TRENDS IN INVESTMENT MANAGEMENT THE CHANGING FACE OF FUND DISTRIBUTION s Investment Manager Conference in September 2010 discussed how regulatory change is impacting on fund operation and distribution. BACKGROUND Investment managers are faced with an array of legislative change with the potential to fundamentally affect how they continue to run their businesses and reach their clients. From the latest development of the UCITS brand across Europe to the advent of the FATCA legislation in the United States, managers should be aware that their business could be affected in unexpected ways. Our role is to assist our investment manager clients with the issues they face to listen, advise and help them implement any required changes as seamlessly as possible Peter Cherecwich Chief Operating Officer, Corporate and Institutional Services and Head of Global Fund Services North America + 00 1 312 444 3366 pbc1@ntrs.com Against this backdrop, s Investment Manager Conference in London explored where areas of potential threat and opportunity may lie. Among the conclusions reached were that mangers will face increased cost and time pressures resulting from new compliance and administrative obligations. While some will be able to take advantage of efficiencies and economies of scale, many will also need to demonstrate greater levels of transparency and a more sophisticated understanding of risk issues in the near future. These trends carry long-term implications for investment managers business models. Ongoing investment management regulatory initiatives include: UCITS IV Directive legislation developing the Undertakings for Collective Investment in Transferrable Securities (UCITS) fund regime, primarily aiming to make European Union (EU) fund distribution easier through harmonisation across member states. Alternative Investment Fund Managers (AIFM) Directive EU legislation that aims to bring a higher level of supervision to the management of alternative investments. Dodd-Frank Act a US Act of Congress overhauling the system of financial regulation in the United States (US); it aims to make financial institutions more accountable for their actions and enhance oversight of them in order to detect and prevent systemic risks to the US financial system. Foreign Account Tax Compliance Act (FATCA) another US Act of Congress, aiming to combat tax evasion by imposing an information exchange requirement on financial institutions about US citizens with overseas financial affairs.
THE UCITS IV OPPORTUNITY In extending the principle of funds harmonisation further across the European landscape, UCITS IV presents investment managers with substantial opportunities for wider and more cost-effective fund distribution. Opportunities and obligations The ability to passport funds from country to country through a single pan-european management company is among the most significant opportunities presented by UCITS IV. The new framework will allow a UCITS-authorised management company in one EU member state to manage a UCITS fund located in another, negating the need for a management company to operate in every jurisdiction where distribution takes place. This may offer a number of substantial cost consolidation opportunities. The use of a master feeder UCITS IV fund can result in the reduction of tax drag and afford institutional investors greater returns on investment Karen Hamilton Head of Fund Administration Product Development +44 (0)207 982 2234 kh67@ntrs.com Karen Hamilton, s Head of Fund Administration Product Development, also highlighted the significant potential tax efficiencies available through the process of asset pooling: The use of a master feeder fund to pool investor assets under UCITS IV can result in the reduction of tax drag potentially by as much as 50 basis points and afford institutional investors greater returns on investment, she said. Other potential benefits available include a simplified and swifter process for entering and distributing in new European markets through the recognised and trusted UCITS brand. UCITS IV s opportunities come with a wider set of obligations, however. These include requirements for increased levels of governance and oversight over the day-to-day operations of the fund, its policies and controls. In order to take advantage, managers will need to take a number of actions. These include producing a Key Investor Document (the document providing investors with an understanding of each fund s risks and rewards) for each fund and/or share class, as well as identifying opportunities for the use of master feeder funds. The opportunities afforded under UCITS IV from its expected implementation in July 2011 mean investment managers will also need to conduct reviews of their funds and company structure to determine their fit with the UCITS framework. If they are to take advantage of passporting opportunities, the country of choice for their management company should also be carefully considered. Choosing a UCITS IV management company base With EU member states currently considering their individual interpretations of the Directive, investors will need to carefully assess the UCITS IV regime that is eventually implemented in every country and how each fits with their own business requirements. When considering the jurisdiction of choice for their management company, the potential opportunities available for investment managers will of course vary in each case. Multicounty managers in particular will need to carefully assess their operations in each EU
