17 Oct 2013, Mark Mannion , BNY Mellon , Maurice Murphy , KB Associates , Devarshi Saksena , Simmons & Simmons , Hedge Funds Review
Mark Mannion, managing director, head of AIS sales & relationship management, EMEA
Maurice Murphy, senior consultant, risk management services
Simmons & Simmons
Devarshi Saksena, managing associate, financial services
HEDGE FUNDS REVIEW: The Alternative Investment Fund Managers Directive (AIFMD) is a big subject, still quite controversial and with many question marks over it. Are hedge funds ready for the directive?
Mark Mannion, BNY Mellon: We have thought the same within BNY Mellon. We recently completed a very extensive survey on this subject, and the key theme from it is that managers are not ready. The vast majority do not have everything in place that they need in order to be AIFMD-compliant and are undergoing a complete review as to what its implications are.
There are a few earlier adopters who see the advantages of the European passport to expand distribution and protect marketing within the European Union (EU). But, for the vast majority – and we’re talking three-quarters here – compliance with AIFMD will be a 2014 phenomenon.
To get there, significant work needs to be done. The remuneration aspect aside, there are very significant implications in terms of regulatory reporting to investors and the annual report. That’s something we can help them with, but there are certain aspects that managers need to do internally in order to be ready. One interesting aspect we found from the survey is that this will be a point where many will choose to review their existing product range. They may choose to close certain funds that may no longer be economic or viable under AIFMD, they may choose to merge funds, or they may choose to run parallel funds with some funds remaining in the EU – specifically targeted at EU investors – and some outside the EU, aimed at the rest of the world.
It really is an interesting time for asset managers to look at their complete product range and decide what the best fit would be going forward. We’re working with them and we’re helping with that.
There are early adopters, so we’re already in place as depository in certain instances, and that’s a theme we can come back to when we discuss the depository role.
Devarshi Saksena, Simmons & Simmons: Managers need to do a number of different things. First, they need to review their product range and understand which of their products are likely to be alternative investment funds (AIFs) and to what extent that they can rely on the exemptions set out in AIFMD.
To the extent that their products are AIFs, if they’re sub-threshold entities based on assets under management, there might be certain exemptions available or, for example, if they’re family offices or certain types of holding companies.
If they are managed accounts that comply with the requirements provided by the European Commission – in terms of actually making sure they are genuine single investor funds – potentially, they could be outside the scope of AIFMD altogether. If that’s not true, what they need to do is to work out which entities in their management group – assuming they have more than one entity – are likely to be the AIF manager (AIFM) and, based on whether or not that is going to be an EU or non-EU entity, they will need to follow different routes.
For non-EU AIFMs, I think the key question for managers is going to be whether or not they see Europe as a source of capital going forward and whether they want to market in the EU over the next few years.
Maurice Murphy, KB Associates: I agree. It’s investor-driven to a large extent.
Devarshi Saksena: Absolutely. You know they need to take a view as to where the pools of capital they want to target are, or whether a non-EU AIFM is happy relying purely on reverse enquiry from investors in the EU. If you’re likely to be an EU AIFM, there are more issues you need to think about. You need to make sure you are going to have the right regulatory permissions in place. That will involve varying your current permissions, because most investment firms that manage hedge funds are currently Markets in Financial Instruments Directive (Mifid) asset managers – rather than AIFMs.
Maurice Murphy: Indeed, the directive doesn’t permit the AIFM to be a credit institution or a Mifid firm, so that has a bearing on the decision with regard to which entity will be the AIFM.
HEDGE FUNDS REVIEW: So you have to be one or the other?
Devarshi Saksena: That is absolutely right. You could apply for certain top-up permissions under Article 6(4), to the extent that your AIFM needs the ability to manage segregated portfolios or to provide investment advice, then you can apply for those permissions. But that’s a question you’re going to need to think about.
Beyond that, on a practical level you will need to engage with service providers to work out which new service providers you need, if any. You will also need to understand the operational requirements going forward in terms of remuneration, risk management, liquidity management and conflicts of interest.
HEDGE FUNDS REVIEW: What kind of timings are we looking at now?
Devarshi Saksena: In terms of the timing for variations of permission, the UK Financial Conduct Authority (FCA) has stated most recently for managers who are making use of the transitional provisions that they should submit the variation of permissions form by January 22, 2014. That’s slightly earlier, I think, than the industry was expecting. The assumption had been based on Article 61 of the directive – that managers who are relying on the transitionals had until July 22, 2014 to submit their application, provided they were compliant, in practice with the directive.
This statement from the FCA – although it appears in line with the [UK] Treasury’s regulations, which transpose AIFMD – does appear to bring the timeline forward, and I know that certain industry bodies have considered taking this up with the FCA to see how flexible that statement is.
