AIFMD –Time for action for hedge fund managers

Whether hedge funds contributed to the financial crisis is still a widely debated topic. However post the crisis, investor protection and monitoring systemic risk became increasingly important.  

Thus policy makers realised the need to bring hedge funds too under the regulatory framework. In Europe, they created Alternate Investment Fund Manager’s Directive (AIFMD), to regulate alternate investment funds like hedge funds and private equity. As per the legislation, all Alternate Investment Fund Managers (AIFMs) marketing in Europe, needs to get authorised by the competent authority of the member state in which it is doing business and will have to comply with stringent regulatory norms to do business. 

Though European member states adopted and converted the directive into national law by July 2013, fund managers have time till 22 July to seek authorisation and become compliant

For hedge fund managers, this regulation will create a big impact, as they will be moving from an unregulated environment to a regulated one. Broadly speaking, AIFMs will have to upgrade their compliance systems, restructure their operations and make transactions more transparent. But fund managers argue that it is easier said than done. From the first step of getting authorised, to appointing a depository and reporting to competing authorities, the directive puts forth a bundle of challenges to hedge fund managers.

Check out AIFMD's latest infographic here.

AIFMD is a transformational piece of regulation. Unlike its counterpart in US, Dodd Frank form PF that stresses on quantitative changes, AIFMD insists on both quantitative and qualitative measures. For non-EU fund managers the impact is even stronger as they will have to deal with regulations of multiple jurisdictions.

The depositary regime – The new watchdog

AIFMD mandates hedge fund managers to appoint a depositary. Prime brokers who have been donning the role of depositaries will be prohibited from doing so unless they meet some hierarchical conditions. This means that the hedge fund managers may have to abandon the current model and need to appoint a depositary as per the directive. With increased liability asserted on depositaries cost of appointment and maintenance of depositary will lead to additional costs. For the depositary to manage the assets under custody and monitor cash flows, fund managers should ensure that the depositary receives appropriate information. This means alterations to the existing workflow. Additionally, fund managers are expected to demonstrate that they have exercised due diligence in the appointment of the depositary.

Risk management – neither simple, nor easy

Risk management can no longer be considered as an ad-hoc function. The directive requires fund managers to separate the risk management functions from portfolio management. Fund managers should ensure that there is functional and hierarchical separation. Small hedge fund firms will find it difficult and costly to maintain a separate risk management division. Fund managers are expected to put in place strict risk management measures to monitor liquidity, leverage, valuation and expenses. Risk management procedures and its results are also part of the reporting requirements. To establish such detailed risk management procedures and processes means increased cost and changes in operations and governance.

Valuation & Remuneration – transparency is key

AIFMD has given great importance to valuation process and provides detailed framework of valuation procedures. Fund managers are required to appoint a person who is independent of portfolio management to value their holdings and carry out valuation function impartially, with skill and diligence. They may also need to appoint an external or third party valuation expert. Hedge fund managers should ensure adequate information reaches the valuation team and manage the version controls and documentation.

Remuneration is another area, which is given significant importance in AIFMD. For example, the directive requires that at least 50 percent of any variable remuneration of AIFMs consist of units or shares of the AIF. Variable and fixed remeration of senior management and AIFM need to be disclosed to investors and regulators in annual reports.  Hedge fund managers may have to review whether existing remuneration arrangements meet AIFMD guidelines and take appropriate action.

Disclosures – for close monitoring

The directive insists fund managers to file quite a lot of disclosures like investment types, strategies, concentrations, asset valuation, risk management procedures, stress test reports, remuneration, liquidity and leverage patterns etc. Such disclosures need to be made to both investors and regulators at regular intervals. The stress of paper work and documentation in this regard increases the burden of compliance for fund managers.

For hedge fund managers, moving from an unregulated structure to a regulated framework will not be a cakewalk. There is ample amount of work to be done with significant business implications and a smaller time frame. Adopting the potential strategies needed for the business will go a long way in ensuring success in the European soil.