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.”
