Such is the complexity of the regulatory landscape in Europe that it is enough for any new start-up manager to resemble Edvard Munch's `The Scream'. Alongside the Markets in Financial Instruments Directive (MiFID), is the Alternative Investment Fund Managers Directive (AIFMD) and just to add to the complexity, MiFID II is scheduled to go live in 2018.
At first glance, one could be forgiven for thinking it's all too complicated.
But there are numerous forks in the road available to start-ups, and indeed solutions that can make adapting to life as a regulated entity somewhat more palatable.
The first thing to consider is that being a star trader at an existing fund management group is not necessarily enough to attract investor capital. There's a world of difference between trading in Goldman Sachs with a vast network of resources at one's disposal and running a regulated business, with third party investor capital.
Investors will want to see evidence of good governance and for any new manager to demonstrate that they are conscious of trading and operational risks and that the right risk management framework is place. For most start-ups, that's not at all easy.
"That's where the benefit comes in to using hosted platforms, which provide that substance and allow managers to focus on what they are good at – namely portfolio management – without worrying about compliance and risk management. They don't want to spend 10 hours a day operating a business," says Daniel Maycock, Director, Investment Management Services with Lawson Conner.
"Whether you are a star trader or not you need to ask yourself whether a fund is even the right vehicle. Is a family office a better option, or a managed account?" adds Alex South, Director, Saxo Capital Markets.
Start off with a managed account
Operating a managed account can be a useful first step towards eventually becoming an FCA regulated entity. It is the easiest way to trade a strategy and build a track record (unfortunately, this is not audited) whilst remaining out of scope of regulation.
The managed account might consist purely of private capital, including that of a few friends and family. All that is required is to set up a brokerage account with a bank to run a managed account. Provided the individual who sets up the managed account does not begin offering advice to external investors and encouraging them to allocate into the managed account, they can stay out of scope of regulation.
The moment any advice is offered to external investors, that individual will have to be regulated under MiFID. One cannot run a managed account or a series of managed accounts with third party money and expect to avoid the regulator's gaze.
Indeed, even if a start-up manager appoints an AIFM and establishes a standalone AIF, they, as the investment adviser to the fund, have to be FCA authorised. They cannot just trade the strategy out of London and assume that they are doing everything by the book.
Sticking with the managed account structure, the easiest way to operate within the FCA's rules is to join a MiFID hosted platform and become an Appointed Representative. This involves using the platform's MiFID license without going direct to the FCA. As long as one is on such a platform, one can invite as many people as they want into the managed account.
"From our perspective, we prefer to work with managers who are regulated. Even if this is within an Appointed Representative arrangement, it shows a level of commitment that the investment manager has to running the strategy," says South.
When to rotate from managed account to standalone fund?
Over a period of time, the individual might develop a good track record, build a good level of assets across one or a series of managed accounts, and decide that the time is right to establish a standalone fund structure.
At this point, it is important to know how to value how the managed account has performed.
"You can ask a fund administrator to do an `NAV lite' calculation on the managed account. The problem is you don't own the managed account, your investors do, so you need them all to sign off on the managed account's performance," explains Clayton Heijman, Managing Director at Privium Fund Management, which has a fully regulated investment management entity in London as well as on the continent.
There is also no fixed answer to determine how long a track record one should have in place before deciding to launch a fund. This will ultimately depend on the investors. "What's important to any start-up manager is to have day one investors locked in; they are your seed investors. From there, you move on to attract early stage investors via book building. Investors might say they want to invest but only when the strategy has EUR10mn. So you have to build the book of soft commitments," adds Heijman.
Aside from track record, another determining factor before choosing to go down the fund route is how many managed accounts are being operated. By their very nature these are not scalable structures. There's no problem running two or three managed accounts for a series of different investors, but as Maycock states, "The minute you start running 10 or more managed accounts from a regulatory and compliance point of view that's a lot of monitoring you need to do. It's much easier to set up a fund structure as the cost of compliance would fall and the manager would get the benefit of an audited track record, more visability and so on."
Standalone AIF or platform AIF?
Assuming that the time is right to launch an AIF, start-up managers can choose to either do this on a standalone basis or decide to operate a sub-fund on a fund umbrella platform; an AIF platform such as the MontLake QIAIF platform operated by ML Capital in Ireland, for example.
