Hedge funds “need to get going” on IFPR overhaul as January deadline looms


Hedge funds and other alternative asset managers have just three months left to prepare for the Investment Firms Prudential Regime, the far-reaching new regulatory framework which potentially heralds “complex and multi-faceted” compliance processes for firms.

The Financial Conduct Authority’s new IFPR, set to take effect from January 2022, heralds sweeping changes to rules covering capital, liquidity, remuneration, reporting, and disclosures, among other things.

As part of the overhaul, the existing Internal Capital Adequacy Assessment Process (ICAAP) framework – which stems from EU legislation covering banks and other financial institutions’ capital adequacy, in force since 2006 – is being replaced by the Internal Capital and Risk Assessment (ICARA), a new way of measuring institutions’ capital adequacy.

FCA-authorised investment managers, advisors and brokers who provide MiFID services are affected by IFPR, and the shake-up will see a whole spectrum of investment firms - including hedge funds - now subject to their own dedicated prudential regime under the IFPR, which includes the ICARA. 

Under the existing ICAAP regime, regulatory capital requirements are calibrated and calculated around various potential risks facing firms, and how they can address those risks. These include credit risks, market risks, operational risks and business risks, such as cyberattacks or large client redemptions. In contrast, the incoming ICARA framework focuses on harms posed not only to the firm itself but also externally. These may include, for instance, the impact of poor investment performance on the firm itself, its clients, and the wider financial services industry.

Matt Raver, managing director at compliance consultancy firm RQC Group, said over 90 per cent of his firm’s hedge fund clients are likely to be impacted by the ICARA, adding that establishing the new framework is likely to be “a particularly complex and multi-faceted task.”

“If you are a hedge fund and you’re subject to ICAAP now, you’re probably going to be doing an ICARA going forward,” Raver told Hedgeweek.

Building on this point, he noted that while the ICAAP takes account of regulatory capital, ICARA scrutinises both regulatory capital as well as liquidity – and firms will require more comprehensive wind-down plans going forward, which not every hedge fund manager may currently have.

These include detailed practical steps, such as a timetable of any wind-down process, how money may be returned to investors, and how the wind-down will be communicated to employees, prime brokers, fund administrators and other stakeholders.

Another major change centres around regulatory capital. Raver highlights the introduction of K-factors, which form part of the new regulatory capital calculations, and which will now be required of asset managers meeting certain thresholds including GBP1.2 billion or more in AUM or total gross revenues from investment activity of GBP30 million or more. Some of these thresholds might need to be considered on a group basis. 

“Where the firm is acting as an AIFM of record to the AIF, it does not need to factor this into the K-factors, because this is dealt with under the existing regulatory capital regime for that activity.

“However, there are a number of K-factors depending on other activities you’re conducting. If you’re a hedge fund manager, you’re likely to fall into one called K-AUM, where you take two basis points of your funds under management.

“It doesn’t apply to the smaller firms, which are called ‘small and non-interconnected firms’. And so if a hedge fund does not meet the thresholds, it will likely to not need to worry about K-factors,” Raver said. “But larger firms will be subject to this.”

Elsewhere, the new regime calls for increased notifications to the FCA should a firm’s regulatory capital or liquid assets requirements diminish to certain levels that may impact markets more widely. It sets out certain trigger events that require investment managers and other firms to notify the FCA.

“Among our client base, there are firms which are extremely well-capitalised and are in absolutely no danger of breaching the regulatory capital requirements. But there are other firms which often hover around the limits. These firms may find that they will need to activate their recovery plans to rectify the situation, including asking the owners to increase capital, or alternatively instigate the firm’s wind-down plan,” Raver said.

“I think some firms are going to struggle if, every month or every few months, they are having to tell the FCA that they are within 110 per cent of their regulatory capital requirement, which is one of the trigger events.”

With just three months to go until the new rules take effect, anecdotal evidence indicates some hedge fund firms have been more proactive than others in preparing for what looks set to be an onerous implementation process.

To address the potential hurdles ahead of the 1 January 2022 deadline the Alternative Investment Management Association, the global hedge fund industry trade body, this month published an IFPR implementation guide, and is supporting members by facilitating peer-to-peer workshops during the fourth quarter.

Jennifer Wood, managing director and global head of asset management regulation and sound practices at AIMA, said the timeline for IFPR implementation will be challenging for firms.

“Firms that have previously had to perform the ICAAP process will have a leg-up on the firms that have not had to do this before, although the ICAAP and ICARA processes do differ a bit. The K-factors will be new for everyone and will be more challenging for firms with more complex business models and even more so for firms that deal on their own account or underwrite on a firm commitment basis,” Wood explained.

“At the end of the implementation process, some firms will find themselves having to set aside significantly more capital and own funds than was previously the case.”
Raver meanwhile underlined how the ICARA is not simply a ‘direct replacement’ for the ICAAP. 

“It’s not as conceptually similar as a lot of people think it is - this is something we’ve been speaking to firms about for some time now,” he observed. “I would reiterate that while the ICARA is in some ways similar to an ICAAP, you’re still going to have to do a brand-new exercise and brand-new analysis on this.”

He added: “If you look at IFPR holistically – because it’s not just the ICARA, there are various other elements – I would say if a firm hasn’t started its preparation then it really needs to get going, otherwise it’s going to run out of time and realise there are a lot of moving parts. You can replicate certain elements from the current prudential frameworks, but there are additional elements that need tackling.”

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Hugh Leask
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