Challenges From the Crisis

Solutions that Luxembourg offers hedge funds

MICHAEL FERGUSON, ERNST & YOUNG LUXEMBOURG

Notwithstanding the industry’s recovery from the dark days of 2008, with hedge funds reporting positive returns for both 2009 and 2010 and with assets under management approaching their all-time high, the industry is still dealing with some of the challenges which arose during the financial crisis. These challenges identified in Restoring the Balance, our global hedge fund survey (conducted in association with Greenwich Associates), include dealing with the impact of restrictions introduced on redemptions during the financial crisis, implementing measures to retain and attract capital, establishing a compensation structure that is aligned with investors’ interests, and improving transparency.

Impact of restrictions on redemptions
At the height of the financial crisis, many hedge funds were forced to introduce restrictions on redemptions simply to survive. Although only around one-third of all hedge funds were forced to employ strategies to limit redemptions, 75% of all investors reported that they were directly/indirectly impacted by these restrictions. The experience of redemption restrictions in whatever form is frequently listed by investors as a key concern when considering investing in the hedge fund sector. Once the redemption restrictions were finally lifted, hedge funds had different experiences as regards retention of assets – half experienced 5% or less of their assets being redeemed, several reported that 15%-20% of assets were redeemed, while a small percentage experienced redemptions of 50% or more.

As regards future investment intentions and expectations, investors and managers have very different views. Around 75% of hedge fund managers believed that investors are less likely to invest with managers who limited redemptions while less than 50% of investors agree with this view.

Working to retain and attract capital
Hedge funds have made significant changes to increase liquidity and lower management and incentive fees. These changes have been made primarily in order to attract new capital rather than to keep existing capital. Most investors feel they have increased bargaining power and are also applying pressure to improve liquidity terms, with many reporting that the maximum lock-up and the maximum gate they will accept is lower than it was pre-crisis.

Hedge fund managers who have lowered their management and incentive fees have reported that they expect to experience more difficulties in attracting and retaining talent. Hedge fund managers that have modified liquidity terms have also, in many cases, amended their investment strategy.

During and immediately post-crisis, separately managed accounts (SMAs) initially became the “must have” offering for hedge fund managers in order to both maintain and potentially increase the size of client mandates. However, much of the initial hype around SMAs has died away despite their well-known benefits, such as greater transparency, better control and more overall influence on fees.

Despite the high-profile press headlines around new alternative UCITS (sometimes referred to as “NewCITS”) in Europe and elsewhere, they still rank relatively low as a priority for either managers or investors. Notwithstanding the challenges associated with alternative UCITS, the majority of the large institutional hedge fund managers have, or are in the process of launching, alternative UCITS, while smaller boutique hedge fund managers are using platforms to help them get established in this space.

Aligning compensation structures
The discussion on compensation structures is to a great extent a spill-over from the very politically charged discussion on the same issue in the banking industry. The vast majority of investors highlight the managers’ compensation model as one of the critical criteria in selecting a hedge fund.

There appears to be a significant gap between the views and perceptions of investors and managers on how well the current compensation structures align risk and performance of individual managers with investor objectives. Hedge fund managers overwhelmingly (95%) believe that their current compensation model fairly aligns fund risk and performance with investor objectives. However, only half of investors agree with the managers on this.

The current compensation structure has, on average, 75% of compensation for risk-taking personnel being taken in cash and only around 15% in deferred compensation, with less than half of that subject to any type of claw-back. The vast majority of investors have a strong preference for some type of deferral mechanism, whether of cash compensation, or in the form of equity participation in the fund or management entity. In addition, a large majority of investors also favour a claw-back mechanism during the deferral period.

Improving transparency
Three quarters of hedge fund managers believe that they are providing investors with all the information they want, whereas nearly half of the investors disagree or express uncertainties. There are contrasting views between the managers and the investors as to what information is key: 40% of investors interviewed are seeking full position transparency.
Most investors see the level of leverage as key. The next most important information for investors was identified as largest holdings, asset class and portfolio volatility, liquidity and risk information. Counterparty risk or stress testing have not been identified as key information by the investors. One could interpret this in a number of different ways – for example, that post-Lehman, disclosure of counterparty risk goes without saying.

Investors are facing the ongoing challenge of how to process information provided across a wide range of managers and to consolidate it into a meaningful and useful form. This entails significant infrastructure, both technical and human and this comes at a cost which should not be underestimated

AIFM looms
Voted in November 2010, the AIFM Directive will have a profound structural impact on the hedge fund industry, both in Europe and internationally. While the main focus of the Directive is on managers, the Directive will not only impact European Union and non-European Union managers, but also EU and non-EU domiciled Alternative Investment Funds (AIFs), the service providers to these funds and their investors.

Briefly, the Directive lays down requirements which must be met by an AIFM, covering authorization, capital, marketing, remuneration, conduct of business, conflicts of interest, functions and service providers and transparency. Specific provisions cover the use of leverage and acquisition of major holdings and control.

In return for more regulation of AIFM, their service providers and funds, the proposed Directive provides for the introduction of passports enabling AIFM to offer their management services and market their AIF throughout the EU.

The AIFM Directive attempts to address a number of the challenges the hedge fund industry has faced since the financial crisis introducing a number of requirements:

• On restrictions introduced, periodic disclosure to investors on AIF assets which are subject to special arrangements arising from their illiquid nature and, more generally, liquidity management obligations (including the regular use of stress tests);

• On fees, overall disclosure to investors on fees, charges and expenses directly or indirectly borne by investors and on any preferential treatment obtained by other investors;

• On remuneration of managers, policies should not promote undue risk taking, must be based on long-term incentives, and involve detailed requirements on remuneration structures and on total remuneration and breakdowns of the AIF;

• On transparency, disclosure to investors (before they invest) on:

– The use of leverage by the AIF and the risks;
– The amount of leverage employed and any collateral reuse (regular disclosure);
– The current risk profile of the AIF and the risk management systems employed by the AIFM to manage these risks (periodic disclosure).

