In a wide-ranging interview with the leaders of Ernst & Young’s (EY) Global Hedge Fund Practice, The Hedge Fund Journal explores trends in the industry and how EY goes about helping its clients meet the challenges they face.
EY is the most global of the Big Four accounting firms due to its Global Financial Services Office structure. The Global Hedge Fund Practice sits squarely within that structure. The hedge fund practice has operated in this way as a cohesive group of professionals around the world for more than 25 years. “The practice combines width with unrivalled depth across the globe,” says Global Asset Management leader Ratan Engineer. The cohesion comes from people who have worked together for a long time and understand the need to be responsive to a client issue, however remote from their home base. “It retains the touch and feel of an entrepreneurial business: people know and trust each other instinctively,” says co-leader of the Global Hedge Fund Practice, Michael Serota.
1) Consolidation versus fragmentation
There is considerable debate about whether the industry is maturing and therefore inevitably consolidating. Consolidation appears unlikely as an industry-wide phenomenon. The industry manages $2.5 trillion and has some 9000 managers so it is highly fragmented. “What is certainly true,” says Arthur Tully, co-leader of the Global Hedge Fund Practice, is that “there is evidence of flows concentrating on the larger funds and institutions assessing the market directly as fiduciaries”.
You would imagine that EY remains focused on the largest managers and funds but, says Serota, “we remain very keen to support start-ups and entrepreneurial business: it’s in our DNA.” This no doubt comes from EY being early to focus on the industry in a professional and organised way in the late 1980s and early 1990s – many of those start-ups are now iconic names in the industry.
Barriers to entry have increased with greater participation from institutional investors and far greater regulatory scrutiny and imposed compliance standards. “We see a steady stream of start-ups”, says EMEIA Practice leader, Julian Young, “but they often come endowed with assets and are more ‘fully-formed’ as businesses with thought given to the middle and back office”. A number of these are secondary lift-outs from existing funds.
It has become a generally tougher environment. Investors do far more due diligence than they used to and the combination, in Europe for example, “of short-sale restrictions, custody requirements, AIFMD, transaction taxes, to name but a few, have all taken their toll,” adds Young. Break-even level for operating as a business has risen considerably.
Yet despite these daunting obstacles, EY is still very interested in helping start-ups with their corporate and partnership structures, advising on jurisdictions and compensation structures, and holding their hands through the mass of regulations. Some will no doubt fail, but many will grow to become major clients of the firm and demand a full panoply of services. “Watching and supporting such growth in our limited way, is reward in itself,” says Serota.
2) Combating costs and generating operational efficiency
“Managers need to re-evaluate their entire infrastructure and operating platforms in order to cope with growth and deal with the questions from investors and regulators,” says Samer Ojjeh, EY’s US Hedge Fund Advisory leader.
Institutionalising the back office is becoming expensive, and managers cannot avoid these costs as “governance requires back offices to provide stronger oversight and focus on fewer processes,” says Ojjeh. At one extreme is a manager’s decision to hire a second administrator to duplicate the role of the primary administrator. Such a model is too expensive for most managers. At the other end of the spectrum, self-administration is also very rare now. In between these extremes, managers have many choices over which processes to shadow. EY has helped many managers carry out a cost/benefit analysis that emphasises oversight and governance rather than duplicative activities. The areas that are most critical which still need to be shadowed are valuation and reconciliations.
Prime brokers and fund administrators continue to upgrade infrastructure and architecture to support an evolving industry. These service providers must be nimble with technology, reporting and data management capabilities – as “hedge funds are always hungry for more normalised and enriched data,” says Ojjeh.
Administrators should not assume that hedge funds are captive clients cemented by the inertia factor. Managers can and do increasingly switch fund administrators in search of better systems, more timely and accurate data and broader strategy coverage. In response, many administrators are also enhancing their operations to provide better solutions to managers.
EY has worked with many hedge fund managers in assessing infrastructure and building operating models to support strategies, determining where automation can be embedded, and in reducing the number of redundant processes and breaks. Managers need to determine how to extract the most value out of systems, integrate them and build reporting capability to service all areas and stakeholders such as firm principals, portfolio managers, compliance, risk and so forth. They need best-of-breed systems, configured and integrated to optimise the functionality of packages, “so that an industry bombarded with demands for data can cope,” says Ojjeh.
