Guernsey's fund administrators take on regulatory challenge
If Guernsey's hedge fund industry has a fault, say industry practitioners, it may be an unwillingness to blow its own trumpet. But faced with competing jurisdictions that have no such inhibitions and armed with a new streamlined authorisation procedure, there are signs that the island's days of bashfulness may be over.
On February 7 the Guernsey Financial Services Commission unveiled the Qualifying Investor Funds (QIF) regime, offering a guaranteed three-day turnaround time for new fund authorisations. This is achieved by handing the task of due diligence on the fund's investment rationale and the fitness of its promoter and manager to a licensed service provider.
Industry members concur that the importance of the QIF regime lies less in its actual provisions than in the signal it sends to the global hedge fund industry that Guernsey has added pragmatism and flexibility to its depth of professional expertise and its acknowledged regulatory rigour. And not before time, they argue.
Robin Fuller, head of HSBC Securities Services on the island and chairman of the promotional agency Guernsey Finance, says the new regime, like Jersey's Expert Fund rules launched a year ago, can help to dispel an undeserved impression that Guernsey's approach to the industry is rigid and rule-bound.
"It makes an important contribution in terms of Guernsey's perceived competitiveness in the funds sector, and generally as an international financial services centre," he says. "In many ways, we've been too defensive in the past. Now we're learning to promote ourselves a bit more effectively."
In fact, as Guernsey Finance chief executive Talmai Morgan points out, the industry is launching the QIF regime from a position of strength, not weakness. Last year the total assets of Guernsey-domiciled funds increased by 35 per cent too £56.6bn, and the growth in open-ended funds, the structure adopted by most Guernsey hedge funds, was even higher at 52 per cent. The value of non-Guernsey funds serviced on the island also rose by a more than respectable 16 per cent to £17bn.
Guernsey is refocusing itself in other ways. For example, in February the Guernsey Fund Managers Association renamed itself the Guernsey Investment Funds Association, in order to reflect better the industry's focus on fund services rather than portfolio management (although one Guernsey-based manager, Financial Risk Management, accounts for a significant share of locally-domiciled fund of hedge fund assets).
According to fund data specialist Fitzrovia International, there are some 30 fund administrators in Guernsey, a mix of large global players such as HSBC and Credit Suisse and niche independent firms. "Between 80 and 85 per cent of total assets are concentrated among the top six to eight administrators," says Rob King, head of sales at the island's largest administrator, Guernsey International Fund Managers. GIFM is owned by Barings, which is in the process of being acquired by Northern Trust.
Open-ended funds can be established under Guernsey's Protection of Investors Law as Class A (retail), Class B (which can be used for hedge funds but require extensive transparency regarding investment strategy and Class Q (reserved for professional and sophisticated investors, with the main emphasis on disclosure of risk).
Fund promoters can choose between three structures: unit trust, company or protected cell company (PCC), an umbrella fund-like structure favoured by funds of hedge funds in which the assets and liabilities of each cell or compartment are kept legally separate. Closed-ended funds can be established with these structures and also as limited partnerships; they are mostly used for property funds and structured products.
According to Mike de Haaff, chief executive of Close Fund Services, the success of the PCC concept since its launch in 1997 has contributed greatly to the growth of the fund of hedge funds sector. At the end of June 2004, he says, 71 funds of hedge funds already accounted for £17.5 billion in assets, some 62 per cent of the total for all funds of funds.
Morgan insists that the QIF regime complements and enhances this existing framework rather than constituting any major new departure. "QIFs are not a revolutionary development at all," he says. "We haven't had to change any laws. It's an evolutionary development in tune with the market. Basically all we're doing is clarifying what to some extent is existing practice in relation to the turnaround of approval of schemes."
Mark Huntley, head of business development for Baring Financial Services Group, which includes GIFM, acknowledges that the island's fund regime suffered from an adverse image that needed to be remedied. He says: "There was a perception, albeit one that was probably wrong, that our regulatory regime was more stringent, more uncertain in terms of its impact.
"From a practitioner's point of view, fund promoters and more particularly their advisers are looking for is greater certainty. The message being put out is that Guernsey is still very much open for business. By putting certainty on the regulatory approval timeframe and as to who is defined as a qualifying investor, it enables the industry to be clear when talking with advisers and promoters."
King argues, however, that there is still considerable ground to make up. He says: "One area that is still struggling is single-manager hedge funds. Why? Guernsey is coming to the party late and finding that all the drinks have run out. The Cayman-Ireland package is still the easiest for fund promoters, while Jersey has stolen a march with its Expert Funds regime.
"We have an opportunity to change that perception with the launch of the QIF regime. What it needs is a generic jurisdictional message that Guernsey can deliver these services. I'm sure the QIF regime will attract new hedge funds business to Guernsey, but we won't know for one to two years how successful it is."
Morgan argues that another important signal is the fact that the regime was drawn up as the result of a dialogue between the industry and the regulator, in little more than six months from start to finish. He says: "You will be hearing more about the product of this dialogue, relating to both funds and other financial services. We've set up a committee under senior advocate Peter Harwood to re-examine the whole regulation of the investment management and mutual funds sector. They will look at what is appropriate, taking into account industry developments and the services we provide in Guernsey."
