Last August, the Central Bank of Ireland (CBI) authorised Carne Group as an alternative investment fund manager (AIFM) in accordance with the EU’s alternative investment fund managers directive (AIFMD).
But, curiously for an AIFM, Carne doesn’t employ any traders or portfolio managers. In fact, it isn’t really in the business running hedge fund strategies at all.
Instead, Carne will serve as the authorised AIFM for external hedge fund managers – giving them the ability to freely market their funds in Europe under AIFMD’s passporting provisions without going through the rigmarole of complying with the directive themselves.
“If a non-EU manager wants to launch an alternative investment fund and market it across Europe, but they don’t want the substantive presence on the ground in Europe to obtain an AIFM licence, we can take on the role of AIFM for their funds,” says Aymeric Lechartier, a managing director at Carne Group in London.
Carne is one of a number of independent management companies that have popped up in Europe in response to AIFMD. DMS Offshore Investment Services, KB Associates and Crestbridge have established similar operations in Ireland. The advisory firm Kinetic Partners has a so-called ‘super’ management company in Luxembourg that manages Ucits and alternative investment funds (AIFs). The compliance consultancy Cordium is setting up a management company in Malta, while fund manager Alceda has a licence that allows it to act as an AIFM for externally managed AIFs in Germany.
The field is expected to become even more crowded with a number of fund administrators and investment banks also rumoured to be getting into the management company market.
“Lots of firms are considering getting into this business,” says Mikael Johnson, a lead partner in KPMG’s alternative investments practice in the US. “If you’re a financial services firm with existing investment and risk management infrastructure in Europe, it’s a pretty straightforward exercise to obtain an AIFM licence and offer this service. There’s a lot of demand – especially among US managers that market their funds in Europe but don’t have a substantive presence on the ground there,” he says.
The management company model relies on the delegation provisions of the directive. Under AIFMD, an authorised AIFM must be appointed to provide investment services – such as portfolio and risk management – to alternative investment funds (AIFs) marketed to European investors. However, the AIFM is allowed to delegate its duties to third parties, so long as it retains responsibility for either the risk or portfolio management functions.
The management company fulfils the role of AIFM for AIFs managed by external hedge funds, while delegating portfolio management back to those firms. The management company retains responsibility for risk management and may perform any other functions the manager chooses not to keep in-house.
The concept of a management company is not novel. “These firms are replicating a service that already exists and is well established in the Ucits sphere. The regulators are comfortable with this model in the Ucits context and it provides a flexible option for hedge funds operating under the AIFMD regime,” says Peter Astleford, a partner in the London office of Dechert and head of the law firm’s global financial services group in Europe.
Indeed, many of the management companies cut their teeth in the Ucits business. Alceda runs one of the largest Ucits management companies in Europe, with more than €7 billion in assets, while Kinetic and Carne are also active in the Ucits sphere. Converting an existing Ucits management company into a super management company for Ucits and AIFs is portrayed as a fairly simple exercise and is seen as a natural extension of these business lines.
However, Ucits and AIFMD are fundamentally different regulations. The former regulates a specific product and only indirectly applies to asset managers. The directive contains a set of rules for Ucits products governing everything from eligible investments and risk controls to liquidity requirements and counterparty standards. The management company’s role is to ensure the product complies with those rules.
AIFMD and Ucits
AIFMD is different in that it directly regulates the asset manager and does not specify product requirements. The regulated alternative asset manager is left to determine the appropriate investment guidelines, risk limits and operational controls for their strategy. As a result, an AIFM is generally considered to have a more substantive role than a Ucits management company.
“The Ucits directive is very prescriptive, whereas AIFMD is far more flexible and requires the manager to take more responsibility in terms of defining the risk indicators, analytics, controls, liquidity requirements and valuation processes of their funds. That’s a fundamental difference compared to Ucits,” says Alan Picone, global head of risk at Kinetic Partners and head of the firm’s management company in Luxembourg.
Given AIFMD’s emphasis on regulating asset managers, some observers question the legitimacy of a management company delegating the portfolio management function to an external firm. “I don’t think this is what was envisaged when the EU came out with AIFMD. It seems to be within the letter of the law, but it’s a little strange to see firms that are not asset managers taking over the AIFM role,” says a hedge fund manager in London.
