Convergence and Evolving Distinctions

How will Europe define “hedge funds”?

JAMES TINWORTH, PARTNER, STEPHENSON HARWOOD (LONDON)

Many commentators have talked about, and continue to talk about, the convergence between “alternative” and “traditional” fund management. This article considers what this actually means and explores how this convergence has been happening in Europe.

Hedge funds have tended to be defined by what they are not, as opposed to what they are. Given this convergence, and the distinctions made by the framework of the Alternative Investment Fund Managers Directive (AIFMD), the article concludes with some thoughts on how Europe may define hedge funds in the future.

Alternative to what?
The talk of convergence began in earnest after UCITS III (which, among other things, relaxed the restrictions on the investment in derivatives by UCITS). The traditional distinction between “long only” and “alternative” was replaced by the distinction between “UCITS” and “non-UCITS”. This latter distinction has been cemented by the AIFMD and now any fund that is not a UCITS will be an “alternative investment fund” under EU law.

Convergence of techniques and strategies
I will come back to the contribution of regulation later but any discussion of convergence needs to start with UCITS III.

After UCITS III, traditional fund managers started launching UCITS funds that used techniques and strategies that are more usually associated with hedge funds (e.g. long/short equity strategies). On the other hand, hedge fund managers started launching onshore UCITS versions of their offshore hedge funds and sometimes long-only funds.

Convergence of investors
It is important to note that hedge fund managers did not start launching UCITS in order to access the retail market. Historically, high net worth investors accounted for the majority of assets under management (AUM) in hedge funds. Over the first decade of the century, however, institutional investors came to account for the majority of hedge fund AUM.

The concerns of the institutional investor (particularly during, and immediately after, the financial crisis) were stereotyped into the mantra of transparency, liquidity and regulation. UCITS were felt to address these concerns.

Whilst UCITS are retail products, direct retail investors account for the minority of AUM of the traditional fund management industry. The clear majority is provided by institutional investors. Institutional investors therefore now account for the majority of AUM in both hedge funds and “traditional” funds.

Whilst the breakdown of the institutional investors differs between the two industries, there is an increasing overlap and institutional investors tend to want fund managers to have more of an institutional approach.

Convergence of infrastructure and operations
The institutionalisation of hedge fund investors has therefore contributed to the institutionalisation of hedge fund managers themselves. Hedge fund managers have had to focus more on non-investment functions and strengthen, in particular, risk management, compliance oversight, reporting, corporate governance and related systems. The model of two guys, a dog and a Bloomberg screen is no longer realistic for most hedge fund managers and was never possible for traditional fund managers.

As an aside, the traditional fund management industry sometimes appears to have been more about the manager’s brand (i.e. Legal & General, Aviva etc.) than individual portfolio managers, whereas the hedge fund industry has been the other way around. This is changing, however, particularly in relation to the larger hedge fund managers, and transition planning andthe avoidance of key man risk are becoming increasingly important.

Convergence of regulation
The AIFMD will specifically regulate “alternative investment funds” (including hedge funds) on an EU-wide basis for the first time. The AIFMD contains a number of requirements that are common to the UCITS Directive and some that may go further than the current UCITS requirements (e.g. those requirements applicable to depositaries and remuneration). Additionally, ESMA’s advice to the Commission proposes alignment with the UCITS Directive requirements where there is commonality.

The UCITS V Directive will introduce measures that correspond to the more onerous requirements of the AIFMD and will thus lift the regulatory bar for UCITS higher than the regulatory bar for alternative investment funds (AIFs).

The point, however, is that hedge fund managers will now be required to comply with rules that have previously only applied to managers of UCITS funds. In the UK, for instance, both UCITS managers and AIF managers (AIFMs) will be subject to the FSA’s proposed FUND sourcebook.

The impact of convergence on the definition of “hedge fund”
Richard Bookstaber said that “the hedge funds/alternative investment moniker is a description of what an investment fund is not rather than what it is”.

Historically, the starting point for a definition of “hedge fund” has been that hedge funds are not long-only retail funds (i.e. mutual funds). To supplement this definition, the characteristics that were most commonly associated with hedge funds were then considered: hedge funds are “offshore” (often in a favourable tax/regulatory jurisdiction), they have flexible investment powers (often including short-selling, derivatives and leverage), they pay performance fees to their managers, they have relatively high minimum investment restrictions, they are seeking to generate alpha, they are aiming to deliver absolute returns rather than to beat a benchmark etc. There are many UCITS funds that have these characteristics, hedge funds are increasingly using performance benchmarks and hedge fund indices are increasingly being used to monitor, or promote, performance.

The classic distinctions between “long-only” and “alternative”, “retail” and “non-retail”, “onshore” and “offshore”, “regulated” and “unregulated” have either become no longer applicable or too blurred.

The definition of “hedge fund” in the post-AIFMD EU
The definition of “hedge fund” in Europe will inextricably be linked to the AIFMD and the EU’s approach. In the post-AIFMD EU, UCITS cannot be “hedge funds”. Hedge funds can only be (EU or non-EU) AIFs.Hedge funds will share the AIF label with, among others, private equity funds, real estate funds and funds investing in alternative assets (e.g. art, wine etc.) as well as Non-UCITS Retail Schemes and investment trusts.

Whilst the AIFMD has numerous references to the “type” of AIF or AIFM, in its mapping out exercise to establish the types of AIF which currently exist in the EU, ESMA declined to identify a specific category for “hedge funds”. ESMA noted instead that funds which are typically referred to as hedge funds will fall, in particular, under three identified categories of existing AIF.

ESMA proceeded to apply the framework of the AIFMD in order to identify the “types” of AIF, namely: open-ended and closed-ended AIFs, AIFs that are significant in size, AIFs that are leveraged or employ substantial leverage, internally managed AIFs, externally managed AIFs and AIFs that contract with a prime broker.

Does the EU actually need a definition of “hedge fund” or will hedge funds generally be open-ended externally managed AIFs, which are leveraged and contract with a prime broker?

It doesn’t really roll off the tongue, does it?
The AIFMD, however, has numerous references to the “investment strategies” of AIFs. For example,Article 8(4) provides that national regulators of an AIFM “may restrict the scope of the [AIFM’s] authorisation, in particular as regards the investment strategies of AIFs the AIFM is allowed to manage”.

To be fair to ESMA, it actually went on to say that “[c]onsideration of the investment strategies employed, for example, is more of relevance to competent authorities in the context of their regulation of the AIF.” So perhaps the EU will view “hedge funds” as AIFs that pursue certain investment strategies such as long/short equity strategies.

Hang on though. What about UCITS that pursue those same strategies? Don’t be silly. In the post-AIFMD EU, UCITS funds cannot be “hedge funds”. UCITS funds are “mainstream”; anything else is “alternative”.