Quarterly Newsletter – Q4 2010

Laven Partners releases guidebook on UCIT

Laven Partners releases guidebook on UCITS III

Laven Partners is proud to present the new Laven guidebook on UCITS III, providing practical advice on establishing and operating UCITS III funds.

The Laven guidebook is a comprehensive introduction to various elements of the UCITS III framework, including the suitability of investment strategies, risk management requirements and distribution opportunities. It also covers new developments from the UCITS IV Directive.

The Laven guidebook was officially launched during a breakfast seminar held in November, where Laven delivered a presentation on the UCITS III market and trends. It offers a unique insight combining experience from both the global regulatory firm, Laven Partners, and the legal practice, Laven Legal Services.

The guidebook is available for download at http://www.lavenpartners.com/UCITS Booklet.pdf. We hope you will find the material both informative and useful in your day-to-day operations and when planning for future projects.

The AIFM: The True Story – an Article into the practical implications of the new directive

By Jérôme de Lavenère Lussan and Robert Mirsky, published in the Hedge Fund Journal

While alternative investment funds did not cause the 2008 financial crisis, there is certainly a need for better regulation in the alternative investment sector. The European Union (“EU”) introduced the Alternative Investment Fund Manager (“AIFM”) Directive to effect that change. The AIFM Directive will add a new compliance burden that is primarily targeted at hedge funds and private equity fund managers in the EU. Despite rigorous debates concerning the overreaching supervision of managers and the fact that it will add to costs, the Directive is an attempt to provide better protection for investors.

On October 19th, 2010 EU finance ministers met and agreed the text of the Directive. The following week, the EU Parliament Economic committee provided backing to the Directive, and on November 10th and 11th 2010 the EU Parliament debated and voted on the Directive. Pursuant to this, the entry force of the AIFM Directive was 2011, and at the beginning of 2013 EU member states will be required to have fully implemented the Directive. Non-EU funds, such as Cayman Islands based funds, will only be able to apply for a “passport” to market funds in the EU in 2015. In the meantime, the implication is that non-EU fund managers will be able to market their funds in the EU as they do at present, however non-EU managers should expect to be asked to abide by the standards of the AIFM Directive.

On October 19th, 2010 EU finance ministers met and agreed the text of the Directive. The following week, the EU Parliament Economic committee provided backing to the Directive, and on November 10th and 11th 2010 the EU Parliament debated and voted on the Directive. Pursuant to this, the entry force of the AIFM Directive was 2011, and at the beginning of 2013 EU member states will be required to have fully implemented the Directive. Non-EU funds, such as Cayman Islands based funds, will only be able to apply for a “passport” to market funds in the EU in 2015. In the meantime, the implication is that non-EU fund managers will be able to market their funds in the EU as they do at present, however non-EU managers should expect to be asked to abide by the standards of the AIFM Directive.

Authorisation of AIFM

The AIFM Directive introduces a key new provision on the authorisation of asset managers which will require a significant increase of the initial capital requirement from (previously) EUR 50,000 to EUR 125,000. For UK based managers this nearly threefold increase raises the barriers to entry and places a greater burden on the managers, however, this is not necessarily punitively costly either.

It is not clear whether there will be any grandfathering provisions for existing management companies.  In addition, a further authorisation requirement is that the head office and registered office of the AIFM should be in the same EU Member State. Here, we should be aware of potential tax structuring issues, as well as what this means if the manager is acting as an advisor.

Operating conditions of AIFM

The AIFM Directive will address many aspects of operations and will require new policies and disclosures from managers. Some of these will prove onerous and potentially subject to other European Directives. The main policy will be concerned with remuneration and practices which must be in place for specified categories of staff. This is new for managers and it is still unclear how this will be applied. It may be confusing in particular for UK LLPs. The Directive is very broad in its application to remuneration (e.g. it will extend beyond risk takers and control functions to any employee receiving a total remuneration that takes them into the same remuneration bracket as senior management and risk takers). The Directive also requires new processes requiring the establishment of remuneration committees made up of members of the management body, but excluding any member performing executive functions.

Managers will also be required to identify and take steps to prevent all conflicts of interest. The Directive does not however provide guidance on what constitutes a conflict of interest, so managers will have to invest time to determine the scope of any conflicts of interest and whether this will affect the fund’s internal operations.

