The month of May has been full of twists and turns in the financial markets and at the regulatory level on both sides of the Atlantic. Europeans began the “hostilities” on 18 May with the approval, by the European Parliament, of the draft text of the new Alternative Investment Fund Managers (AIFM) Directive. The Americans followed suit on 14 May 2010, with the Senate passing the Restoring American Financial Stability Act of 2010, following the Wall Street Reform and Consumer Protection Act of 2009 (HR 4173), which the US House of Representatives passed in December 2009. Both US Acts and European directive have not yet obtained the status of law as they need to be reviewed in the US by the conference committee so as to reconcile the discrepancies between the Senate and the House bills, and in Europe by the European Council so as to finalise the document. The purpose of the Conference Committee is to send the final bill to the president for signature before the 4th of July recess. In Europe, a first reading is scheduled on 6 July before the European parliament.
The ongoing financial crisis, as well as various hedge fund fraud cases, have rocked the world economy and forced financial regulators worldwide to react and propose new regulations with the goal of preventing the reoccurrence of such dramatic events. The main challenge for a new regulatory framework to be effective is the need to harmonise different national regulations so as to avoid regulatory arbitrages. In light of current documents made publicly available in the US and in Europe, it appears that we are quite far away from harmonisation and very close to the enforcement of regulatory protectionism. In this article, we will attempt to elucidate the main differences between the American and European approaches and will conclude with some thoughts on the real benefits, if any, investors may derive from the increased involvement of the regulators in the financial markets.
After the failed attempt in February 2006 to make the registration of investment advisers mandatory with the SEC, the newly proposed Act shall make this obligation a law. The Restoring American Financial Stability Act of 2010 raises the asset threshold for federal registration of US investment advisers from $25 million to $100 million under management and eliminates the exemption from registration under Section 203(b)(3) of the Advisers Act for investment advisers who had fewer than 15 clients in the preceding 12 months and who did not hold themselves out to the public as investment advisers. The European directive threshold for registration is set at €100 million under management with the possibility to raise this limit to €500 million for investment advisers who did not use leverage and lock client assets for at least five years. A threshold of €100 million implies that roughly 30% of hedge fund managers, managing almost 90% of assets of EU-domiciled hedge funds, would be covered by the directive, according to the European Commission. The threshold of $100 million and €100 million, respectively, clearly demonstrates that the focus of the regulators is on systemic risk as a large portion of investment managers would fall short of these thresholds. Though it could be seen as a disappointment for investors, these thresholds make US and European regulators more credible as they reduce the scope of their oversight to a more manageable universe. However, European and US regulators would allow any investment adviser to opt-in and register, even if it does not meet the minimum criteria.
The registration procedures are very different in the US and in Europe. In the US, the investment adviser needs to complete, online through the SEC’s IARD system, Part I of Form ADV. The SEC has 45 days, after receipt of Form ADV, to declare an applicant's registration effective. After the registration, the investment adviser has to abide to the provisions of the Investment Adviser Act of 1940. This Act provides guidance on topics such as: the need for a code of ethics, the need for a disclosure document or statement to be provided to a client (usually the Part II of Form ADV), the type of books and records that the investment adviser must keep, the details on compliance programmes to be implemented, the adviser’s obligations regarding proxy voting, the need for a best price and execution policy, the specifications on contracts with clients and the limits on advertising the advisor’s services.
In the European directive, the registration process looks more like an obstacle course. In order to become an AIFM, the investment advisor needs to demonstrate to its local regulator that it has the requested minimum level of capital (€125,000+0.02% for assets above €250 million), demonstrates the robustness of its internal arrangements with respect to risk management, in particular, liquidity risks and additional operational and counter-party risks associated with short selling; the management and disclosure of conflicts of interest; the fair valuation of assets; and the security of depository/custodial arrangements. Given the diversity of AIFM investment strategies, the proposed directive foresees that the precise requirements, in particular, with regard to disclosure, will be tailored to the particular investment strategy employed. The investment manager also needs to provide detailed information about the funds it intends to market within the European market. The competent authorities shall inform the applicant, within two months of the submission of the application, whether or not authorisation has been granted.
In terms of implementing new regulations, the US will be much faster than Europe as the US Act would become effective one year after its enactment. However, it is worth noting that an adviser may register with the SEC during the one-year transition period. In Europe, a three-year transition period will be granted to investment advisers so as to give them time to fully comply with the directive.
Another difference between the two regulatory approaches is the type of disclosure advisors are expected to give their respective regulators with respect to investments.
