AIFMD & the Death of the traditional Hedge Fund

Date: Thursday, July 5, 2012
Author: Shane Brett, Global Perspectives, on HedgeTracker.com

“So the EU has closed its doors to the US hedge fund industry”. - Financial Times, Oct 2011

Make no mistake the AIFM directive is going to change the Hedge Fund industry forever. This legislation (now in advanced draft form) effectively marks the end of the free-wheeling unregulated years of the Hedge Fund.

A new era of regulation is upon us and the consequences of this EU Directive means the traditional, secretive Hedge Fund model is effectively dead.

Background

Rightly or wrongly Hedge Funds in mainland Europe have an unenviable reputation. Despite no Hedge Fund ever having required a public bailout, the EU has used the current economic crisis as a pre-text to increase regulation across the industry in Europe.

Across the industry focus to date has been on Dodd Frank (especially in the US) but the Alternative Investment Fund Managers Directive (AIFMD) is likely to have far greater affects on the wider Hedge Fund Industry in the years to come.

The third and final draft version of the AIFM Directive was published recently (May 2012) and unsurprisingly, against a background of extreme Euro Zone turbulence, they have reintroduced many of the more prohibitive requirements that were first seen in the original draft but had been successfully lobbied down in the second version.

Incredibly, this final version has even been criticised by such unlikely sources as ESMA (the EU’s own super regulator) and the ECB but still looks likely to become law across the EU in July 2013.

We believe the adoption of AIFMD signals the death of the traditional largely unregulated alternative investment “black-box” which pre-dominated the industry for so long. Instead we are moving towards a more standard and invasive model of financial regulation, similar to the UCITS regime in Europe.

This means Hedge Funds will be trying to implement the required operational reforms (including around leverage, reporting and depository liability) while the outcome of the on-going Euro Zone saga is being played out in the background. It will make for a challenging environment to try and implement substantial regulatory change.

We will look at the main changes required under AIFMD and what the likely (largely negative) effects of this will be on the Hedge Fund Industry.

1. Domiciliation

One of the thorniest issues in the AIFMD proposals is what will happen to non-EU based managers who want to market and sell their funds inside the EU.

To date the legislation has taken an inside or outside of Europe view – i.e. that the Hedge Fund either operated fully within the EU or fully outside it. This view also applied to Hedge Fund investors, Managers, Custodians and the Hedge Funds themselves.

Of course in reality this is nonsense. There is no such clear division. Funds (and their service providers) operate across multiple jurisdictions just like companies in other global industries.


Likely Effects - There is a real fear that many Hedge Funds may have to re-domicile their funds within the EU in order to be able to market their products (or potentially “co-domicile” their funds in EU/Cayman by setting up a mirror fund inside the EU - potentially operationally tricky).

Indeed some large fund of funds (like Amundi Alternative Investments) have already changed their existing structure and moved their funds fully onshore, re-domiciling within the EU regulated framework. We expect to see a lot more of this in the future.

Hedge Fund friendly EU locations like Ireland (which already has nearly half the global hedge fund administration market) are pushing hard to promote themselves as an alternative domiciliation location (using their existing AIFM compliant QIF structure).

2. Reporting

Like Dodd Frank in the US, AIFMD massively increases the level of record-keeping reporting required by Hedge Fund Managers.

Managers will have to register with their national regulator (essentially the FSA in the UK (itself changing shortly) given that 80% of EU based Hedge Funds are in London). Details will be required of investment strategy, the main instruments funds will be trading and what the likely level of exposure will be.

Similar reporting will be required on a frequent on-going basis in relation to its exposure and risk calculations. The stated aim of this is to allow the regulators to determine if a systemic threat is building up in the financial system.

Likely Effects – Hedge Funds will have to invest heavily in their operational software in order to be able to access large volumes of data quickly and flexibly for reporting purposes. This will obviously favour larger, more established managers who should have deeper pockets.

It will also favour larger Administrators. As they are holding the official books and records of the fund and can easily access and report this data, many Managers may decide to fully outsource the AIFMD reporting requirements to them.

Administrators themselves will likely have to invest in their existing reporting capabilities in order to satisfy their clients. Smaller administrators will find this more difficult, reinforcing the process of consolidation already underway in this part of the industry.

Additionally these reporting requirements will feed down pressure to the industries main software vendors; to make their software more malleable and dynamic for reporting purposes, right across all aspects of the fund. There is likely to be a year or two lag once the Directive is finalised, while many vendors built out the required enhancements in their applications

Hedge Funds using proprietary software will likely have to make substantial investments to bring their systems up to the new required standard. They may decide the gap is not worth trying to bridge and opt to migrate to an off-the-shelf platform which will do this for them.


