Paul Farrell, Gayle Bowen and Catherine Fitzsimons examine the changing hedge fund landscape, with increased costs, transparency, liquidity and consolidations expected to shape the next few years.
The hedge fund landscape changed dramatically in 2008 with assets under management in severe decline, the imposition of redemption gates, NAV suspensions and general restrictions on investor withdrawals being imposed on a scale that was previously unseen. As Lord Turner, Chairman of the UK Financial Services Regulatory Authority, noted, although specific national banking crises in the past have been more severe, none have had the global impact of the 2008 financial crisis.
The 2008 financial crisis has led to increased investor demands for higher levels of regulation. As a result, financial regulation has risen to the top of the political agenda. While it is widely acknowledged that hedge funds neither caused nor played a significant role in the 2008 financial crisis, concerns regarding the impact of highly leveraged funds on the stability of a financial system and the perceived lack of transparency associated with hedge funds meant that increased regulation of hedge funds was inevitable.
The Alternative Investment Funds Managers' Directive (AIFMD), which is due to come into effect in July 2013, seeks to harmonise the regulation of hedge fund managers that have funds domiciled or marketed within the EU (Funds). The broad scope of AIFMD captures not only European fund managers, but also any non-European managers that establish, market or distribute Funds within the EU. It also captures most types of fund structures, including open and closed-ended funds, property and private equity funds, which previously were outside the scope of regulation in some jurisdictions. There are limited exceptions available for fund managers, including a de minimum exception for managers whose assets under management fall below set thresholds.
AIFMD introduces new obligations on both Funds and their managers, which include obligations in relation to capitalisation, the appointment of an independent depositary to hold the Fund assets, risk and liquidity management and additional investor disclosure have all been introduced. Certain requirements in relation to the compensation received by employees of Fund managers have also been introduced in order to tie the personal financial gain of employees that make investment decisions for Funds with to the performance of a Fund over time to discourage undue risks being taken for temporary performance enhancements.
However, in exchange for this increased regulation, AIFMD provides access to a pan-EU passport allowing Funds to be marketed to EU professional investors once the Fund is authorised in any EU member state. This will mean that, for example, Irish Funds complying with AIFMD may be marketed across the EU, without being subject to further marketing requirements in each jurisdiction. This EU marketing passport will not be available to non-EU Funds/their managers until at least July 2015 and so the private placement requirements in each jurisdiction will need to be relied upon until that time.
Another key area that global financial regulators have sought to increase regulation is the use of OTC derivatives, which hedge funds often engage in to assist their trading strategy. In 2009, the G-20 summit agreed that all standardised OTC derivatives should be centrally cleared by the end of 2012 and that all OTC derivatives should be reported to trade repositories.
The EU has introduced the European Market Infrastructure Regulation (‘EMIR’) to meet this commitment. EMIR generally became effective across the EU in August 2012, although some provisions require further clarifications and specific implementing measures to be introduced by regulators before becoming effective.
Generally, EMIR will impose reporting obligations for all OTC derivatives, central clearing obligations for some types of OTC derivatives, common rules for central counterparties and trade repositories and obligations aimed at reducing counterparty credit risk where OTC derivatives are not centrally cleared.
Like the EU, the US has also introduced major legislative reform of the financial services industry. These reforms have serious implications on the operation of hedge funds, both in the US and globally. The legislation introduced to effect these changes is the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the ‘Dodd Frank Act’). While the Dodd Frank Act came into force in 2010, substantial rule making by regulatory bodies is needed before all provisions can be effective. As a result, implementation measures are still ongoing and the full extent of the impact of the Dodd Frank Act on hedge funds is yet to be fully realised.
Two key aspects of the Dodd Frank Act affect the hedge fund industry outside the US. The first of these is known as the Volcker Rule, which limits the involvement of US financial institutions in hedge funds, regardless of their domicile, and the second is the registration requirements for investment managers seeking to market their funds to US investors. While the registration requirements do not prohibit investment into hedge funds, the increased costs associated with compliance may act as a bar to the US market for many hedge fund managers.
