Investors
Here is the second instalment of COOConnect’s five part series summarising the key events to impact hedge funds in 2013.
Alternative Investment Fund Managers Directive (AIFMD)
When the AIFMD was first proposed in the aftermath of the financial crisis in 2009, there were widespread predictions the directive would facilitate an exodus of hedge funds from the EU towards New York, Hong Kong, Singapore, Switzerland, and even Liechtenstein. AIFMD, in its original form, would have been a hammer-blow to the alternatives industry. Industry group lobbying has dampened the directive making it far more palatable for hedge funds, with some optimists even predicting an AIFMD-brand not too dissimilar to Ucits could emerge. That is not to say AIFMD will be a breeze for hedge funds with BNY Mellon estimating the average manager will pay anywhere between $300,000 and $1 million to achieve full compliance. Nonetheless, the majority of EU member states are giving managers a one-year transitional period to become compliant, although progress in transposing the directive into national law across the bloc has been varied. The challenges though of AIFMD should not be underestimated and a number of sticklers do remain.
Depository liability
Depository liability has been the biggest worry for managers since AIFMD was first proposed. An alarmist study by the Alternative Investment Management Association (AIMA) in 2011 warned depository liability could cost hedge funds $6 billion in extremis. These costs have been revised downwards with most custodian banks willing to charge several basis points, and some even providing depository services for zero basis points as part of a bundled offering. Disputes between global custodians, which under Article 21 of the AIFMD must accept strict liability for loss of assets, and prime brokers and International Central Securities Depositories (ICSDs) appear to be on-going with the European Securities and Markets Authority (ESMA) unlikely to intervene to settle the matter. Custodians are loath to accept responsibility for assets not in custody with them such as unencumbered assets held at the prime broker or within the sub-custody network of a prime broker or ICSD. Custodian demands that prime brokers hold assets in segregated accounts will probably lead to nothing, mainly because it will be operationally awkward for the primes to earmark those assets. Other experts predict custodians could clamp-down on the traditional prime brokerage practice of re-hypothecation, in what could lead to an increase in borrowing costs for hedge funds. While it is unlikely custodians will impose a hard and fast cap on how much prime brokers can re-hypothecate, it is probable they will demand a line of sight over where assets are held at the prime broker. The consensus is that prime brokers will eventually have to agree to indemnify custodians against responsibility for loss of assets in prime brokerage accounts although full transparency is likely to be some way off. A lack of transparency by prime brokers could prompt some custodians to refuse to work with certain primes or terminate relationships with hedge fund clients that are reluctant to change prime broker. ICSDs such as Euroclear and Clearstream which hold assets on behalf of prime brokerage clients in their own sub-custody networks in high risk markets could also be forced to use the sub-custody network of a depository bank. Expect some sort of tentative agreement between the prime brokers, ICSDs and custodians in 2014.
COOConnect held a webinar on how managers should best choose their depository bank. To view the webinar, please click here.
The rise of the depo-lite
Article 36 of AIFMD permits managers of non-EU funds marketing to EU investors through national private placement regimes to appoint what is known as a depository (or depo-lite) lite, which is not subject to the strict liability for loss of assets as mandated under Article 21. Depo-lites will be responsible for monitoring cash flows (subscriptions and redemptions plus any other cash movements), safekeeping of assets and oversight of service providers (such as the fund administrator calculating the net asset value (NAV) or prime broker). At present, there is just one independent depo-lite, which has been given the go-ahead by the UK’s Financial Conduct Authority (FCA) – INDOS Financial, established by a former hedge fund COO. Standalone fund administrators lacking a banking license to operate as a full depository, are also looking to set up depo-lites. SS&C GlobeOp has already submitted a request to the FCA to establish a depo-lite as a wholly separate subsidiary to its fund administration business, while Centaur Fund Services has set-up a depo-lite entity in Dublin. Whether the FCA issues approval in good time remains to be seen. Some standalone fund administrators are simply electing to merge with well-capitalised banks. Quintillion, a Dublin-based administrator, became the latest to do so and sold itself to US Bancorp Fund Services while Butterfield Fulcrum was acquired by Mitsubishi UFJ Financial Group earlier this year. Depo-lites are not without their challenges and many fund administrators will struggle to convince clients they can deliver. The most obvious problem facing them is whether their subsidiaries can be truly independent. If the depositary lite spotted an error at the fund administration arm of the same business, what guarantees are there that the error will be reported? The Central Bank of Ireland recently warned standalone administrators they needed to convince regulators that their businesses would not suffer from conflicts of interest or capacity issues, although the Irish regulator has issued little clarity on its stance on depo-lites, something which is frustrating a number of Dublin-based fund administrators. Another challenge lies with depo-lites’ lack of balance sheet capital and experience in providing custody of assets. Admittedly, these firms are not ensnared by the strict liability provisions in the AIFMD but that does not excuse them from liability through negligence. Furthermore, ESMA will launch a wholesale review of AIFMD in 2015 and could force all funds marketing into the EU to appoint a full depository, something which would render depo-lites obsolete. Expect the depo-lite to be a short-term fix in 2014.
