| PARTICIPANTS |
• Tony McDonnell, Head of Alternative Sales and Business Development, Europe and North America, HSBC Securities Services
• Simon Kellaway, Managing Director, Global Head of Product Development, Prime Services, HSBC
In just under a year from now the European Union’s AIFMD will be transposed into national law, creating a tighter regulatory framework for managers of alternative investment funds (AIFs) – hedge funds, private equity funds, real estate funds and a range of other funds.
The big question, though, is how well prepared are alternative investment fund managers (AIFMs), in particular managers of hedge funds? The answer, in many cases, is not well enough, especially if they are based outside the EU because they may believe, erroneously, that it is of no relevance to them.
The Directive’s requirements will be significant and its implications far-reaching for both EU hedge fund managers and (increasingly over time) non-EU hedge fund managers seeking to raise capital in Europe. The costs of compliance will be high, but there are other factors they will need to take into consideration, such as the impact on business strategies, the commercial implications of the requirement to appoint a single depositary for each fund and relationships with prime brokers.
The AIFMD requirements
When it is implemented in July 2013 the Directive requirements will apply to all EU AIFMs, irrespective of whether the AIFs they manage are domiciled in the EU or outside (though there are certain dispensations from the depositary requirement for non-EU AIFs). Certain transparency requirements will also apply to non-EU AIFMs marketing AIFs in Europe, again irrespective of where the AIFs are domiciled.
The ‘level 1’ framework Directive setting out the main principles was adopted by the EU last year, and although the detailed ‘level 2’ implementing measures will not be known until this September a draft has been circulated and it is expected that the final text will largely conform to the draft (though we will need to wait and see).
The main requirements, subject to modification in September, are:
• Authorisation. EU AIFMs must be authorised by their home state regulator. There is a lighter-touch regime for managers of smaller AIFs, which only have to register with the regulator rather than be fully authorised.
• Operations. EU AIFMs must comply with a number of operating conditions, including the use of appropriate risk management techniques, the employment of liquidity management systems, adherence to regulatory leverage limits, transparent asset valuation models and compliant remuneration policies.
• Appointing a depositary. EU AIFMs must ensure that, for each EU AIF they manage, a single depositary is appointed for the safekeeping of assets. Such depositaries will assume a significantly higher degree of liability than is currently the case.
• Transparency. AIFMs must disclose more information to investors, enhance their regulatory reporting and provide detailed disclosures in annual reports.
• Marketing in Europe: The Directive will introduce an EU ‘passport’ scheme under which an AIFM authorised in one member state will be able to market EU AIFs in all member states. This is a major benefit of the directive for AIFMs.
Impact on strategy and product design.
The Directive will affect the hedge fund sector in many ways, especially in respect to how managers and funds comply with its requirements, the costs of compliance, its impact on business strategy and product design, the use of depositaries for the safekeeping of fund assets and relationships with prime brokers.
In terms of how it could impact hedge fund strategy and product design, EU AIFMs have a number of choices.
At one end of the spectrum EU AIFMs could decide to embrace the AIFMD regime wholeheartedly, creating many more EU AIFs to serve the European market and using non-EU AIFs mainly, though not exclusively, for other distribution markets. Such a strategy might also entail selling UCITS (assuming a compatible investment strategy) to professional investors in Europe, funds which are already tightly regulated to protect retail investors.
Taking the middle ground, EU AIFMs could carry on as they are, serving the EU market mainly with non-EU AIFs through the existing national private placement schemes. Yes, they would still have to comply with most aspects of the AIFMD, but they would regard the EU market big and lucrative enough to make it worthwhile; and although the passporting regime may become the only distribution channel available after 2018, and therefore require full compliance with the directive, 2018 is in the distant future in many managers’ eyes. Managers may also consider creating one or two new EU-domiciled AIFs to test the market and cater for clients looking to invest in onshore funds.
