A senior UK Financial Services Authority official has examined the proposed regulations issued under the EU hedge fund Directive by the European Securities and Market Authority (ESMA). The proposals were issued at the request of the European Commission. In remarks at a PwC global alternative investments seminar, Sheila Nicoll, Director of Conduct Policy, discussed leverage, risk management, depositary liability and transparency around the Alternative Investment Fund Managers Directive, 2011/61/EU.
She noted that, in many cases, the proposed regulations have been aligned to existing requirements in the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive or Markets in Financial Instruments Directive (MIFID). But in others, the AIFMD is in new territory, requiring new rules on leverage for example. The proposed regulations are in two stages. The first stage is a set of proposals on non-passport areas, which has just been issued, while the second set to be proposed later in the summer will deal with passport issues.
Depositaries are a highly sensitive subject which has received a lot of political scrutiny. Several important principles in this area were agreed to during the original debate on the Directive, but authority was delegated to the Commission to develop more detailed rules covering some very significant policy issues. According to the Director, one of the most contentious aspects of this part of ESMA's proposed rules is the liability of a depositary to provide restitution to the fund for lost assets.
ESMA is consulting on whether the starting point should be an assumption that the depositary should be liable for the actions of its sub-custodians as if those actions were performed by the depositary itself. The UK official noted that, when delegating custody to its sub-custodians, the depositary must follow the comprehensive due diligences procedures which are in the ESMA advice, and monitor them on an ongoing basis. Ms. Nicoll finds it counterintuitive that the robust requirements proposed by ESMA do not change the extent to which the depositary is liable for actions within its sub-custodians. She questions if this mean that the depositary will be liable for events outside its reasonable control.
ESMA considers that depositaries must identify and monitor potential loss events if they want to avoid liability for the loss. The proposal also says that depositaries, in some cases, must take additional appropriate actions but unfortunately it does not then go on to explain what these are. The Director urged ESMA to explain what these additional actions look like and when they must be taken.
ESMA has also considered the relationship between the depositary and prime broker which is particularly important in the hedge fund area. Depending on the option selected in relation to the financial instruments that can be held in custody, noted the FSA official, the prime broker could be viewed as a sub-custodian to the depositary when holding assets as collateral. This may not be an optimal outcome, said the official, and it is important that the consultation fully examine the consequences if this were the final result.
Under the Directive, the fund manager must for each fund it manages, that is not an unleveraged closed-ended fund, employ an appropriate liquidity management system and adopt procedures which enable it to monitor the liquidity risk of the fund and ensure that the liquidity profile of the investments of the fund complies with its underlying obligations. The fund manager must regularly conduct stress tests, under normal and exceptional liquidity conditions, which enable it to assess the liquidity risk of the fund and monitor the liquidity risk accordingly.
Regarding leverage, the Director said the focus here needs to be on proportional application and robust methodology. With regard to proportional application, ESMA seeks to take account of how the fund and its investors view leverage by providing for an advanced method allowing for tailoring by the manager so as both to meet the disclosure needs of investors and to act as a reasonable benchmark against which maximum leverage limits can be assessed. A robust methodology should help limit the extent to which leverage can be hidden behind layers of derivatives or via complicated hedging and netting relationships.
The Directive requires fund managers to implement and annually review adequate risk management systems in order to identify, manage and monitor appropriately all risks relevant to each fund investment strategy and to which each fund is or can be exposed. Overall, noted Ms. Nicoll, risk management has been a relatively uncontentious area since it draws heavily on existing UCITS requirements. The one area of contention is around the provision of a non-exhaustive list of specific safeguards the fund manager should apply against conflicts of interest to ensure the independent performance of risk management activities. The debate relates to whether all or certain safeguards should be mandatory. The Director would like to see comments on what the impact of these safeguards would be in practice, particularly for smaller firms, and their likely effect on cost or potential to create barriers to entry.
The Directive requires an independent performance of the valuation function, but this can be done within the fund manager or by an external valuer. ESMA clarifies that the valuation function refers only to the valuation of individual assets and not the administrative function of calculating the NAV; and that there can be more than one external valuer. In the view of the FSA official, the implications are that fund administrators that calculate the NAV should not be considered to be external valuers. She also noted that, when a fund manager performs the valuation function it can still delegate or separately contract with third parties for the performance of some of the tasks involved, provided it retains responsibility for the valuation function itself.
One of the main objectives of the Directive is to increase the transparency of AIFM vis-à-vis investors and regulators. In furtherance of this goal, the Directive includes requirements regarding the annual report of the fund, initial and ongoing disclosure to investors and reporting to competent authorities. ESMA has proposed that all fund managers should be required to report to the competent authorities on a quarterly basis. The Commission’s mandate asked ESMA to provide advice on the appropriate frequency of such reporting, taking account the potential risks posed by specific types of fund managers. The FSA Director encouraged commenters to consider the extent to which they feel that that Commission’s mandate has been met, and the practicalities and costs of such reporting in practice.