By Simon Gray - As much as any country, Switzerland has observed with trepidation the European Union’s painful progress toward regulation of alternative investment fund managers. However, now that the EU has finally agreed on the top-level outline of the Directive on Alternative Investment Fund Managers, the country’s fund industry is gearing up to fall into line with the new rules, which will become part of the 27-member union’s law around the middle of 2013.
Swiss alternative managers already have significant business ties across the EU that promise to help them adapt to the new environment. For example, many managers have established funds in Luxembourg or Ireland and have management companies there that can ease the transition to operating under the AIFM Directive rules, because these entities will be able to delegate investment management functions back to their Swiss parent.
This means that such managers will be able to take advantage of the marketing passport to offer their services throughout the EU as soon as the directive takes effect, instead of having to wait the expected two years for passporting to be extended to non-EU managers. It would also, in theory, spare Swiss-based managers from full compliance with the directive’s provisions in areas such as remuneration.
Matthäus Den Otter (pictured), chief executive of the Swiss Funds Association, says that most members of the organisation already have EU-based management companies, for instance managing retail Ucits funds in Luxembourg or Qualifying Investor Funds in Ireland. “They should easily be able to transform these entities in order to obtain an AIFM Directive passport, and then delegate investment management to the parent company in Switzerland,” he argues. “Already having a presence within the EU make things less complicated than they might otherwise be, although it’s more difficult for the country’s small unregulated boutiques.”
However, members of the Swiss fund management community remain cautious about the outlook for living with the AIFM Directive, not least because many details of how the legislation will be implemented remain unknown. They will hinge upon the advice that the new European Securities and Markets Authority (Esma) provides to the European Commission, which is responsible for drafting secondary legislation and regulations.
Den Otter notes that the perspective for Swiss managers is not identical to that facing managers based within the EU, especially for those that plan to take advantage of the rules governing delegation of investment management functions. “With delegation, which will be possible from 2013, you do not have to be compliant with everything in the AIFM Directive,” he says.
“You do have to be regulated and there must be a co-operation agreement between the EU regulator and that of the country to which investment management is delegated. This is most urgent point to tackle for the Swiss fund industry, which is why we are already looking at our legislation. We are examining exactly what we will have to do to ensure that all Swiss managers that want to undertake investment management on a delegated basis for an EU management company can be regulated.”
The big unknowns, he says, are the Level 2 measures of subsidiary legislation and regulations, and especially how co-operation between EU and external regulators, a key element of the plans to allow non-EU managers and funds access to the union’s internal market, will actually function. “It is still a bit of a moving target,” Den Otter says. “We do not yet know what conditions will be attached to the signing of co-operation agreements and how co-operation will work between EU regulators of management companies and supervisors of entities to which they delegate investment management.”
Delegation should not require Switzerland to undertake wholesale changes to its fund legislation, but it may be a different story when Swiss managers can obtain direct access to the EU market. “The second question is about 2015 and those asset managers who want an EU passport and that will have to comply with the directive as a whole,” he says. “Our legislation may have to be adapted for that, but we don’t know yet whether there should be a different chapter of the law for those managers who want to opt into the AIFM directive.
“Because we are not within the European Union, we could think about making a distinction between on one hand managers that want to do business with professional investors within the EU, and on the other those managers that do not want to market at all into the EU. A lot of managers receive clients from abroad in Switzerland, but do not market their funds at all within the EU. The question is to what extent, if any, they will have to abide by the AIFM Directive.”
Den Otter was a vociferous critic of some early drafts of the directive that appeared poised to exclude outside managers and funds from the EU market altogether, and he gives a guarded welcome to the compromise that eventually emerged last November. “We see no reason to be overly pessimistic,” he says, but notes that EU officials have trouble giving an unambiguous response when asked whether adapting Swiss legislation to the new rules will guarantee the country’s managers access to the single market. “It’s not yet clear how powerful Esma will be and what its regulatory philosophy will be.”
One complication lies ahead for Switzerland’s private equity industry. “A lot of firms are concerned because most of them would fall within the exemptions under the AIFM Directive for assets under management below the thresholds of EUR100m for open-ended funds or EUR500m with a five-year lock-up and without leverage,” Den Otter says.
“We will have to decide whether to introduce these exemptions into our domestic law as well. Currently, to establish a fund management company you have to put up minimum capital of CHF1m, irrespective of whether you are running a hedge fund, a government bond fund or a money market fund, a level that is higher than what the EU directive prescribes.”
However, he believes that those discrepancies that exist between the Swiss and EU regulatory approaches can be ironed out. “Generally speaking, our regime is quite similar, although we may have different approaches to certain details,” Den Otter says. “In the past we used to over-regulate in some areas, but now regulation of Swiss managers is now less prescriptive and restrictive than the EU regulations. That is something that must be sorted out by comparing the two pieces of legislation section by section.”
A new white paper issued by SwissAnalytics and Advent Software, entitled Trends in Alternative Investment Regulation – Key Issues for Swiss Managers, notes that adherence to the directive’s prescriptions would increase the compliance and reporting burden for Swiss managers in areas including portfolio transparency, manager compensation, internal organisation, risk management, and prevention of money laundering and terrorist financing.
Many of the relatively small number of Swiss single hedge fund managers could currently expect to fall into the exempt categories, with the report estimating that 61 per cent of managers currently manage less than CHF100m, mostly in offshore funds. However, Swiss fund of hedge funds managers – despite a decline in assets triggered by performance losses in 2008 and the knock-on effects of the Madoff scandal – remain large global players, accounting for some 30 per cent of the world’s fund of funds market. A large proportion of funds are domiciled within the EU, mainly in Luxembourg and Ireland, and much of their capital comes from EU-domiciled investors.
