With the regulatory environment for alternative managers about to change significantly under the Alternative Investment Fund Managers Directive (AIFMD), depositary banks discuss if the industry is sufficiently prepared. Chaired by Nick Fitzpatrick.
Brian McMahon, managing director, business development, alternative investment services (BNY Mellon Asset Servicing)
Georg Lasch, head of client development (BNP Paribas Securities Services, Luxembourg)
Pervaiz Panjwani, securities and funds services head (Citi Luxembourg)
Olivier Renault, country head (SGSS Luxembourg)
Eef Verachtert, senior vice president, head of alternatives Europe (Brown Brothers Harriman)
Funds Europe: Is the fund management industry at a point yet when it can manufacture AIFM-ready funds? If not, what is needed?
Brian McMahon, BNY Mellon: Luxembourg has worked hard to get the industry as ready as it can be. Last year, there was a change to the SIF [specialist investment fund] law which brought in some of the necessary risk-management and conflict-of-interest polices a year ahead of time. Upcoming regulations, including the limited partnership regulations, are going to be important for the alternative investment business in future. The question is, though, whether an alternative investment fund manager – the AIFM itself – is ready to actually be an AIFM. This entails the question about who the AIFM is. That’s where I would start.
Luxembourg’s legislation is strong but our challenges centre on the AIFMs themselves rather than the legislation to support them.
Georg Lasch, BNP Paribas: The whole AIFM story will start when the AIFMs start moving. I expect the majority of the future in-scope AIFMs are now aware of what’s coming, but probably only 25% of them know what they have got to do. The question is, how quickly can they do it?
The majority of funds in Luxembourg are self-managed SIF structures which means that – going by regulations already in place – they do not need to put in a lot more substance.
They will next need to select a manco [management company] as the AIFM, or give themselves up as being an AIFM. Both tasks are challenging and so I would expect that only a few companies will be ready
on July 22 [when the Alternative Investment Fund Managers Directive (AIFMD) comes into force] and they will be the ones that want to take advantage of the distribution opportunity under the AIFMD. They are the large managers that probably already have quite a lot of substance in place.
Eef Verachtert, Brown Brothers Harriman: A good number of asset managers are ready but there are still a significant number that are not – particularly those managers that do not have a European infrastructure or have not been actively focused on the European market.
In fact, some of those managers are not even aware that they might be in-scope. For example, a US-based asset manager, managing a Cayman-domiciled fund, with a few European investors. That type of manager will be in-scope eventually but they have probably not started thinking about the AIFMD yet.
Those asset managers that are ready will look at AIFMD beyond it being a compliance issue and take a more strategic and longer term approach when it comes to product launch. For example, will their next fund be domiciled in Luxembourg, or elsewhere? And how will they define which products to launch for which investor?
Pervaiz Panjwani, Citi: As an industry, Luxembourg is reasonably well positioned and could adapt the directive in local legislation by May 1 or much earlier.
But, as mentioned, it really is about whether the alternative investment managers are ready, who will take the lead and at what point the regulators would be able to approve an AIFMD-compliant fund.
For this to happen it is necessary to continue the partnership between the Luxembourg Fund Industry Association and the CSSF [Commission de Surveillance du Secteur Financier].
Olivier Renault, Societe Generale: AIFMD is mainly concerned with EU hedge funds and private equity managers. For a non-EU AIFM, they have until 2015 to launch AIFMD-compliant funds. For EU AIFM funds, it’s more complicated.
I’m not sure AIFMs are ready to launch funds. The regulation overall is more constraining and this means more cost. However, this could be an opportunity for Luxembourg.
Funds Europe: How will the greater risk for depositaries under AFIMD and Ucits stricter liability rules be priced? Has this issue already impacted pricing? Are clients prepared for this?
Panjwani: This is going to be the most contentious issue. It will create enormous pressure on the margins of all parties in the funds industry chain right from the asset managers to the service providers.
As service providers, we will be taking on a much higher level of liability.
There is an absolute need for the education process for clients as well as a proper analysis about the right level of pricing, given the additional risk taking by the depositary banks.
A few months ago the market discussions were around six or eight basis points risk premium but now the talk is between one and three basis points.
That could change again depending on whether depositaries have to take a capital charge on their balance sheets, which is not yet clear. That’s a big question.