Maurice Murphy: I guess there are, perhaps, resource constraints as well. But, going back to the point on remuneration, the FCA did publish a consultation paper recently on this and the clarity it provided was definitely welcome because it has been one of the more controversial provisions of the directive.
They are seeking feedback on the size thresholds they have suggested, which I think, if the FCA has taken that approach, regulators in Ireland, Luxembourg and other large fund domiciles may follow suit to ensure a level playing field.
Mark Mannion: This whole point raises something that people have spoken about for a long time before the limitation date but has now come to fruition: capacity. Acknowledging the FCA’s approach, encouraging managers to go early – will managers really do that, given the huge implications around remuneration and other costs they need to incur?
Our survey brought out the fact that there is some concern about the amount of internal costs managers will have to incur to make themselves compliant – not an insignificant amount. We in the service provider industry are likely to be faced with a very significant number of managers looking to convert to AIFMs at the same time.
Naturally, we’ll be there for our clients, but those who are entering this for the first time perhaps should consider early adoption of things such as depot light. If they have non-EU funds, maybe sign one up sooner rather than later.
HEDGE FUNDS REVIEW: Can you explain what that is, as a lot of people don’t know the difference between the Cap D and depository light?
Mark Mannion: It was really one of the key focuses of AIFMD: the enhanced or increased responsibility on the depository for restitution of assets, and again in certain situations where assets are lost. It could be the situation that the depository would be required to restore those assets to the fund.
That’s a huge responsibility, and there has been huge focus around getting the legalities, the contracts and everything else right.
But, for an EU manager, the requirement up until 2015 would not necessarily be to appoint a full-blown depository with restitution, but it can appoint a firm to carry out a depository-like duty without restitution. This takes away a lot of the risk to the service providers in that area.
Devarshi Saksena: It is also worth noting that, with depository light, it doesn’t need to be one particular entity. It doesn’t have to be a sole entity providing all of the services required by the depository article, it could actually be some of your existing service providers performing one or more of the functions needed.
Mark Mannion: We’ve had some clients come to us looking for the full service and some who are exploring the more modular approach where various parties will carry out either the cash monitoring, the safekeeping of assets or the manager oversight.
Maurice Murphy: On the full service, for different types of assets there are different degrees of restitution and liability pertaining to the depository. So, for example, if they are partnership interests, they are classified as ‘other assets’ and there is a lesser liability attached to them and their safekeeping than applies to ‘in custody’ assets such as listed equities.
Mark Mannion: Where the London manager really wants to secure their ability to a private place in Europe, they may consider the appointment of a depot on a depot-light basis. Some countries have already made noises that they will insist on such a depot being in place for the managers to continue to be available for the private placement regime. We have seen an uptake in the number of enquiries from Cayman Islands fund managers that are based in the EU at the moment.
HEDGE FUNDS REVIEW: Is this going to change the relationship managers have with their prime brokers, as most of them aren’t used to using a custodian?
Mark Mannion: Many of them do use custodians, albeit as an operational custodian, so they’ll have prime brokers they’ll often use for holding long assets or encumbered assets. What they’re perhaps not used to is this concept of oversight – the concept that a player will monitor all of the cashflows on a daily basis that go through their funds.
We’re talking about cash transactions that can number in the thousands per day for some complex commodity trading advisers. They are also going to have oversight in terms of the activities of their investment management division and a generally more enhanced oversight model than they’re used to, so I agree with you there.
Operationally, they’re used to it but, in terms of the oversight, it’s certainly something new.
Devarshi Saksena: I think that goes to the different functions of the prime broker versus depository, because the depository is very much there for investor protection, whereas a prime broker, primarily, is a means by which a fund can borrow securities and take more risk through leverage in order to maximise gains.
HEDGE FUNDS REVIEW: Are we going to see a lot more new names and a lot more competition coming in with more service providers? Is that going to be good or bad?
Devarshi Saksena: We definitely will see new service providers. I think there is a gap in the market where certain service providers aren’t willing to provide oversight. There’s one new provider that comes to mind – Indos – that will be providing oversight for managers where their existing service providers are unable to provide that function.
Mark Mannion: Yes, there are many new entrants and that’s fine, but there aren’t the same barriers to enter on the depository-light side as there are on the full depository side. But people must keep in mind that the depository-light regime could be transitory in nature.
From 2015, many hedge funds that want to access Europe are likely to be required to appoint a full-blown depository with all the necessary banking credentials. There’s a market in the short term, but I think managers should consider a longer-term view on this and that is going to benefit the global custodians.
HEDGE FUNDS REVIEW: Is 2015 going to put a squeeze on the main global custodians, as there are suddenly going to be only a handful that can do this?
