The unprecedented turbulence of the past two years placed fund managers under significant pressure from investors: greater scrutiny of the risks inherent in the investment strategies employed, demands for liquidity at a time when many of the underlying securities were frozen or deeply discounted in value and persistent requests for reassurance about the future of the industry.
In addition to taking action to steady the markets and support the banks most affected by the credit crisis, governments have also taken aim at the financial services industry by introducing a raft of regulation that will change the industry in fundamental ways. Now, as the dust settles and all indicators point to a strong recovery, there is time to reflect on the forces that are likely to shape the industry over the next few years. This article will examine the issues that we see as being most important to managers worldwide, as well as taking a look at what the new regulations could mean for their future operations.
In Europe, the Alternative Investment Fund Managers Directive aims to rewrite the regulation of the funds industry within the European Union. At the heart of the debate about the Directive are differing political ideas about the level of regulation that is appropriate, necessary and beneficial. Even regulators acknowledge that the hedge funds and private equity funds did not cause the crisis and are not large enough to present a systemic risk to the financial system; but the political momentum demands some new regulation. The industry hopes any new regulation will be constructive and proportionate, particularly since the funds that are likely to be affected are typically offered to institutions and sophisticated (rather than retail) investors who perform extensive due diligence prior to investing and during the life of a fund. Indeed, it is not uncommon for institutional investors to make annual site inspections to their investment managers and ask for due diligence questionnaires to be completed and restated annually. Managers are often under significant disclosure obligations to ensure the investors are informed of any material events affecting the fund or the manager’s operations. There is a strong argument that self-regulation can and does work well for managers and investors alike. However, the thrust of the Directive is to increase the regulation of funds registered in the EU or offered to EU investors – some say at the cost of blunting the competitive edge of EU managers and compromising the returns of EU investors.
One of the key provisions is aimed at restricting the marketability of funds formed in “third countries” to investors based in the European Union. Precisely how the regulation will shape up is still uncertain; but it is clear that, without some form of compromise or parallel preservation of existing EU private placement regimes, it could have a profound impact on the factors to be considered when deciding on domicile for fund formation. After it is adopted, there will be a delay of a few years before the Directive is implemented in the member states, including the UK, so that it is unlikely to take effect before 2013 at the earliest.
These proposals have been hotly debated, and the US government has criticised the Directive as protectionist, restricting as it does the ability of US managers to offer their traditional third-country funds to EU nationals. Several non-European jurisdictions are negotiating for a resolution and, with this kind of outcry from national governments, investors and managers hopefully a sensible compromise can be reached. Many are concerned that certain managers will exit the EU to focus on raising capital from non-EU sources.
One potential compromise solution may be the introduction of a “passport system”, under which non-EU managers would have access to investors in all of the EU member states so long as they meet certain criteria with regard to cooperation between regulators, tax information exchange and anti-money-laundering laws. As long as such criteria are clear and fairly applied, leading fund domiciles such as Cayman or BVI are confident that they can comply with these standards as they now have a good history of compliance with international standards laid down by bodies such as the IMF, FATF, OECD and IOSCO. Managers would also be required to ensure that funds formed in third countries meet certain depositary and reporting requirements, which would be enshrined in agreements between the third country and the relevant member state.
It is hoped that the passport system will coexist with the current private placement rules applicable in each member state, until a passport system can be properly and fairly introduced. As all of this is still under discussion, the actual form of these rules could change again before a compromise is reached.
Other widely debated provisions of the Directive will place added burdens on managers; there are proposals for capital adequacy rules, third-party depositary rules and rules relating to manager compensation, among others. Some EU managers have expressed reservations about the proposals, which they believe will put them at a competitive disadvantage. Likewise, private equity and venture capital managers are equally concerned at the impact that the Directive will have on their respective industries. There is concern as to the level of disclosure required from private equity firms about holding companies owned by them, which will be greater than that required from other types of shareholders and investors, as well as to more stringent rules relating to “asset stripping” under the Directive. This is discriminatory as it does not treat investors across the market equally. Investors are wary that the added regulation will negatively affect the financial performance of funds, and concerned that the additional rules are unlikely to result in enhanced protection for investors in practice. In March 2010, the European Private Equity & Venture Capital Association issued a survey of the views of its members about the Directive. Sixty-seven per cent of the investment firms surveyed indicated they would either withdraw from venture and growth investment completely in the EU or reduce their allocations by over 30 per cent if the Directive is implemented in its current form. This would have a serious impact on the economies of the EU member states as the EVCA contends that over 90 per cent of European venture capital is invested in small to medium-sized enterprises as well as depriving developing countries who rely on investment funds raised from EU investors to finance important infrastructure projects such as hospitals, roads and power plants in emerging market countries.
