On 1 May 2020, the Federal Bureau of Investigation issued an intelligence bulletin warning, reported on in late July by several members of the media, concerning the use by threat actors of the “private placement of funds, including investments offered by hedge funds and private equity firms, to launder money, circumventing traditional anti-money laundering (AML) programs.” The FBI asserts that hedge funds and private equity funds have been used to facilitate transactions in “support of fraud, transnational organized crime, and sanctions evasion.”

What can hedge funds and private equity firms do to lessen their use in this way? The following provides actionable AML program best practices to avoid this growing fraud.

How Threat Actors Use Investment Funds to Circumvent AML Programs

Private investment funds under management have grown over the past 25 years into a several-trillion-dollar industry in the United States, providing ever-increasing opportunities for threat actors to co-opt investment funds without being overly scrutinized. 

Specifically, the FBI is concerned that many hedge funds and private equity firms receive funds from entities registered in nations that maintain laws conducive to “masking underlying beneficial owners,” which make it more difficult for U.S. financial institutions and regulators to understand funding sources.

Unlike most industry participants, who are subject to certain AML-related regulations (such as Bank Secrecy Act (BSA) filings) and who must publicly  register with the Securities and Exchange Commission, private investment funds historically have not had to disclose information publicly due to the private adviser exemption. These entities are also not subject to many of the public reporting requirements that other investment advisers (such as mutual funds) are subject to.

Of the limited information available about hedge funds, most is not publicly reported. The funds do have to file with the SEC Form PF, “Reporting Form for Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors.” Once completed, however, the results of this form are not available for public consumption as the form is primarily for use by potential investors in evaluating financial risks associated with a fund. The FBI is concerned that this form is not adequate, as it only requires fund advisors to disclose the total amount invested by beneficial owners who are non-U.S. persons (non-USPERs). The disclosure of these names and entities through Know Your Client (KYC) and Know Your Entity (KYE) processes would be invaluable to regulatory and law enforcement, as they could use the form to understand the underlying investors in investment vehicles like private equity and hedge funds and assess a fund’s specific money laundering risk. 

The FBI has produced the chart below describing the open issues with the current regulations and why private equity and hedge funds are targeted versus mutual funds and other-broker dealer funds.

Increased AML Vulnerability for Investment Funds

*Click here to view this table on a mobile device. 

Regulatory Requirement

Broker-Dealer Fund

Hedge Funds

Private Equity Funds

Anti-Money Laundering Program

Required.

Not required.

Not required.

Bank Secrecy Act Filings

Required.

Not required.

Not required.

Customer Due Diligence

Customer Due Diligence (aka Know Your Customer) process required

Not required.

Not required.

SEC Filings (private)

Subject to examination by the Financial Industry Regulatory Authority (FINRA) and the SEC. Detailed trading data and access to the firm’s books and records must be made available upon request.

SEC Form PF: Reporting Form for Investment Advisers to the Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors:

  • Required for funds over $150 million.
  • Not publicly disclosed.
  • Designed primarily to evaluate health of the fund(s) under management.
  • Identifies assets under management for which there is no identifiable underlying beneficial owner.

SEC Form PF: Reporting Form for Investment Advisers to the Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors:

  • Required for funds over $150 million.
  • Not publicly disclosed.
  • Designed primarily to evaluate health of the fund(s) under management.
  • Identifies assets under management for which there is no identifiable underlying beneficial owner.

Participate in information sharing programs pursuant to the USA PARTRIOT Act

Required.

Not required.

Not required.

Source: FBI

Avoid Becoming a Statistic

How can financial institutions safeguard their organizations and avoid becoming part of 2020’s victim statistics? Applying the following AML best practices ensures an organization is set up for success:

  • AML and Sanctions Risk Assessment: Entities should regularly conduct an enterprise-wide risk assessment, including analysis of their customer base, transactions, products and services, and geographic areas; identification of inherent risks and a subsequent ranking of these risks; and design and implementation of a methodology and controls for managing those risks.
  • AML Independent Testing: Additionally, it is a best practice to evaluate your entire program, from transaction monitoring and policies and procedures to tone at the top and technology to staffing and staffing models. AML compliance programs should not only meet regulatory standards but be able to withstand regulatory scrutiny—this can be accomplished by applying global best practices across the program.
  • Enhanced Due Diligence/Periodic Reviews/Remediation: It is crucial that institutions have adequate policies and procedures in place for performing enhanced due diligence, reviewing their investor base along with supplementing KYC and KYE due diligence, and performing periodic reviews. Supplementing these procedures ensure that an organization has the means to draw information from everywhere in the world to protect the investment franchise.
  • Educate the Organization: Lastly, it is critically important that organizations keep up to date on these and other evolving frauds and scams. Continuous, targeted training helps create a compliance structure that is sustainable and effective for years to come.
  • Know Your Compliance Capacity:  AML compliance is a resource-intensive undertaking requiring an alignment of people, processes, and technology. Understand your compliance capabilities, including budgets and other compliance assets. If needed, considering outsourcing all or part of your most taxing components, such as transaction monitoring or investigations, to a third-party managed services provider that has experienced, dynamic staff able to jump in with little notice. This can help alleviate the backlog of compliance work faced by internal teams and streamline processes that would otherwise be strained. 

Amidst uncertainty, having a strong AML compliance program can help those in the investment world stay ahead of the curve, and drive further transparency in investing.