3) Asia Pacific – still optimistic and less fatigued
The obsession with costs and regulation that so haunts the US and European markets is much less evident in the vibrant markets in Asia. “Break-even levels are lower and growth is still the single-minded focus of most funds,” says Brian Thung, EY’s practice leader in Singapore, a fact echoed by George Saffayeh, his counterpart in Hong Kong. “The costs of operating an asset manager depend on many factors including the structure you start with, the build-out of your platform, what you develop in-house versus outsource and the consolidation of functions across service providers,” says Saffayeh. “We assist our clients by helping them make the right choices in each of these areas which will prove critical in the medium term”. Although break-even levels are probably higher in Hong Kong than Singapore, the costs of doing business are still significantly lower than in the US and Europe and the entire environment is different: “The authorities here want you to abide by the rules but want you to succeed in building businesses,” says Thung. “The atmosphere is welcoming, not hostile, and the infrastructure is designed to help you succeed,” he adds.
As a natural area for funds to invest, Asia is beginning to attract talented managers from all around the world as well as building talent locally. This gives rise to a series of issues around the movement of human capital, an area where EY has a highly developed practice. Dealing with these issues is often fraught with a combination of legal, tax and regulatory issues overlaid by highly charged human emotions. “You need to come up with pragmatic solutions that are acceptable rather than search in vain for the ‘right’ answer,” says Saffayeh, having gone through some of the traumas of relocating himself.
The regulatory agenda has somewhat dominated the discussion in recent years and there is a slow return to a focus on growth and rewards rather than purely on risk. The regulatory landscape may be unsettled but a large part of EY’s job is to assist clients through the morass. For example, pan-European distribution “does not have to be a two-cornered fight between UCITS and AIFMD,” according to Luxembourg leader, Michael Ferguson.
Smaller hedge funds and other alternative managers may find it makes more sense to redefine their role as an advisory one, and plug into a third-party AIFMD-approved manager to handle the operational, risk management and compliance issues. “Luxembourg has pioneered the concept of a third-party management company and its service providers have plenty of experience at doing this,” adds Ferguson.
Yet the patchwork quilt of regulations worldwide remains a challenge for the industry. EY appreciates that regulators need to be able to assess and attempt to control systemic risks and need to collect the data and information to do so. There remains a risk that some hedge funds could become systemically important, even if there is little evidence to suggest any are at present. “As some hedge funds move into originating loans and mismatching debt maturity they may look increasingly like shadow banks and may become regulated accordingly,” says Engineer, but this is hardly an excuse for the never-ending, uncoordinated hammer-blows of regulation hitting the industry.
Ojjeh estimates only 30% overlap between AIFMD and Form PF reporting requirements, with another 30% of questions being similar while the remaining 40% are completely different. An integrated approach is needed because multiple regulatory filings need to be consistent with one another – and with the firm’s own records. That requires holistic systems for data warehousing and manipulation. EY has helped many firms develop architecture and infrastructure to deal with this onslaught of regulatory filings.
The aspiration to harmonise globally both regulatory reporting and investor risk was demonstrated by the Open Protocol submission to ESMA, which was signed by hundreds of illustrious institutional investors. These high hopes, alas, have so far not materialised with Australia’s ASIC regulator the only one so far to adopt Open Protocol. All Australian pension funds and externally verified derivatives, however, require a Derivatives Risk Statement (DRS), says Sydney practice leader Mark O’Sullivan.
O’Sullivan, who has chaired the local AIMA chapter, is also pleased by the increasingly constructive attitude of the local regulator. ASIC had been criticised for its capricious behaviour over short-selling bans, but since then ASIC has taken the time to consult the industry before changing policies.
Regulatory exams are also getting longer and tougher. They can involve as much as nine months of intermittent visits for larger fund complexes, while sweep exams might last an intensive two days or two weeks. Natalie Deak, partner in the New York Hedge Fund Practice, notes, “the regulators are bringing in talented, experienced and knowledgeable people”, and are not likely to be satisfied with superficial or short-cut answers. So EY also spends a lot of time readying clients for examinations, with mock reviews to go through routines for policies and procedures. Firms need to automate and document rigorous processes so that regulators can easily see an audit trail and receive explanations of assumptions. EY has been helping firms to prepare their front, mid and back offices ahead of regulatory deadlines.
Ireland was one of the first countries to transpose AIFMD into law. Some managers have already registered, but Ireland practice leader Eoin MacManus says that “people are still grappling with what AIFMD is, and there is an impressive amount of misunderstanding”. Consequently, alternative managers all over Europe are “leaning more heavily on EY to help with the AIFMD reporting requirements,” says MacManus, while other service providers including depositaries are also calling upon the expertise of EY to upgrade their own processes, controls and systems.