The irony is that the regulations may ultimately harm the interests of EU investors that they are supposed to be protecting. Institutional investors within the EU may be deprived of access to managers of third-country funds unless they can find a way of investing in the funds without breaching the Directive. One school of thought is that only those managers with a large European base of investors will submit themselves to the added rigours of the Directive. An alternative theory is that certain managers may offer the stringently regulated products to EU investors and the more loosely regulated alternatives to non-EU investors. Increased cost and lack of access to perhaps the fastest growing non-EU emerging markets could severely hamper returns for the European pension fund industry just at a time when pension obligations are increasing.
It is unlikely that the non-EU investors will wish to invest in products or managers regulated under Directive if they can also invest in a non-regulated fund managed by the same manager (or an affiliate) that is free from the expensive and inefficient regulatory constraints. The ultimate effect of all of this increased regulation may simply be a decrease in the amount of capital that finds its way into EU markets to the detriment of the EU member states, and an exodus of fund managers from the EU. With that in mind, a sensible compromise must surely be seen to be in everyone’s interests.
When looking at the new United States regulation, you cannot avoid two important pieces of recent legislation: the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act), and the Hiring Incentives to Restore Employment Act of 2010 (the Hire Act).This article does not permit a detailed analysis of these groundbreaking statutes, both of which will have a material impact on the financial services industry for years to come, including the funds industry in the US and globally.
The Dodd-Frank Act will affect US public companies and non-US entities who do business in the US or with US persons. One of the notable changes is that the Act extends investment adviser registration and record-keeping and SEC inspection requirements to advisers of private funds (whether US or non-US) and to other advisers, who had previously relied on the fewer than 15 clients rule, if a fund has at least US$100m of US assets under management and regardless of the number of US clients. There are certain exemptions to this rule, but broadly, hedge fund managers (who have not already done so) and private equity managers alike will be registering with the SEC in droves until 21 July 2011. This will have the effect of bringing many of the private equity fund managers under SEC regulation for the first time. In addition, many smaller hedge fund managers will be required to register. The additional costs relating to the infrastructure necessary to operate as an SEC-regulated adviser will affect the number of new entrants to the market.
The other much discussed rule is the “Volcker Rule” which prohibits proprietary trading and limits sponsoring or investing in hedge funds or private equity investments for banking entities (as defined in the Dodd-Frank Act). The Dodd-Frank Act does provide certain flexibility including the retention of up to 3 per cent of the Tier 1 capital to be held in private equity and hedge funds and provides for reasonable time frames to wind up the proprietary investments above this threshold. However, one likely impact of the Volcker Rule is that the financial model for many of the banks will change dramatically with a swing back to more traditional and conservative banking practices or will at least limit the part of the bank’s business to within 3 per cent of its Tier 1 capital. The 3 per cent exemption may be sufficient for many banks to manage their business going forward without having to spin out their investment arms. However, although the numbers of spin-offs may be less than would otherwise have been the case had the 3 per cent exemption not been included, one can still expect to see increased activity within the banking sector as banks unwind structures which do not fall within the exemption or simply determine that this is no longer a core business for them going forward.