member state in order to ascertain the jurisdiction where efficiencies can best be gained for their business. In addition, tax treatment is likely to be among a fund promoter s foremost considerations. Here, Ireland and Luxembourg have potentially stolen a march on other member states, having already given assurances they will not create local tax liabilities for foreign UCITS IV funds managed by an Irish or Luxembourg UCITS IV management company. The ability to access local advice through a broad pool of experts such as accountants, lawyers and other types of financial professional is also likely to be important to investors, as well as high regulatory standards. In this respect, those countries with well-established and strongly-supported fund management industries will enjoy some advantages: It is very likely that investors and fund promoters will seek to align themselves with the strongest regulatory regimes, said Hamilton. Assisting investment managers with UCITS IV adoption "The CCF is a potentially useful option for investment managers who do not currently have the scale or desire to fully set-up their UCITS fund structure from scratch" Phillip Caldwell Global Head of Cross- Border Pooling +44 (0)207 982 2471 pdc1@ntrs.com A range of products and services are available from to help managers take advantage of UCITS IV. These include a fund hosting service available through our Irishdomiciled Common Contractual Fund (CCF). Investment managers lacking an efficient fund vehicle can use this platform as the vehicle within which their fund is housed, and deliver investment strategies through it in a timely and cost-effective way: We have developed this platform to be a useful option for investment managers who do not currently have the scale or desire to fully set-up their UCITS fund structure up from scratch, said Phillip Caldwell, s Global Head of Cross-Border Pooling. Managers from outside the EU can also host their fund on the platform as an efficient means of distributing their investment strategies to European clients, he added. As well as allowing investment managers to distribute products to the institutional market without setting up their own UCITS structure, the CCF makes use of our expertise in cross-border pooling. This innovation allows certain institutional investors to invest on the tax-efficient basis mentioned above, making use of treaty arrangements in place between their home jurisdiction and the country of investment to potentially reduce certain taxes on the fund's investments. UCITS IV places increased emphasis on the monitoring of risk, and is also well-positioned to assist here. Ian Castledine, Global Head of Investment Risk Product for Asset Servicing, said: With UCITS management companies required to observe stringent risk management arrangements, a real need exists for investment managers to fully understand their risk and reporting obligations.
This goes beyond simply monitoring levels of Value at Risk, and concerns areas such as counterparty, credit, concentration and other risks. The key is not only monitoring these, but understanding how the interaction between them impacts on your overall risk. To this end, services available range from the delivery of daily exposure reporting to providing a complete suite of reporting and analytical tools. Where it is useful, these can also be delivered through technology that allows the display and delivery of information to be tailored to suit managers particular monitoring requirements. Northern Trust is also experienced at working with both clients and regulators to design, develop and implement systems that can help managers meet their obligations. Hedge funds: towards greater transparency and the rise of newcits A real need exists for investment managers to fully understand their risk and reporting obligations Ian Castledine Head of Investment Risk Product for Asset Servicing +44 (0)207 982 2471 ic14@ntrs.com Turning to hedge funds, this is an area where investors are continuing to retain and increase their exposures 1 ; however they are responding to industry events such as Madoff and Lehman in four distinct ways: a) Retaining their offshore Cayman funds but demanding greater transparency b) Demanding a shift to a so-called regulated jurisdiction such as Ireland or Luxembourg c) Demanding a shift to separately managed accounts d) Demanding a shift to UCITS The flexibility of the UCITS regime is being increasingly used by hedge fund managers to distribute their funds across Europe in the form of so-called newcits. This is also likely to continue under UCITS IV. Newcits are UCITS-compliant vehicles that are allowed to engage in some hedge fund-like investment activities, but are nonetheless