In relation to risk management, the Directive requires that managers must set a maximum level of leverage (for each AIF) and state the extent of the right of re-use of collateral or guarantees. This is good news for the market as it attempts to reduce the risk of a financial crisis reoccurring. However, specific risk management requirements are vague and will be a cause of much debate as to what the Directive expects for managers to comply. For example, managers will be required to separate risk management from the operating units and perform in-depth risk profile analysis. Here, the question arises as to how will these requirements be enforced? The Directive states that full risk management systems must be reviewed at least once per year but is no more specific.

Additionally, the AIFM Directive requires that, for each fund, the manager must appropriately monitor liquidity risks to ensure compliance with any policy or control systems.

Organisational Requirements

The new Directive also requires that managers put in place new systems, notably with regard to valuation. Managers will have to establish how to put in place methods for independent valuation of assets for each fund. Managers will be required to calculate and publish annually the Net Asset Value (NAV) per share/unit of a fund, and they must ensure that valuation is performed either by an external valuer, or internally if no conflict of interest arises. An interesting point under valuation is that the manager is still ultimately responsible for “proper valuation” of the fund, calculation and publication of NAV. This should help gain clarity on the pricing of existing assets but may increase liability of managers.

Delegation of AIFM Functions

The Directive seeks to address matters of delegation and creates a degree of responsibility for managers to properly choose qualified and capable third parties. This requirement involves a new onerous task for managers, and managers will have to think at board level as to how they justify selecting providers and on the basis of what types of legal obligations.

With regard to the depositary, the AIFM Directive states the manager must ensure that a single depositary is appointed for each fund. The main role of the depositary is to ensure proper management of cash flows and safe-keep financial instruments and other assets for which it shall bear sole responsibility. An additional and new role required of the depositary is to ensure that any activity pertaining to the fund’s shares or units accords with national law. This may well add a new burden on depositaries although it would not seem to add anything beyond what are standard responsibilities.

A further requirement is that custodian activities can be delegated to a third party, although there must be a written contract in place giving the fund a direct right of action against the third party.

Transparency Requirements

In addition to the above, managers will be required to produce an annual report for each fund that the manager manages and/or markets in the EU, as well as regularly report to authorities of the home member state. The new transparency requirement involves disclosure to investors before investing in a fund, and notification of material changes. This is a welcome requirement and likely done by many managers already, although not always a legal requirement.

AIFM Managing Specific Types of AIF

The AIFM Directive includes a new disclosure requirement for managers managing a leveraged fund. Managers must provide home Member State authorities with information which will be used to assess the systematic risks of use of leverage which may ultimately be used to impose limits on leverage or other restrictions. This will probably not prove popular with managers, but should be easily available as part of standard risk management monitoring.

Specific Rules in relation to Third Countries

Since non-EU managers only have to apply for a passport in 2015, there is some ambiguity regarding what to do until 2015. Presumably, non-EU managers will be able to continue to market in the EU as they have done to date, under private placement rules.

(i)         EU AIFM with a Non-EU AIF

  • When managed but not marketed in the EU, the manager must comply with all the Directive’s requirements, except provisions related to the Depositary and filing of an Annual Report. The Directive broadly states that the manager must also ensure that “appropriate cooperation arrangements” are in place. The issue here is that the Directive does not specify the meaning of such arrangements, and therefore managers are left with no guidance regarding this ambiguity.
  • When managed and marketed to professional investors in the EU with a passport, the manager must comply with all requirements (except those specific to EU manager with an EU fund), and ensure that appropriate cooperation arrangements, multilateral tax agreements and anti-money laundering are in place and notifications are submitted to competent authorities.
  • When managed and marketed to professional investors in EU Member State without a passport, it is important to note that EU Member States may impose stricter rules on the manager in respect of the marketing of non-EU fund investors on their territory. Also, the manager must comply with all requirements, except those provisions related to the Depositary, and provide for appropriate cooperation arrangements and anti-money laundering.

(ii)        Non-EU AIFM with a Non-EU AIF

Non-EU managers will need to meet a number of requirements, including appointing an EU legal representative to be a point of contact within the EU for regulators and others.

  • When marketed to professional investors in the EU with a passport, authorised non-EU managers must comply with all the AIFM Directive requirements, and also ensure that appropriate cooperation arrangements, multilateral tax agreements and anti-money laundering are in place.
  • When marketed in EU Member States without passport, Member States may impose stricter rules on the manager in respect of marketing of the fund to investors in their territory. Non-EU managers must comply with transparency requirements and ensure that appropriate cooperation arrangements, multilateral tax agreements and anti-money laundering are in place.

