05 Aug 2011, Wilton McDonald, Finab, and Ron Geffner, Sadis & Goldberg, Hedge Funds Review
What impact will the Dodd-Frank Wall Street Reform and Consumer Protection Act really have on hedge fund managers?
The biggest impact of the Dodd-Frank Act will be felt by managers of small and mid-sized funds. Since the managers of larger funds tend to have legal and compliance programmes already in place, managers of small and mid-sized funds will generally be the ones to expend relatively large amounts of capital to prepare themselves for the changes.
Thesechanges include new record-keeping and reporting requirements, and possible registration as an investment adviser with their state or the Securities and Exchange Commission (SEC), or a transition from SEC to state registration. Under the new rules, all advisers to hedge funds with more than $150 million in assets under management (AUM) are required to register with the SEC. Managers with between $100 million and $150 million are required to register
with the SEC unless they solely manage hedge funds and/or private equity funds. For example, a manager with $125 million in AUM that manages one hedge fund and one separately managed account will now be required to register with the SEC. Managers with between $25 million and $100 million in AUM are now categorised as mid-sized advisers and will generally be required to register at the state level, absent an exemption. It is estimated that approximately 4,000 federally registered advisers will need to transition to state registration.
How could over-the-counter (OTC) clearing change hedge fund strategies and models?
A key component of the Dodd-Frank Act that will likely affect hedge fund strategies and models is the change to the trading of derivative instruments. By providing for a comprehensive framework for the regulation of derivative products previously traded on an unregulated OTC market, the Dodd-Frank Act increases transparency throughout the system and spreads the risk of default among market participants.
Previously, the OTC market consisted of individually negotiated bilateral contracts between dealers and customers. The new regulations provide for standardised contracts traded on an exchange and cleared by a clearing organisation. Under the previous system, smaller funds tended to receive worse terms than larger funds, as they were considered to have weaker credit, but with the change to standardised, cleared contracts, the playing field will be levelled. This will increase competition and impact the strategies that many funds use in trading derivatives.
What impact will proposed shorting bans have on strategies and hedge fund models?
By limiting a hedge fund’s ability to hedge, funds may expand their long positions or seek derivative products that simulate a short return. Ultimately, some funds may be suspended or close based on an inability to implement their respective strategies.
What does the Alternative Investment Fund Managers (AIFM) directive mean for European-based and US-based managers?
Having been adopted by the European Union (EU) Parliament on November 11, 2010 and the EU Council of Ministers on May 27, 2011, the AIFM directive will significantly change the legal framework in which fund managers operate, and how investment funds are marketed in Europe. Having been in the making for some time, the directive will come into force on July 21, 2011 and EU Member States will have until July 22, 2013 to implement it.
The scope of the AIFM directive is broad and will catch a wide range of fund managers, including those that manage private equity, hedge, real estate, infrastructure, venture capital and listed funds. Neither the form of the fund nor whether it is open- or closed-ended will have a bearing on whether the directive applies.
The purpose of the directive is to encourage all hedge funds to target EU investors onshore. The biggest remaining concern is the strict liability rule for custodians in the case of losses to investors in certain situations. This rule increases the cost to the pool of custodians and, with hedge funds outnumbering custodians by a large number, these costs may be passed onto funds. This may affect the smaller funds, while larger funds can negotiate deals and economies of scale.
For the US market, a few funds may withdraw from it rather than comply, but most will likely invest in the process.
What changes will hedge fund managers need to make to accommodate increased regulatory oversight and meet compliance requirements in the US and EU?
By registering with the SEC, managers will be required to introduce and maintain a formal compliance programme and designate a qualified chief compliance officer. Registered and unregistered managers will now be required to maintain certain records, as well as file certain reports relating to their advisory businesses and the funds they manage.
Those managers setting up offshore fund structures will have to do more legal and regulatory consultation with their respective home/onshore legal advisers. This will increase the cost of setting up offshore hedge funds.
What do managers really need to know about the US and EU regulation of the industry?
Managers need to develop a realistic timeline and project plan to ensure compliance with the new registration requirements and to develop a comprehensive compliance programme specifically tailored to their operations. The SEC recently extended the compliance deadline for investment adviser registration for certain private managers until March 30, 2012. However, in order to comply with the new deadline, such managers must file their Form ADV on or before February 14, 2012.
What questions should hedge fund managers ask their legal counsel about documents?
Managers should ask their legal counsel to assist them in analysing the implications of the Dodd-Frank Act on their business, including whether they will need to be registered at the SEC or state level as an investment adviser. In addition, managers should work with their fund’s legal counsel to ensure that the disclosure language in their offering documents is current.
How should existing documents be reviewed and revised in light of the financial crisis and new regulation?
The existing documents used by managers must be updated to account for the new requirements. A manager that was not previously required to be registered as an investment manager at the SEC or state level will have to modify their fund’s offering documents to now disclose such registration, if required.
In addition, if the fund charges US-based investors performance-based compensation, the manager will need to ensure that the fund’s subscription documents are appropriately updated for the ‘qualified client’ definition.
Why do institutional investors want to see significant changes in offshore hedge fund documentation?
Institutional investors want to ensure the funds that are offering documents adequately describe the manager’s strategy and redemption requirements. Most investors are demanding more transparency and independent net asset value calculation. Offshore documentation should also contain ample tax disclosure, as well as treatment of distributions to onshore principals and holders of the voting shares.
Why do hedge funds still need offshore fund structures?
The low tax and, in most cases, zero tax structures of offshore funds will retain investor demand and appeal going forward, despite the introduction of new EU and US legislation to regulate the global funds industry.
In the case of the Cayman Islands, the country’s primary financial regulator, the Cayman Islands Monetary Authority, still reports that fewer than 10,000 hedge funds are regulated there. The number of unregulated Cayman Islands funds is not reported, but industry experts estimate that it could be as many as three times the number of regulated hedge funds.
Non-US and US tax-exempt investors will not typically invest in a US-based fund.
What do fund managers expect from their legal counsel?
Managers expect their legal counsel to keep them informed of recent changes in the laws and regulations that are applicable to their business. Also, with the dramatic increase in regulatory rulings, managers are looking for their legal counsel to render practical legal and business advice on compliance, operational and financial issues.
What do investors want from their legal counsel?
Investors typically want assistance in the due-diligence process of managers and funds with whom they might invest. This assistance often includes a review of the offering and governing documents of the funds advised by the manager, as well as a review of the manager’s compliance policies and procedures.
There is also a current push for sound, timely and up-to-date business and commercial legal advice across a number of jurisdictions. Clients are seeking practical solutions, especially when structuring new funds that need to take into account changing US and EU legislation.
Lawyers that are competitive with respect to fees and available outside of standard business hours will be in heavy demand, especially when it comes to setting up offshore funds.
Pictured: Wilton Mcdonald, Finab (above) and Ron Geffiner, Sadis & Goldberg (below)