There are further questions over whether a business model developed for Ucits can be applied effectively to AIFMD. “[The Ucits management companies] weren’t required to have the level of risk management capabilities expected of asset managers and they’ve had to beef up that side of their business considerably to become AIFMs,” says Joe Vittoria, chief executive of Mirabella Financial Services, a subsidiary of Cordium, which provides ‘regulatory hosting’ services for hedge funds in London and has a management company in Malta for non-EU managers.
But firms that operate a management company insist the service is in keeping with the spirit of the directive – some even argue a model where the management company retains the risk management function and outsources portfolio management actually reinforces the goals of AIFMD.
“If you think about the genesis of AIFMD, it started with a debate about the systemic risk of alternative investments. AIFMD is about risk management. The directive says risk management has to be segregated and independent from portfolio management. That’s what we do – we’re the independent risk function,” says Carne’s Lechartier.
AIFMD specifically states that a ‘letterbox’ entity cannot be an AIFM. To avoid classification as a letterbox entity, the AIFM needs to have the expertise and resources necessary to supervise its delegates and the power to make key decisions in relation to the implementation of the AIF’s investment strategy.
Derek Delaney, executive director of Europe at DMS Offshore Investment Services, says AIFMs should retain as many functions as possible in-house to avoid any question of being a letterbox entity.
The CBI’s AIF rule book outlines 16 managerial functions for which the AIFM is responsible, including portfolio and risk management. The list includes compliance monitoring, regulatory reporting, complaints handling and recordkeeping. DMS delegates portfolio management and distribution to the investment manager and retains control of the other functions. “One of the objectives of the directive is to have European funds managed in Europe. The objective is diluted with every function that is delegated outside Europe. We want to stay within the spirit of the directive, so we generally keep it to two delegations,” says Delaney.
The legitimacy of management companies hinges largely on the robustness and independence of their risk management capabilities. An AIFM that adopts the external fund manager’s risk policies without question and monitors for breaches “doesn’t have much substance – all they’re doing is keeping a record of the damage”, says Kinetic’s Picone.
The management company should work closely with the fund manager to establish the risk management policies for the AIF and implement any additional controls that may be necessary, says Picone. “As the AIFM, you have to embed a strong risk management framework with the fund manager. Risk management loses its value if it’s purely a post-trade function,” he says.
Delaney at DMS echoes those sentiments. “We will have an on going conversation with the manager about the risk metrics, controls and limits appropriate for the strategy and compare that to what they’re doing internally. Ultimately, the fund manager runs the AIF in accordance with the investment and risk policies established in conjunction with the AIFM. The AIFM should be playing an active role in establishing that framework,” he says.
The AIFM needs to have “a sophisticated risk management function supported by experienced professionals with deep knowledge of hedge fund strategies”, says Cordium’s Vittoria. As the management company will be overseeing a range of funds, its risk management infrastructure should be comparable with a multi-strategy hedge fund manager – with staff capable of diagnosing coding and data errors in ‘black box’ quant strategies on the one hand and assessing the liquidity or concentration risks of a distressed debt strategy on the other.
The management company’s risk management function has to be fully independent from the investment management process. Delaney says the AIFM should be collecting “raw trading data” from the fund’s prime brokers or administrator and feeding into a reputable, third-party risk system, with qualified professionals on hand to perform risk calculations, analyse the results and report that information to the fund’s board of directors.
“Some third party management companies are taking the risk reports generated by the investment manager or administrator and reviewing them. For me, that’s not an independent risk function because the substantive work isn’t being done by the AIFM. The risk management has to be taken very seriously,” says Delaney.
To some extent, the early entrants into this business are finding their way in the dark. The directive leaves a lot of room for interpretation in terms of how the requirements are transposed into local laws – and some regulators are still finalising the guidelines and standards for the risk management function. “The risk management function will take shape over the next few years as the regulators provide more guidance. Our view is that any tick-the-box approaches will be deemed unacceptable over time. Risk management will become a significant focus for regulators,” says Delaney.
