Putting the house in order

With a file of draft European Union regulations – which may enter the law of member states in 2011 – looming over a beleaguered hedge funds industry, managers of alternative investments and their service providers are already beginning to position themselves in order to respond effectively to product manufacturing needs. The proposed directive requires alternative investment fund managers to be authorised by local regulators in their home states, to appoint EU-regulated banks as depositaries and to make full disclosures of their investment strategies to the authorities. “The EU directive and the struggle to hang on to assets are by far the biggest issues for our clients,” says John McCann, managing director of Dublin-based Trinity Fund Administration, which services assets of $1.5bn (E1.06bn) for around 100 clients, including groups such as Integrated Asset Management, Petronas and Templar. “Even those guys who performed really well have become cash machines for people who need the liquidity,” he adds, although with counterparty risk issues now addressed, Trinity has seen the beginnings of “green shoots” in tenders for external managers. However, the due diligence being carried out for these RFPs has already increased significantly, with private banks and other institutions beginning to pre-empt the tighter measures envisaged in the forthcoming EU rules. “Due diligence from investors has increased more than ten-fold,” says Mr McCann. “Last week, we had three or four funds going through our systems, our disaster recovery arrangements, valuation capacity, our bank accounts and who counter-signs them. Even 18 months ago, they would not have gone into that level of detail. The investment managers would have kicked the tyres and walked around a little bit. They have definitely increased their scrutiny.” The elements of the legislation concerned with strengthening operational risk requirements are particularly good, believes Mr McCann, with best practice including segregation of assets and independent valuation making up areas of concern which must be addressed by the industry. The belief in the industry is that hedge fund groups should get their own house in order first, so there is not so much for the regulators to be concerned with. “It’s not too early for groups to start looking at their own practices, with independent administration being the main change needed,” believes Mr McCann, adding that self-administration, still the norm in the US industry, led to many of the blow-outs there, including Amaranth. “The European private banks such as UBP and Mirabaud are now saying: if you don’t have an independent administrator, we are not going to invest in you.” Managed platforms A broader trend in the industry being anticipated is a movement by investors from third party investment vehicles to managed accounts and platforms, such as the one developed by Lyxor. “The outlook for them is very bright,” says Anthony Limbrick, CEO of New Zealand-based hedge fund Pure Capital, about to launch a protected fund to handle equity beta exposure. “That’s how we see our strategy developing, by getting onto those platforms,” he explains. “This involves the outsourcing of due diligence and style analysis. They have had no blow-ups so far. Maybe they have not been tested, but there is confidence in the platform approach.” Since Lyxor was set up 11 years ago, there has been one case of suspension of authorisation of a manager. Through replicating the fund’s positions, the platform strategists were able to see the performance was differing significantly from the numbers the managers were reporting for their main fund. If the EU directive is implemented, Mr Limbrick believes there will be much simplification of large-scale funds. “Where strategies are dependent on large, illiquid positions, it will become very expensive to run them.” He also sees many new opportunities for regulatory arbitrage amongst financial centres, with certain forward looking jurisdictions able to enact more user-friendly legislation, in order to attract fund groups. Compliance costs should not be a problem for diversified businesses, but will push the critical mass of asset managed up from the current $100m minimum to something approaching $300m, believes Mr Limbrick. There is little doubt that the current moves are a response to a populist groundswell of public opinion, being exploited by Europe’s politicians. “These moves are about as popular as saying let’s regulate MPs’ expenses,” says Martin Cornish, senior partner at London law firm, Katten Muchin Roseman Cornish. “They are pushing at a fairly open door.” But there is some debate about the ability of the politicians to come up with an effective framework, with the EU regulators envisaging even more detailed rules to be handed down from Commission level. Katten’s lawyers say imposing this level of detailed requirements is completely contrary to the way EU regulation has worked in the past. “Most of us have seen regulators collect information and not know what do with it,” says Mr Cornish. “Expect this to happen again. Clearly, the regulators want to make doing business for hedge funds that little bit more difficult.” A great opportunity Speaking at the recent Hedge Fund Insights event in Frankfurt, Philippe de Beaupuy, head of the long/short equity desk at Lyxor’s fund research and selection team said he expects a 30 per cent attrition rate in the industry. This will be due to poor performance, gates coming down and investors demanding their money. “Despite all this, we are telling our investors to push the ‘play’ button, as investment opportunities are coming back,” he believes. “Coupled with the environment of high, but manageable volatility, correlation