“The key challenges with which Swiss-based managers will be confronted are related to their ability to access the European institutional investment market on an equal footing with EU competitors going forward,” the white paper says. “Given the increased compliance and reporting burden that the AIFM Directive will entail, it is extremely important for Swiss-based managers to assess properly their particular position along with the costs and benefits of obtaining an passport.”
The report underlines that for the manager of an EU-domiciled fund to obtain a passport, co-operation agreements must exist between the manager’s designated regulator in its ‘member state of reference’ within the EU, the fund domicile’s supervisory authority and the Swiss Financial Market Supervisory Authority (Finma).
Finma has not yet signed co-operation agreements with Ireland and Luxembourg, a cause of concern for managers with funds in these domiciles, which account for 38 per cent of Swiss-managed funds of funds. However, it is anyway not yet clear whether existing regulatory co-operation agreements will be sufficient to meet the directive’s requirements.
The white paper says that in any case Swiss managers will remain able to access sophisticated European investors under national private placement regimes up to at least 2018 under conditions broadly comparable with those applicable today. It concludes: “For the majority of Swiss single hedge fund managers, it does not appear that the AIFMD will have a significant impact on their European operations both in the short and long run.
“This is due to the relatively low level of assets under management, which would prevent the majority from requiring registration in any case, as well as to the longer phase-in period for the remainder considering an AIFM Directive passport for their Swiss-based operations. However, given the difficulties or impossibility of these single manager funds to register with Finma, the opportunity set for Swiss-managed single manager funds may be increasingly limited.”
For managers of funds of funds domiciled within an EU member state, “the requirement to comply with various transparency measures, for instance, will apply even to funds of managers not seeking immediate application for a passport, who wish to continue operating under the private placement regime until 2018. For Swiss managers with non-EU domiciled funds of funds, there remain many of the same challenges. However, they may be confronted with increased difficulties due to lack of harmonisation and regulatory agreements between the fund regulator’s domicile and that of their EU member state of reference.”
Philippe Bens, managing director of fund administrator Caceis Fastnet (Suisse), does not expect the forthcoming regulatory changes to affect existing fund domicile trends among Swiss managers. He says: “Many Swiss managers have traditionally gone to Luxembourg to create fund structures. They continue to do so despite regulatory changes introduced into national law in 2007 that for the first time enabled Swiss asset manager to become regulated whether they were managing Swiss funds or Ucits.”
The government has already signalled its readiness to make whatever changes are required to enable Swiss managers to compete in the new environment, Bens notes. “The Swiss Federal Council has said in a statement that it would amend Swiss law to meet the requirements of Ucits IV and the AIFM Directive,” he says. "We expect a lot of asset managers in Switzerland that today are unregulated to become regulated, but the domicile of the products they create will not change much.”
One result of the ongoing uncertainty over the eventual form of the AIFM Directive has been to encourage Swiss managers – and others – to offer hedge fund strategies within the EU’s Ucits retail fund structure, something made possible by more liberal rules on use of derivatives and on the use of recognised indices, including those measuring hedge fund performance, as the basis of Ucits investments. In addition, the rapid growth in the number of alternative Ucits on the market is now opening up opportunities to create ‘Newcits’ funds of funds.
The SwissAnalytics-Advent Software white paper argues that despite some constraints on investment strategy and product design, the Ucits route is likely to remain attractive to Swiss managers even when the AIFM Directive comes into force. “The growth of the Ucits sector may be related to the pending requirements and uncertainties regarding the final impact of the directive on individual fund managers,” the report says.
“If fund strategies can be easily adopted to this format, and managers see little incentive to hold on to existing operations that will be constrained by the AIFM Directive, it may pay off to consider a move to the Ucits structure, or adopt a dual structure with a European onshore Ucits and an offshore fund that is marketed internationally to non-EU investors.”
Swiss fund of hedge funds managers that have launched Ucits funds of funds over the past three years include Harcourt, Man Investments/RMF and GAM, the white paper notes, as have private banks such as Credit Suisse, Pictet, Bank Syz through 3A, Clariden Leu and EFG.
It argues: “The framework does not provide for direct translation of portfolios of traditionally-structured hedge funds into a Ucits-compliant format, but the hedge fund index replication route remains one option to supply investors with quasi-fund of funds exposure through a Ucits fund. Given the increasing number of hedge fund strategies being operated within Ucits-compliant structures, there is an increasing growth opportunity for a nascent fund of Ucits funds market.”
Dominique Kuettel, head of marketing for Europe at Gottex Fund Management, describes the Ucits structure as “a very elegant solution” for firms in the face of the dilemma posed by the AIFM Directive. “This has led fund providers active in the European space that may not be part of the EU to go down the Ucits route,” he says.
“All the big banks in Switzerland are now largely selling Ucits funds actively to their European clients, which is a big change from three or four years ago, unless the client makes it very clear that the tax consequences of investing in offshore funds are of less importance. That said, the capital flows into Ucits hedge funds have not been particularly large so far, especially if you discount the volumes represented by the redeployment of assets by banks.”
Kuettel adds that in combination with the country’s tax advantages for fund managers, the Ucits option adds significantly to the attractiveness of Switzerland as a domicile for fund managers. “As long as you can go down the Ucits route and market actively into Europe, that is definitely a big plus,” he says. “The AIFM Directive is still the subject of discussion in Switzerland and it is unclear what the end result will be, so people prefer to choose the Ucits route and see if they need to adapt later on. You have at least a couple of years in which to gain some experience.”