subject to certain constraints. They are compelled to meet the transparency, liquidity and regulatory oversight requirements of UCITS III and are barred from using leverage to achieve their investment objectives. All of this is helping satisfy investor preferences for greater liquidity and transparency from their hedge fund managers, as well as for less exposure to risk. According to Ian Headon, s Senior Product Manager for Alternative Asset Servicing, the most visible trend in this market is investors demand for significantly increased levels of transparency: Transparency is now institutional investors number one concern and expectations of their managers in this area have shifted accordingly, he said. Headon outlined how investors have become more exacting than ever in setting out their requirements not just for visibility over portfolio composition, but over a range of connected investment issues: Investors are demanding a much greater level of detail, not just on portfolios but also on the processes used to build them, he said. In fact, I would argue that 1 Source: 2010 Preqin Global Hedge Fund Investor Review
transparency of reporting around hedge fund managers investment processes is now as important as reporting on the portfolio itself. With a recent survey of the alternatives industry finding that 78% of institutional investors believe is the biggest challenge they face over the next three years 2, most other concerns have been relegated to secondary status. For example, almost no concern exists over the domicile of funds and even performance has slipped down investors list of worries. Investors are demanding a much greater level of detail, not just around portfolios but also on the processes used to build them Ian Headon Senior Product Manager, Alternative Asset Servicing Tel: +00 353 1 542 2062 ih8@ntrs.com Having been affected in many cases by falling asset values, institutional investors are developing a heightened awareness of risk issues, however, and are looking for closer communication with their investment managers. In fact, Headon feels that investor communication is likely to become a service differentiator: Again, transparency and the communication of risk issues are fast becoming fundamental to the client experience and investors are asking themselves a range of questions on a daily basis regarding their investments, he said. These include: Do I understand what my manager is doing? Do I have warning systems in place to let me know if they deviate from their strategy? And do I have ongoing communication from them in terms of letting me know what they are doing? Managers that are unable to meet these demands will increasingly find themselves at a competitive disadvantage, he added. One thing is certain: as both investors and regulators demand more information on the risks being taken by managers, the ability to demonstrate a sophisticated understanding of risk issues will become an essential part of the investment management toolkit. FUNDS REGULATION: BUSINESS AND SYSTEMS CHALLENGES UCITS IV is only part of an ongoing wave of regulation spanning Europe and the US. However, it is perhaps unique in that investors can be relatively certain of its governing rules and timetable to implementation in July of next year. By contrast, the potential effect of new measures such as the Alternative Investment Fund Managers (AIFM) Directive or the US Dodd-Frank Act is far less certain at present. Unlike UCITS IV, much of this new legislation has emerged largely in response to the 2008/09 market crisis, and is intended to enhance quality of governance and investor protection through tighter controls and greater levels of scrutiny. Managers and those who support them should be prepared for its impact; failure to prepare could prove very costly. Unfinished business: The AIFM Directive The EU s AIFM Directive aims to impose tighter regulation on hedge funds, private equity investors and other alternative investment managers, and conference delegates heard how it looks set to impact on various aspects of fund distribution and operation. These include 2 Source: Transformation The Future of Alternative Investments, KPMG, 2010
some restrictions being placed on the use of non-eu domiciles for vehicles and managers selling products in the EU; the latter are likely to be required to apply for a passport in order to market their funds across Europe. It is also likely that the product strategies and domiciles used by investment managers will require review in order to ascertain whether they remain fit for purpose. Other potential impacts of the AIFM Directive include a significant increase in recordkeeping and disclosure obligations. Possible consequences here include an increased level of administration and compliance, while operational staff may be required to take on more complex roles. The outsourcing of back and middle-office functions may be an option considered by many investment managers as a result. Managers should keep a watching brief on regulation, and remain in touch with their custodians, administrators and professional advisers Karen Hamilton Head of Fund