between asset classes and hedge fund strategies is declining and increased dispersion presents great opportunity for hedge fund managers.” Due to attrition, less players will be seeking increased opportunities, with shrinking proprietary desks at investment banks meaning there is more room in the market for hedge funds. Against this background of changing activity amongst funds, Mr de Beaupuy believes regulation is now inevitable, triggered by the industry’s institutionalisation, as well as the financial crisis. “People have been talking about further regulation of hedge funds for quite a long while. This time it will come, as the need for transparency is even greater than it used to be and Washington and the G20 are both in the mood for regulation,” he says, even though it has been acknowledged by the International Organisation of Securities Commissions (Iosco) that fully-regulated commercial banks rather than hedge funds were the triggers of the crisis. “What regulation will look like, it is a bit early too tell. But it will cover offshore centres, managers and the way prime brokers and service providers will have to operate.” Key to the changes, according to Mr de Beaupuy, is likely to be greater transparency, starting with increased segregation of assets and stronger custody and independent valuation arrangements. Current cross-border regulatory provisions, mostly included in Ucits III rules, only apply to a limited number of liquid strategies in the market, he adds. Along with other compatriots in the hedge funds business, Trinity’s Mr McCann sees a huge degree of Franco-German protectionism behind the legislation, with the aim to sideline non-EU fund domiciliation, administration and regulatory environments such as the Cayman Islands. “If you look at fund of funds structures, the vast majority of hedge funds included in them are Cayman-based products. The question is, how will the promoters implement the regulatory changes?” One of the ways which Europe will try to exclude Caribbean domiciled funds and US-headquartered managers from gathering assets in Europe is through restricting them to EU service providers. There may also be a calculated decision to strengthen the power of European banks, by withdrawing the right of non-EU entities to administer assets in the EU. “This looks like a back-door attempt to drive business into the hands of continental European banks,” says Katten’s Mr Cornish. “In the classic hedge funds structure, use of non-EU entities will be severely limited. This runs pretty counter to what you see in most custodian agreements.” Even if the investments are being made by a group on the other side of the world, the requirements are likely to restrict the fund servicing entity to groups headquartered in Europe. “Even if you are investing in Australia, you will need an EU depositary who remains liable for activities in a non-EU territory,” says Mr Cornish. “There is also a big question mark whether the arrangement of a typical prime broker doubling up as a custodian will work.” But there is a broader question here and a good reason why the likes of Trinity are not getting too obsessed with the devil in the detail of the proposed legislation. We have been here more than once before. EU Commissioner Charlie McCreevy has said previously that there is no real need to regulate hedge funds, because the financial crisis was caused by misbehaviour of banks, rather than funds shorting stocks. It is the EU parliament that has invoked a clause allowing it to force the Commission to issue regulations. The belief among many groups is that the Commission has allowed the draft directive to go out in its current form because it is expected to change significantly. Failed initiatives Political precedent provides us with the history of other directives which failed to make it, such as those on tax harmonisation, even if they had the support of most member states. “There is a precedent for initiatives coming out that will never actually happen,” says Trinity director Peter O’Dwyer. “The expectation is that governments will oppose it and it will be changed. But the lobbying needs to happen first,” he believes, adding that the draft directive is unworkable and could lead to between 10,000 and 20,000 job losses in London alone. Major hedge groups are already threatening to leave the UK capital if the rules are not modified. With new members of the European Parliament elected in June, the shape of the regulatory programme is also expected to change during 2009. Mr O’Dwyer believes the political motivation behind the legislation has very little to do with hedge funds, but a lot to do with private equity funds and that many Europeans simply don’t understand the difference. Katten’s lawyers agree, saying the involvement of the EU parliament’s Socialist group in drafting the legislation explains the targeting of their ‘bete noir’ of private equity within a catch-all sweep up of alternative managers and products. Critics of the legislation claim it is a rearguard action to protect the “cosy capitalism” prevalent in Germany and France, where corporate power stays within an enchanted circle of directors, who might typically hold board seats at both Deutsche Bank and Daimler Benz. “The Germans and French both took great exception at people breaking up their conglomerates,” says Mr O’Dwyer, referring to activities of some of the buyout funds in corporate deals. Requirements to set out investment strategies in significant detail will also make life difficult for those types of fund managers who want flexibility in switching strategies according to the market climate. The consensus is that there is much to commend the inevitable regulations, but that this time, the Europeans have simply gone too far.