Regulatory considerations for today’s start-up manager
For a European hedge fund start-up, the AIFMD is the first piece of regulation to address. In addition, rules set by the Commodities & Futures Trading Commission (CFTC) in the United States under Dodd-Frank, requiring hedge funds to execute and clear their Over The Counter (OTC) derivatives using swap execution facilities (SEFs) and central counterparties (CCPs) are due to come into effect under EMIR in Europe in 2014. This is a key consideration for new managers who have trading strategies that incorporate OTC derivatives.
“Regulatory risk is very much front-page news. Front and back offices now need to be more closely aligned to make sure the business is able to withstand the operational challenges of regulation on many different fronts,” comments Bobby Johal, managing consultant at Cordium, a leading regulatory compliance consultancy to the asset management industry.
The Alternative Investment Fund Managers Directive
Much has been written about the AIFMD. At the risk of too much detail, the premise of this directive, drafted by European regulators is to protect investors, is to regulate hedge fund investment practices and make hedge fund operations more transparent.
The idea was to create a regulatory framework similar to UCITS: Undertakings for Collective Investment in Transferable Securities, a globally accepted set of guidelines established in 1985 to allow any UCITS-compliant fund established in an EU Member State to be freely marketed across the whole of the EU. The UCITS framework has become a gold standard for investment funds recognized and favoured by investors across all major global markets.
Any manager who complies with the directive will be referred to as an AIFM, Alternative Investment Fund Manager, while their fund(s) will be referred to as an Alternative Investment Fund (AIF). Like UCITS, the best attribute for a manager to have will be their ability to freely passport their AIF across all 28 EU Member States, provided they have authorized representation in at least one European jurisdiction.
The first consideration for a start-up manager, many of whom have offshore (i.e. non-EU) funds as opposed to onshore funds (such as a Qualified Investor Fund (QIF) in Ireland), is determining where to domicile themselves. They ask themselves: Is there any regulatory arbitrage to be gained by setting up as a non-EU manager in Switzerland or another offshore jurisdiction? Where is it optimal to set up as a hedge fund manager from a regulatory and legal perspective?
There is no single answer to this as every manager is different, suffice to say that setting up as a non-EU (third country) manager may only bring short to mid-term advantages. A hedge fund with less than EUR100 million (with leverage), or less than EUR500 million (without leverage), in assets under management remains outside of the AIFMD and is classified as a sub-threshold manager.
Once the applicable de minimisthreshold is exceeded, the manager will have to register as an AIFM and thus, fall under the full regulatory requirements of the AIFMD including the full range of obligations: the appointment of an independent depository for the AIF and regulatory reporting.
“Knowing where your business is likely to be 12 months ahead is critical in terms of determining whether you will remain as a sub-threshold manager. A manager that does not expect to exceed EUR100million in the foreseeable future, identified as two or three years, will have plenty of time to plan for the eventual need to comply and become an AIFM. The bottom line is, when applying to the regulator for a license, the business plan needs to clearly communicate all of the above,” advises Johal.
Regulatory requirements under the AIFMD for UK sub-threshold managers are quite limited. One still needs to apply to the FCA to become authorized and gain permission to manage an AIF but most of the detailed provisions of the AIFMD are switched off; the manager is effectively "AIFMD-lite".
Certain obligations also apply to non-EU managers marketing in the EU, where the primary requirements relate to reporting and investor disclosure.
A key reporting requirement under the AIFMD is known as the Annex IV report. This applies to managers of all sizes, from a EUR10million start-up right through to a EUR5billion manager.
Understanding the operational and technical requirements around this report is vital; this means having a complete understanding of what the report requires and how that data will be gathered.
“One of the main considerations for a sub-threshold London start-up manager is the Annex IV report, which is a key challenge, and also that they have all the attendant policies and procedures in place - which from an AIFMD viewpoint are fairly light. Only part one of the FCA FUND handbook applies to sub-threshold managers of unregulated funds,” says Johal.