At the other end of the spectrum some non-EU hedge fund managers may decide that the EU market has become so regulated as to make it less viable for them. They may scale down their European distribution, even phase it out altogether, to focus instead on an Asian, Latin American or US strategy. Hedge fund regulation is increasing in those jurisdictions too, but some regimes may be less restrictive – and even if all were equally tough, some non-EU hedge fund managers may decide that complying with them all would be so complicated and costly that it would be better to be selective about which markets they operate in.
We believe that there are still a large number of AIFMs – mainly non-EU managers, but EU ones too – who have not yet thoroughly analysed the implications for their business strategies and product design. They understand what the AIFMD requires of them, and are well advanced down the compliance path – but this is a tactical, not a strategic, approach. Dovetailing product design with evolving investor needs is a challenge facing all AIFMs.
Many EU managers running offshore Cayman vehicles appear to be sitting on the fence and plan to continue as they are, taking the middle ground course of action, by continuing to pursue the offshore route for new funds. There was an expectation the Directive would create many more onshore funds but for as long as the private placement regime remains in place this is unlikely to happen.
Using a depositary
As we have already said, and subject to the phased implementation outlined above, the Directive will require managers to appoint a single depositary for each fund. This could cause several issues for managers and funds, particularly in relation to how the three distinct pools of assets held by funds (unencumbered, pledged and rehypothecated) are custodied and monitored.
First, if a depositary is uneasy about taking on liabilities in certain markets it may increase its pricing to reflect the higher degree of risk associated with these markets, or even potentially refuse to provide depositary services in specific markets, thus restricting an AIF’s access to its complete investment strategy.
Second, a depositary may be unable or reluctant to appoint an AIFM’s favoured prime broker as a sub-custodian of pledged assets (if this becomes necessary under the level 2 measures) due to the latter’s inability to clearly demonstrate a functional and hierarchical separation of its independent custody capabilities or the depositary’s concerns over the latter’s financial stability and/or sub-custodian network. Conversely, those prime brokers with established, yet segregated and independent, global custody capabilities may appeal most to AIFMs and depositaries. Again, the depositary’s strict liability for unencumbered and (potentially) pledged assets (notwithstanding some minor flexibility for exculpation of this liability) will play a key role in determining how the various service providers will interact.
Third, if the prime broker’s role is reduced to offering financing and only rehypothecating pledged assets on a fund by fund basis (rather than considering an aggregate pool of pledged securities across all of its counterparties), then it is likely that financing rates may increase. Prime brokers may consider that the operational burden and risk of rehypothecating pledged assets outweighs the economic return resulting in potentially significantly higher funding and securities borrowing costs to underlying AIFs.
Fourth, complex and cumbersome operating models could result from the use of a depositary and a third-party custodian to safekeep unencumbered and pledged assets respectively. Coupled with a prime broker, this could give rise to significant operational risks and costs. However, prime brokers that are able to operate in co-operation with a ring-fenced, in-house custody platform in another part of the organisation that can also capture independent depositary business – such as HSBC Prime Services’ relationship with HSBC Securities Services – will probably be able to offer more the most efficient operating models and also more attractive financing and securities borrowing rates.
Thinking long term and taking action
Hedge fund managers – whether they are EU or non-EU based, managing funds domiciled in Europe or elsewhere – must focus on more than just compliance. They need to look at the impact on their overall business – on strategy and product design, and on their choice of depositaries and prime brokers.
Unfortunately, over-concentration on regulatory compliance is clouding the true picture for many. EU managers by and large know what they have to do to comply by July 2013 and are well-advanced in their preparations, but because offshore funds will continue to dominate for as long as the private placement regime remains, they are perhaps not paying enough attention to the stricter regimes that will come into effect in 2015 and 2018.
Similarly, non-EU managers are aware of the AIFMD rules they must comply with by July 2013 – which are less onerous than those for EU managers – if they want to market EU or non-EU funds in Europe, but they are tending to ignore the longer term impacts, in particular the likely end of national private placement in 2018.
Many hedge fund managers believe that because most or all of their funds are offshore they will not be greatly affected by the directive. They could not be more wrong. They should consider all the implications now, short and long-term, and take appropriate action sooner rather than later.