Managers should ask themselves at the pre-launch phase: How much is it going to cost and how long is it going to take?
With respect to cost, it depends on the lawyers that the manager uses. Costs vary substantially but one can often find out how much they can expect to pay by looking at the disclosures in fund prospectuses, which need to name the price of the launch.
If cost is less of an issue, the standalone AIF option will always be preferable to going with a sub-fund as the manager will not be able to develop a brand identity or have full ownership of their fund in such an arrangement.
Three platforms
There are potentially three platform considerations under AIFMD.
Firstly, there is the platform for the AIF if managers choose to run a sub-fund under a SICAV or ICAV umbrella structure.
Secondly, there is a platform for the AIFM – the management company charged with overseeing the proper management of the AIF from a risk and compliance perspective; both Lawson Conner and Privium would be examples of such.
And thirdly, there is the regulatory platform (the MiFID hosted solution) for the investment advisor based in London.
The plug and play option of running a sub-fund helps avoid the costs of setting up a standalone fund but the problem with this, in a similar way to the managed account structure, is that the manager does not own the track record. This makes it quite difficult to move a sub-fund that one might have been running for a year or two across into a standalone fund structure.
However, platform providers who provide an efficient route to market under AIFMD by acting as the AIFM and also providing fund platform capabilities, will often prefer clients to run sub-funds as they are easier to manage in their role as the AIFM. After all, each sub-fund will be using the same service providers as all the other sub-funds under the umbrella.
With respect to the AIFM platform, this will provide the investment manager with compliance and risk management, as well as asset management expertise. In reality, though, the asset management function is sub-delegated to the portfolio manager living in London who has appointed the AIFM.
Operating under MiFID
For the London-based start-up, assuming they have got a non UK AIFM in place, and they've launched the AIF, they have two choices. Either to become an FCA MiFID regulated entity, and act as a sub investment manager to the AIFM, or to operate under a MiFID umbrella for the purpose of dealing in asset management, which again means they can act as the sub investment manager.
If the investment manager files his own application, it might take anywhere up to 12 months to get the FCA's authorisation to perform regulated activities. By joining a MiFID hosted platform, however, they are able to operate the investment strategy using the platform's FCA license; this only takes a matter of weeks.
"We take care of all the risk, compliance and operations management. We sit at the front of all the trades going in and out of the fund – this is similar to what the outsourced AIFM is doing, but they tend to do that post trade as opposed to in real time.
"You would have to duplicate this, even if you were to become a standalone FCA regulated firm with a non-UK AIFM. You would still have to make sure trades were being filled and reconciled properly, even though that is something the AIFM is also supposed to do as part of overseeing the risk management function under AIFMD. This system works very well," explains Jerome Lussan, CEO of Laven Group, which offers a MiFID hosted solution to investment advisers.
It sounds complicated but using the outsourced AIFM solution, with the manager sitting on a MiFID hosted platform, is probably more cost efficient than going down the full standalone AIFM route.
As Lussan adds: "In my view, the only part that should be standalone in a startup's set up, if they can afford it, is the AIF itself. This helps protect the fund's track record rather than have a fund that is on a fund umbrella which limits the future options for the fund management group."
Most people tend to stay on a MiFID hosted platform even after they've received their FCA approval simply because it means they don't have to set up their own compliance infrastructure.
If, however, the start-up manager decides to leave the AIFM platform and the MiFID umbrella, they would effectively combine both platforms into a standalone AIFM. Only the very largest fund managers in Europe such as the AQR's of this world, with billions of assets under management, prefer to operate their own AIFM for brand purposes.
The vast majority of fund managers will likely stick to using an outsourced AIFM and operate as a MiFID regulated entity.
AIFM needs substance
In conclusion, Maycock says that when thinking about appointing an AIFM, start-ups should look at their experience in managing different strategies.
"We've seen examples of investment managers changing AIFM platforms because they found someone cheaper, only to discover that the new AIFM can't fully support their strategy. That's a disaster if you've got an investor with capital waiting to be deployed.
"Secondly, understand what service level you are going to get. The AIFM should have proper substance. I heard one story of an AIFM that had one person doing risk management effectively on a part-time basis. At Lawson Conner, each of our clients has a dedicated risk and compliance expert supporting them."
Although it may at first glance appear to be a minefield, there are plenty of options and solutions available to new managers to make the process of running an onshore AIF as stress-free as possible.
