Under the stewardship of Mary Jo White, Chairperson of the SEC, the US regulator is pursuing a “Broken Windows” enforcement strategy, as used to great effect by the New York police department in the 90s.
In recent times, the SEC has become increasingly active in monitoring the activities of hedge funds to ensure that investor interests are protected. The fact that they now have enormous amounts of information on hedge funds filing Form-PF under Dodd-Frank is proving effective, not to mention the regulator’s improved technology capabilities.
“I think they are trying to gauge a better understanding of hedge funds and the marketplace. There’s been a huge influx of managers who have registered with the SEC since the implementation of Dodd-Frank. They’ve updated Form ADV since Dodd-Frank and they’ve introduced Form PF to obtain more information on hedge funds than they ever have in the past based on concerns over potential systemic risk in the markets.
“Dodd-Frank regulation was passed, the SEC has gathered information and digested it over the last couple of years and now they are writing guidance and taking enforcement action. We are in the final development phase of Dodd-Frank right now,” comments Mark Ruddy, attorney and founder of Ruddy Law Office, PLLC in Washington, DC.
There is now a post-Dodd Frank certainty in the way the SEC operates, with Ruddy noting that the SEC “is finally prepared to more aggressively implement an enforcement programme”.
At the end of June this year, the SEC’s Investment Management Division issued its guidance on proxy voting guidance responsibilities and how investment advisers with special purpose vehicles may comply with the custody rule.
Currently, the Division is looking to address issues surrounding Regulation D Rule 506 offerings, the most commonly claimed offering exemption by private fund advisers. These filings could be an area for increased SEC scrutiny in the future as more information is gathered and potential violations are uncovered.
“The bottom line is that the SEC is beginning to take a hard look at the internal controls and reporting obligations of hedge funds and investment advisers, so these firms need to take the necessary steps now to avoid potential sanctions later,” advises Ruddy. “Advisers are required to have written policies and procedures in place on who is going to vote proxies and they also need to review whether their proxy voting procedures are being complied with on an annual basis.”
Just to underscore the level of scrutiny being felt by managers, the SEC has also begun its appraisal of alternative mutual funds. If regulators are looking to better protect investors in hedge funds, imagine the concerns they have over managers launching ’40 Act funds and getting access to retail money.
It is believed that between 25 and 30 alternative mutual funds are on the SEC’s radar screen including the likes of BlackRock. Part of the review will be to ensure that the liquidity and leverage profiles of these funds are being correctly managed.
Leonard Ng is a partner in the Financial Services Regulatory Group at Sidley Austin LLP in London. Ng is one of the leading experts on AIFMD regulation in Europe and as one might imagine with a US law firm, many of its US managers are seeking advice on the issue.
Deciding on whether or not to market under national private placement rules (NPPRs) will largely depend on the individual manager. In a recent report that Sidley Austin published on AIFMD, it found that out of the 100 largest hedge funds it advises, 25 of them are being advised currently on the Directive.
The report found that of the non-EU AIFMs (mostly from the United States) who have decided to market their AIFs under the relevant NPPRs, most have chosen to market only in four or five EU Member States; the most popular of these are the United Kingdom, the Netherlands, Finland and Sweden where only the minimum AIFMD NPPR requirements apply.
“Of the largest US managers running north of USD5bn in assets there is more or less a split; some managers are doing private placement, some are not. Those who are doing private placement – and we help with all the registration work, preparing supplements and notifications etc – have an active European investor base.
“We also have some large managers who say to us, ‘Our European capital base isn’t actually that large, and some of funds are closed anyway’. In that situation, there’s no need for firms like this to go down the private placement registration route,” says Ng.
Indeed, with private placement likely to remain in Europe until end of 2018, Ng’s advice to US managers is quite simple: “It is too early to pre-judge what will happen at the end of 2018, so one should focus on the immediate needs for now.”
Sidley Austin’s report showed that for US managers running sub-USD1bn, it’s a different story. Most are staying away from Europe for the time being and waiting to see what the experience of larger managers turns out to be.
Ng stresses the point that for large managers who are thinking about private placement, the cost and the complexity really aren’t that high. Many managers are already battle hardened having gone through several rounds of Form-PF filings under Dodd-Frank.
“That’s given comfort to some of these larger managers – there’s no real shock and horror. My perception, based on the experiences we’ve had, is that the process hasn’t been unduly onerous nor expensive. The slight catch is that no one yet knows how difficult the Annex IV reporting requirements will be as the first filings are not due until the end of January 2015,” says Ng. He adds that the costs to private placement largely relate to the preparation of a supplement to the manager’s offering document.
“If your offering documents are good your supplement is going to be fairly short; covering the shortfalls, the mismatch between AIFMD and what the manager does in the US. That’s not expensive. And if you’re only focusing on a small number of AIFMD-friendly jurisdictions, the process in each is not that difficult. Some of the application document questions can be a bit confusing but by and large it’s not a costly process.”
One industry spokesperson who asked not to be identified tells Hedgeweek: “A lack of clarity has made US managers cautious. They don’t want to get things wrong and if they do decide to operate under AIFMD, what are they really signing up for?”
