We’ve all received that dreaded job interview question: What are your biggest weaknesses?  As strange and superfluous as it may seem in context, that question has a kind of analogue in the hedge fund industry: the annual compliance review.  Rule 206(4)-7 under the Investment Advisers Act of 1940 (Advisers Act) generally requires registered hedge fund managers and other registered investment advisers to evaluate, at least annually, the adequacy of their compliance policies and procedures and the effectiveness of their implementation.  In effect, Rule 206(4)-7 poses a recurring regulatory question to registered advisers: What are your biggest compliance weaknesses?  But like savvy jobseekers faced with the weaknesses question, hedge fund managers can approach the annual compliance review as an opportunity to shine, not just an opportunity to mess up.  While there is scant regulatory guidance on how to prepare for, conduct and document an annual compliance review, considerable custom and practice has developed in this area; and managers who familiarize themselves with best practices – or who retain and closely monitor service providers conversant with best practices – can reconcile the competing goals of such a review.  On one hand, hedge fund managers want to communicate to the SEC that they take their compliance obligations seriously.  On the other hand, hedge fund managers do not want to provide the SEC with an open book revealing all weaknesses in their compliance programs for fear of SEC enforcement activity.  Complicating things is the increasing interest on the part of the SEC in holding investment advisers, and in some cases compliance officers, liable for compliance failings.  See “Three Recent SEC Orders Demonstrate a Renewed Emphasis on Investment Adviser Compliance Policies and Procedures by the Enforcement Division,” Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).  Therefore, it is imperative for hedge fund managers to thoughtfully consider how to approach the annual compliance review process with the goal of mitigating weaknesses in their compliance programs.  This article – the first in a two-part series on the intricacies of the annual compliance review process – is intended to help hedge fund managers identify relevant questions and think through answers.  In particular, this article discusses: what the annual compliance review is; the enforcement actions that make conducting the annual compliance review imperative; how to prepare for the annual compliance review, including a discussion of information gathering and the three types of testing that should be performed prior to the review; and who should conduct the annual compliance review.  The second article will discuss: when the annual compliance review should be conducted; the annual compliance review process itself, including identifying the scope of the review, reviewing the policies and procedures, conducting a risk assessment for changed circumstances, identifying compliance weaknesses and taking appropriate remedial actions; how to document the annual compliance review; the most formidable challenges in conducting the review; and common mistakes made by hedge fund managers in conducting the review.