Strict depositary liability essentially requires that physically held assets have to be replaced by depositaryor trustee. Therefore, due diligence needs to be done at the sub-custodian level to identify the risks of assets being lost. This in turn means trustees (and investment fund boards) need to focus on procedures, processes, markets and any third parties to whom liability has been discharged. EY has been asked to carry out quite a lot of gap analysis, advising depositaries on how to upgrade their processes, and there is heavy investment by the depositaries in this area.
The so-called exotic funds in frontier markets, or other places without a developed regulatory environment, may face the highest increases in depositary costs. Early indications are that depositary fees could rise by two or three basis points on average. On top of higher direct fees for depositaries, administrators will need to charge more to help with regulatory reporting, and some firms may have to set up dedicated regulatory departments. Ultimately, these costs often get passed on to end investors, and EY surveys have identified investor angst about the growing incidence and magnitude of such costs being passed on.
As “large sections of AIFMD were initially copied and pasted from UCITS,” says Ferguson, managers who already managed UCITS have had 25 years of experience in dealing with product and management regulation. These managers can expect to have to enhance existing procedures and controls, rather than starting from scratch to qualify for a “Super-Manco” dual licence to handle both AIFMD and UCITS products. The greatest challenges may be faced by non-European-domiciled funds that have to switch from a private placement and reverse solicitation distribution model to become compliant with the AIFMD. In any case EY expects to see a significant uptake in AIFMD licences being awarded beginning in late 2013 and early 2014.
Asia also raising regulatory game
“All jurisdictions are ramping up regulatory requirements and Singapore is no exception,” says Brian Thung. Gone are the days of exempt regimes, zero capital requirements, and light-touch regulations. Since August 2012 even firms with assets beneath SGD $250 million (US $200 million) and fewer than 30 accredited investors have to register, while those above this threshold must be fully licensed. In one respect, however, Asia — including Singapore — is less restrictive than the US and the EU: remuneration is still set by market forces without interference from regulators.
Many changes afoot worldwide
Taking the UK as a case study, in general, both anti-avoidance legislation and changes in public opinion have “profoundly changed the environment” in terms of what is and is not appropriate tax planning, says UK hedge fund tax leader Fiona Carpenter. “Old-fashioned tax schemes are a thing of the past: there is a strong trend now toward revenue approved planning arrangements,” says Carpenter. Funds and fund managers can still optimise tax efficiency by looking at relocating operations, securing capital gains status where applicable, keeping trading activities offshore and using double tax treaties.
Substance has always been a key requirement for any businesses or funds using low-tax jurisdictions, but awareness of this has been heightened by recent cases such as those of Google and Starbucks. “People appreciate more than ever that they need to give more care and attention to transfer pricing,” says Carpenter. She is also seeing managers devote more care and attention to the location of operations. If a manager is keen to set up operations in a low-tax jurisdiction, Carpenter encourages them to look to locations where they have a natural connection, so it is more realistic and sustainable to build a business there. For example, if an individual is prepared to live and work in Malta, whilst it is not necessarily the lowest tax jurisdiction, it is very often better than seeking to move to a lower tax jurisdiction. Similarly, “letterboxes” are insufficient to obtain the 10% corporate tax rate for Singapore fund managers or investment advisors.
Hedge funds should not take their tax status for granted – sometimes they need to manage it to secure the best available treatment for investors. A number of countries, including the UK, have anti-avoidance provisions designed to tax gains from offshore funds as income rather than capital, or at higher rates. Usually where certain specified conditions are fulfilled tax authorities may permit this treatment not to be applied for some hedge funds. In the UK, for example, providing the fund is deemed to be investing as opposed to trading, and the fund applies for Reporting Status, UK individual investors can pay capital gains rather than higher income tax rates on gains on disposal. Surprisingly few UK hedge funds have so far availed themselves of UK Reporting Status although the initial and ongoing process for doing so is far from onerous.
The US is not unique in treating carried interest at multiple rates. The UK, in fact, has a similar treatment so long as specific criteria are met. Crucially the carried interest has to sit inside the fund, and cannot just be a fee. Convergence between hedge fund and private equity structures might allow some less liquid hedge funds to make use of these rules. Many governments and authorities are closely scrutinising the taxation of carried interest, despite the fact that it remains politically important to encourage private enterprise.
Double tax treaties (DTTs) are of limited benefit to many hedge funds that do not hold assets for long enough to receive significant amounts of dividend or coupon income. Hence, tax-neutral Cayman’s absence of DTTs is not a drawback for many strategies (and some funds in tax-neutral domiciles can, in any case, set up special purpose vehicles elsewhere to make use of DTTs). However, as hedge funds evolve and move into loan portfolios, Carpenter expects to see more funds established in jurisdictions such as Luxembourg, Ireland and Singapore that do have DTTs.