Annex IV report
The frequency of reporting is determined by the amount of assets managed. For a sub threshold manager this will be an annual filing, but that filing is challenging as it is immensely detailed; more so than Form PF which U.S. managers are required to file. The information required pertains to the various strategies the fund is operating, the markets and securities traded, leverage, the annual turnover of the fund, primary exposures and concentrations, etc.
“It’s very specific and detailed information about a fund’s portfolio. There are some third-party solutions emerging to help firms aggregate and report the information. This report is unlike anything we’ve seen in Europe. In the US, they introduced Form PF last year which is similar but slightly less onerous in detail,” adds Johal.
Clearly then, for any new manager, this is a vital compliance obligation to be aware of from the start.
As Johal refers to above, there are third-party solutions coming to market to help firms accommodate to their needs. Also, for a lot of managers, independent administrators should be able to support them to a large extent in populating the Annex IV report as they sit on the majority of the data – but not necessarily all of it. It will be the manager’s responsibility to identify those data gaps and fill them. To be clear, it is not beholden on the administrator to file this report. It is the full responsibility of the manager to ensure the report is filed accurately and in a timely fashion.
As a sub-threshold manager, it will only be possible to market the fund to potential investors in Europe through a private placement regime. Once a manager is compliant under the directive (EU managers can ‘opt up’), the manager can avail himself of the passport. This option may become available to non-EU managers in 2015.
It will be necessary to understand how the AIFMD has been implemented across Europe and how this will potentially impact a fund’s marketing strategy, even if a manager is pursuing private placement; an option that may eventually be phased out in 2018 and which will require all managers from EU and non-EU who intend to target European investors, to have their fund management company registered and authorised under the AIFMD.
“One of the key derogations used by the UK for small managers is that they are not required to appoint a depository for funds marketed in the UK. Other jurisdictions may differ. For example, Germany will require non-EU managers to appoint a depository,” says Johal.
Looking ahead, if a start-up manager has grand designs about building significant AuM beyond the de minimus thresholds of the AIFMD they will need to consider whether to remain onshore or move offshore and operate as a third-country manager. Commercial considerations aside, considering depository and remuneration requirements under the AIFMD should be a primary consideration when debating location.
“Will they remain onshore or move offshore? This is really a question of marketing. If a manager thinks the marketing passport will be important, then remaining onshore as an AIFM will be an attractive option,” says Johal.
“The end game is to switch off private placement at some point after 2018, after which it will be impossible for any non-registered AIFMs to do business or market their fund(s) in Europe. So, choosing the third-country option might be suitable in the mid-term; however, if you have a long-term plan to be a successful manager, then you need to look at the big picture: the need to be compliant with AIFMD in the future."
Reporting under EMIR
Another significant piece of regulation for European start-ups to watch are the reporting requirements under EMIR, which the European Securities and Markets Authority (ESMA) has announced will come into effect on 12 February, 2014.
Any manager trading OTC derivatives will be required to use a trade repository and report on his executed and cleared interest rate swap positions. Four trade repositories have recently been authorized by ESMA: DTCC Derivatives Repository Ltd (DDRL) and UnaVista Ltd in the UK, Krajowy Depozyt Papierów Wartosciowych S.A. (KDPW) in Poland and Regis-TR S.A. in Luxembourg.
Many have been caught by surprise by the February deadline for reporting obligations.
“In the UK, managers will need to register with the UnaVista matching and reconciliation platform, operated by the London Stock Exchange with a deep understanding of the prerequisite and workflow of the platform. A manager will also need to request a legal entity identifier (LEI) for themselves and their fund a legal entity identifier (LEI), as required by EMIR,” advises Johal.
Whether it is AIFMD or EMIR, the key message for any start-up manager is: don’t make compliance an afterthought. Make sure someone with suitable experience or credentials is put in place to deal with regulatory obligations, establishes the right relationships with service providers, and ensures that a close relationship between operations and compliance staff is in place from the outset.
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