When that question gets verified the actual charge will become firmer to allow more meaningful discussions with the prime brokers and managers.
Renault: Depositaries will need to perform more controls and this will cost more money. The impact will be on operational risk and operational cost. The risk of the liability of the restitution of the asset is an insurance risk.
It will be difficult to explain to clients that they will have the same service as before, but that they must pay higher fees for it.
Depositary banks should increase trustee fees, though I am not optimistic that this will happen.
McMahon: There will be more effort, more risk and, potentially, more capital needed on our balance sheets. Even with competition, I can’t see how fees will remain the same as they are today.
I’ve heard some interesting comments from clients and potential clients about fees they expect. In some cases, they are significantly higher. Some clients are prepared to pay more. Other clients are turning around and saying, “Surely this is the sort of work you have already been doing.”
Verachtert: With the additional liabilities and the additional duties that a depositary clearly has to demonstrate, which requires additional manpower for them, the industry has to expect upward pressure on fees.
Lasch: The issue is also linked to the complexity of funds.
Even with AIFMs there are funds with traditional assets in them that are not so far from what a Ucits would hold. There are also funds with complex assets for which there is much more additional work to be done.
The impact both in terms of cost and, probably, of fees is going to be different for different types of funds.
I assume also that funds will be regarded differently depending on the quality of the actors. If we have to take additional liability for funds that have prime brokers that are of a lesser reputation, that will probably have an impact in terms of risk-reward and, therefore, on fees.
In general, people expect a rise in fees. The question is, what is the additional charge? Is it one, two, three basis points? I’ve seen people mentioning 20, 40, 50 basis points. That’s clearly out of range.
McMahon: We are also being asked about fee caps.
Lasch: And what of a cap on liability?
Panjwani: We must also be careful with risk arbitrage among service providers to avoid a situation where some people may take a view that they need to drop prices to get new business.
That will compromise the risk management practice.
Funds Europe: How will depositaries and prime brokers work together under the AIFMD given historical issues where prime brokers lost assets in the safekeeping of despositary banks?
Lasch: There is still an issue in the hedge fund space with prime brokerage. Liability for the restitution of assets lies on the AIFM’s depositary.
In other words, if there is a default at any level in the structure, the depositary has to restitute the assets. A prime broker has a certain amount of control about where assets are, but does not have to restitute them.
So on one side there is the depositary with full liability, and on the other side there is another player in the market that does not have that same liability. This is a kind of a hands-free blank guarantee for the prime broker.
Hedge funds are well informed and are generally gearing up for AIFMD, but prime brokers are not.
It’s a tricky subject, certainly for Luxembourg, though it’s slightly different for Ireland. The introduction of the requirement under the AIFMD for depositaries to restitute assets means that, as hedge funds deposit a large piece of their assets with prime brokers, there is a new potential liability for a depository versus a prime broker.
That is something that will have to be fixed contractually and if prime brokers do not move in that direction and accept a similar liability to a depositary, they will quickly find that some depositaries will not be able or willing to work with some of them.
McMahon: The serious prime brokers understand that in order to have depositaries working with them they have to approach this in a serious way.
It obviously changes the economic model of the prime brokers quite considerably depending on which way they look at it.
The Irish model is touted by some as what they want to pursue, and by this they mean the status quo. But there’s going to be a significant conversation about this. We’ve been having conversations for a long, long time.
As an industry, we have to be consistent so that there isn’t regulatory arbitrage. There is supposed to be commonality across Europe as to how this is approached.
The challenge is to get to an agreed model with agreed contracts in play in the next six months, which is going to be tough.
Renault: The main difference between the sub-custodian and the prime broker is the fact that the prime broker can re-use the assets, which is not the case with the sub-custodian. With a sub-custodian you can be sure that you control the assets. This is not the case with a prime broker.
Lasch: Even if they don’t re-use the assets, the problem remains that the prime broker has a different sub-custodian network.
Panjwani: So what needs to change are the contractual terms between the prime broker and the depositary. If a depositary appoints a prime brokerage as its sub-custodian, the depositary needs to see how the level of enhanced liability is either guaranteed or indemnified by the underlying prime brokerage so that we can ensure that the depositary continues to remain fully indemnified for the liability that it is taking.
This is one model where market is potentially heading.
McMahon: As an example, one of the drivers of the directive is the safeguarding of individual funds’ assets, which is meant to be done through segregation. But a prime broker uses more of an omnibus account, so there is a break between what the directive demands and how the prime broker model works.
