Dechert LLP: Funds and European Regulation Update

A constructive outlook for Europe’s hedge fund industry

The Hedge Fund Journal spoke to three of Dechert’s London office partners, who highlighted notable trends and issues in the often inter-related areas of fund formation; domiciles; global fund distribution; credit funds; multi-manager structures; fee structures; MiFID II; PRIIPS, and derivatives reporting.

Dechert offers ‘jurisdiction-neutral’ advice, by virtue of its global network of offices (and relationships with law firms from other domiciles).

European domiciles: Ireland, Luxembourg and others

Dechert received The Hedge Fund Journal Awards 2018 award for ‘Leading European Practice – London, Dublin, Luxembourg, Frankfurt & Paris’. In all of these locations and many more, Dechert’s corporate, regulatory and tax lawyers advise managers and funds on optimal structures and domiciles. Dechert partner, Chris Gardner, who specialises in credit, private equity and real estate funds says: “For credit funds, for instance, the OECD’s BEPS initiative can strengthen the case for having both fund and downstream structures in the same domicile. Hence, Luxembourg has picked up many structures, as it has a good Double Tax Treaty network, and is popular with continental European investors. Some private equity and credit funds have opened offices in Luxembourg with several staff, and they expect to be there for the long term”. Dechert partner, Abigail Bell, who featured in The Hedge Fund Journal’s ‘50 Leading Women in Hedge Funds 2017’ report in association with EY, agrees: “Luxembourg is the natural place to set up credit strategies, with a flexible partnership structure and the optionality to add downstream structuring to assist in managing the tax position”.

Ireland has not historically had the same presence in credit, but more flexible rules for loan origination funds now allow them to hold non-debt instruments. “The previous restrictions were quite constraining,” reflects Gardner.

“For European funds marketed cross-border, most structures use Ireland or Luxembourg,” Gardner finds, though there are exceptions. “Dechert has also been doing work with a Maltese angle for more than ten years,” he reveals. In the onshore space, we have seen increased deal level activity and investor interest in both France and Germany. Gardner points out that “In France, a loan origination fund has to use a domestic French structure or a European Long-Term Investment Fund (ELTIF). Our Paris office has been helpful in creating such funds”. Gardner notes that German pension funds and insurance companies have special tax and regulatory requirements, which Dechert’s network of German offices can advise on, in addition to setting up domestic German structures.

We expect to see continued symbiosis between private equity and private credit.

Chris Gardner Dechert LLP

Delaware and Cayman

“Most new start-ups talk about Europe, but the majority do not immediately set up a European vehicle,” says Bell. “In addition to the marketing angle, different strategies can also lead to different structures. More liquid alternative strategies are more likely to be housed within Cayman and Delaware structures,” Bell observes. Dechert’s US offices create public and private US funds.

Offshore and onshore structures can be complementary. A composite structure, combining more than one domicile, may maximise opportunities for asset raising. Says Gardner “a Cayman vehicle is good for raising money in the Middle East, and Luxembourg or Ireland would be on the shortlist for continental European investors”. An example structure using this combination could include a Luxembourg master fund, using Dechert’s team there, and a Cayman feeder fund, created by one of the Cayman firms that Dechert regularly works with. The reverse combination of a Cayman master and Luxembourg feeder is less helpful. “As Luxembourg is more regulated, it takes longer to get a fund established and approved there than in Cayman. A Luxembourg fund managed by an EU manager would also be able to access the AIFMD marketing passport benefits, which would be lost if a Luxembourg fund invested more than 85% of its assets into a Cayman one,” Gardner explains.

AIFMD marketing passports versus NPPRs

Depending on where managers anticipate raising assets, Gardner reckons the marketing passport will often be preferable to the EU’s 28 country-by-country National Private Placement Regimes (NPPRs), as some are costly and time consuming. “There are marked differences in how countries interpret and implement NPPRs. For example, the UK has a simple notification filing to the FCA that takes about two hours, with a relatively small fee. But Germany’s BaFIN regulator makes a qualitative assessment of documents, which takes longer. We inform clients of the costs and sometimes they may reconsider pressing the button in respect of a particular country as they balance ongoing costs with the likelihood of raising assets there. The AIFMD Annex IV submissions also vary by country for the NPPRs, whereas the marketing passport removes friction by allowing one home regulator to gather the data and disseminate it to other regulators,” Gardner elaborates.