Mark Mannion: Coming back to what I mentioned earlier, which is the possibility of capacity issues within the industry, hence why we’re keen to work with existing clients, potential clients, and so on, now so that issue is lessened when it comes to 2015.
HEDGE FUNDS REVIEW: Another big issue worrying everyone is delegation. What does that really mean? What is and what isn’t a letterbox?
Maurice Murphy: Delegation is permitted under AIFMD. In relation to investment management, specifically, AIFMs are allowed to delegate, but must not delegate substantively more portfolio and risk management functions than are retained. This represents a subtle nuance where I think there is some discretion left to the local regulators to determine whether the AIFM or the manager shall be considered a ‘letterbox entity’ or not.
The onus is on the AIFM to demonstrate to the local regulator that it does indeed have the substance required. I think it’s obviously a lot easier for the bigger fund managers to demonstrate this substance, but there are lots of managers with only a handful of people that may not be able to demonstrate that substance as easily. They have to think about how they can supplement their existing organisational structure in order to prove they are not a letterbox entity.
Mark Mannion: We’re seeing this play out in Ireland and Luxembourg. There’s a whole menu of approaches you can take. For the well-funded large global financial institutions, the best option is to set up substance on the ground – that takes away any issue, any questions, and there are certainly some well-known case studies where there are significant personnel on the ground to cover that.
Another option people can look at is to enhance the infrastructure they have around their own qualifying investor fund or collected investment fund in Luxembourg. That involves making sure either the administrator, depository or other service providers provide more services to the entity around risk compliance and regulatory reporting and, perhaps, enhancing the role of the directors to ensure the local regulators are comfortable around it from the onset.
Maurice Murphy: There is quite an extensive list of organisational requirements or managerial functions that need to be performed by named, regulator-approved, individuals or designated persons, one of them being risk management, on which there is a significant emphasis in this directive. Existing directors of the funds can act as these designated persons. Alternatively, these functions can be outsourced to third-party consultants.
Devarshi Saksena: It’s very important, though, that the personnel on the board of these funds have the experience and the knowledge to be able to perform portfolio or risk management. If you have someone with a considerable background in risk management or portfolio management on the board, it is definitely going to help you demonstrate this is a self-managed AIF. The slight problem we are grappling with is that the FCA hasn’t provided any guidance on what ‘over-delegation’ would be, and exactly when there would be a letterbox entity beyond what is set out in the level 2 regulation, so the onus is very much on the managers to prove that they are not a letterbox entity.
HEDGE FUNDS REVIEW: Is the possibility of the FCA, or another regulator, changing its mind or implementing different criteria a real risk for funds?
Maurice Murphy: It is definitely a risk. If you’re late in your application – and I know the FCA and the Central Bank of Ireland have made fairly strong statements saying they want applications in by the end of January 2014 – if there are errors, omissions or if the application wasn’t substantive enough, this could pose a serious disruption to your business. If you had to come back, redraft and resubmit, there’s definitely a risk of disruption.
Mark Mannion: There has to be a risk whenever there’s not enough precedent to be able to look at case studies and quote with confidence that a particular approach will work. I think industry participants have been excellent so far in predicting what the key challenges will be across a whole range of issues, and delegation was always pointed out as being a possible big issue for managers. I think, until we see more live cases in the key domiciles, it will be difficult to make a call as to whether a particular approach will be viewed as unacceptable or perfectly reasonable.
Maurice Murphy: I think self-managed fund structures, which are very popular in Ireland and Luxembourg, and which by definition are not overly resourced with most functions delegated definitely need to look at their organisational set-ups if it is decided that they will act as the AIFM.
HEDGE FUNDS REVIEW: Maybe we can expand on these operational requirements under the directive: risk management, liquidity management and transparency. What does that actually mean? How is that going to change what funds do?
Maurice Murphy: In relation to liquidity management, the requirements of the directive are to consider your stated liquidity policy in your prospectus, align that with your underlying portfolio investments and, furthermore, to align that with the redemption or liquidity terms offered to your investors. That was part of the problem in 2008 during the credit/liquidity crisis. I think a lot of managers will have addressed this liquidity alignment issue already, so it shouldn’t be overly onerous to comply with AIFMD in this respect.
Devarshi Saksena: For existing Ucits managers, a lot of these concepts are already familiar – so it won’t be too much of a step change to have to roll that out for AIFMs.
Maurice Murphy: There are transparency requirements to the investors into the funds and also to regulators in order to monitor systemic risk and to share information with each other. If managers have previously been subject to Form PF requirements, then I don’t think the AIFMD transparency/disclosure obligations are a huge leap from that requirement – in terms of Annex IV of Level 2 of the directive.
