As the EU implements the Alternative Investment Fund Managers Directive, the hedge fund industry seeks ensure that the regulation of hedge fund and private equity fund managers is accomplished in a way that is consistent with the G-20 commitment to international coordination. In a letter to the European Securities and Markets Authority (ESMA), the Managed Funds Association said that a coordinated approach would be particularly important to global fund managers required to expend significant resources responding to requests for data, as well as to regulators seeking to assess the state of the financial system in a globally integrated marketplace. As the successor to CESR, ESMA is advising the European Commission on the implementation of the Directive, which creates a comprehensive and effective regulatory framework for hedge and private equity fund managers at the EU level.
During 2013 to 2015 there will be a passport for sales of EU alternative investment funds to investors within the EU. For US and other non-EU funds and managers, national private placement regimes will continue to operate. However, noted ESMA Chair Steven Maijoor, for these regimes to be used, appropriate co-operation arrangements will have to be put in place between the EU regulator concerned and the authority of the third country. The Commission has asked ESMA to provide advice on the establishment of these co-operation arrangement. In recent remarks, Chairman Maijoor said it would be more efficient for a single MoU to be negotiated by ESMA rather than obliging the US and other non-EU authorities to have separate discussions with up to 27 different EU regulators.
More granularly, the hedge fund association asked ESMA to consider that the calculation of assets under management pursuant to the Directive should be based on a fund manager’s net assets under management, which best reflects investor capital that is at risk, and not based on gross assets. Net assets, as calculated on an alternative investment fund’s balance sheet and audited annually, are easily verifiable, noted the MFA, while gross assets would be difficult for regulators to define and confusing for fund managers to calculate, which could lead to uncertainty for market participants. In addition, the calculation of assets under management should exclude certain assets that may be invested in a fund alongside investors’ assets, such as the manager’s own funds.
The association also asked ESMA to advise the Commission to calculate assets under management for non-EU fund managers that are regulated in their home jurisdiction by including only the assets of EU-based funds, the assets of non-EU based funds that are beneficially owned by EU investors, and the assets managed out of a place of business in the EU, such as by an EU sub-manager of a non-EU fund manager. The MFA believes that these three asset categories should be the primary focus of EU regulators and, therefore, should be the relevant factor in determining whether a fund manager should be within the scope of the full regulatory framework created by the Directive.
More broadly, continued the MFA, this approach would achieve the G-20 goal of regulating hedge fund and private fund managers in a manner that avoids inconsistent or unnecessary overlapping regulation. The MFA noted that the US has taken a similar approach with respect to registration of foreign private fund advisers under the Dodd-Frank Act.
The Directive defines leverage as any method by which the fund manager increases the exposure of a fund it manages whether through borrowing of cash or securities, or leverage embedded in derivative positions or by any other means. Neither the Directive nor the ESMA Discussion Paper defines the term “exposure” or how fund managers should calculate the exposures of their funds. The MFA urged the Commission to implement a similar approach for fund managers to calculate the exposure of the funds they manage as that used under the UCITS Directive, which provides alternative methods that managers may use for determining the global exposure of their UCITS funds, including any appropriate advanced risk measurement methodology.
According to the MFA, the definition of leverage has significant implications beyond the issue of determining which hedge fund manager will be required to be authorized under the Directive. It will be relevant to a wide range of regulatory considerations, including regulation of OTC derivatives and systemic risk monitoring and regulation.
With respect to hedge funds, leverage is generally obtained from large financial counterparties, including global banks and broker-dealers, that conduct substantial due diligence and engage in ongoing risk monitoring. Also, fund borrowings are done almost exclusively on a secured basis, which limits the amount of leverage that any fund may obtain. In the MFA’s view, this collateral posting reduces the credit exposure of counterparty financial institutions and makes hedge funds substantially less likely to contribute to systemic risk by causing the failure of a systemically important institution, such as a major bank.
Given the limited leverage and the collateral posted by funds, any losses that they incur are almost exclusively borne by their investors, not the general financial system. Thus, the MFA reminded that the leverage profile of an alternative investment fund is very different than that of other types of financial institutions, such as banks or principal dealers.
With that in mind, the MFA urged ESMA and the Commission to consider a number of factors relevant to the calculation of leverage and the extent to which leverage should be regulated. In considering leverage as a contributor to systemic risk, it is important to consider not only the aggregate amount of such leverage but also the sources and terms of such leverage. Debt that is secured, for example, significantly mitigates systemic risk compared to debt that is unsecured.
Also, the degree of an investment fund’s portfolio leverage must be considered in the context of its asset mix, including the liquidity of those assets, the liquidity rights of fund investors, as well as the size and nature of the capital markets in which those assets are transacted. MFA said that off-balance sheet exposures should be considered as part of determining overall leverage. However, the market value or risk of loss must be considered from a risk exposure perspective, as opposed to simply looking at notional values. Additionally, the nature of the instruments in question and risk of loss must be considered. For example, a purchased option has substantially less risk than a sold option.
The hedge fund association supports regulators having information about funds for purposes of systemic risk assessment, provided that sensitive, proprietary information is kept confidential by regulators. In this regard, the MFA urged the Commission to ensure that such confidentiality be maintained. Because a number of regulators around the world request information from fund managers, the MFA encouraged an internationally coordinated approach to such reports, as well as encouraging regulators to consider the extent to which requesting information from the prime brokers and other market participants and utilities used by fund managers may be a more effective way to gather and analyze information.
Moreover, in this area as in others, a coordinated approach would be more valuable to regulators, noted the MFA, since coordinated reports are more likely to produce data that can be compared across jurisdictions and would eliminate double counting of managers of funds, which will be critical to assessing the state of the global financial system.