Marketing to Retail Investors

The manager will be allowed to market Funds to retail investors, regardless of whether funds are marketed on a domestic or cross-border basis, or whether they are EU or non-EU funds. Accordingly, EU Member States may impose stricter requirements in their territory. In addition, the manager must inform the Commission and the EU Securities and Markets Authority (“ESMA”) of the types of retail investors and other information. Here, we do not know whether disclosure of such information should be prior to the marketing or on an on-going basis.

Conclusion and General Implications of the AIFM Directive

The full impact of the Directive will not be clear for many years. Much of the Directive though complete in concept will need to be distilled through European and local country legislation as well as practical application. One immediate implication of the Directive is that it will be more difficult to establish new managers and funds due to the increased up front and ongoing costs of policies, procedures and disclosures.  Though many managers will bear some of those costs, much of the increase will be passed on to investors.  However, while there will be higher costs, investors will benefit from some increased degree of protection and disclosure. The real question is whether this degree of increased protection will be worth the cost to investors and impact on the European industry.

Laven Partners is a global leader in regulatory compliance, providing practical solutions for financial institutions. Please do not hesitate to contact us if you have any questions with regards to the new Directive and how it will affect your business

Remuneration: Another Attack on the Hedge Fund Industryby Jerome Lussan, to be published on COO Connect

Stifling innovation and industry in the financial heart of London appears to be a recreation of choice among some figures in the European Union (EU) at the moment.

The Capital Requirements Directive (CRD), which was agreed by the European Parliament and European Council of Ministers in July 2010, is going to disproportionately impact hedge fund managers when it is implemented by the UK’s Financial Services Authority (FSA).

The FSA has updated its existing remuneration code to take on board the European requirements that came into place on January 1, 2011. The proposals force hedge funds and other financial institutions, including all asset managers and UCITS investment companies to curtail the bonuses they award.

At least 40% of a bonus must be deferred over three years. If a bonus exceeds £500,000, at least 60% must be deferred.

Notwithstanding the merits of these new provisions as they will apply to a banking sector that survived only thanks to taxpayers’ money, it is misguided for these proposals to be imposed on hedge funds. The initial purpose of the legislation was to prevent major investment banks from taking unnecessary risks with capital from their retail customer base. This is understandable – banks were taking significant risks using other people’s money, and these actions needed to be curbed. However, to target hedge funds as part of the banking clampdown is wrong and not in the interest of the broader public.

There are two reasons why alternative asset managers have possibly been targeted – one – politicians are unable to grasp what they are dealing with and don’t understand the concept of hedge funds and – two – hedge funds are an incredibly easy target for politicians to attack, being perceived as a tool for the rich. It is regrettable that hedge funds are not seen as a positive contributor to our pension plans.

Regardless of the rights and wrongs of politicians targeting the sector – is imposing remuneration on hedge funds actually going to do anything constructive? The simple answer is no. Forcing hedge funds to adopt a remuneration policy will do nothing to protect the general public for a multitude of reasons.

Firstly, hedge funds are not investment banks – their actions do not impact unsuspecting individuals who are unaware of how their money is being utilised or invested. Hedge funds are private vehicles whereby clients have agreed to put their money in the hands of a manager adopting a certain investment strategy. Investors into these private funds have agreed to any potential risk or losses that may be incurred by that manager. These investors are sophisticated – they will or should only invest after carrying out appropriate operational due diligence and will review trading strategies adopted by managers thoroughly – in short, such sophisticated and institutional investors ought to know what they are doing when they put their money into a hedge fund. They should have a solid perception of risk when making their investments. For many investors this was a very material protection against traditional long only strategies.

Secondly and more importantly, hedge funds do not pose a systemic risk to the broader financial system – unlike the major investment banks that caused the crisis. This law is therefore unfairly painting banks and hedge funds with the same brush. Not only are hedge funds not giving rise to a systemic risk but the people that put money in them have the means to know full well what they are doing.

Furthermore, the law doesn’t actually address the problem of reducing risk. The premise of the legislation assumes that managers are paid accordingly to what they make which would entice them to take risks to earn more. This ignores the fact that anyone in the market who takes excessive risks is just as likely to lose as much as they gain. Any fund manager that loses cash therefore won’t get a bonus anyway. The law in this respect will not change much for hedge funds. There may be some benefits in reducing the short term focus of some managers. Short-termism has indeed tended to benefit managers who take an annual performance fee, for example. They can earn large performance fees in one year even if they lose the capital the following year. However, the law on remuneration does not directly address this either.

