meeting the standards will benefit their hedge fund clients in two ways. First, they offer these clients significant savings on in-house personnel, and second, they make their clients more money by allowing them to focus their attention on core competencies and the areas where they’re most efficient.  

This cost-efficiency means this new proposed rule creates the perfect opportunity for firms to reassess their outsourcing strategies and choose to work with quality vendors.  

The Bottom Line

The proposed SEC rules will impact the hedge fund industry and how funds outsource some responsibilities. Still, the change will benefit everyone in the investing pipeline, from advisers to third-party service providers to the public.    

While the proposed rules bring more oversight to outsourcing in hedge funds, the benefits of outsourcing remain significant, mainly when guided by experienced, competent providers.  In this evolving landscape, it’s crucial to establish robust processes for due diligence, monitoring, and compliance. 

Here in our Hedge Fund Advisory at Arootah, we’ve developed streamlined methodologies to support firms in navigating these regulations. That means enhancing the transparency and ease of outsourcing by providing our clients access to pre-vetted, top-quality consultants and focusing on the overarching goal — improved investor protection. 

We encourage you to schedule an introductory consultation with our hedge fund advisors to get started. During this session, you can bring your most pressing concerns, and together we can explore how Arootah can support you in navigating these regulatory changes and ensure that your outsourcing practices remain compliant.