The Hire Act may be the most far reaching tax and information reporting law ever enacted. It could affect all types of investors from individuals to family trusts, non-US banks, funds (mutual, hedge and private equity) and other institutions with any investments in the United States. In summary, the Hire Act requires an entity falling within the definition of a “foreign financial institution” (FFI) to either enter into an arrangement with the IRS pursuant to which the FFI agrees to determine which of its investors are US persons or entities substantially owned by US persons or suffer 30 per cent gross withholding on all US source income. Unless exemptions are granted to non-US funds that expressly preclude US persons from investing, this could have a major impact on the reporting and “know your client” due diligence requirements imposed on such funds and on their investors. It will require all existing funds to verify the identity of their investors and, where their investors are not natural persons, the identity of the owners of corporate investors.
Representations have been made that certain types of funds will be excluded. In September 2010, the IRS issued a notice offering formal guidance about the account-holder identification requirements. There is a distinction between pre-existing accounts and new accounts and between accounts held by individuals and accounts held by corporate and other entities. For example, individuals holding existing accounts can submit a W-8BEN form certifying that they are not a US person for US tax purposes. However, for new accounts, documentary evidence will be required establishing the tax status of the new account holder. For non-US entities holding pre-existing accounts, each individual and entity with an interest must be identified and documentation produced establishing whether such person is a US person for tax purposes. While it remains to be seen precisely what additional burdens the enhanced due diligence requirements will involve in practice, it is clear that the provisions will make due diligence more time-consuming and, therefore, increase the costs that may be passed on to investors.
Although many investors may welcome the increased regulation of the industry, there are some investors and managers (and their advisers) who are concerned that it will also diminish the returns that can be offered and that it will act as a barrier to entry for new managers. The increased costs will be passed on to investors and it is already clear that the number of start-up managers has diminished from the halcyon years of 2000 to 2007. As referred to above, the vast majority of private equity managers will, for the first time, be regulated by the Securities Exchange Commission and all managers subject to the registration rules are required to submit applications by 21 July 2011.
In summary, one can see that the increased regulation of managers and the increased administrative burden placed on the managers, funds and their service providers will have a detrimental effect the size and future growth of the funds industry globally. It is unlikely that we will see new managers enter the market unless they are either very small and fall within certain exemptions to registration or large enough from launch to support the infrastructure required to operate within the new regime of regulation and disclosure. We may see some spin-offs as a result of the Volcker Rule and law firms in Ireland and Luxembourg may experience an uptick in the formation of private investment funds formed solely for EU investors, while the Cayman Islands continues to form appropriately regulated funds for sophisticated non-EU and US tax-exempt institutional and high net worth investors.
Having surveyed the regulatory landscape ahead, below I take stock of the current numbers to see how the industry is bearing up to these additional pressures.
The Cayman Islands has been recognised as the leading jurisdiction outside of the United States for the formation of open ended “hedge funds”. Since the number of fund registrations acts as a bellwether for the health of the funds industry, the statistics demonstrate that it is alive and well and growing in the Cayman Islands. The latest figures record approximately 9,600 funds registered with the Cayman Islands Monetary Authority (CIMA), so it would appear that, notwithstanding the barriers to entry for new managers, fund formation has at least stabilised after the reduced formation rates over the last two years, and is arguably once again on the increase. CIMA’s figures indicate that the number of open ended “hedge” funds registered with CIMA will soon be back to the levels recorded in 2005, while terminations decreased by 40 per cent compared to comparative 2009 figures. The new growth is very good news for the industry and the nature of the growth is also significant; while a large number of new funds registered in the last quarter of 2008 and in 2009 were opportunistic in nature, focused on distressed debt opportunities and TARP-related investments, 2010 has heralded the formation of ever increasing numbers of funds being formed by new and existing managers to capitalise on opportunities other than those created by the market dislocation caused by the economic meltdown.
We have also noted that despite much press attention to the contrary, managers are not moving their funds from the Cayman Islands in droves to Ireland or Luxembourg. The numbers of private funds registered each month in Ireland and Luxembourg supports this conclusion. However, following the introduction of the Directive, we may see an increase in Irish and Luxembourg private funds solely for the EU market for the reasons referred to above, with Cayman Islands funds continuing to be offered to US tax exempt investors and non-EU investors. Fund managers going forward seem focused on offering both Cayman or BVI funds and complimentary UCITS or “Newcits” products depending on the appetite of the investors.