AIFMD provides a case study of how regulatory plans for bonuses can have unintended effects. Although AIFMD does not have direct tax implications, the implications of its rules on remuneration can be profound. Deferring part of bonuses can create tax complications that could result in negative cash flows for both management firms and individuals (as pointed out in a recent EY article for The Hedge Fund Journal).
Ignore FATCA at your peril
Like other regulations, FATCA has been delayed, but funds are now preparing in earnest for FATCA rules coming into force in 2014. EY has been working with funds and fund administrators to help them satisfy the needs of hedge funds to supply data to the tax authorities. Funds are at different levels of readiness: EY’s Serota thinks that larger funds have generally had sufficient advice – from tax advisors – to get up to speed. Non-compliance is not a realistic option when the 30% penalty applies to the gross sales price of assets and not to gains or income.
6) Domiciles, jurisdictions, fund structures and distribution
Cayman reigns supreme but other domiciles offer unique attractions
Dan Scott, managing partner of EY’s Bahamas, Bermuda, British Virgin Islands and Cayman Islands Practice, says Cayman remains one of the most popular domiciles because “the legislation provides flexibility and speed to market, and there is a very strong professional infrastructure of service providers”. The ‘three B’s’ are also sought-after domiciles, carving out their own niches in particular areas.
The Bahamas, for instance, is popular with funds from Latin America and Brazil in particular. The British Virgin Islands are often used for Asian products. Bermuda leads the market for reinsurance-wrapped funds although some are also domiciled in the Cayman Islands.
Offshore hedge fund-backed reinsurers
Hedge fund-backed reinsurers are attracting more attention thanks to some high-profile IPOs and firms that have taken advantage of the manifold benefits afforded by these structures. Firstly, as EY discusses in Offering a Case for Convergence, the returns from insurance-linked securities are uncorrelated with those from conventional asset classes. Secondly, any student or disciple of Warren Buffet’s will be familiar with the concept of “free leverage” provided by the “float”. “Reinvesting premiums typically gets you to 1.5 or two times the original capital for investing,” says Scott, who adds that publicly listed hedge fund-backed reinsurers give investors daily liquidity and give managers permanent capital. The first movers in setting up hedge fund-backed reinsurers have been multi-billion-sized funds. However, a new incubator structure has been created in Bermuda allowing asset managers to set up their own reinsurer, for a relatively small initial investment, removing some of the execution risk while simultaneously dramatically reducing the time and cost to set up a hedge fund-backed reinsurer. EY advises many of the largest firms in this area and provides assistance beginning with the first steps of formation all the way through IPO and beyond.
Ireland and Luxembourg
Dublin and Luxembourg together have 90% of Europe’s cross-border UCITS (i.e., mutual funds) fund domicile market. EY advises clients with funds domiciled in both locations, and is always happy to give clients the pros and cons of each.
Luxembourg investment funds have been around longer, since 1988, and have more assets: $3.4 trillion, of which $2.7 trillion is UCITS, while Dublin, which entered the market in 1998, has $1.7 trillion, of which $1.4 trillion is UCITS. Dublin’s cross-border domicile is complemented by its market leadership in servicing non-domiciled hedge funds, particularly those in Cayman.
The principal criterion for choosing a fund domicile is “which markets funds want to distribute into,” says Ferguson, and what the investors’ (especially institutional investors and the local fund distribution network) preferences there are. Ferguson highlights that the marketing passport available under AIFMD should eventually streamline the costly and cumbersome process of seeking separate approvals in each country. Indeed, if some countries shut off or severely restrict private placements altogether, the Directive may become the only route.
Hong Kong gateway to China
When and if agreements are finalised, the mutual recognition platform allowing Hong Kong-domiciled funds to be sold in the mainland, and vice versa, will be a huge milestone for the industry. It will continue to support Hong Kong in achieving its aspiration of becoming the major international asset management centre in Asia. Hong Kong is also a good base from which to obtain the necessary licences and access for investing into mainland China. EY’s structuring experts can assist with jurisdictional, organisational structure and tax efficiency issues, says Saffayeh. While the firm does see many benefits in Hong Kong as a jurisdiction to domicile funds, most managers so far have viewed a Hong Kong domicile as complementing rather than replacing fund structures domiciled elsewhere.