World Compass and World Passport

Dechert’s perspective on fund marketing is global, with two online-based systems created to help clients. Dechert’s World Compass gives an overview of fund marketing, distribution and compliance rules, in over 100 countries, for various fund types (hedge, private equity, UCITS, and other open ended and closed ended funds) and in over 65 countries for separately managed accounts and advisory services, both on a private placement basis. “For instance, can marketing people make a phone call, leave a slide deck, attend meetings alone, or do they need to be chaperoned by local distributors?” illustrates Gardner. It also touches on non-fund issues, such as beneficial ownership reporting guidance eg definitions, thresholds and timelines.

Dechert’s World Passport, the brainchild of Dechert partner, Karen Anderberg (who featured in The Hedge Fund Journal’s ‘50 Leading Women in Hedge Funds 2017’ report in association with EY) focuses on AIFs (registered inside and outside the EEA) and UCITS. Dechert can handle local fund registration requirements, and interface with additional service providers where relevant, in Europe, Asia, Latin America and other regions. Dechert can also review literature and websites, and advise on third party distributors.

Dechert has hired Nigel Austin, who was formerly Head of International Compliance at Janus Capital Group, as COO of World Compass and World Passport.

It is about breadth as well as growth: “We see alternative lenders active in a greater cross section of the space than we used to. At one end of the spectrum, there is more niche financing of smaller and medium sized enterprises (SMEs). At the other, there are bigger ticket sizes,” says Gardner. “Some funds are originating their own deals, particularly in special situations, while others focus more on buying secondary pieces, where there are syndication opportunities,” he adds. Dechert is also active in private equity, which sponsors over 80% of companies that borrow through private credit. “We expect to see continued symbiosis between private equity and private credit,” says Gardner.

Traditional lenders’ ongoing deleveraging, especially in Europe, is one driver for private credit but Dechert and AIMA perceive a structural shift in the economic and financial landscapes. “As smaller organisations, private lenders can offer more flexible structures and terms, and execute faster, as there is no need for bank credit committees. There is also a different ethos and relationship, more akin to an equity investor than a debt provider,” says Gardner.

Gardner sees credit funds running the gamut from monthly or quarterly liquidity, out to 8 or ten-year private equity vehicles with commitment and drawdown structures. Dechert’s Dublin and Luxembourg offices can also set up credit UCITS funds with daily, weekly or bi-monthly liquidity.

New multi-manager models

Some managers find creating their own vehicle is too onerous or costly however. “It is becoming more expensive and challenging to set up a standalone asset manager, and very talented individuals want to manage money but not set up their own fund,” says Bell. Three approaches Bell has seen are: “rather than a traditional fund investing in underlying funds, managers are bringing PMs in house to manage a sleeve of a fund. To address liquidity concerns, funds are being set up to take interests in underlying managed accounts, so that the investing fund has more control than in a traditional fund of funds model. The third approach is to set up a fund that appoints third party managers to run a sleeve of the fund, with the fund of funds manager rebalancing allocations according to performance,” says Bell.

“These structures can obtain enhanced counterparty and leverage terms from prime brokers facing the entire pool rather than sub-funds. Prime brokers still calculate margin separately for each sleeve, but if something goes wrong the prime broker has recourse to the entire pool,” adds Bell.

Fees on these structures are being charged at the top level, rather than passing individual PMs’ performance fees through to investors.

MiFID II is bedding in 

Best execution

Surveys suggest many still doubt if they are ready for MiFID II, though Dechert partner, Richard Heffner, is confident that managers can handle some of the routines. “The definition of best execution has not radically changed between MiFID I’s “all reasonable steps” and MiFID II’s “all sufficient steps”. The language is a bit stronger, but the fundamental obligation has not changed significantly. And before MiFID I the UK FCA had its own definition,” says Heffner, who has worked for two of the FCA’s forerunners. Still, those firms that are best execution neophytes must not be complacent – “they need to show that a process was followed, and that steps were taken to obtain best execution,” he points out. Much fuss is also made about the subjectivity of best execution factors, but Heffner says, “there has always been an element of objectivity and an element of subjectivity to defining best execution”.

Some managers are worried about the first round of MiFID II submissions, due in April 2018. Heffner expects regulators will leave managers with some latitude to work out the details of submissions. The national regulators define standards, and Heffner reckons that the FCA’s expectation that firms must take reasonable and diligent steps to comply will be typical of what the others require.

