By James Williams – Every which way you look in Europe there seems to be a new piece of legislation lurking via the corridors of Brussels, with a specific aim of targeting hedge funds. To say it is disproportionate is an understatement. Nevertheless, London’s hedge fund community cannot change the reality of the situation: regulation is not going to go away. It’s a case of embracing it and understanding it, whilst at the same ensuring their business operations remain steadfastly competitive.
London has always been blessed with an entrepreneurial spirit. Like New York, its fund management centre is dynamic and diverse. With the Alternative Investment Fund Managers directive now at Level Two, the worry is that the barriers to entry will become too high, and that, potentially, London’s bristling hedge fund community will have its entrepreneurial spirit squeezed out of it.
Granted, the year is now 2012, which according to the Mayan civilisation means the end of the world is nigh, but let’s not get too apocalyptic. London is still, by a country mile, Europe’s leading hedge fund centre. One report estimates that London is home to around 70% of European hedge funds’ assets (USD423billion), equivalent to some 700 hedge funds, and enjoys a 19% share of total industry AUM (which at its latest count was USD2.01trillion according to Hedge Fund Research). Some of these are massive funds in terms of assets under management. According to another recent industry survey of ‘billion plus’ funds, London was home to 63 such hedge funds - each with assets under management of USD1billion or more - in 2011, up from 56 the previous year.
However, as regulation becomes more burdensome some managers are actively considering more attractive jurisdictions such as Singapore, Jersey, Guernsey and Switzerland, where managers can enjoy significant tax savings. For example in Singapore the top tax rate is 20% and corporate income tax is a respectable 17%. Factor in the UK FSA’s remuneration code, the UK government’s tax hike to 50% on high earners and expensive real estate costs and you start to wonder quite what London might look like in five years’ time.
However, corporate migration is not for everyone. “We’ve seen some people going to Switzerland but there certainly hasn’t been an emptying of the Mayfair mansions. The taxes over there have gone up too so I think Switzerland is fine if you are one of the partners in one of the larger hedge funds but for a lot of the guys in the mid-salary range, Switzerland is a very expensive place to live,” comments Oliver Godwin, a partner based in law firm Ogier’s London office.
He points out that managers relocating to places like Singapore is less of a negative reflection on London, and more a positive reflection on the rise in importance of the Far East. “Singapore has risen in popularity on a relative basis,” adds Godwin.
The key point here is that for managers who have trading exposure to Asia, and possibly key Asian investors, making that jump and relocating outside of Europe is logical. It’s the opportunity that Asia presents as opposed to any fundamental dissatisfaction with London.
As Richard Frase (pictured), a partner at Dechert LLP, London, reflects: “Asset managers generally speaking don’t queue up to live on rocks in the middle of the Atlantic so there remains a fundamental attraction to being in London. There has been some movement to Switzerland, for example, but not to any noticeable extent. If that does happen it’ll be a gradual process.”
That’s not to say that Europe is the only market introducing lots of regulation. It’s also tough in the US. Frase comments: “There are various rules coming in which will have a huge impact – the OTC derivatives clearing initiatives are, if anything, slightly more vicious than they are here (in Europe) where they retain an aura of making the market safer whereas there’s some genuine hostility behind the US rules. Europe might not be as attractive as it was but it’s difficult to say that one area is better than another.”
Without doubt the biggest piece of regulation facing London hedge fund managers is the AIFM directive. Although Godwin believes that managers have had more than enough time to come to terms with what’s going to be in the directive he admits the devil is still in the detail. “We’re just waiting to see what the details say,” says Godwin.
Certainly, one of the key issues that the London-based Alternative Investment Management Association (AIMA) has concerns with is the issue surrounding depositaries: specifically the liability burden on depositaries, which AIMA estimates could end up costing the industry USD6billion annually.
But it’s the overall impact of AIFMD, in addition to specific important details such as depositary or leverage regulation that concerns Jiri Krol, Director of Government & Regulatory Affairs at AIMA, London. “There’s a whole raft of proposed changes which all add up - increased capital requirements, increased risk and liquidity management requirements - which could lead to homogenisation of the industry - reporting requirements which are potentially too burdensome for smaller managers: it’s a whole complex of issues,” says Krol.
Krol thinks that small managers might even need to rely on an intermediary to provide a kind of regulatory back-office support to allow them to concentrate on their core activities – i.e. managing their portfolios, developing trading ideas.
If the EU commission overshoots on the depositary issue, Krol thinks they “risk incentivising managers to remain offshore”. Ironically, the AIFM directive could potentially boost the very thing the commission is looking to control: offshore markets. That’s because the one advantage of retaining a non-EU fund is that a manager won’t have to comply with the depositary provisions. “This is what leads many to think that the UK manager/offshore fund model will stay with us longer than expected when the AIFM directive was first published,” says Krol.
One thing that London hedge fund managers will need to think about is the passporting benefits that would arise from having an onshore EU fund. This is still a long way off, with private placement scheduled to be phased out, potentially, in 2018. Were that to happen, London managers would have no choice but to establish new EU-based funds, or move their existing offshore funds onshore, if they intended on continuing to market their product(s) to EU investors.
Could private placement run parallel to the passport under the directive?