Of greater concern to US hedge funds is the lack of agreement between Europe and the US on how its derivative markets should operate. There are two issues that need resolving. The first relates to clearing members and CCPs. If the EU does not acknowledge a US clearing house as a recognised third country CCP the result would be a significant increase in capital requirements placed on a European bank.
For example, say a US fund uses a US affiliate of a European clearing member such as Barclays. Under such an arrangement – with a European bank facing a US CCP – the European head office would incur a higher capital charge.
The risk here is that it could create a bifurcation of the derivatives markets where US managers only trade with US counterparties and vice-versa in Europe.
“The US and Europe don’t fully agree on how clearing should work in practice, with additional complications on asset segregation. That’s why they’ve yet to reach an agreement on this point,” says Ng.
The second issue relates to Article 13 of EMIR (European Market Infrastructure Regulation). In the US, under Dodd-Frank, certain alternative investment funds legally incorporated outside the US e.g. a Cayman hedge fund, but managed by a US-based manager are to all intents and purposes considered “US persons”.
The problem is that this equivalence does not extend to EMIR. If the Commission does not regard the AIF as being “established” in the US for purposes of Article 13 the upshot is that both the AIF and the EU counterparty would need to comply with both Dodd-Frank and EMIR.
“I think this is a case of EMIR not seeing the wood for the trees,” says one manager.
The Managed Funds Association, which represents the global hedge fund industry, has urged the Commission to address this issue swiftly “to facilitate the continued vitality of the global derivatives market and ensure that market participants are not subject to duplicative or conflicting regulations in the EU and US”.
Much to do then, between the US and Europe. Not that this is putting off US service providers.
One firm making its presence felt in New York is Peregrine Communications. Having worked with some of the world’s leading hedge funds the London-based integrated communications firm is not your typical PR agency. Style and substance are at the heart of their philosophy.
For US managers keen to stand out from the crowd and develop a digital brand, firms like Peregrine are filling a vital gap in the market; especially now that the JOBS Act has removed the fear of managers wishing to market and advertise themselves.
“Managers have the opportunity to use an incredibly cheap global distribution channel: the internet,” says Anthony Payne, Group CEO and Peregrine founder.
“With ’40 Act funds, AIFMD, UCITS, as well as offshore funds, the internet represents a huge opportunity for managers to distribute their funds. But to do so requires working with a specialist partner that can develop a systematic multi-channel approach. It’s a complete messaging platform that communicates a manager’s investment thesis.”
According to Max Hilton, who heads up Peregrine’s New York office, the JOBS Act has levelled the playing field.
“One of the best websites out there is SkyBridge’s. They have a series of videos on their website providing clear insights into their investments. That is what investors now expect,” says Hilton. “If you’re not using video you’re way behind the curve.”
The JOBS Act could well prove beneficial to smaller hedge funds that need to catch the eye of investors. A more pressing concern for mid-sized US managers is the impact that Basel III bank regulation could have on their prime brokerage relationships. In a nutshell, those who are not fully utilising the bank’s balance sheet of their prime broker will face higher costs; especially if credit lines are not being used, cash is being held in the margin account and a high degree of leverage is required.
Those managers likely to be hit first by higher financing costs could be fixed income arbitrageurs who need to use a lot of leverage to generate the required returns. If a bank does not see enough return on investment they will simply up the financing charge. BarclayHedge estimates that returns could fall anywhere between 40 to 80 basis points.
“That’s consistent with what we have been hearing since this time a year ago. Given the nature of those strategies and the leverage they employ it’s likely that they would be the first in line to feel the impact,” says Jack Seibald, managing member at Concept Capital Markets LLC.
Alternatively, the primes will simply reduce the amount of leverage they make available, especially if, as predicted by Citi, the hedge fund industry grows to USD5.8tn by 2018. Under such a scenario, a bank’s balance sheet will truly become a precious commodity.
Commenting on the potential impact of short selling activity, one industry source who wished to remain anonymous told Hedgeweek: “It is a concern. The real issue is what impact higher costs of capital could have on the broader markets. If it becomes difficult to sell short, for example, what could that mean for the depth of liquidity?”
Seibald says that under Basel III banks will be less reluctant to use their balance sheets to set aside cash for hedge funds that have cash on deposit as they will earn next to no interest. It’s not inconceivable that managers will have to pay to hold cash. US banks have already warned the Fed that if they were to lower Interest on Excess Reserves (IOER) to zero they would have to start charging depositors, including households and companies.
“The extent to which the banks need to set capital aside is causing them to reduce the size of their balance sheets as one part of the equation aimed at improving their returns. What is happening now is that primes are asking clients to move unused cash off their balance sheets and custody it somewhere else,” says Seibald.
He adds that increased liquidity requirements imposed by regulators is likely to cause a further contraction in hedge fund lending as banks are forced to hold higher quality collateral such as US Treasuries: “This will in turn likely make it more expensive to execute and manage certain strategies that require lots of collateral.”
These are challenging times for US hedge funds. The tectonic plates of regulation continue to shift. Nevertheless, as assets keep pouring in – some USD57bn in the first two quarters according to Hedge Fund Research – managers have good reason to remain upbeat.