Funds Europe: Which services or products in the fund management space have been most in demand? How has this changed?
Renault: Statistics over the past four years show that in Europe Ucits assets increased by 36% and non-Ucits funds increased by 67%. Although Ucits are still bigger in total assets, it means that non-Ucits funds are more and more common and services for them have been more in demand.
I would say real estate funds, front-ranked private equity funds, family offices and SIFs have been important.
In terms of the services asset managers ask for, they have asked us to develop their distribution in new countries. They want to widen their range of financial products and the countries they want to invest in.
They want to invest more and more in emerging markets.
Verachtert: The asset classes we have seen growing fastest have been fixed income – as can be expected during economic uncertainty – exchange-traded funds, as well as alternatives across the major alternative asset classes of real estate, private equity and hedge fund strategies. We could question if those alternative asset classes will continue to grow in the form of funds, with the increased regulatory pressure hence increased costs; that is, will investment managers continue to set up fund structures for their clients, or will they move instead to segregated accounts which – though typically more expensive for the asset managers to run – than the additional costs of becoming compliant with AIFMD?
McMahon: A study last year found that between January 1, 2008, and June last year 400 billion left traditional assets and 1.3 trillion went into alternative assets. That word alternative is misleading, therefore.
They were alternative back in 1990s but now these assets and strategies are common.
The managed account pieces in segregated accounts are coming much to the fore. It’s where people want to go on managed account platforms. It’s certainly an area that we see substantially growing.
Luxembourg is well positioned in respect of some debt and infrastructure funds.
The master/feeder structures are interesting at the moment, and from a company perspective, one of the things that we’re looking at and have been asked more about is limited partnership servicing, which is where pension funds are actually the investor and handle some of their investments. That’s something that’s certainly growing.
Lasch: We see the alternative space growing in terms of clientele too, often real estate and private equity. Loan funds and infrastructure funds are growing as well and, generally, fixed income funds.
Now that global stock markets are coming back a bit, we’ve seen strong demand for pure equity funds over the past three months.
In terms of services that our clients are looking for and requesting from us, anything we can do to help them in their risk management has been in strong demand for the past year and has been driven by regulation or by the requirements of mancos to provide risk management services.
But also other services like collateral management, anything around over-the-counter markets is still a trend and will continue over the few next years.
Panjwani: Our clients want us to help them grow their business globally, whether its Asia, Latin America or the US , they want us to help them connect to the distribution support network.
There is also demand for regulatory-led related services to help our clients prepare themselves for the changing business models in this regulatory environment.
Funds Europe: How long does it take to bring a traditional fund, and a Ucits alternative fund to market? How does this compare with three years ago? What are the complications?
McMahon: It’s taking longer for funds to get investors into them. It’s not the regulation per se. Fundraising in private equity can be from a one-year process to a two-year process, so some funds, on that basis, are taking longer but it’s not from a regulatory point.
Last year, when the SIF laws changed so that a SIF couldn’t be launched without approval, other markets tried to take advantage of that.
But, in reality, the majority of funds always went for SIF approval before launching. few funds went for the launch before approval.
Lasch: We do get questions that we did not get before and this is largely because the regulator is proactively looking at future regulations. We get a lot of questions about agreements and even about depositary liability and so on, just to write it in a more precise wording as it will be required in future regulation.
In the alternative Ucits space, we must also recognise that the regulator is itself learning. They obviously want to understand products, so when something new comes along they ask many more questions than they used to for certain types of alternative products as they want to understand and grasp the risks behind them in a more efficient way.
Regulators in Hong Kong are extremely slow because they are in the same boat.
Panjwani: It also depends on how straightforward or complex a fund structure is, which can impact the fund launch timeline.
Renault: I agree. I would say there are two main drivers.
The first one is how well the asset manager is used to filing funds in the CSSF and the second driver is the complexity of the product.
If the manager is used to filing funds then the process is quite quick. If it is both a plain vanilla fund and the manager is used to CSSF filing, I don’t see any delay.
But for asset managers that are new to the market, or if the product is exotic or complex, it does take more time to reach the market with funds, though I don’t know if this is due to the efficiency of the regulator or to the complexity of the fund itself. On top of that, I would say the commitment of investors is also important.
