AIFMD & the death of the Traditional Hedge Fund - A Global Perspectives white Paper - May 2012


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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.

This excellent White Paper examines the main changes being proposed, what the likely effects will be for the industry and why this European Directive means that the traditional, secretive Hedge Fund model is now effectively dead.

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AIFMD & the death of the Traditional Hedge Fund - A Global Perspectives white Paper - May 2012

  1. 1. A Global Perspectives White Paper ` AIFMD & the Death of the traditional Hedge Fund By Shane Brett, Managing Director May 2012 Global Perspectives 1 Email: Phone: +353 (0) 42 9339951 Mobile: +353 (0) 87 115 2173
  2. 2. ContentsIntroduction 2 IntroductionBackground 2 “So the EU has closed its doors to theAIFMD & the Hedge Fund Industry 3 US hedge fund industry”.1. Domiciliation 3 Financial Times, Oct 20112. Reporting 33. Depository Requirements 4 Make no mistake the AIFM directive is going to change the Hedge Fund industry forever. This4. Leverage 5 legislation (now in advanced draft form)5. Valuation policy 5 effectively marks the end of the free-wheeling unregulated years of the Hedge Fund.6. Remuneration 5Conclusion 6 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
  3. 3. alternative investment “black-box” whichpre-dominated the industry for so long.Instead we are moving towards a more Likely Effects - There is a real fear that manystandard and invasive model of financial Hedge Funds may have to re-domicile theirregulation, similar to the UCITS regime funds within the EU in order to be able to marketin Europe. their products (or potentially “co-domicile” their funds in EU/Cayman by setting up a mirror fundThis means Hedge Funds will be trying inside the EU - potentially operationally tricky).to implement the required operationalreforms (including around leverage, Indeed some large fund of funds (like Amundireporting and depository liability) while Alternative Investments) have already changedthe outcome of the on-going Euro Zone their existing structure and moved their fundssaga is being played out in the fully onshore, re-domiciling within the EUbackground. It will make for a regulated framework. We expect to see a lotchallenging environment to try and more of this in the future.implement substantial regulatorychange. Hedge Fund friendly EU locations like Ireland (which already has nearly half the global hedgeWe will look at the main changes fund administration market) are pushing hard torequired under AIFMD and what the promote themselves as an alternativelikely (largely negative) effects of this domiciliation location (using their existing AIFMwill be on the Hedge Fund Industry. compliant QIF structure).AIFMD & the Hedge FundIndustry 2. Reporting Like Dodd Frank in the US, AIFMD massively 1. Domiciliation increases the level of record-keeping reporting required by Hedge Fund Managers.One of the thorniest issues in the Managers will have to register with their nationalAIFMD proposals is what will happen to regulator (essentially the FSA in the UK (itselfnon-EU based managers who want to changing shortly) given that 80% of EU basedmarket and sell their funds inside the Hedge Funds are in London). Details will beEU. required of investment strategy, the main instruments funds will be trading and what theTo date the legislation has taken an likely level of exposure will be.inside or outside of Europe view – i.e.that the Hedge Fund either operated Similar reporting will be required on a frequentfully within the EU or fully outside it. This on-going basis in relation to its exposure andview also applied to Hedge Fund risk calculations. The stated aim of this is toinvestors, Managers, Custodians and allow the regulators to determine if a systemicthe Hedge Funds themselves. threat is building up in the financial system.Of course in reality this is nonsense. Likely Effects – Hedge Funds will have toThere is no such clear division. Funds invest heavily in their operational software in(and their service providers) operate order to be able to access large volumes of dataacross multiple jurisdictions just like quickly and flexibly for reporting purposes. Thiscompanies in other global industries.Global Perspectives +353 (0) 42 9339951Mobile: +353 (0) 87 115 2173
  4. 4. will obviously favour larger, more Under the AIFMD proposed regulationsestablished managers who should have Depositories (Custodians/Prime Brokers) willdeeper pockets. have a much higher degree of liability for any losses that are incurred – even losses that areIt will also favour larger Administrators. outside of their control (i.e. delegated to a thirdAs they are holding the official books party).and records of the fund and can easilyaccess and report this data, many In many ways this regime will be even tighterManagers may decide to fully outsource than the existing UCITS requirements. This is athe AIFMD reporting requirements to huge change whereby hedge funds arethem. effectively more tightly regulated than the existed onshore regime.Administrators themselves will likelyhave to invest in their existing reporting Non-EU funds must have a Depository eithercapabilities in order to satisfy their within the EU or in their “home country” (mainclients. Smaller administrators will find location) or country of domiciliation. However thethis more difficult, reinforcing the catch here is that non-EU Depository must beprocess of consolidation already subject to the same level of EU regulation in theunderway in this part of the industry. “home” jurisdiction as they would be in the EU (including mutual tax and regulatory co-Additionally