Pressure on, pressure off
The 22 July deadline for implementation of the Alternative Investment Fund Managers Directive (AIFMD) is looming. As with other EU financial legislation, AIFMD will be enforced via national regulators and with varying approaches, so this will not be consistent across EU member states. Some, like Germany, are insisting on additional ‘safeguards’ for domestic managers and funds seeking registration. Neither is it clear if some of the smaller EU member state regulators will have any managers, depositaries, or funds seeking to register under the legislation at all. In the UK, the Financial Conduct Authority (FCA) has already said it need only receive completed applications by the July deadline – applicants can continue trading until the authority has time to assess them.
As the deadline nears, there is more thinking about possible outcomes. The concept of strict liability, already in force for UCITS funds and a key component of the enhanced investor protection promised by AIFMD, is a good place to start. The added cost of meeting strict liability must be met from one or more of the following: the depositary’s overall balance sheet, its risk capital, or through insurance. Strict liablity has been touted as an extra, business-inhibiting cost but a glance at the list of depositaries approved by the FCA suggests a more nuanced conclusion.
Take LanghamHall, an independent provider of fund administration and depositary services to private equity, real estate and infrastructure funds. “We are an FCA-regulated AIFMD depositary,” says Marie Fitzgerald, head of private equity depositary at the group. “But the cost of strict liability for illiquid assets, such as those for which we provide depositary services, is very different to that of strict liability for hedge funds which buy and sell liquid financial instruments.” The firm charges a fixed fee rather than a basis point of assets under management, in contrast to industry practice for hedge funds.
“Not only are the assets we have on deposit illiquid, but the volume and velocity of portfolio turnover tends to be much less than that of hedge funds or UCITS equity and bonds funds,” Fitzgerald continues. Ownership of heritable assets such as real estate is established through acquiring legal title to the relevant asset after purchase. Private companies are similarly bought and sold off exchange and infrastructure projects set up by legally complex exchanges of tender and contract, with central or municipal government a frequent counterparty. “We could, in principle, trigger strict liability but the risk is much smaller than is the case with financial instruments,” Fitzgerald adds.
Many predictions about the post-AIFMD depositary landscape assume that there will be fewer providers, but this may well turn out to false. Niche providers will survive and may multiply. Elsewhere, larger custodians are likely to pick and choose the managers to which they provide depositary services.
AIFMD grants a partial exemption on strict liability to offshore non AIFMD-regulated managers seeking AIFMD approval for funds to be marketed within the EU. This is particularly relevant to hedge funds using prime brokers for safekeeping. These funds do not have to use a single depositary offering strict liability, as long as the lack of strict liability is fully disclosed to potential investors. This ‘depo-light’ arrangement, as against full depositary, is already offered by major custody banks like BNP Paribas, not to mention niche prime brokers.
Depo-light allows offshore hedge funds to retain their existing arrangements with third-party service providers. Safekeeping can stay with existing prime broker, cash-flow monitoring with the administrator and oversight with the depo-light provider. Nor does it look as if as many offshore fund managers or funds feel compelled to seek AIFMD registration as expected. After all, trustees and pension boards can still choose to invest into non-AIFMD managers and funds. “I do not yet see registration as an important or even a marginal issue in the investment decisions taken by our clients,” observes Sebastian Reger, an associate director at Sackers which advises many pension funds. This could change and, no doubt, EU-domiciled managers and funds obliged to seek AIFMD registration will seek to persuade potential investors that their status offers extra guarantees and securities.
“[This is] not necessarily the case,” says Reger. “You have to take account of any agreement between the investor and fund manager, which may offer the same level of comfort as would the AIFMD”.
At first sight, a fund with the AIFMD stamp of approval might be easier to sell to pension fund trustees concerned about a possible future negligence claim regarding the performance of their duties. In a tie-break between identical funds, one compliant and the other offshore, trustees might have to explain why, in the event of a claim, they chose the offshore fund. This is an unlikely eventuality but we can expect arguments of this kind to be deployed when AIFMD-compliant managers are competing for new business.
Investor reporting is another area in which consequences will be felt. AIFMD requires granular, although confidential, disclosure to the regulator on every aspect of the individual funds seeking approval. For instance, a hedge fund will have to disclose the strategies it uses and break down the value of assets under management (AUM) per strategy as a percentage of aggregate AUM. Portfolio concentration must also be disclosed using a number of different metrics including investment type, geographic exposure and counterparty.
Alternative investment funds will also be risk-profiled in detail and fund managers must report the fund’s net dollar value per basis point and the fund net equity delta. Counterparty risk must also be analysed in full; trading and clearing mechanisms, value of posted collateral, re-hypothecation rates, and the top five counterparties per fund must all be disclosed.
These levels of disclosure are comprehensive; they include all the data fields required for investor reporting. “Investors will be aware of the level of reporting required to the regulator and may want the same themselves,” warns Maria Contillion, global head of alternative strategies at State Street. Offshore fund managers may come under pressure to improve their disclosure if approved funds start to disclose regulatory reports to investors in part of whole.
“There will be a drive to greater transparency and consistency of reporting and it will make alternative fund managers and their performance much easier to compare,” adds Mark McKeon, a senior vice-president at State Street. The attitude of investment consultants may be crucial; access to AIFMD reports can only be of commercial benefit to them.
Where will all this lead? “Offshore alternative investment managers, particularly those in the States which might have a Cayman fund, are just starting to think about the Directive,” notes Ian Headon, head of depositary advisory and regulatory services at Northern Trust. On the other hand, there still seem to be plenty of investors comfortable with the idea of Cayman funds: “They can live outside the AIFMD without direct marketing into the EU,” as Headon puts it.
All in all, the true effect of AIFMD will only be manifest in the future: “Wait five years and we can judge. This is a matter of weighing cost and benefit,” concludes Headon.