The consequences of the remuneration policies on hedge funds may nonetheless be significant for the development of the alternative industry.

The new law will not only curb fund managers paying themselves and their staff but will also force them to make public disclosures about how much and how they are paid. This could cause new scrutiny from the media that may further embarrass an industry used as a scapegoat for the errors of central bankers.

It may also have an unexpected impact on the UK’s favourite form of hedge fund management company – the limited liability partnerships (LLPs), which are of course fundamentally different in terms of structure from limited liability companies. One difficulty is how will remuneration be applied to LLPs when the money is deemed to be owned by the members even if it is not received by them.

Apart from the managers, who else stands to lose? Investors may suffer. While supportive of increased hedge fund compliance, investors are unlikely to approve of the industry becoming excessively regulated if this pushes it towards less innovation and compels only the larger managers to survive. It may also mean more correlation amongst the survivors. The sector could ultimately end up becoming a very uncompetitive environment to work in.

Promising managers hoping to start up their business today will get the short end of the stick. Start-up costs and ongoing compliance costs have increased exponentially over the last few years. New policies on remuneration, capital requirements and not to mention the impact of the Alternative Investment Fund Managers Directive could prove to be a serious deterrent to some budding entrepreneurs.

London is going to join the list of cities in Europe that could lose jobs as a result of the EU’s short sightedness. The city, after all, is a major hedge fund player and the location of choice for many international fund managers.

Whether this remains the case, is yet to be seen.

Laven Due Diligence Team Get It Right Again: Loch Capital Management Had Failed Laven Partners’ Due Diligence Analysis

At the end of November the FBI raided three US based hedge fund managers following insider trading allegations. This development reemphasizes the importance of carrying out thorough due diligence assessments prior to making an investment. Earlier in 2010 Laven Partners’ operational due diligence team performed a due diligence analysis on the Dundonald Offshore Fund, which failed to meet the firm’s best practice standards. The fund is managed by one of the investigated hedge fund managers, Loch Capital Management LLC.

Laven Partners performed its initial pre-onsite visit due diligence assessment, called the Redflag Report, for one of its clients in July 2010. Following the findings Laven Partners did not launch into a full on-site operational due diligence assessment as the initial red flags already contained in the pre analysis had deterred the client from proceeding further.

Jérôme de Lavenère Lussan, CEO of Laven Partners comments: “Well organized and expert due diligence teams can detect issues in a manager or a fund quite easily but few have made the commitment to effect such analysis. Despite all the publicity Madoff received almost two years ago now, some investors remain lax in the way they carry out due diligence. There has been a lot of hype about due diligence in the media but has anything really changed in practice?”

Loch Capital Management is run by twin brothers, Timothy and Todd McSweeney. The firm was set up in 2003 with a handful of employees and at one point was managing assets in excess of USD 1.50 Billion. As of September 2010, assets had fallen to USD 331 Million.

The most important red flag which Laven Partners identified was the close link between Loch Capital Management and Steven Fortuna, the co-founder of S2 Capital Management, who had ties to the Galleon Group’s scandal which took place earlier in the year. Fortuna pleaded guilty to exchanging insider information about Dell Computer Inc with the Galleon Group.

“Although insider trading is extremely hard to detect, as operational due diligence experts we can identify in a number of ways fund structures that are systematically weaker than usual, thus providing unique insights to our clients”, said de Lavenère Lussan. “Compliance needs to be an integral part of every financial institution. When it is taken seriously by market participants, we will see a reduction in insider trading.”

“This fund actually has good risk/return characteristics and a generally impressive track record which would suit most investment focused due diligence. However from an operational point of view, you are presented with a different picture, as can often be the case. Those investors who can make the difference and commit sufficient resources to maintaining proper checks in their due diligence, will benefit in the long term.”

MUST READ: “Gathering Storm”, by Lee Robinson

Laven has recently read Gathering Storm, a book written by Lee Robinson of Trafalgar Asset Managers and other intellectual market heavy weights. In the book, 18 top fund managers and economists who predicted the last asset bubble give their thoughts on how to avoid the next crisis.

Out of all the books we have read, this one is sharp and stands out. The book is a vivid read of the possible forthcoming problems and a clever analysis of what our industry and notably governments have failed to repair.

Further, and in a typical fashion for the writer, all profits from the book go to charity. Copies of the book are available for purchase at http://thegatheringstorm.info.


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