3. Depository Requirements

All Alternative Investment Funds will have to appoint a single independent Depository to safeguard the fund’s assets.
Under the AIFMD proposed regulations Depositories (Custodians/Prime Brokers) will have a much higher degree of liability for any losses that are incurred – even losses that are outside of their control (i.e. delegated to a third party).

In many ways this regime will be even tighter than the existing UCITS requirements. This is a huge change whereby hedge funds are effectively more tightly regulated than the existed onshore regime.

Non-EU funds must have a Depository either within the EU or in their “home country” (main location) or country of domiciliation. However the catch here is that non-EU Depository must be subject to the same level of EU regulation in the “home” jurisdiction as they would be in the EU (including mutual tax and regulatory co-operation agreements).

It is completely unclear how this will work in practice and is a source of much concern in the industry. Our view is that this requirement is close to unworkable.

Likely Effects – We would expect to see some depositories withdraw completely from perceived risky markets. Additionally we would also expect to see them offer less coverage for markets which they deem are in any way inherently risky.

Many existing Depositories will be reluctant to continue to offer coverage in certain Emerging Markets. This could have a huge effect on these countries. If Hedge Funds are effectively unable to allocate their investment capital to the assets in these countries, it serves to undermine investment in the markets that most need it.

Non-EU funds will have to spend the next couple of years (the Directive becomes law in July 2013) working with their national regulator to ensure that their home regulations satisfy the Directive’s requirements. The real issue will be when the gaps are identified.

The Directive is mandating that the “home” regulator must itself introduce regulation to bring itself up to the EU level. This, of course, will be close to impossible politically. The EU will be seen as trying to supplant other countries sovereignty.

We expect many countries (including the US) to lodge official objections to these rules (perhaps at the WTO level) and if this is not resolved satisfactorily, then reciprocal rules will be imposed on EU resident Hedge Funds.

4. Leverage

As well as stricter rules on the use of leverage, the current draft proposals contain an unusual and very strict methodology for calculating leverage.

This proposal has raised many eyebrows right across the industry. The EU actually rejected the more common leverage methodology recommended by ESMA (its own markets regulator).

Likely Effect – If this calculation is adopted it will further limit the amount of leverage a Hedge Fund can adopt in its investment strategy and could be a major change from the model of the traditional hedge fund.

Furthermore adopting these new calculations will be an operational nightmare for smaller firms, as they struggle to change/add existing leverage calculations to their risk analysis reporting and software.

Service providers such as Administrators and the industries system vendors will have to move quickly to ensure they are compliant with these calculations if they are in the final treaty text (as currently looks likely).

5. Valuation policy

AIFMD mandates that all assets of a fund will be independently valued. The valuation of the Funds assets must either be performed by an independent entity (i.e. an administrator) or they can be performed by the Hedge Fund - as long as it is not valued by the Portfolio Management function or the area that sets remuneration policy for the fund.

Likely Effect - Funds will be required to use administrators (as all EU managers do now) but further restrictions on the valuation of hard to mark assets by Hedge Fund Managers may mean some may start to steer clear of potentially illiquid investments.

Firms will need to document their valuation procedures, valuation committee processes and pricing policies carefully, ready for external regulatory inspection or submission.

The best managers do this already, however the focus of the regulators will be squarely on the hard to value, illiquid securities which they will be concerned (in aggregate across the industry) may cause a systemic risk in the future.


6. Remuneration

Under the directive company remuneration must be published in detail in the Fund Managers annual reports. Also, salaries and bonuses must be weighed towards long term rewards and away from short term payments.

Likely Effect – The industry will have to become use to a new level of transparency and openness in some of the most sensitive areas of any business – how much its staff are remunerated. This will be a major cultural change.

Like in investment banking, Hedge Funds are likely to increase their basic salaries to staff, in order to mitigate unfavourable reporting in the press (this will be the first time mainstream media will ever have access to Hedge Fund remuneration).


Conclusion

It is clear from the draft AIFMD proposals that these new EU regulations will change forever the way Hedge Funds operate.

The industry will have to reconcile itself to a far more open, more invasive and more regulated operating environment in Europe. This is likely to become the de-facto standard globally, bringing the era of the traditional, secretive Hedge Fund to an end.

The question in the years to come is whether this is in fact only the start of a pipeline of future regulation designed to bring Alternative Investments tightly within the regulatory net.