The Volcker Rule imposes a ban on most proprietary trading by US financial institutions and their affiliates, subject to limited exceptions. Relevant institutions will not be permitted to invest any amount greater than three per cent of their Tier 1 capital in hedge funds and that investment may not represent more than three per cent of the total ownership interests of the fund.
The Volcker Rule also prohibits these institutions from owning, sponsoring or investing in hedge funds or private equity funds. Sponsoring includes most activities associated with raising a fund, including providing a general partner or selecting or controlling the board of directors, trustee or management of a fund.
One notable effect of these rules is in the movement of former investment banking professionals, previously employed on proprietary trading desks, encouraging them to leave and form their own hedge funds.
The registration requirements of the Dodd Frank Act require all fund managers over a certain size, other than managers of venture capital funds, to register with the SEC and impose new record keeping and disclosure requirements in relation to their funds. As compliance with these obligations will be costly, fund managers will be keen to avail of one of the limited exemptions to these requirements. The Dodd Frank Act also increases the financial thresholds used to determine an investor's eligibility to invest in private funds.
Previously, non-US investment funds seeking to market to US investors were able to avail of an exemption from these registration requirements, known as the ‘private investment advisor’ exemption. This exemption has now been removed and managers will need to avail of one of the other more limiting exemption to avoid full compliance.
One of these exemptions the ‘foreign private adviser’ exemption may be of use to non-US investment managers. In order to avail of this exemption, the fund manager must have no place of business in the US, have a total of fewer than 15 US clients and investors and aggregate assets relating to US investors of less than US$25 million. A further difficulty arises if any of those US clients are themselves investment funds, as these are looked through to calculate the number of US investors.
Another, arguably more useful, exemption for hedge fund managers is the ‘private fund’ exemption which exempts managers from SEC registration requirements that act solely as an advisor to qualifying private funds and who have assets under management in the US of less than US$150 million. Non-US advisers are permitted to manage an unlimited amount of qualifying private fund assets provided that its principal place of business is outside the US and it does not manage any assets for US persons, other than qualifying private funds, and those qualifying private fund assets are less than US$150 million.
Similar provisions to the EU's EMIR have also been included in Title VII of the Dodd Franck Act, an example of the results of regulatory efforts in the EU and the US to reduce opportunities for regulatory arbitrage between these jurisdictions.
With financing no longer being readily available from US financial institutions, hedge fund managers will need to assess the benefits of marketing to US investors in the face of the increased operating costs associated with this level of increased regulation.
The Unites States Foreign Account Tax Compliance Act (FATCA) is another piece of US legislation the effects of which will be felt by hedge funds globally. FATCA requires foreign financial institutions, including hedge funds, to disclose information on investors and beneficial owners who are US persons to the US Inland Revenue Service. If they do not provide this information, a withholding tax of 30 per cent will apply to the entire fund on US source payments.
With the legislation effective from 1 January 2013, it has become more common for managers to include certain withholding tax provisions in the offering documents and governing documents, giving them the ability to take action against any investor whose status caused a withholding tax to be applied to the fund. Such action may include placing the investor into a separate class of shares, redeeming all or a portion of their shares and deducting the tax from the proceeds, or clawing back payments previously made.
The costs of implementing FATCA will undoubtedly be high. However, these costs can be mitigated for hedge funds domiciling in jurisdictions, such as Ireland, that have signed an intergovernmental agreement with the US agreeing reciprocal information exchange between their taxation authorities. This means that Irish funds will only need to provide the relevant information to the Irish Revenue Commissioners in order to avoid the withholding tax on their US source income, ensuring a lighter administrative and compliance burden for Irish funds.
The focus on increased regulation will continue to be a focus throughout 2013. Notwithstanding this fact, Irish hedge fund assets continue to grow, reaching an all-time high of over €250billion, with the number of assets serviced in Ireland being in excess of €2 trillion. Increased costs, transparency, liquidity and consolidations will also shape the hedge fund landscape over the next few years, as hedge fund managers continue to adapt to this ever changing environment.
Catherine Fitzsimons Associate
Gayle Bowen Of Counsel
Paul Farrell Partner
Walkers Bermuda, British Virgin Islands, Cayman Islands, Dubai, Guernsey, Hong Kong, Ireland, Jersey, London and Singapore.