In the US, no matter if you are registered with the SEC or not, every investment advisor with over $100 million of assets invested in US securities has to fill a quarterly 13F Form, in which it has to disclose his long holdings. The filling needs to be done two months after the end of each calendar quarter. For SEC-registered investment advisors, an annual update of the ADV Form Part I has to be posted onto the IARD system within 90 days at the end of the fiscal year. It is important to point out that these documents are made publicly available for investors on the SEC’s website. Furthermore, the new US Act will require advisers and the private funds they manage to maintain and file records and reports regarding such private funds, including descriptions of assets under management, use of leverage, counter-party credit risk exposure, trading and investment positions, valuation policies, types of assets held, side arrangements or side letters, trading practices and other information with provisions for confidential treatment of such records and reports. The SEC is required to inspect the books and records of private funds maintained by an investment adviser and must provide an annual report to Congress, describing how the SEC has used the data collected to monitor the markets for the protection of investors and the integrity of the markets.
In Europe, the reporting requirements are more cumbersome since the investment manager shall regularly (usually quarterly) report to the competent authorities of its home member state on the principal markets and instruments in which it trades on behalf of the funds it manages. The investment manager shall also provide aggregated information on the main instruments in which it is trading, the markets to which it is a member or is actively trading, the level of leverage used and on the principal exposures as well as concentrations of each of the funds managed by it. Furthermore, for each of its funds, the investment advisor needs to provide regulators with an annual report (similar to an audit report). The European directive also describes the investment advisor’s reporting requirements to its investors (not very different than the information which is usually included in the fund’s offering memorandum and monthly factsheet).
The matter which will most likely be controversial is the treatment of foreign investment advisors. In the US, the Act would require SEC registration of foreign advisers, absent an applicable exemption. The new US Act creates such an exemption for a "foreign private adviser" that has: (1) no place of business in the United States; (2) fewer than 15 clients in total who are domiciled in or residents of the United States; (3) aggregate assets under management attributable to US clients and US investors in “private funds” advised by the adviser of less than $25 million (or such higher amount as the SEC may deem appropriate); and (4) neither (i) holds itself out generally to the US public as an investment adviser nor (ii) acts as an investment adviser to any investment company registered under ICA or a business development company under ICA. Under the European directive, authorisation for a foreign investment manager to market its funds in Europe will be dependent on the existence of an equivalent regulatory framework in the third country as well as an effective access for AIFM established in the European community to the market of the third party. The two countries must also have tax agreements in place. The acceptance of a foreign investment advisor will therefore be dependent on the European Commission’s assessment of the equivalence and effective enforcement of third-country legislation on prudential regulation and ongoing supervision. Since no general equivalence criterions are defined in the European directive, it leaves the possibility for discussion with their American counterparts.
The major difference between the two regulations is the intervention of the European regulator on the fund’s operational structure and strategy. Under the AIFM, each investment manager shall appoint an independent valuation agent for each fund that it manages to establish the value of assets acquired by the fund and the value of the shares and units of the fund. The AIFM-regulated investment manager should also ensure that each fund has a depositary, which is a credit institution, having its registered office in the community and authorised by the Commission. Delegation of those activities to companies outside the European community will be subject to a process similar to the one relative to the acceptance of foreign investment advisors. The directive, in a way similar to UCITS directives, puts liability on the financial institutions, which will be responsible for the safekeeping of assets. The Economist opined, in one of its articles, that pension funds and other investors may fear that they will be charged a higher premium by custodians as a result of the new regulations. Pension funds and other investors may also find it more difficult to invest money into emerging markets, especially if custodians become wary in delegating assets to sub-custodians in those countries. The proposed European directive empowers the Commission to set leverage limits, when required, so as to ensure the stability and integrity of the financial system. The scope of those limitations is still unknown but could be detrimental in the implementation of some hedge fund strategies.
The real question today is: what benefits will investors derive from the newly proposed regulations? As mentioned above, the focus of the regulators, whether by choice and perhaps due to their resources constraints, is mainly limited to the largest investment managers. In Europe, 70% of the hedge fund managers will not be affected by the new directive. Furthermore, the new regulatory requirements will incur an important cost to investment managers. According to Kinetic Partners, the implementation costs of the Commission’s proposal will be around £3 billion to the UK hedge fund industry. Moreover, it will cost “several hundred million pounds annually” for UK managers to comply with these newly proposed rules. A potential side effect of the European directive would be consolidation in the hedge fund industry, wherein some of the smaller players might have to join larger groups. In addition, since the level of fees charged by hedge funds is already so controversial, fund managers will probably not be able to pass those extra costs onto investors.
The benefits of the new regulations will only be visible in several years and it is difficult to assess today whether or not investors will be able to invest safely in hedge funds in the future. However, one thing should not be forgotten, even if regulators have to do their job, they will never replace the investors due diligence on hedge funds. Remember, Bernard Madoff was an SEC-regulated broker dealer and an SEC-registered investment advisor and we all know what happened.
This article first appeared in the May 2010 issue of the Hedge Fund Due Diligence Bulletin of Hedge Fund Appraisal. For more details, please visit www.hedgefundappraisal.com.