AIFMD reporting
A study by KNEIP revealed reporting requirements under AIFMD were a primary concern for 40 per-cent of managers with a further 80 per-cent acknowledging they were unprepared for these new obligations. AIFMD regulatory reports are likely to vary across the 28 EU member states although some business-hungry fund administrators warn managers there could be glitches when filing in a multi-currency, multi-language format. Optimists had previously hoped they could simply leverage the data they had submitted to the Securities and Exchange Commission (SEC) through their Form PFs until lawyers informed them just one third or so of that data could actually be replicated in AIFMD. The FCA has taken the lead and demanded managers submit the Variation of Permission (VOP) application to become an AIFM by January 22, so as to give the regulator six months to approve those applicants. The Central Bank of Ireland wants AIFMs to provide regulatory reports by February 21. A City of London Law Society challenge against the FCA’s deadline argues the regulator is gold plating the directive and is demanding managers be able to submit their VOP up until AIFMD’s actual implementation date of July 22, 2014. It is unlikely this challenge will succeed though. The VOP is highly detailed. One outstanding issue is that the VOP demands managers identify their depository or depo-lite and confirm the appointment was made after full operational due diligence. The FCA has yet to approve a number of depo-lites and other regulatory regimes have yet to issue clarity. This lack of clarity could result in some managers being forced to leave details about their depo-lite blank in the VOP. Expect AIFMD reporting to come and go without much fanfare much like Form PF in 2014.
COOConnect held a webinar on regulatory reporting. To view the webinar, please click here.
Other AIFMD challenges remain
Fears that hedge fund remuneration would be subject to similar restrictions as to investment bankers through the Capital Requirements Directive IV have been largely quashed. AIFMD has sought to align hedge fund managers’ interests with those of their investors by requiring senior personnel to defer between 40 per-cent and 60 per-cent of their variable remuneration over a three to five year period while a substantial portion of their pay packages must be disbursed in shares or other approved financial instruments. The FCA – the regulator of the majority of Europe’s hedge fund industry – issued a consultation in September 2013 strongly hinting it might issue a deferral exemption threshold for fund managers running between £500 million and £1.5 billion. The FCA has been praised for its proportional approach on the issue of remuneration although different national regulators might take a tougher line while ESMA could yet rein the UK in over its stance on remuneration when the European body conducts its review of AIFMD in 2015. Confusion surrounding national private placement regimes continues with a number of jurisdictions yet to issue clarification on the matter. There is widespread legal debate as to what constitutes reverse solicitation. Managers in the US were also dealt a rude awakening. Having previously assumed they were excluded from the full ambit of AIFMD, many discovered they were impacted and started to conduct cost benefit analysis so as to ascertain whether the benefits of AIFMD compliance made economic sense. Newer US managers have reportedly stopped marketing into the EU instead focusing their capital raising efforts on the larger US market. US firms with a small European client base are debating whether to pull out operations from the EU. Some optimists though believe an AIFMD-brand of manager could emerge potentially rivalling Ucits. Nonetheless, such a development is a long-way off, particularly as AIFMD implementation has not even begun yet. Expect clarity on remuneration and private placement and the exiting of some US managers from the EU in 2014.
