Has Middle East unrest hit hedge funds?

Date: Monday, February 28, 2011
Author: George M. Mangion, The Malta Independent

It comes as no surprise that the unrest in Libya and the rest of the Arab world has upset the investment world. It directly affected the price of oil that hit the unprecedented high of $119 per barrel.

This week, we are witnessing a massive exodus of expatriate staff leaving the oil fields in the Sahara desert, as well as other experts pulling out of Libya. Again during the unrest in Egypt the possibility of the Suez Canal being blocked to oil tankers also pushed up the level of uncertainty and political risk. Analysts at Goldman Sachs and Deutsche Bank warned that given the sluggish growth of both European and even more the US economies, a heavy increase in oil price will not be sustainable and leads to higher inflation.

Again social unrest compounds the problem for hedge funds and other types of funds as the resulting albeit temporary uncertainty will exacerbate the chances of a fast recovery.

Let us also consider its effect on the fast-growing markets such as Latin America, China and Russia where increasing wealth is prompting a greater focus on investment planning and structuring issues. Here surplus funds are seeking safe shelters and it comes as no surprise that investors demand higher regulatory protection.

At the same time, we hope that an upturn already evident in fund activity in emerging countries will lead to an overflow of such funds to seek shelter in Europe. One hopes that the current unrest hitting Europe due to higher oil prices is only temporary and that the markets will stabilise given the fast revival of the Asian and emerging countries. Leaving aside the turmoil hitting the oil rich Arab countries, one hopes that the alternative funds industry continues to demonstrate an encouraging recovery away from the downturn experienced in the past three years.

As markets strengthen, there is greater appetite for funds, although investor attitudes remain cautious and the fund-raising environment for start-ups is more challenging than a few years ago.

To make matters more complicated, regulators on both sides of the Atlantic have introduced stiffer rules. Regulatory changes such as the Dodd-Frank Act in the US, and the European Union’s Directive on Alternative Investment Fund Managers, are both formidable tools in their respective arsenals to tighten up an otherwise lax attitude towards the goose that lays the golden eggs. In a world of increased regulatory focus, it’s incumbent upon each European jurisdiction including Malta to attract a fair share of funds that are seeking shelter particularly from the so-called BRIC countries. So, in a nutshell, what is the Alternative Investment Fund Managers (AIFM) directive and how can Malta gain from it?

The Directive adopted in November 2010 contains new rules on the marketing of alternative investment funds in the EU by both European and non-European managers. It introduces for the first time the concept of a “passport” through which authorised AIFMs can market EU AIFs to professional investors throughout the EU, subject to a notification procedure.

The passport for EU AIFMs marketing EU AIFs comes into effect in 2013. It will apply to all EU and non-EU AIFMs, irrespective of where the AIFs are domiciled. Thus it will enable non-EU AIFMs to market across the EU without first having to seek permission from each member state and comply with different national laws. On the other hand, non-EU AIFMs will only obtain a passport if the non-EU country in which they are located meets minimum regulatory standards and has agreements in place with member states to allow information sharing.

There will be at least a two-year time lag before a passport is available for non-EU AIFMs marketing any AIFs or for EU AIFMs marketing non-EU AIFs in Europe. Accordingly, Maltese qualifying investment funds managed by US investment managers should be able to take advantage of this passport from 2015. One of the aims of the Directive is to enhance the transparency of AIFMs and the AIFs they manage. The new transparency requirements cover disclosure to investors prior to investment, reporting obligations to competent authorities and detailed disclosures in AIF annual reports. It is advisable to define at this stage what an AIF is. It is self-managed fund that is does not appoint a third party manager.

The Directive has different effects depending on whether the AIF or the AIFM is established within or outside the EU. There is a lighter regime for smaller AIFs below a threshold of €100 million.

Consequently, the smaller AIFMs will not be subject to full authorisation but to a registration in their home member state. There are notable exemptions which exclude segregated managed accounts, funds managed by public sector entities supporting social security or pension systems, such as certain sovereign wealth funds, or family office vehicles that invest without raising external capital. It is interesting to note that authorized AIFMs must effectively employ resources and procedures that are necessary for the proper performance of its business activities.

Naturally, they are expected to employ an appropriate liquidity management system for each AIF. The additional cost of regulation imposed by the Directive is a moot point now that the markets are experiencing some turbulence. On the other hand, as a result of scandals such as the Madoff Ponzi scheme, both the US and European leaders do not want investors facing similar losses. For added investor protection, the Directive demands the functions of the depositary to be both qualified and independent. Furthermore, an AIFM cannot act as depositary. A prime broker is also prohibited from so acting, unless it has ‘functionally and hierarchically’ separated its functions as a prime broker from those as a depositary, among other requirements.

Depositaries will be held to a high standard of liability in the event of a loss of assets and the burden of proof will reside with the depositary. The Directive requires that if a depositary legally delegates its tasks to others, it must provide a contract which allows the AIF or AIFM to claim damages against the entity to which the tasks are delegated. This is intended to ensure that at no point in the chain will liability be irretrievably lost.

The directive also requires that the AIF investors concerned must be informed about the potential delegation of liability and the reasons for this. These new rules are likely to create additional operational and compliance burdens for depositaries but such costs are inevitable to assure transparency and fuller accountability. One hopes that stabiliting returns to the funds market will help Malta expand its nascent AIf market. Its global appeal is thanks to a sound and business-friendly platform of legislation combined with flexibility and user-friendliness administered by MFSA.

The MFSA already meets many of the requirements of the Directive. Once the passport scheme comes into force, it could pave the way for the floodgates to open to more investment.

To conclude, the recent unrest in Middle East can only complicate matters and might, if prolonged, disrupt the tender grass shoots of an early recovery. At a glance since the start of the year there were healthy signs that economies were on the mend.

US stocks experienced the best January in several years, but losses in the second half of this month due to disappointing earnings and political turmoil in Egypt detracted from returns. Equally, many hedge funds posted a strong performance in January, but losses in global-macro and trend-following strategies overshadowed any overall gains in the industry.

It is a positive note that both Greece and Portugal successfully issued new debt as European leaders showed stronger resolve to support the euro currency union. We all hope that when the political storm that hit the oil rich Middle East and North African countries subsides, we can enjoy the vision of a healthy hedge fund revival.



The writer is a partner in PKFMALTA, an audit and business advisory firm.



gmm@pkfmalta.com