Comments Ernst & Young partner Peter Franks: "It's interesting that it's now the industry driving the development of rules and regulations to encourage new business, rather than the regulator. In the late 1990s and early 2000s, after all the corporate collapses, the regulatory burden became too much. The industry is now seeing a move in the opposite direction and the regulatory environment is being relaxed to a more realistic level."
Franks argues that the rules on what constitutes a qualifying investor have been drawn up imaginatively. As well as institutions and professional traders, they cover experienced investors who understand investment risks by virtue of have traded in derivatives, securities or funds over the previous 12 months; other investors who can certify that they have been assisted by an investment adviser; and "knowledgable employees" in the financial industry whose understanding of complex investments comes from their job.
However, he cautions that some promoters may be put off the QIF regime because of the ongoing responsibility on the administrator to ensure that the investor restrictions are still adhered to. "You must have a framework in place to ensure that going forward, you only have other qualifying investors going into the fund," Franks says. "This is an extra burden for the fund and the administrator.
It remains to be seen how compliance with the regime on the part of funds and their service providers will be monitored. Says Peter Moffat, director of investment business at the Guernsey Financial Services Commission (GFSC): "Because the QIF regime will depend on a measure of self-certification by applicants, the monitoring process will need to expand to review the due diligence formerly conducted by the Commission and now to be conducted by the local applicant."
Moffat argues that the new regime follows a general regulatory philosophy that favours adequate disclosure of risks over excessive prescription of investment policy. He says: "We have generally tried to treat alternative investment vehicles as far as possible in the same way [as] any investment product.
"It is unrealistic to expect regulators directly to oversee the day-to-day operations of all the funds on their patch. What we try to do is ensure that fund structures themselves have effective oversight built into them. In the open-ended sector, we have always regarded the custodian as having an important role in oversight.
"If a hedge fund does not have a custodian, and the prime broker does not provide oversight, other solutions need to be found. We have not been prescriptive about this - what we need to see is that oversight arrangements work in a practical sense. We will take action if those requirements are not met, or cease to work in practice."
Transferring the burden of due diligence to administrators does not necessarily mean any diminution in the regulator's workload, Moffat says: "It simply shifts it from the authorisation teams to the monitoring teams. One benefit of our structure, with one Commission division responsible for authorisation, monitoring, and remedial action where necessary, is that we continue to build up expertise in the relevant areas."
Moffat and his colleagues at the GFSC have already demonstrated their pragmatism in waiving for hedge funds a requirement that funds must have a Guernsey custodian. He says: "If our rules create unnecessary hindrances, or if they do not deliver useful protection, we will change them. What we did last year was driven by our experience of practical problems faced by the hedge fund community. What we aim to do is make the regime as light as possible while ensuring it is effective."
In some respects, the role of the administrator will not change under the QIF regime, Says Huntley: "As a provider, you still have to do your own due diligence, as you would do in the ordinary course of events. We would never go to a regulator with a promoter we were uncomfortable with. We are also part of a close-knit community, so it's not in our interests to let the jurisdiction down, either. There will be strong peer pressure to maintain the standards that have been among Guernsey's strengths."
He adds: "We will have to demonstrate more clearly that we have a paper trail in terms of the due diligence we have done on the underlying promoter. We will also have to be much more involved in determining and agreeing the investor base. If we don't understand what it is, we can't do the investor relations side of the business. It's just a logical extension of where we're going, but it engages the service provider in a much more active role.
Based on an island with a relatively small population and little space to increase it, Guernsey's fund administration industry has benefited from the flexibility of the regulator delegate some functions to other jurisdictions. But in general companies look to higher productivity, derived both from investment in systems and better use of human resources, to handle increased volumes of business.
Morgan cites Guernsey's Training Agency, a joint venture between government and industry that has helped the financial sector to boost skills at an acceptable cost. He says: "One of our comparative advantages is that our workforce is ever better trained and professionally qualified, certainly more skilled, and allied with better and better systems, giving rise to greater and greater productivity."
Huntley argues that training is particularly important because of the type of funds administered in Guernsey: "They are at the cerebral end of the business, so you need people who can understand complex fund structures. Issues such as carried interest fee calculations and performance fee calculations are not something you can handle without experience and training.
"You can apply systems very effectively to maintain a static workforce in terms of headcount, but productivity per person has gone up materially through the effective use of systems and people knowing what they're doing. I look at it stuff that used to take us two days, and it now takes two hours. And capacity remains, even though the industry has been absorbing new business throughout last year. Guernsey remains open for business because of that scalability."
Franks adds: "As systems are improving around the world to run all these funds, the man-hours required is being reduced, there's more capacity to take on new business. Guernsey had 30 per cent growth in assets under administration last year - with an improvement in technology, they can take on a lot more than that.
Industry members are divided as to whether the arrival of HSBC and Northern Trust signals that the administration sector is moving into the hands of global giants. Says Fuller: "There has been consolidation in the fund administration industry over the past couple of years, and I'm sure that many if not all of the independents will disappear into larger parents."
However, director Kevin Boscher of Collins Stewart believes there will still be a place for the independents. He says: "Our experience of using fund administrators - and we deal with a lot - is that just because a firm is a big global player, that doesn't mean it is necessarily more efficient. I'm not sure that everyone wants their funds administered by big global organisations."
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