Administration Product Development +44 (0)207 982 2234 kh67@ntrs.com New universal depository requirements will also expand the role of the custodian and impose additional responsibilities and greater levels of liability upon them. Finally, the introduction of a similar remuneration framework to the investment banking sector is also likely to present a number of challenges. The AIFM Directive has been an ongoing area of uncertainty and negotiation between EU member states. Investment managers should keep a watching brief and remain in contact with their custodians, administrators and professional advisers regarding any measures that may be required before it comes into force. On the day this paper was issued, 11 November 2010, the AIFM Directive passed into law following a plenary vote of the European Parliament. A significant amount of level-two work on the Directive s implementation will now commence and will be issuing further communication shortly. Developing trends in the US marketplace: Dodd-Frank and FATCA Both the Dodd-Frank Act and FATCA potentially present non-us managers with challenges of which they may be unaware. The preamble to the Dodd-Frank Act, or The Wall Street Reform and Consumer Protection Act (its full title), states its lofty purpose: it is intended to, create a sound economic foundation to grow jobs, protect consumers, rein in Wall Street and big bonuses, end bailouts and too big to fail [and] prevent another financial crisis. Investment managers should be aware of the scope of the Dodd-Frank Act since it will increase the likelihood that they will need to be registered with the US Securities and Exchange Commission (SEC) if they manage money on behalf of US clients. While there are a number of exclusions that require further clarification before the Act can be implemented, broadly speaking managers who advise any fund that is not a US fund registered under the US Investment Company Act of 1940 and which currently avails of exemptions from the requirement to register under section 3(c)(1) or 3(c)(7) of the 1940 Act, will be required to register with the SEC.
These managers will therefore be obliged to file regular reports covering areas of their business ranging from counterparty and credit risk to valuation and trading practices, and will also need to develop their knowledge of the SEC requirements. The obligations faced may prove to be very arduous. FATCA and Dodd-Frank are not simply compliance issues; they present significant systems and business issues which managers need to start considering now Patrick Wilkinson General Counsel Tel +00 353 1 542 2097 pw40@ntrs.com FATCA is broad and penal in its scope and imposes a 30% withholding tax on all withholdable payments paid to any non-us institution that refuses to identify its US clients, even if these persons directly or indirectly hold only non-us assets. With the withholding tax effective from 2013, and detail of the regulations now being drawn up, investment managers affected need to be conscious of their likely obligations. Early preparation and close consultation with their professional advisers is again recommended. Where exposure to FATCA is less clear, investment managers may need to undertake analysis of their underlying client base and drill-down to a significant level of detail in order to ascertain if any of their beneficial owners are US customers. In such cases, product and delivery strategy may again require re-examination especially if managers are affected in what they consider to be non-core markets. They should also investigate whether their business fits within the scope of the FATCA exemptions. Commenting on the potential impact of Dodd-Frank and FATCA, s General Counsel in Ireland, Patrick Wilkinson, said: If investment managers have US clients or beneficial owners, they certainly need to be aware of these pieces of legislation and the issues they potentially raise. Their obligations may prove to be very arduous and the solutions required could be highly resource-intensive. For those reasons, regulation potentially throws up systems issues and significant business issues, Wilkinson added. As ever, preparedness is absolutely key. PREPARATION WILL BE KEY TO ACHIEVING A COMPETITIVE EDGE Many of the actions necessitated by regulation and changing client behaviour are likely to require investment by managers in their systems, personnel, communications and compliance infrastructure. For many, this will highlight the need to make use of efficiencies and economies of scale wherever possible, in order to reduce costs and increase effectiveness in the face of a more demanding regulatory and client environment. To adjust, some managers could potentially reshape their business models to distribute more effectively, while others may reduce the complexity of their businesses and distribution processes to focus on their core products and clients. While the pressures facing managers may have the potential to erode profitability, early preparation will help them avoid unnecessary penalties and enhance their competitive positioning.
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