“That’s the key question. People will be perfectly happy if they can continue under the private placement regime until 2018, at which point one assumes the Caymans and BVI will have got themselves into shape. The question is whether individual countries around Europe will choose not to play ball. That’s unlikely to happen in the UK and you’d still be able to market your Cayman hedge fund to institutions in London. But the private placement issue is one to watch,” says Frase.
Adds Krol: “Our ideal would be for private placements and passports to co-exist indefinitely. It may well be ESMA’s assessment come 2018 that that is the right way to go because otherwise you might cause too much unwanted disruption.”
Frase thinks that going forward there will be an increase in onshore funds but agrees that the dual option of ‘co-domiciliation’, with managers maintaining their offshore vehicles whilst in addition establishing AIFMD-compliant onshore funds, is feasible. “I think that’s right. There’s a tendency for anyone who’s more than a single fund manager to want an onshore fund in their portfolio.”
The other quandary facing managers is whether to retain their MiFID license or have an AIFM license. At the heart of the issue is remuneration. MiFID rules are driven by banking regulation where remuneration rules are applied in a proportionate manner – the FSA, for example, uses four tiers, with hedge fund managers in tier one.
“The question is will we be able to maintain that system under the AIFM directive? Some think ESMA is unlikely to replicate the CRD II approach,” says Krol. For it to work, remuneration rules would perhaps need to be based on size of fund managers, with the very largest multi-billion firms sitting in the top tier and small, emerging managers in the bottom tier.
“It could be done on the basis of size, for example, but whether this happens is anyone’s guess. We would hope that people listen to reasonable arguments and make sure the two remuneration codes are aligned so that there isn’t an incentive for regulatory arbitrage. It’s a big risk because managers do care about remuneration rules. If they’re designed improperly, that could have a huge impact,” states Krol.
On top of that, Krol admits that AIMA has a number of concerns with respect to MiFID II. Chief among them is the issue of third country restrictions on trading with eligible counterparties outside the EU. “This is potentially more explosive than any other piece of legislation. We believe that reason will prevail and third country regimes will, in the end, be workable but it’s potentially very disruptive and requires a lot of time and effort to counter.”
Under AIFMD there will unquestionably be more onshore funds being established. For the UK to capitalise on this, and compete with existing onshore fund domiciles like Luxembourg and Dublin, it would need to establish a suitable regulated fund vehicle for hedge fund structures.
Even though discussions of this nature have been occasionally discussed with the FSA “the stumbling block is often the uncertainty over the potential tax treatment”, confirms Rob Mellor, UK financial services tax markets leader at PricewaterhouseCoopers. “For example, uncertainty around the operation of stamp duty reserve tax on units in the new fund vehicle.”
Mellor adds that although restricted in its use to UCITS IV funds the recently released Consultation on contractual schemes for collective investment does at least suggest “an intention by the UK Government to increase its competitiveness with a wider range of fund vehicles. That said, there must be a risk that existing onshore fund jurisdictions such as Dublin and Luxembourg are so entrenched in the hedge fund market that it will be difficult for London to make any headway as a location for onshore European hedge funds.”
The UK’s existing Qualified Investor Scheme (QIS) regime needs a number of changes for it to compete with the Irish QIF and Luxembourg SIF, one of the main ones being approval timing. Whereas a QIF can be approved within 24 hours and a SIF within a month, in the UK it can take up to six months according to John Newsome of the FS Regulatory Centre of Excellence at PwC. “A QIS also has much stricter investment powers than QIFs or SIFs including narrower borrowing powers, exposure through derivatives and eligible assets that can be held by the fund.”
Despite the QIS regime removing onerous tax issues, such as investors only being allowed to hold 10% in the fund before paying additional tax, and offering “genuine diversity of ownership” where investors could hold over 10% as long as the ownership was diversified, the fact it restricted fund managers for several years makes Newsome think it will be tough to convince managers to launch these funds in the UK.
“The government has taken steps in the right direction with the implementation of a protected cell regime and proposals for a tax transparent fund structure, suggesting they are supportive of funds being set up in the UK, but it may all be too little too late,” says Newsome.
Right now, London managers are coping with the regulatory burden. Little in the way of mass exodus has been seen. However, were the controversial Financial Transactions Tax (Tobin Tax) to be introduced across Europe, that could be disastrous for London. Dermot Butler, CEO of Custom House Group, a leading hedge fund administrator, thinks it would, however, more likely lead to the emigration of traders as opposed to hedge fund managers.
“It is dangerous to speculate how the tax regulation would be implemented, but I would expect that the accounts being managed by hedge fund managers would sign up with a management firm in Switzerland, Singapore or a similar country that has not imposed the Tobin Tax or has introduced a very low rate that really won’t have any effect. But there is no doubt the Tobin Tax would be pernicious as currently defined,” says Butler.
As for what London would need to do to re-attract big names such as Alan Howard (Brevan Howard) and Mike Platt (BlueCrest), Butler comments: “I’m presuming they left because of the penal tax rates that were introduced in London. If that is the case, then, presumably, a repeal of those tax rates together with an undertaking to maintain the “new” low rates for at least 10 years or more might bring them back. But it must be remembered that they would only have left in the first place if they had been happy with the lifestyle etc. in Switzerland, so they may be reluctant to move back.”
Right now, London’s myriad benefits – lifestyle, time zone, quality of service provider infrastructure, proximity to investors – are proving strong enough to retain its hedge fund talent pool, despite the tough regulatory backdrop.