Fees
Institutional investors never tire of informing managers and service providers that they adopt a no-nonsense approach towards hedge fund fees – historically a 2 per-cent management fee and 20 per-cent performance fee. A survey by J.P. Morgan’s Capital Introductions Group indicated investors had become more aggressive on fees with 42 per-cent and 26 per-cent of allocators saying they had successfully reduced the management fee and performance fee respectively at hedge funds. A number of new managers are compromising on their fee structures with the industry norm for a start-up today being around 1.5 per-cent and 15 per-cent. Cantab Capital Partners, a Cambridge, England-based quant shop went even further launching its CCP Core Macro Fund which charged investors a paltry 0.5 per-cent management fee and 10 per-cent performance fee. Nonetheless, Cantab is the exception rather than the rule. The unexciting performances at hedge funds and their inability to reach pre-crisis high-watermarks have all helped facilitate a decline in fees. Growing hedge fund investing by pension funds, consultants, sovereign wealth funds and insurers – all of whom are writing decent sized tickets – is another key driver for the downward pressure on fees. Other surveys suggest the contrary, and argue fees have remained consistent. Eighty-three per-cent of investors told a Goldman Sachs prime brokerage study they paid full fees in 2012 instead of individually negotiated ones. The majority of pension funds (68 per-cent), historically the most vocal investor constituent on fees, told Goldman Sachs they paid full or non-negotiated fees, while just one in ten endowments said their investments came with a fee discount. Expect fee pressure to continue, particularly if performance at hedge funds is static in 2014.
OPERA
Open Protocol Enabling Risk Aggregation (OPERA), the risk-reporting tool developed by Albourne Partners, has divided the hedge fund industry. Given Albourne Partners’ clout, few hedge funds will publicly admonish OPERA although privately many chief operating officers (COOs) concede it is an added reporting headache and expense. Institutional investors, to whom the report will be supplied, are broadly supportive as it consolidates a number risk and regulatory reporting data into a comprehensive document. The number of hedge funds filing OPERA has jumped exponentially after a disappointing start. This take-up is certainly attributable to the no-nonsense approach taken by Simon Ruddick, CEO at Albourne, whereby he warned managers they faced relegation from the consultant’s approved list of hedge funds if they fail to complete OPERA. Albourne Partners has also lobbied ESMA and the SEC to align OPERA’s reporting methodology into their own regulatory reports. A technical submission to ESMA on the issue gathered 242 signatories from the hedge fund industry. The head of risk at Albourne Partners has said the biggest stumbling block to creating a global, standardised risk reporting toolkit is US and European regulators’ lack of uniformity on risk reporting methodology although added Albourne Partners’ lobbying efforts with the SEC appears to be making more headway than at ESMA. Albourne scored a coup in Australia in April 2013 when it was revealed the Australian Prudential Regulation Authority (APRA) was considering forcing hedge funds to adopt OPERA if they wanted to manage money on behalf of the country’s $1.5 trillion superannuation funds industry. However, little has been said of this since although one lawyer said the requirement was unlikely to be enacted before the middle of 2014. Expect OPERA take-up among hedge fund managers to grow in 2014.
Data Security
That a paper on systemic risk published by the Depositary Trust & Clearing Corporation (DTCC) identified cyber-crime as the biggest threat to market stability, putting it ahead of counterparty risk and concentration risk at central counterparty clearing houses (CCPs), was telling. Cyber-crime can take many forms – the most obvious being Denial of Service, unwanted disclosure of non-public material or misleading information and corruption of books and records. The reputational risk of falling victim to one of these attacks is potentially enormous. The same DTCC survey revealed 53 per-cent of exchanges confirmed they had been subject to a cyber-attack over the last 12 months. CME Group became the latest firm (alongside J.P. Morgan and the New York Stock Exchange) to admit it had been subject to a hack whereby its clearing system was breached and customer information compromised. Hedge funds should be under no illusion that they are immune to similar breaches. Portcullis Trustnet, a Singapore-based fund administrator, suffered the ignominy of having 260 gigabytes of confidential client data containing information on 120,000 offshore entities being leaked by a disgruntled employee to the International Consortium of Investigative Journalists prompting a deluge of embarrassing news articles. As the National Security Agency (NSA) discovered courtesy of Edward Snowdon, the majority of these leaks are not the doing of sophisticated cyber-criminals but rather frustrated employees. Simple inexpensive procedures can be adopted by hedge funds to prevent data leakage, such as checking and restricting what employees are downloading, and ensuring sensitive information is password protected. Expect more leaks and data breaches in 2014.
COOConnect will be hosting a webinar on cyber security on January 27.
Tags:
AIFMD
depository
remuneration
depo-lite
SEC
ESMA
INDOS Financial
SS&C GlobeOp
Centaur
ICSD
Euroclear
Clearstream
AIMA
J.P. Morgan
Goldman Sachs
Cantab Capital
OPERA
Albourne Partners
APRA
DTCC
data security
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