Regulatory change in Europe is gathering pace following the pandemic, and as ESMA’s plans for enhancing AIFMD and MiFID remain on managers’ radars, the post-Brexit FCA implementation of the new IFPR may bring added headaches.
Regulatory change in Europe is gathering pace following the pandemic, and as ESMA’s plans for enhancing AIFMD and MiFID remain on managers’ radars, the post-Brexit FCA implementation of the new IFPR may bring added headaches.
Designed to bolster investor protection in the aftermath of the 2008 Global Financial Crisis, the EU’s Alternative Investment Fund Managers Directive (AIFMD) – which took effect in 2013 – brought substantial changes to how hedge funds and other investment managers operated in Europe, putting them under closer regulatory scrutiny and subjecting their activities to greater transparency.
As part of its review of the bloc’s Capital Markets Union, the EU and the European Securities and Markets Authority (ESMA) have set out plans to update certain parts of the directive with new rules covering marketing, delegation, liquidity and reporting.
The AIFMD II proposals – which are expected to be ratified by the European Council and EU parliament in the second half of 2022 – have split the hedge fund industry in the region. A survey of European managers conducted by Hedgeweek shows 50% are ‘somewhat concerned’ by the AIFMD II plans, with a further 9% ‘very concerned’, while 41% say they are not concerned.
‘Problems’
Among other things, AIFMD II will introduce tighter curbs for hedge funds and other asset managers looking to delegate parts of their portfolio management to non-EU entities, as well as stricter rules on the pre-marketing process. Specifically, investment firms looking to pre-market in Europe are subsequently prohibited from reverse solicitation for 18 months. In practical terms, this measure could potentially upend capital-raising activities for some hedge funds, as well as impacting certain firms who offer marketing services, says Gary Pitts, founder and managing partner of boutique compliance and governance consultant Tetractys Partners.
“The pre-marketing issue has, for a number of distribution models, caused a few problems for firms pre-marketing in Europe,” Pitts tells Hedgeweek, adding there is growing degree of “regulatory discomfort” over the concept of seconding people to other entities in Europe to market a fund where a UK firm has no other marketing options available in the EU.
In response, hedge fund firms are now drafting in additional legal counsel or compliance support in order to be able to decide which jurisdictions to go into and how to make an initial foray into certain countries, particularly since they can no longer rely on reverse solicitation.
“We have a lot more queries coming in from hedge funds,” says Kavita Devani, head of compliance operations at Coremont. “With stricter guidance, they need legal counsel, or compliance support, to be able to make that decision on when and how to enter the marketplace. They are asking what the rules are in each particular country – is it better to register or not register? Should they pre-market or not?”
Expanding on this point, Devani tells Hedgeweek how hedge fund managers can no longer expect to simply organise investor roadshows across EU countries. Each country’s rules need to be reviewed individually, she explains.
“Before they were able to speak to many more potential investors – but it’s not so easy now,” she says. “Managers need to really think about what countries they are targeting. Due to the new regime on pre-marketing it can preclude relying on reverse solicitation for a period of 18 months following the start of pre-marketing and fund managers will need to notify the relevant regulator of their pre-marketing activities, within two weeks of starting to pre-market.”
Pitts adds: “Whereas in the past, you would normally spend 20% of your effort getting to 80% of your AUM, and just focusing solely on that because of limited bandwidth, I have seen some managers now who are sufficiently AUM-desperate to the extent that 80% of their efforts are going to try and capture that final 20%, with all sorts of costly regulatory contortions to try and distribute to sophisticated retail investors either in the UK or throughout Europe. It’s an ad-hoc process, and it’s becoming quite difficult.”
‘Focus’
Meanwhile, as part of the ongoing review of the Markets in Financial Instruments Directive (MiFID), the EU last year spelled out a package of measures designed to further strengthen transparency and the availability of market data, as well as levelling the playing field between execution venues, which the bloc hopes to will help “ensure that EU market infrastructures can remain competitive at international level.”
MiFID II, which took effect in January 2018, brought sweeping transparency and transaction reporting requirements across the financial services industry and, for hedge funds, heralded new rules on how managers source, pay for, and utilise third party research – as well as the unbundling of research from brokerage fees – aimed at offering greater transparency for investors and curbing the risk of inducements to trade.
Industry consensus suggests MiFID II has led to a reduction in hedge funds’ research spend, though anecdotal evidence indicates portfolio managers have sought to capitalise on the reduced amount of stock analysis with targeted research budgets to help them gain an edge.