Directors devoting more time to duties
EY is keenly attuned to the corporate governance debate. As regulators around the world make changes to corporate governance code, they must keep front of mind what they are trying to achieve and for whom. Michael Lee, markets leader in the Global Asset Management Practice, comments, “the purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management of a fund to help ensure its long-term success. Governance is the system by which funds are directed and controlled for the benefit of investors”.
Dan Scott thinks that EY was selected to carry out the Corporate Governance Survey for the Cayman Islands Monetary Authority (CIMA) because of the firm’s global reach – and also its reputation for carrying out research independently. Scott has received “good feedback and insights” on the survey, with independence, capacity and disclosure of directorships the issues that aroused the greatest interest.
Scott expects greater debate over how to define the notion of independence: are service providers such as administrators and lawyers, who offer director services to existing clients in fact independent? Regarding hard ceilings on numbers of directorships held, Scott argues that a fixed number seems “arbitrary and challenging”. He suggests that one or two “extremely complicated funds with esoteric trading strategies” could be more time-consuming than “an umbrella structure of funds trading vanilla securities, which could be very straightforward and not complicated in the least”. “In the end,” says Scott, “the regime should ensure disclosure and transparency such that investors can decide on matters such as the capacity or independence of directors”.
As far as Cayman is concerned, Scott expects CIMA will spend some months digesting the results of the survey and consulting with stakeholders, before promulgating policies. Ireland already has a voluntary corporate governance code, endorsed by the Central Bank of Ireland, and observed in practice by the vast majority of funds. In Luxembourg, boards of directors have a duty to do due diligence on selecting service providers including depositaries – and here, for example, the Luxembourg regulator requires written due diligence on all UCITS service providers, not just trustees and depositaries. Luxembourg’s regulator also stipulates that monitoring and oversight are the ultimate responsibility of the board.
The Luxembourg local fund association, ALFI, also has issued a detailed corporate governance guide discussing the role of directors and is active in providing continuous education programmes. Ferguson has noticed boards much more engaged with all service providers, including auditors, which regularly formally report to boards. Although no hard limit exists on the number of directorships, the number of board mandates held by directors is one factor that is considered, along with their qualifications and competencies. While each fund is different, the number of hours devoted by directors has greatly increased, and between formal meetings directors are continuously scrutinising changes to key documents.
As the industry has matured, succession for its founders has become an increasingly important theme. The original model, in which the founders never had any intention of building a “business”, and in which, therefore, nothing would outlive them, has been superseded by founders wanting to ensure a smooth transition to the next generation without major losses of assets. In some cases, they have succeeded admirably; in others, an abrupt departure has been followed by significant redemptions. These issues need careful, thoughtful planning and execution and are becoming increasingly important as institutional investors are far more inclined to back firms and processes rather than individual stars. “EY has had innumerable discussions with founders as to their succession plans, encouraging clarity of intent and assisting with smooth handovers,” says Deak.
As with the industry, so with EY — except that the firm was always built as an enduring business. EY has developed long-standing processes to pass on the baton and give younger people the limelight who increasingly express themselves through leadership forums, conferences, surveys and thought leadership pieces.
“Thought leadership is our way of giving something back to the market,” says Lee, who adds that EY professionals “love writing articles and giving speeches.” Since 2007, EY’s Annual Global Hedge Fund and Investor Survey has become one of the most authoritative barometers of industry opinion. The survey is deliberately designed to canvass differences of opinion between investors and managers anonymously. The EY Hedge Fund Symposia are also an important fixture in the calendars of managers, allocators and service providers. Throughout the year, EY also publishes ad hoc updates to keep clients apprised of the latest regulatory and other developments. The firm also sponsors numerous external surveys, such as The Hedge Fund Journal’s 50 Leading Women in Hedge Funds survey and the Tomorrow’s Titans survey. Interestingly, one of the fifty leading women, Fiona Carpenter, was the CFO at TT International and returned to EY recently to take up her new role.
In addition to providing thought leadership and timely commentary on latest developments, “we are also active in industry associations and forums such as AICPA, MFA, AIMA and ALFI, as well as charitable organisations such as Hedge Funds Care and Robin Hood Foundation,” says Serota.
EY remains confident about the continued growth of the industry, and continues to invest heavily in the sector. EY has no worries at all about its own succession plans. “Our investment, like the industry’s, is largely in people, and we continue to attract the best people to serve the industry and its multiple stakeholders,” says Engineer. “We are particularly encouraged by the number of strong younger partners now in the practice, and it is hugely gratifying to note that the next generation is brighter, smarter, hungrier and far better-rounded as individuals than we could ever hope to be,” adds Tully.