While management companies are only just starting to establish themselves, demand for the service appears to be strong. New York-based Marketfield Asset Management launched its Marketfield Dublin fund in October 2013 with Carne as the independent AIFM – one of the first AIFs with this structure. Carne’s Lechartier says the firm expects to launch several more AIFs with “a few billion” in assets in the next three months. DMS serves as the AIFM for two funds that have already launched and has seven more in the pipeline, while Kinetic is in the process of launching its first AIF – a fund of hedge funds.
For US managers distributing funds in Europe, hiring a management company to perform the AIFM role is a cost-effective alternative to establishing an EU office that meets the licensing requirements of the directive. This approach allows the manager to freely market a fund across Europe under AIFMD’s passporting provisions, rather than having to rely on national private placement regimes or reverse solicitation. It also means the management company rather the fund manager is responsible for complying with many of the provisions of directive – such as the AIFM capital requirements, regulatory reporting and the appointment and supervision of the fund’s depository.
“A lot of US managers are not really in a position to establish substance in Europe, so this could be the model of the future for distribution into Europe,” says KPMG’s Johnson.
While most of the demand has come from US managers, “a surprising number” of the early adopters are European managers, says Lechartier – including some sizable firms with assets in the billions. These companies are deciding to maintain licences obtained under the Markets in Financial Instruments Directive (Mifid) rather than convert to AIFMs.
AIFMD requires hedge funds that hold a Mifid investment licence to be re-authorised as AIFMs. However, as the Mifid licence permits a wider range of activities, such as proprietary trading, some managers are choosing to retain their Mifid authorisation and appoint an outside party as AIFM for their funds, says Lechartier.
Hiring a third party as AIFM could also minimise the effect of one of AIFMD’s most contentious elements – the remuneration guidelines. The directive requires AIFMs to establish remuneration policies that are consistent with and promote sound and effective risk management and do not encourage risk-taking inconsistent with the risk profile of the funds they manage. The rules require an appropriate balance between fixed and variable remuneration, deferral of 40–60% of bonus payments – with at least 50% of bonuses in the form of equity – and clawback provisions for deferred bonuses if subsequent performance declines. AIFMD requires firms that perform risk or portfolio management functions for the AIFM on a delegated basis to adhere to the remuneration rules.
However, the transposition of AIFMD’s remuneration rules varies significantly across jurisdictions.
The UK’s Financial Conduct Authority (FCA) has implemented a stripped-down version of the rules – allowing firms that manage less than $1 billion in AIFs to ignore most of the requirements. Essentially, a hedge fund could establish an AIF for EU investors with a third-party AIFM and manage up to $1 billion on behalf of European investors without worrying about the remuneration rules, irrespective of how much they manage for international clients in other offshore vehicles.
Malta has decided the rules will not apply to an AIFM’s delegates. This means a London-based hedge fund manager that retains its Mifid licence and manages an AIF portfolio for a Maltese AIFM on a delegated basis will continue to follow the remuneration rules of the Capital Requirements Directive (CRD) rather than AIFMD.
Regulators in Ireland and Luxembourg, still working on the final remuneration guidelines, are expected to incorporate the stance taken by the FCA and the Maltese regulators into their own rules.
Many of the remuneration rules provided for in AIFMD are of course similar to the remuneration rules for banks and investment companies set out in CRD; the European Securities and Markets Authority has deemed CRD remuneration rules “equally as effective” as those of AIFMD. But a delegated portfolio manager in the US would not be subject to any remuneration requirements.
The emergence of AIF management companies has been widely welcomed by hedge funds struggling with the restrictive requirements of AIFMD. However, it is still early days and these firms will have to show there is real substance to their operations – particularly risk management – as the number of AIFs under their purview increases. Some observers believe regulators may take a much harder line with these companies in the future. “So far, the regulators have been fairly accommodating. The main goal right now is to encourage hedge funds to adopt the AIFMD regime. The regulators may come out with more teeth once they’ve got everyone through the door – at that point some of these outsourcing arrangements may come under more scrutiny,” says a hedge fund executive in London.
As one industry source says: “They seem to be allowing everyone into the party now, but at some point they’ll stop serving booze and it won’t be as much fun.”