ALFI in London

Managing change amid expanding regulation

Originally published in the June 2012 issue

Delegates to the Association of Luxembourg Fund Industry May conference in London were left in no doubt that the regulation of alternative funds is rapidly accelerating. Many speakers provided ample examples of regulatory issues that had become too complicated and examples of situations where regulators are bypassing relatively simple solutions.

A key concern is the tripartite structure of separate regulations for banking, insurance and other financial companies of which asset management is a key component. It was observed that the tripartite regime should either be unified into one structure or broken down in a good many more specific regimes.

Overall, there was broad agreement that investment clients face an altogether more complicated world and that fund managers need to provide more direction and assistance to them. But there was considerable debate about whether bigger or smaller alternative investment operators would adapt best to the growing burden of regulation.

A tsunami of regulation
Gareth Adams, principal of GSA Associates, likened the onslaught to a “tsunami of regulation.” He observed that smaller investment firms would likely prove more adaptive that the bigger asset managers. In addition, Adams argued that more regulation actually increases uncertainty about what firms can and cannot do, meaning those firms with a clear and prioritised conception of what they are doing will fare better.

The assertion that smaller firms would be better placed to handle increasing regulation was questioned by Sheenagh Gordon-Hart, client and industry research executive, with JP Morgan Securities Services. She argued that barriers to entry are rising, something that will obviously impact smaller players most. “I fear that innovation which has been strong in Europe will decline sharply,” Gordon-Hart said.

Though broad initiatives like the Dodd Frank Reform Act and the Alternative Investment Fund Managers Directive are key regulatory milestones, a plethora of other measures are ongoing. Claude Kremer, president of the European Fund and Asset Management Association, urged that cross border considerations be emphasised in order to generate regulatory coordination.

One cross border issue that was highlighted was the lack of fund mergers. It had been expected that earlier regulatory change would facilitate fund consolidation. The process of merging funds from different jurisdictions would promote economies of scale and perhaps over time improve returns to investment clients.

Fund mergers thwarted
Freddy Brausch, a partner with law firm Linklaters, brooked little ambiguity on the subject. “Cross border mergers are a failure,” he said. What was stopping them from happening, he added, was a lack of sufficiently rapid progress on tax harmonisation.

It was also pointed out that harmonisation is also still lacking on local market entry rules. Despite the structure within the European Union, it was noted that progress was extremely limited. Lou Kiesch, an enterprise risk services partner with Deloitte, predicted that the asset management industry is unlikely to see harmonised rules as such moves will instead be short circuited by local regulations.

On a more positive note, the arrival of UCITS IV rules in 2011 provided one example of regulation improving the operating environment for alternative investment managers. The revised UCITS regime extended provisions on pooling arrangements to master-feeder structures allowing more flexibility on portfolio construction. It means that non-UCITS offerings, such as a UK open ended investment company or OEIC fund can be inserted into a Master fund.

“For small managers this is a significant step forward,” said Rob Lay, European and Middle East head of distribution for UBS Global Asset Management. “But there are still many other variables – such as local rules for marketing or reporting – that stop it from being a panacea.” But Lay decried what he termed the “bewildering complexity” of the Key Investor Information Document that must accompany all new UCITS funds. For asset managers, it is an “onerous” burden, he said.

AIFM Directive
Though the AIFMD isn’t yet finalised, enough about it is clear for alternative funds. For a start, the regime obviously marks a wide ranging move to regulate managers rather than funds. Hedge funds and funds of hedge funds are likely to designate an external AIFM. The impact on management companies is expected to bring about a similar process to that now employed by UCITS management companies. One possible outcome of the Directive is that asset managers may find it advantageous to concentrate their operations in one or at most two key locations.

A real time poll of over 200 delegates found that the main concern of over two-thirds (68%) of them was the heightened cost of AIFMD for depositaries and prime brokers. In contrast, only 15% found delegation rules the main concern, with 14% citing third country rules and just 4% naming manager remuneration provisions. In sum, for investment managers the cost of the AIFMD provisions is the main issue. However, for non-EU managers the possibility of eventually being able to secure passports to market funds across the EU is judged to be a potentially very strong benefit. Yet it was pointed out that the uncertain timeline for the passport to come into being may see non-EU investors and managers take a wait and see approach, in effect, circumventing the new regime by staying out of the EU.

SIFs gaining ground
Since their origination in 2007, over 1400 specialised investment funds or SIFs have been registered in Luxembourg for hedge funds and other alternative strategies (See Fig. 1). The structure has recently been revised to be brought in line with strictures being included in the AIFMD.

One change is that SIFs now require prior regulatory approval from the Commission deSurveillance du Secteur Financier (CSFF), an undertaking which takes some four to six weeks. Managers must also now be regulated by a home market regulator. New risk management procedures are being formulated by the CSSF with the aim to avoid conflicts of interest within a broader framework of measuring, managing and monitoring risk. The changes are expected to be finalised and come into effect in two stages: 30 June 2012 and 1 January 2013.