Well over half (59%) of European hedge fund managers are ‘somewhat concerned’ about the MiFID/R III review, while 9% are ‘very concerned’. In contrast, only a third of European hedge funds (32%) say they are are not concerned about the proposals.
“There is talk of transaction reporting being required for both AIFMs and MiFID firms further down the line, but this has not been confirmed,” Devani says of the MiFID plans.
“This was previously one of the key advantages for a firm to be regulated as an AIFM instead of a MIFID firm, as transaction reporting takes up so much of a firm’s time and costs,” Devani explains.
Such additional burdens are often the reason for managers outsourcing certain processes to third party service providers. “If it means that both regimes will require that reporting, it puts the regimes onto a more level playing field,” she adds.
Delving deeper, key for the alternative asset management industry is a potential shake-up to rules covering UK firms with European operations and exposures, and the way MiFID rules may ultimately be applied by the Financial Conduct Authority to UK managers following the UK’s withdrawal from the EU.
In a recent market commentary, Linda Gibson, director of regulatory change, BNY Mellon | Pershing, suggested that regulatory divergence “should very much be the focus” for those at EU and UK firms tasked with reviewing and advising the business on the impact of proposed changes to MiFID II.
‘Surprises’
While EU-based MiFID investment firms are bound by the Investment Firms Regulation (IFR) and the Investment Firms Directive (IFD), which took effect in June 2021, UK-based MiFID investment firms are subject to a comparable set of rules, the Investment Firms Prudential Regime (IFPR), which kicked in from January 2022.
Specifically, one central issue currently facing many managers in the UK hedge fund space are the MiFIDPRU provisions which apply where the hedge fund manager also has permission to manage individual managed accounts, and the accompanying ICARA document requirements which form part of the new IFPR.
“The FCA in theory did not have to do MiFIDPRU. It only decided to do MiFIDPRU because the rest of Europe was doing it and the FCA was originally one of the main drivers in creating MiFIDPRU in Europe in the first place,” says Pitts.
The new framework has brought a number of “nasty little surprises” for certain hedge fund managers, Pitts says, including the degree to which certain elements of the IFPR rules will apply to those fund managers considered SNI (small and non-interconnected investment) and non-SNI firms.
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 not just institutions’ capital adequacy, but their liquidity and “overall financial resources”.
“One of the issues here is helping firms to understand their group structure, for example. It’s quite complicated, and part of the issue with the ICARA itself is that historically the ICAAP for most firms was a tick-box exercise,” says Pitts. “Additionally, if you are now one of those firms that has been suddenly surprised and has become a non-SNI simply because of the way you trade, then suddenly being told you have to submit your ICARA is a shock, rather than just having it on file in case you are asked to show it.”
The new framework also heralds additional compliance challenges for hedge funds and other investment managers, including more extensive wind-down plans and detailed risk assessments, and the introduction of so-called K-factors in capital calculations, which are required of asset managers meeting certain thresholds including £1.2 billion or more in MiFID AUM, or total gross revenues from investment activity of £30 million or more.
“One of the things that firms – small hedge funds, especially – have been very reliant on is a fairly standard template risk assessment which has been pre-populated by a consultant. Firms are actually having to go back to scratch and do a proper risk assessment of their own business,” Pitts says.
“It takes time and effort – the wind-down plans are done off the back of stress scenarios, and the FCA has guidance on how to do these things, they’ve been doing virtual visits to firms, asking to see the wind-down plan.”
He adds: “In reality it’s making it a lot harder, and the barriers to entry now for the smaller hedge funds are quite significant. Having seen the FCA’s expectations on the ICARA when people are asked to show the documents at authorisation stage, there’s quite a high expectation – it’s becoming much harder to get regulated, much harder to operate, barriers to entry are going up, and I think the days of starting off with $30 million and hope are long gone.”
Key Takeaways
- A majority of European hedge fund managers surveyed by Hedgeweek are concerned about the potential impact of the EU’s AIFMD and MiFID regulation, which could significantly alter firms’ business models. As a result, many managers are said to be drafting in additional legal counsel or compliance support to handle the additional work
- The FCA’s new ICARA documents, which form a key a part of the UK regulator’s new IFPR regime and introduce new methods of measuring firms’ capital adequacy and liquidity, carry extra requirements and potential “surprises” for hedge funds
