Thursday, September 26, 2013

US Hedge Fund Industry Asks for Revision of ESMA Proposed Guidance on Hedge Fund Directive

The U.S. Hedge Fund Industry has asked the European Securities and Markets Committee to revise and clarify its proposed guidance under the E.U. Alternative Investment Fund Managers Directive. In a comment letter to ESMA, the Managed Funds Association asked that the proposed guidance be amended with respect to master/feeder funds, funds of funds, and other tiered funds to avoid duplicative reporting requirements. The MFA also requests that hedge fund managers be permitted to report information on the basis of the best data available, given the short time periods for filing quarterly reports.

The MFA also asks for clarification whether the definition of position or instrument should be an individual security or whether it should refer to a group of securities that have the same risk profile. For example, if a hedge fund owns 5 separate U.S. Treasury bills with similar maturity dates should those 5 positions be aggregated as one instrument or should they each be treated as a separate instrument. In this regard, the MFA also noted that the Annex IV templates in the Directive appear to use certain terms
interchangeably such as “principal instruments”, “important instruments”, “principal exposures”, “main instruments”, “important markets” and “most important concentrations."

Indeed, Items 13 ( principal exposures) and 14 ( most important concentrations) in the Directive seem duplicative by requiring information on both principal exposures and most important portfolio concentrations as the two concepts may overlap significantly. To the extent that ESMA does not see significant differences between them, the MFA suggested that these two be combined into one.

The draft guidelines states that investors that are part of the same group should be considered as a single investor. However, it is not clear what “group” means for this purpose.

Master-Feeder Funds. The draft proposes that hedge fund managers managing non-EU master hedge funds that are not marketed in the EU should report for such master funds the information requested by Article 24(2) of the AIFMD if one of the master fund’s feeder funds is marketed in the EU. In this regard, the Article 24(2) Reporting Template contains various line items requiring investor-related information. In the view of the MFA, this gives rise to a number of issues as to how such investor-related information should be reported.

For example, when reporting for a master fund, presumably the fund manager would need to look-through to the feeder fund that is marketed in the EU. If so, the MFA asked if these investor-related questions are to be answered only with respect to those class(es) of the units/shares of the feeder fund that are marketed in the EU or would they need to be answered in relation to the entire feeder fund.

If the relevant information on the master fund needs to be reported on a look-through basis, reasoned the MFA, it would seem duplicative to require that fund-specific information under Article 24(2) of the AIFMD must also be reported individually for each feeder fund. In order to avoid duplicative reporting in the case of master-feeder structures, the hedge fund association suggests that hedge fund managers should be allowed to report, at their option, either at the individual feeder fund level or at the aggregate master fund level. This would also harmonize the reporting requirements between the EU and the US as the SEC’s Form PF reporting requirements in the US allow this option.

Fund of Funds. Hedge funds that are funds of funds typically have only three types of assets: cash, derivatives, and investments in underlying hedge funds. As a result, said the MFA, for such hedge fund, a significant amount of information as required under Articles 24(1) and 24(2) of the AIFMD is either duplicative or inapplicable.

For example, Item 13 (annual investment return) in the Article 24(2) Reporting Template appears to be inapplicable since a fund of funds does not have information on the portfolios of the underlying hedge funds in which it invests. Item 14 (trading and clearing mechanisms) in the Article 24(2) Reporting Template requires clarification regarding whether investments in underlying hedge funds should be considered “securities” for the purposes of this section, and if so, since such investments are not traded on a regulated exchange, confirmation that OTC should be selected. In addition, information on such fund’s exposures, positions and main instruments will largely be the same since it typically has a concentrated portfolio.

In any event, the underlying hedge fund manager would already be obliged to provide information to the relevant regulators for those underlying hedge funds that are marketed in the EU, reasoned the MFA, so having the fund manager report information again on the fund-of-funds would appear to be duplicative.

To avoid duplication, the MFA suggests that hedge fund manager managing funds of funds should be permitted to disregard any investments made by such funds in underlying hedge funds. In this regard, the MFA noted that, by allowing hedge fund managers managing fund-of-funds to disregard investments in underlying hedge funds This would make the EU reporting requirements consistent with the requirements under SEC Form PF.

Collateral. Hedge fund managers may post collateral in various situations, e.g., collateral on short term borrowing facilities, or collateral on facilities for the purposes of leveraged exposure. The MFA assumes, and suggests, that this item only covers collateral posted on facilities utilized to gain exposure. Further, a hedge fund’s entire prime brokerage account may be subject to a lien in the event of a default by the fund and the value of such prime brokerage account may significantly exceed the value of borrowings. The hedge fund association asked ESMA to clarify whether there are any assets potentially subject to a lien that should not be considered collateral for the purpose of this section.

Value at Risk. The draft guidelines propose that hedge fund managers should report the value at risk (VaR) of the relevant hedge fund. Due to some of the inherent weaknesses of VaR as a risk metric for strategies transacting in less liquid asset classes, many managers do not calculate VaR as part of their risk management processes. As such, the MFA does not believe that the reporting of VaR should be a mandatory requirement. Rather it should be an option for hedge fund managers to decide.

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