2014 will continue to be a challenging time for the industry as regulations begin to take effect, further increasing the barriers to entry for new managers. Recent prime broker surveys report increasing global investor appetite, including for new funds. Deutsche Bank’s 12th annual Alternative Investment Survey 2014 predicts $3 trillion hedge fund assets by the end of 2014 (up from $2.6 trillion in 2013) and attributable to near equal performance and inflows, per the investor community surveyed. Further, more launches are expected this year by second-generation managers, rather than prop traders spinning out, seeking precious seed capital. In this issue:

1. We Q&A Pierre-Emmanuel Crama, a fund of funds operational due diligence practitioner, on ODD hot topics for 2014. I note a recent observation on quantity versus quality from William Jenkins, director, ODD, Amundi Alternatives: “Whilst the amount of ODD done in 2014 will be the highest ever, feedback from hedge fund COOs is that the quality of the reviews varies enormously. This is a result of the size of some houses’ buy lists and the experience of those available to complete the work. ODD on administrators, a great source of corroborative evidence and pivotal to the successful operation hedge fund itself, has not increased proportionately.”
2. We hear from Bill Prew on AIFMD, with only a few months to go until the end of the AIFMD transitional period, 22 July 2014.
3. We learn from lawyer, Peter Bibby, more about the FCA’s proposed changes to the approved persons regime and the associated implications.

I have no doubt that corporate governance will continue to be a closely debated area by both the industry and the HMRC. Matt Auriemma, principal at Highwater, noted, “The role of a hedge fund director has never been more important or more topical. We believe corporate governance is a process that when assessed by investors should give them comfort that the company will be directed in a way that benefits them collectively.”

A recent COOConnect survey on cyber security illustrated a need for industry improvement and the risks investors must consider. Succession planning too is likely to continue to rise up the agenda for investors and scrutiny will continue to be applied over fees and expenses.

OPERATIONAL DUE DILIGENCE

Quick fire Q&A
Pierre Emmanuel Crama, experienced independent ODD practitioner

What are your hot ODD areas for 2014?

1. As more examinations are expected from the regulators, I will look to see managers inviting compliance consultants to perform mock audits on a periodic basis.
2. To rationalise the cost structure, more outsourcing is expected for small and mid-sized managers.
3. Continued focus on expense allocation between the fund and the manager.
4. AIFMD readiness.
5. Succession planning with monetisation of value for the founders retiring and leaving the firm to the next generation of leaders.
6. Implications of larger managers leveraging off of their back and middle office platform to share costs with smaller managers.
7. Innovation in fee structures by emerging managers.

What are some of the most common weaknesses you are seeing amongst emerging managers?

1. Too many hats worn by the COO.
2. Relying too much on outsourcing models coupled with a lack of routine checks of the service providers used.
3. Lack of corporate/fund governance.
4. Unrealistic about the break-even point, e.g., by underestimating the increasing costs of regulation.
5. Trying to become institutional with a small operational team.
6. Not investing sufficiently in information technology, e.g., OMS, PMS.
7. Lack of scalability to manage hoped-for growth.
8. Lack of internal cash management expertise.
9. Disclosing managers’ AUM instead of fund’s AUM when running managed accounts.
10. Misleading marketing literature.

How can a manager best prepare for an ODD visit?

1. Arrange all the team members (senior and junior) to be available upon request.
2. Send all the materials requested prior to the on-site visit and, therefore, make best use of face to face meetings.
3. Be transparent.
4. Demonstrate fixing or work in progress relating to material issues raised in previous ODD visits.

How can the overall ODD process be improved?

1. Spending more time interviewing the independent directors.
2. Verify with all the outsourced parties their roles and responsibilities.
3. Focus on the areas of weaknesses during on-site visit and provide clear feedback and recommendations to the manager.

AIFMD: AIFM APPLICATION UPDATE

The knock-on effect on depositary on-boarding    
Bill Prew, INDOS Financial Limited

Recent data published by the FCA highlights just how many UK managers have taken advantage of HM Treasury’s (HMT) announcement on 20 December 2013 and delayed their FCA variation of permission applications. Previously managers needed to be authorised by 22 July 2014 but now they only need to have submitted an application to the FCA, and be AIFMD-compliant, by this date.

The recent FCA statistics show that it has received around 45% (or 361 out of 800) of the expected number of AIFM applications. Several more managers will likely submit their applications by 22 April 2014, the date by which “complete” applications need to be received by the FCA in order for it to authorise firms by 22 July.

It now seems inevitable there will be a large number of managers that will not be authorised by 22 July. No-one knows for sure what the consequences of this will be for managers and investors. This is partly because HMT’s amending AIFMD Regulations have not yet been published but also because there are a number of grey areas including the ability for firms to market after 22 July if they are not authorised AIFMs.

In common with delays in the FCA applications, there are also delays with AIFMD depositary selection and on-boarding. For most existing UK hedge fund managers, the depositary-lite regime, which will apply in order to continue to market their non-EU funds through private placement in the EU, will take effect on 22 July 2014. Whilst some managers of non-EU funds will choose to rely on reverse solicitation and side-step the depositary-lite requirements altogether, many recognise that marketing in the post-AIFMD era will be a grey area for some time to come. Many managers are viewing depositary-lite as a way to manage the regulatory and general business risk of non-compliance with the marketing rules as well as providing flexibility to market their funds. In practice there are going to be many hundreds of offshore funds looking to on-board depositary-lite providers in a very short period.