these reporting operation agreements).requirements will feed down pressure tothe industries main software vendors; to It is completely unclear how this will work inmake their software more malleable and practice and is a source of much concern in thedynamic for reporting purposes, right industry. Our view is that this requirement isacross all aspects of the fund. There is close to unworkable.likely to be a year or two lag once theDirective is finalised, while manyvendors built out the required Likely Effects – We would expect to see someenhancements in their applications depositories withdraw completely from perceived risky markets. Additionally we would also expectHedge Funds using proprietary software to see them offer less coverage for marketswill likely have to make substantial which they deem are in any way inherently to bring their systems up tothe new required standard. They may Many existing Depositories will be reluctant todecide the gap is not worth trying to continue to offer coverage in certain Emergingbridge and opt to migrate to an off-the- Markets. This could have a huge effect on theseshelf platform which will do this for them. 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. 3. Depository Requirements Non-EU funds will have to spend the next couple of years (the Directive becomes law in July 2013) working with their national regulator toAll Alternative Investment Funds will ensure that their home regulations satisfy thehave to appoint a single independent Directive’s requirements. The real issue will beDepository to safeguard the fund’s when the gaps are identified.assets.Global Perspectives +353 (0) 42 9339951Mobile: +353 (0) 87 115 2173
  5. 5. The Directive is mandating that the“home” regulator must itself introduceregulation to bring itself up to the EUlevel. This, of course, will be close toimpossible politically. The EU will be 5. Valuation policyseen as trying to supplant othercountries sovereignty. AIFMD mandates that all assets of a fund will be independently valued. The valuation of theWe expect many countries (including Funds assets must either be performed by anthe US) to lodge official objections to independent entity (i.e. an administrator) or theythese rules (perhaps at the WTO level) can be performed by the Hedge Fund - as longand if this is not resolved satisfactorily, as it is not valued by the Portfolio Managementthen reciprocal rules will be imposed on function or the area that sets remunerationEU resident Hedge Funds. policy for the fund. Likely Effect - Funds will be required to use 4. Leverage administrators (as all EU managers do now) but further restrictions on the valuation of hard toAs well as stricter rules on the use of mark assets by Hedge Fund Managers mayleverage, the current draft proposals mean some may start to steer clear of potentiallycontain an unusual and very strict illiquid investments.methodology for calculating leverage. Firms will need to document their valuationThis proposal has raised many procedures, valuation committee processes andeyebrows right across the industry. The pricing policies carefully, ready for externalEU actually rejected the more common regulatory inspection or submission.leverage methodology recommended byESMA (its own markets regulator). The best managers do this already, however the focus of the regulators will be squarely on theLikely Effect – If this calculation is hard to value, illiquid securities which they willadopted it will further limit the amount of be concerned (in aggregate across the industry)leverage a Hedge Fund can adopt in its may cause a systemic risk in the future.investment strategy and could be amajor change from the model of thetraditional hedge fund. 6. RemunerationFurthermore adopting these newcalculations will be an operational Under the directive company remuneration mustnightmare for smaller firms, as they be published in detail in the Fund Managersstruggle to change/add existing leverage annual reports. Also, salaries and bonuses mustcalculations to their risk analysis be weighed towards long term rewards andreporting and software. away from short term payments.Service providers such as Likely Effect – The industry will have to becomeAdministrators and the industries use to a new level of transparency andsystem vendors will have to move openness in some of the most sensitive areas ofquickly to ensure they are compliant any business – how much its staff arewith these calculations if they are in the remunerated. This will be a major culturalfinal treaty text (as currently looks change.likely).Global Perspectives +353 (0) 42 9339951Mobile: +353 (0) 87 115 2173
  6. 6. Like in investment banking, HedgeFunds are likely to increase their basicsalaries to staff, in order to mitigateunfavourable reporting in the press (thiswill be the first time mainstream mediawill ever have access to Hedge Fundremuneration).ConclusionIt is clear from the draft AIFMD Global Perspectives offers theproposals that these new EU regulationswill change forever the way Hedge following services to the AssetFunds operate. Management industry:-The industry will have to reconcile itself  Consulting,to a far more open, more invasive andmore regulated operating environment  Bespoke Research,in Europe. This is likely to become the  Product Design,de-facto standard globally, bringing the  Service Provider Reviewsera of the traditional, secretive Hedge  Operational Due DiligenceFund to an end. reviews.The question in the years to come iswhether this is in fact only the start of apipeline of future regulation designed tobring Alternative Investments tightlywithin the regulatory net.Sign up for our monthlyWhite Papers at-!white-papersGlobal Perspectives +353 (0) 42 9339951Mobile: +353 (0) 87 115 2173