Funds Europe: What are the main challenges and opportunities you see in the asset servicing industry in the next two years?
Panjwani: There is a challenge with how we as an industry become more innovative in the face of increased regulation.
I talked earlier about how we can help clients go to where the land of opportunity is, such as Latin America.
How do we help our clients with distribution support? That’s where the opportunities are for.
But to take a step down from this and looking at specific Luxembourg-related challenges and opportunities. Again, the challenges surrounding the compression of pricing and margins due to increased regulation, and how we will continue to play an important role, are important.
Luxembourg is playing an interesting, careful and cautious role in trying to bring out the right legislation at the right time, such as the changes around the limited partnership role, and trying to order and promote the private equity industry. That will play to the strength of Luxembourg as an industry.
We will also see more conversion from long-only management to alternative asset management and if Luxembourg creates the right path, the advantages of this will be seen.
Lasch: A longer-term challenge on the regulatory side lies with Ucits where we are starting to talk about the depositary passport around Europe. That is a challenge for Luxembourg – certainly as a cross-border country – but it’s also a question of whether the Ucits brand will be associated with Luxembourg in the end. That’s a challenge we should be watching closely.
More generally, the biggest challenge as Pervaiz has mentioned, is really on cost and basically the cost of doing business, be it for Luxembourg or be it for the industry, influenced by cost of headcount on the one hand, and by regulation, tax, and everything that we see in our industry.
It is clearly a threat when you have regulation changing on a continuous basis that you will just adapt all the time and won’t find the time to halt for a strategic view. That’s a threat over time for the industry because you have to plan your products in order to be in the market.
AIFMD is a great opportunity for Luxembourg, such as the investor protection piece, even though it’s associated with cost. It will give institutional investors an additional sort of safety feeling that is needed, particularly for some of the assets that are used in those funds, and I do believe that’s going to push more investors into that space.
I also believe that, with future regulation of Ucits, we’ll probably also see the alternative Ucits move back into the AIFM environment, which will allow them to readapt their investment policy to what they wanted to initially do while at the same time getting access to a similar distribution as a Ucits.
McMahon: The immediate challenge, from an AIFMD perspective, is managers actually getting to grips with it and the regulators giving the approvals. It’s going to be a landscape that ebody is just going to watch with interest to see how best to avail of the market and how to apply themselves and invest there.
There’re a lot of concepts around this and there’s a lot of investment. We are seeing a shift in the industry from being benchmark-orientated to being more outcome-linked, so the pension side is becoming more important. The industry will be asking itself which the strategies are that then allow those outcomes to be fulfilled, so we have to be a little bit more solution-orientated with a bit more awareness of the drivers
Clients really do want to have end-to-end servicing. There will be rationalisation through the next couple of years as asset managers look through their portfolios and that will lead to opportunities for some and threats to others.
I agree that distribution is a big piece. It’ll be interesting to see whether distribution of AIFMD is actually something that is a real benefit, or just something nice but isn’t really availed of. Certain clients are optimistic about it, others don’t view it as strategic.
Verachtert: The challenge for the next six months to two years will be to have all parties up and running with the AIFMD from operational and contractual perspectives, and from an organisational-structural perspective.
The AIFMD is just one piece of regulation that makes service providers and asset managers realise that there is more to it than just being compliant with new regulations; the regulations affect their entire organisation, and not just the legal and compliance departments.
In terms of the opportunities, we will see more asset managers embracing the AIFMD as they recognise the benefits of the distribution aspects as a distribution tool to attract wider investment.
At the same time that is also the opportunity for service providers.
The industry is on a curve in terms of distribution support. Now there is opportunity for them to expand themselves to the alternatives sector.
Renault: I agree that regulations for asset managers mean they are focusing a lot on the administrative elements and less on development. This could be an issue for Europe in relation to the emerging markets.
Developments in markets such as the Middle East, Asia and perhaps even in Africa in future might be missed.
AIFMD is a question mark.
If investors want more regulation it can be a real opportunity for Europe.
But I am not sure about the appetite for investors towards regulation. For pension funds and institutional investors it should be of use in theory because they prefer regulated funds to non-regulated funds.
If the appetite of investors increases for regulated funds, asset managers will apply for AIFMD, and if they do, I am not sure if that will make sense to keep their structures in the Cayman Islands. They could decide to relocate their structure in Europe.
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