These are specific provisions of the AIFM Directive. However, our view is that the Directive needs to be considered firstly from a strategic perspective, and secondly from a compliance perspective.

A strategic rethink in each sector
The first challenge for managers of AIFs is to conduct a strategic review of their fund ranges and operating models. Managers should ask the basic questions of: who are my current investors in the context of the Directive? Will they be able to continue to easily access my products? Will the Directive open new distribution opportunities? What should my future fund range look like in order to meet investors’ needs? What organizational model should I implement in order to meet the more demanding requirements of the Directive?

Such a strategic review should generally be performed on a case-by-case basis at group or manager level, and will therefore be likely to go well beyond the local domicile of the product and/or manager. It will, for example, cover potential re-domiciliation of funds, changes in operating models and changes to advisory and delegation arrangements.

Hedge fund managers primarily access EU investors through the private placement of a mix of offshore and onshore funds. Private placement requires compliance with an array of individual country private placement rules and regulations. I believe that many managers will eventually opt to set up new structures and operations onshore in the EU because:

• EU AIFM with EU AIF will use the passport to market their products to professional investors in their home Member State and other Member States;

• An AIF brand will emerge, reflecting the global success of the UCITS brand;

• Institutional investors (which represent over 70% of the total hedge fund investor base) already expect the managers of AIFs to have infrastructure, a governance structure and compensation models which in many cases will be similar to what is set out in the AIFM Directive.

The majority of existing funds will be retained in their current state. Managers with offshore hedge funds sold to European investors may consider setting up parallel onshore and offshore structures – the onshore structures dedicated to investors who require or prefer an EU structure and/or full compliance with the AIFM Directive, and the offshore structures dedicated to those who do not.

Luxembourg, AIF hub
Over the past 20 years, Luxembourg has established itself as an alternative fund center offering a complete range of alternative investment funds, as well as a place of establishment for an increasing number of managers. Luxembourg alternative investment fund structures set to fall within the scope of the Directive include, inter alia, the regulated specialized investment fund (SIF), which can be used to create alternative funds of any asset class, including hedge fund strategies. Today, Luxembourg administers around $180 billion of hedge fund assets in addition to $220 billion in the so-called alternative UCITS, or NewCITS. Seven of the top 10 global hedge fund asset servicers are based in Luxembourg offering fund accounting, shareholder register and transfer agency, risk management/compliance, depositary/custodian, legal and a large array of distribution support services such as cross-border taxation computation/reporting, registration and translation. These service providers leverage the network of their competency centres throughout Europe and beyond.

Luxembourg alternative investment funds captured by the scope of the Directive include, inter alia, the regulated SIF, which can be used to create alternative funds of any asset class, including multi-asset class. Many in the industry see Luxembourg AIF structures as the optimal solution. Alternative investment groups already in Luxembourg will opt to keep, and substantially reinforce, their current Luxembourg fund ranges. Luxembourg will, through its value proposition, appeal to the others. The key drivers that will influence AIFMs to choose Luxembourg as their EU and international hub for alternative investment funds include:

• Renowned expertise in the cross-border and international distribution of all types of investment funds (and of course leveraging its current 80% UCITS cross-border market share) and Luxembourg brand enabling a Luxembourg-domiciled fund structure to access many distribution channels which others may not;

• Country risk profile, reputation of stability in relation to such issues as personal and corporate taxation and domestic legislation, ability to use Luxembourg fund structures to achieve tax neutrality, infrastructure, qualifications of the workforce, and service provider expertise;

• Established system of regulation and prudential supervision, which matches up with many of the AIFM requirements.

AIFM solutions
In general, Luxembourg AIFs are managed by Luxembourg incorporated management company (ManCos). An AIFM must provide at least the investment management services of portfolio management or risk management to the AIF.

Managers are considering the following alternatives to create a Luxembourg AIFM-compliant manager:

• Upgrading their current AIF ManCo;

• Creating a joint venture ManCo with other groups;

• Appointing a third party Luxembourg based ManCo;

• Given the convergence of the principles of the regulation of UCITS ManCos and AIFM (e.g., on rules of conduct and conflicts of interest), using a single Luxembourg ManCo for their UCITS and non-UCITSranges;

• Following a self-managed route where the Luxembourg AIF itself will become AIFM-compliant.

With a view to attracting highly skilled employees to Luxembourg, in December 2010, the Luxembourg tax authorities introduced a beneficial income tax regime for expatriates.

Last but not least, groups will need to carefully consider which services to insource, and which to delegate under the strict delegation requirements of the Directive (e.g., to administrators, valuers and other specialist service providers). They may, for example, consider delegating compliance to a single hub for all the management entities of the group.

Conclusion
The challenge of the hedge fund industry lies in effectively managing the multi-faceted agenda of transparency, governance, compensation, liquidity and operating model issues. All of these became apparent during the financial crisis and are reflected in substantially enhanced regulation.

From a European perspective, the AIFM Directive will drive significant restructuring, with onshore entities playing a much greater role. Luxembourg has a variety of factors which may make it the domicile of choice for AIFs and for many AIFMs and their service providers.

At the same time, hedge fund managers must ensure that they continue to deliver on their promise of consistent superior performance, without morphing back into the broad traditional investment fund industry.