Mark Mannion: As the administrator, we’re likely to be the one party they will come to whenever there are enhanced reporting requirements, so we’ve done a lot of study around the three separate areas. The first – investor reporting – most of that is already there in terms of the offering memorandum that managers put in place for their existing non-Ucits funds.
There isn’t a huge amount of additional work that needs to be done. On the annual report, most of that is there. In terms of fund disclosure, some interesting new additions around remuneration, which may not be particularly popular, will need to be brought in, as well as new additions around fixed and variable elements and some sensitive information around the most important participants in the fund.
Clearly, the area where managers are looking for support is regulatory – particularly for those who didn’t have US registration distribution last year, and so weren’t in the Form PF early movers. Now they are looking for support from us to create a similar type of port. It is extremely extensive in terms of the amount of data that needs to go into it. The calculation methodology for some of the key variables is different from Form PF, and that adds extra complexity. The existing mechanics that will be used to make that a success will be leveraged again for AIFMD.
Devarshi Saksena: One of the missing pieces is that managers don’t know exactly how they are meant to be disclosing this information, similar to what happened with the short-selling regulation, where the means of disclosure wasn’t finalised until the regulation came into force or afterwards. We don’t have any guidance on that right now, so it is quite difficult for managers to understand exactly what their operational burden will be going forward.
Maurice Murphy: Also, on the regulatory end, regulators need to prepare themselves to receive this data in whatever format is agreed and be able to interpret it, share it and achieve one of the overarching objectives, which is to monitor systemic risk. I think there will be a bedding-in period before we see some of the macro benefits of this systemic risk monitoring.
Devarshi Saksena: In terms of disclosure to investors, it’s worth noting that AIFMD doesn’t stipulate exactly how that disclosure from the manager to the investor under Article 23 needs to be made, so some of those disclosures could well be in your prospectus. A number of managers are considering having a stand-alone document disclosed by the manager to the relevant investors, but for which the fund board does not take responsibility.
HEDGE FUNDS REVIEW: Is this going to cost a lot of money?
Mark Mannion: One of the great unknowns is what the total costs to the industry and to investors will be. Some early studies suggested there would be an extremely significant cost burden, rendering certain strategies uneconomic and causing great concern. That was mostly around the depository risk restitution area, where it was felt that depository costs would go to insurance premium levels to keep the industry going.
Our survey asked managers what they thought the potential cost was and what they would need to implement internally, mostly around additional head-count reporting capabilities and the figure was quite significant. That is a cost that managers will have to bear themselves or maybe restructure their product line to have a slightly higher management fee for funds that are privately placed within Europe.
HEDGE FUNDS REVIEW: Are they going to be outsourcing most of these functions? If they do add on these costs, will investors concerned about two-and-20 absorb those costs? How do you think it is going to impact the industry?
Devarshi Saksena: There’s a question, where the AIFM or investment manager is actually performing a greater role. For example, acting as valuation agent in respect of a particular fund, or whether it should charge an additional or separate fee, because of the additional liability it is taking on. I think that’s going to be quite difficult, because fund boards are not going to want to have to remunerate the investment manager to an additional extent for performing valuation. Ultimately, I think, it is going to be the cost of doing business going forward.
HEDGE FUNDS REVIEW: What kind of advice are you giving managers about how to get ready for and be compliant with AIFMD?
Mark Mannion: We are very much focusing on supplying the manager with as much information as we can in our role as depository and administrators. We’re educating the managers on what the implications for them are operationally and looking into those areas in which we can assist them. But really, they have to be looking at their product range, their marketing plans and whether they will need to sometimes make very difficult decisions around the continuance of those products and how they will continue to offer them into 2014.
Devarshi Saksena: Know what you have to do, by when, in order to avoid being non-compliant, so engage with service providers. Read up as much as you can. Look at all of the ‘to do’ lists that service providers have.
Maurice Murphy: If their future marketing strategy involves Europe, then we would advise them to get on with the application process as soon as possible and avail themselves of the marketing passport benefit provided under the directive.
HEDGE FUNDS REVIEW: Finally, is AIFMD going to be good or bad for the hedge funds industry in Europe?
Mark Mannion: The headline around it was increased investor protection, so from that perspective it should be a good thing. Maybe AIFMD will end up being the same gold standard that Ucits became.
Maurice Murphy: I would agree, in that the Ucits product has evolved over a couple of decades and it is now a trusted brand recognised globally and far beyond the borders of Europe. If, over time, AIFMD-approved non-Ucits hedge funds achieve such a status, I absolutely believe it will be good for the hedge fund industry In Europe.
Devarshi Saksena: I think that it will be positive in that there will be increased investor protection. However, I’m not sure professional investors necessarily wanted that level of protection. I will also be interested to see to what extent managers who are outside of the EU find it easy to access European sources of capital.