Thiha Tun, Partner & Samantha Shankar, Senior Associate
Herbert Smith LLP
Hedge funds have been subjected to an increased degree of scrutiny and criticism over the course of last year as a result of global financial events and ensuing demands from investors. They have responded by reviewing their practices and updating their operating models. This article summarises some of the key concerns which hedge funds have been required to focus on over the course of last year and what they face in the immediate future.
Impact of AIFM Directive
The European Commission published a proposed Directive for Alternative Investment Fund Managers1 (AIFM) in May 2009. Given the widespread criticism of the AIFM Directive, there has and will be considerable lobbying for amendments to the existing proposals before it is implemented. Perceptions regarding the impact of the AIFM Directive have already led to irrational fears in some quarters. For example, some investors are already shunning non-EU domiciled funds under a mistaken fear that they will be forced out when the AIFM Directive comes into force.
The AIFM Directive asserts that any alternative investment fund manager that provides management services within the European Union with assets under management of €100 million will need authorisation from their home member state and will be subjected to ongoing requirements. This includes managers of hedge funds and funds of hedge funds. In the UK, the Financial Services Authority already requires UK-domiciled fund managers to be authorised. This requirement will, therefore, not represent a major change for many UK fund managers.
In the UK, however, under the AIFM Directive, managers who fall under the criteria above will be required to report to their home regulator on a regular basis with matters such as risk profile, use of short-selling and exposures and concentrations. Managers will be required to supply investors with a variety of information prior to the investor investing in the relevant hedge fund, and subsequently on a regular basis. Many of the additional disclosures reflect existing standards, such as those of the Hedge Fund Standards Board. Other important requirements of the AIFM Directive are that managers must have documented and effective internal procedures, as well as controls to mitigate and manage risks and prevent conflicts of interest. They must also adopt liquidity management procedures and regularly conduct stress tests.
In the US, the Obama administration has also put forward proposals for hedge fund regulation. These proposals require advisors of hedge funds to register as investment advisors with the Securities and Exchange Commission and stipulate that all funds advised by such advisors are subjected to disclosure and reporting requirements. As well as the Obama proposals, at least half a dozen bills have been introduced in the US Congress calling for hedge fund regulation.
It is, therefore, clear that although the AIFM Directive and the proposals in the US may be amended before they come into force, hedge funds and their managers will, in the future, be subjected to increased regulation. Investors are increasingly concerned with ensuring that there is sufficient disclosure from fund managers to provide a greater level of transparency and the proposed legislation is in part an attempt to deal with this concern.
One way to address investor fears and concerns is for managers to consider structuring their funds as UCITS-compliant funds and to structure their strategies so that it fits within a UCITS product.
There are, however, a number of restrictions that a UCITS fund must comply with on an ongoing basis and managers need to be comfortable that they can operate within such a framework. In spite of this, managers have not, historically, exploited the full potential of using a UCITS vehicle which, with careful thought, can be made to accommodate many hedge fund strategies. UCITS III allows funds to utilise futures and financial indices to increase yield, as well as permitting a portfolio of derivatives including swaps and contracts for difference.
One of the challenges for managers in seeking to structure a hedge fund or a fund of hedge funds in a UCITS vehicle is ensuring that they can comply with the liquidity requirements. The maximum redemption period for a UCITS product is 14 days and redemptions generally must be at net asset value, liquidity mismatches are precluded and “gates” and other restrictions on redemptions are not permitted.
The directors of a UCITS have a responsibility for ensuring liquidity mismatches do not arise and applicable regulatory requirements are met. The manager is responsible for legal and regulatory compliance. Managers would, therefore, need to understand and be comfortable that they can meet the compliance burden that a UCITS and the local regulations impose.
Many investors are reconsidering investing in UCITS vehicles, which are perceived by many as a more liquid and transparent investment vehicle when compared to the existing hedge funds and funds of hedge funds. The attraction of a UCITS fund is that it is more liquid and transparent and there are more regulatory requirements at the level of the fund and the manager.
Protection of Client Assets
In addition to the changing regulatory landscape discussed above, hedge funds have increasingly moved away from engaging a single prime broker towards developing relationships with multiple prime brokers and third-party custodian banks, partly in an attempt to protect their clients' assets. Although proposed new legislation may require hedge funds to appoint independent third parties for the safe-keeping of client assets, it appears that, at present, hedge funds are undertaking this at their own accord to ensure the continuing liquidity of the fund. The risk of this happening has been highlighted, owing principally to the collapse of Lehman Brothers but also to the economic downturn. The collapse of Lehman Brothers in the UK has highlighted some weaknesses in the UK insolvency regime, the FSA regulatory framework, as well as some inadequacies in the prime brokerage agreements themselves.
In the US, there is a growing perception that the US provides greater protection to prime brokerage clients than the UK. The SEC Customer Protection Rules and the Securities Investor Protection Corporation's Trustee regime are cited and contrasted with the UK insolvency regime, whose purpose is to protect the interests of creditors as a whole rather than the customers of the insolvent prime broker (although UK prime brokers quote the FSA client asset and client money rules as adequate protection).
How Will Hedge Funds Respond to the Changing Market Environment?
Hedge funds are facing a challenging time in adapting to the complex market conditions and the evolving regulatory landscape. As a result, hedge funds are seeking to diversify their investment strategies with increasing interest in commodities, energy, litigation funding and lending. It will be interesting to see what other strategies emerge for hedge funds.
This article by Thiha Tun and Samantha Shankar was first published by www.complinet.com on 29 July 2009 and is reproduced with their kind permission. Complinet is the leading provider of risk and compliance solutions to the global financial services community.