Call recording

Heffner points out that fewer orders are now placed by voice or telephone, with more done online eg via Bloomberg chat, and so automatically recorded. Call-recording requirements are substantially clarified: “managers must not place orders on untaped lines and should record mobile phones if they are to be used in relevant transactions,” he says. Heffner acknowledges that “some grey areas are still being worked through” about which conversations around trading, that do not give trade instructions, need to be recorded.

Defining research

A greater area of uncertainty remains how research is defined, and Heffner points out “the ESMA Q&A suggests that macro research may be defined as research in some cases, but not others”. Heffner does have some degree of confidence that “if a MiFID entity provides materials or literature that it has determined not to amount to “research”, then managers can take some comfort from that”.

Simplicity championed as fee structures proliferate

Dechert naturally sees a huge range and variety of fee levels and structures. On credit funds, “hurdle rates are more tied to actual loans that a fund focuses on. It is more common to see an absolute number, such as 4%, 5% or 6%, than a floating rate benchmark,” says Gardner. Leverage can also be tied to fees. Gardner has not seen funds charging management fees on gross asset value, including leverage. Managers are paying increasing attention to ILPA’s Best Practices recommendations on fees.

Dechert’s experience on hedge fund fees substantially echoes the perennial EY Global Hedge Fund Survey findings. “We are seeing downward pressure on fees with more demand for customisation for founders’ classes, seed investments and accelerator capital,” says Bell. Though tailored terms are clearly fashionable, Bell suggests that “more bespoke structures can be complicated. A more simple and transparent fee structure makes it easier for investors to benchmark fees against other managers. Discounts for founders’ classes are expected”. Regarding MiFID II research costs, anecdotally it seems hedge fund managers are somewhat less likely to absorb them and somewhat more likely to charge them to funds, than are traditional managers (though we have not yet seen comprehensive data).

‘Regulatory arbitrage’ of dropping MiFID: counterproductive and ultimately ephemeral?

A number of global macro hedge fund managers, such as Brevan Howard, Tudor and Finisterre, have recently dropped their MiFID licenses. They now rely on AIFM licenses. MiFID licenses are often used for managed accounts, but AIFM license holders can obtain extended permissions to run managed accounts, without a MiFID license, according to Gardner.

“The issue is MiFID II trade and transaction reporting, which AIFMs need not do,” explains Gardner. “Whether avoiding MiFID really makes sense partly depends on managers’ geographic and intellectual capital footprints,” he goes on. “If managers need an AIFM in one location and a MiFID entity in another, the upheaval of moving staff and infrastructure, and reassigning roles, may be more disruptive than the trade and transaction reporting,” argues Gardner.

He also doubts whether this ‘regulatory arbitrage’ is logical or sustainable. “My hunch is that AIFMD II could read across some MiFID II concepts and impose the same requirements,” he suggests. Bell, too, expects regulators may revisit and revamp the AIFMD’s reporting requirements. (Dechert can provide clients with lists of service providers to help with Annex IV and MiFID reporting).

Derivatives reporting headaches 

Bell, who has a background in equity derivatives at JP Morgan, also thinks managers should work with, and not around, derivative reporting. Bell, who helps to negotiate master agreements and bespoke transactions, is something of an agony aunt for clients’ persistent derivative trade reporting problems: “though reporting has been in force for a number of years, there are still technical difficulties, including bespoke exceptions; fields that must be completed in a specific way; counterparty-specific operational issues, a large number of unmatched trades, and IT problems”.

Bell homes in on a specific IT issue: “Due to operational IT issues, it can sometimes be difficult for managers to physically access systems, get into the reports, and view the fields completed electronically, meaning that they do not have transparency as to what delegates have reported to trade repositories, and so cannot check the accuracy and timeliness of reports.

“As the IT issues are not about contracts, consent or permissions, lawyers cannot always directly help with these problems, but can facilitate introductions to service providers that may offer IT solutions,” says Bell.

“The biggest challenges for reporting will apply where cross-border businesses must comply with multiple sets of obligations,” she adds. If there is potential for entities in some jurisdictions to avoid derivative reporting obligations, Bell “does not think it makes sense to move trade activity to work around, as this is having the tail wag the dog. Managers should decide where to trade, and then work through the regulatory issues”.

Industry and UK outlook

Dechert expects 2018 will be a good year for hedge fund managers as strong asset flows into alternatives continue. Surveys, including one from Preqin, find that the majority of allocators expect to retain or increase allocations to alternatives. Gardner is optimistic about a constructive Brexit outcome because “continental European investors want to access the skillset in the UK fund management industry”.