Despite the volume of funds requiring depositary-lite, the lack of preparedness in many parts of the administration and depositary industry to perform these duties may come as a surprise. There are various reasons for this. For most existing depositary businesses, depositary-lite has been a lower priority to finalising the full depositary model for EU funds. Newer entrants, typically independent administrators seeking to provide depositary-lite services to their existing administration clients, have in several cases simply left it too late to be operationally ready in good time for client on-boarding ahead of July. Some firms seeking to pursue UK regulatory authorisation have either only recently, or not yet, applied to the FCA and uncertainty remains around the regulatory framework which may or may not apply to depositary-lite providers in Ireland.

INDOS Financial was authorised by the FCA as a depositary-lite provider in early January, and remains the only authorised AIFMD depositary-lite firm in the UK. Managers need to allow sufficient time to on-board depositary-lite providers in a controlled manner and in order to ensure the manager gets the best commercial deal for the fund. Looking at what on-boarding involves, it can take time to agree the roles and responsibilities of the depositary, prime brokers and administrator. Two-way due diligence is required between the manager and provider. Legal terms require negotiation and disclosures are required in offering documents. Leaving the agreement of operating models, fees and legal terms to near the regulatory deadline will most likely result in a more favourable outcome for providers. There are already some reports that established depositaries may experience capacityconstraints or impose a cut-off for new client take-on. New entrants that are not yet operationally ready and don’t hold their regulatory authorisation are increasingly unlikely to be a viable solution for managers given the time-frames involved.

Considering these factors, managers really ought to be selecting their depositary providers in the near future. Delaying decisions could result in depositary-lite compliance becoming increasingly more difficult than it needs to be.

CHANGES TO THE UK’S APPROVED PERSONS REGIME
Peter Bibby, Partner, Brown Rudnick LLP

In July 2013 the Parliamentary Commission on Banking Standards issued a report which recommended major changes to the Approved Persons regime for banks (which for these purposes includes PRA-authorised firms).

It concluded that the current regime had lacked teeth, been an ineffective tool in curbing reckless behaviour and had failed to enable the regulators to bring those responsible for serious regulatory failure to account. The FCA welcomed the proposals and confirmed that it would consider the extent to which the changes should be applied more generally to the regime applying to all authorised firms including hedge funds and asset managers.

The Banking Reform Act received Royal Assent on 18 December, setting out the framework for the new regime. The changes will represent the biggest shake-up of the regime since its introduction more than a decade ago, and firms will need to be closely engaged in the FCA consultation in 2014 in order to respond to the detailed proposals from the FCA. Some changes to the overall regime are dictated by the Act. The Statements of Principles and Code of Practice for Approved Persons will be replaced by Conduct Rules (which will apply to all approved persons and to employees of banks whether approved or not). The rules will be made by the FCA. The rules can relate to conduct in relation to any business carried on by an authorised person and not just to conduct in relation to regulated activities (as was previously the case with the Principles and Code).
The FCA will therefore have the power to make rules, enforceable by disciplinary sanctions that apply more generally to behaviour in the financial services workplace and to behaviour in relation to activities that are not regulated (for instance spot forex which is not yet regulated but is currently the subject of investigation by the FCA). The limitation period in which disciplinary action can be taken against an approved person is also extended from three years from when the regulator became aware of the facts giving rise to the case to six years.

In other areas the Act imposes requirements on the regulators in relation to banks but gives them greater discretion as to whether to introduce similar obligations more generally. The Act introduces the concept of a “senior management function”, defined as those decision-makers who may be involved in decisions that could have serious consequences for a firm or more generally for business interests in the UK. It is expected that these senior managers will only be a subset of those who were previously approved for Significant Influence Functions. The Act requires the FCA to obtain statements of responsibility from banks for those filling senior management functions. The statements of responsibility will have to set out those aspects of the business the senior manager is responsible for. Banks will be required to update the statements where there is a significant change in responsibility. It seems likely that the FCA will propose that this concept is applied across authorised firms more generally, particularly as in its evidence to the Treasury Committee the FCA cited a lack of clarity about the responsibilities of significant influence functions as one of the reasons why it struggled to discipline senior management successfully.

The Act introduces the concept of “Significant Harm Functions” for banks. These are employees who fill a function in which their activities could cause significant harm to the bank or its customers. It is expected that this group will extend beyond those individuals who were approved persons in the current regime. These individuals will not be approved but will be required to be certified as fit and proper by the bank on an annual basis. The FCA will have the power to make rules governing their behaviour and to take disciplinary action against them. It will be interesting to see whether the FCA proposes that the approved person regime for non-banks is extended to cover the same group of individuals in other institutions (the previous restrictions on the functions that the FCA could designate as Controlled Functions has been removed) or seeks to place additional requirements on non-bank firms in relation to their employees (recognising that if they chose the latter course they could not make rules governing the behaviour of those employees or take disciplinary action against those employees).