Likewise, the number of formations of exempted limited partnerships, the favoured vehicle for private equity fund formation and alternative investment vehicles to US-domiciled private equity funds structured as limited partnerships, has also rebounded to 2006 levels. Although fund formations are still less frequent than in the past, there are signs of private equity managers returning to the market to raise successor funds. In addition, we may also see increased incidence of institutional spin-offs from the banks as a result of the Volcker rule.
PE funds are finding it easier to get deals done as the credit markets ease. As the 2006 to 2008 vintage funds continue to draw down capital this will certainly assist those coming to the market to raise successor funds and will accelerate the fund formation activity in the coming years. Although certain LBO managers have successfully raised new capital recently, (notably Blackstone’s BCP VI raising in excess of US$13 billion), the mid-market managers and sectoral or regional funds have also been successful in raising capital in the past 12-months. Latin America and particularly Brazil appear to be hot sectors for fund raising at the moment with several institutional managers having established a significant presence there. Assuming the markets continue to recover and credit continues to ease, there is likely to be a significant increase in private equity fund formation in 2011 and beyond.
Trends in Hedge Fund Terms
As of 30 September 2010, Maples has acted for over 300 of the 810 funds registered this year with CIMA. Based on our analysis of the offering terms for those funds we have noted some downward pressure on management fees. This is slightly surprising when you take into account that funds have generally got smaller and that the costs of running a regulated fund are likely to increase with increased regulation. Coupled with the pressure of fund-raising, new managers will have a difficult time hiring and motivating key employees until the fund reaches capital levels in excess of US$100 million. It would seem that fund managers raising less than US$50 million are effectively bankrolling the first couple of years of the life of the fund with the expectation that they will break even in terms of operating costs in years two and three. These are changed days from the billion dollar start-ups of less than five years ago.
Incentive fees are still 20 per cent or thereabouts but often with hurdles and high-water marks. There has been much discussion about managed account products. These are often structured as single-investor companies ensuring that the investor retains control over the fund, is not impaired by fund level gates and can enjoy full-transparency from the manager. These types of products seem most popular with the large sovereign wealth funds investing in the best of breed managers in the United States and Europe. Notwithstanding the recent credit crisis and the high level of suspensions and gates operated by funds during this period, approximately 50 per cent of the new funds we have advised on since the crisis have launched with fund level gates and only approximately 15 per cent with investor level gates. Over 25 per cent of the funds launched had soft lock-ups ensuring capital levels were maintained for a minimum of 12 months and penalties were charged for redemptions during that period and approximately 15 per cent of the funds launched had hard lock-ups.
In other trends of note, independent directors are also becoming the norm for funds domiciled in the Cayman Islands notwithstanding that in most cases there is no tax or regulatory requirement to have independent directors. Instead, market practice has evolved and investors now expect to see independent directors on the board to represent their interests. The standards of oversight expected by these directors is also evolving and the directors are participating in more formal meetings with the managers and other advisers appointed to the fund on a regular basis.
There is also an increased demand by investors for the appointment of independent administrators. There appears to be a trend for consolidation within the administration market. Many of the large institutions have acquired other administrators in order to increase their AUA. These types of administrators may appeal to certain fund managers but one can also see that certain managers will be attracted to the smaller boutique operations who can offer a more tailored and independent service, while maintaining an IT infrastructure which is at least the equivalent of the larger administrators.
In addition, notwithstanding the credit crisis and the demise of Lehman, only 25 per cent of new funds launched had appointed more than one prime broker at launch. However, this is not to say that the funds do not plan to appoint additional brokers after launch, size and cost permitting.
In conclusion, it would appear that the number of fund formations suggests that the established managers are raising new funds and that the industry will continue to grow. The best of breed will undoubtedly get larger, attracting investors who are seeking safe havens for capital rather than performance at any cost. Unfortunately, other than the potential spin-offs from the banks; it would appear that the future flux in the market may be as a result of managers having to make careful choices about where they wish to be regulated as a result of the political arbitrage caused by the new regulatory regimes imposed by the EU and the US. The regulation of the financial services industry in the European Union and the United States is undoubtedly going to be the most influential factor that shapes its future, and signals the dawn of a new era.