New rules concerning funds were the hottest topic at The Lawyer’s second Funds Summit. Joanne Harris reports
It is probably fair to say that few funds lawyers have yet had a chance to sit down and digest the latest doorstep-sized document that will affect their industry. But that has not stopped the European Securities and Markets Authority’s (Esma) whopping 500-page report on the Alternative Investment Fund Managers Directive (AIFMD) from shooting straight to the top of the list of hot topics.
Of course, AIFMD has been a key consideration for the European funds industry since it was proposed in April 2009.
After the directive was agreed on by European politicians and bureaucrats in November 2010 Esma was asked to produce technical advice on the plan. This so-called ‘level 2’ work forms the bulk of the final report released in mid-November, just days before funds lawyers and other industry figures gathered near Brussels for The Lawyer’s second Funds Summit.
Accordingly, although the summit focused on a wide range of industry issues, the AIFMD kept coming up. It is likely to affect a large proportion of the funds sector, catching sub-groups including hedge fund and private equity fund managers, and affecting the domiciles in which funds can be established.
Esma’s report comes amid a raft of regulatory changes in the financial sector, including revisions to the Markets in Financial Instruments Directive (MiFID), and puts AIFMD in that context. It adds some elements to the final text of the directive, which was published in July, but also changes some terminology.
The main areas covered by Esma’s advice are operating conditions for managers, the governance of an alternative investment fund’s depositary, transparency and leverage requirements, and the supervision and cooperation arrangements between EU member states and third countries.
During the public debate before the legislation was agreed, the third-country issues proved to be among the most contentious. With a strong focus at the summit on jurisdiction, delegates were keen to examine the relative merits of traditional funds jurisdictions such as the Cayman Islands and the Channel Islands, established onshore domiciles including Ireland and Luxembourg, and up-and-coming countries such as Malta and Gibraltar.
In the past year most offshore lawyers have spoken of their confidence in the health of their jurisdictions, but Dechert partner Peter Astleford, chairing a lively debate on hedge fund jurisdictions, told attendees that he thought more work was going to European jurisdictions than many believed. Astleford pointed out that managers
who have traditionally instructed UK lawyers are turning to other European jurisdictions instead.
“London private practice lawyers are steadily seeing their share of the global market shrink, and are probably not aware of it,” he remarked. “There’s a radical shift going on from Cayman to onshore Europe.”
Maitland Group partner John Langan agreed that managers’ jurisdiction choices were changing as a result of regulation.
“I think the difference is going to be, certainly post-AIFM, that anything in the EU is going to be more regulated than it was,” he said.
Emerging in the EU
It is this move towards regulation that is giving confidence to the ‘emerging’ EU jurisdictions of Malta and Gibraltar. Both have seen significant growth in funds work in the past few years and pride themselves on having sensible, flexible regulatory systems that appeal to managers and investors alike.
Most of the growth has been in the experienced or professional funds area, aimed at sophisticated, high-net-worth investors.
Hassans partner James Lasry said at the summit that the advent of AIFMD would strengthen Gibraltar’s offering.
“Until AIFM came along there wasn’t much difference between the Channel Islands and the other EU jurisdictions,” he pointed out.
Camilleri Preziosi partner Laragh Cassar admitted that the jurisdictions still had some work to do to be as competitive as their larger counterparts, notably Luxembourg and Ireland. For Malta, one of the main things to address is the availability of depositaries.
Under the AIFMD rules every fund will have to have a depositary. Malta has only three custodian banks able to act in this role, but is working to attract more.
At present, both Malta and Gibraltar have an advantage over more established countries because the relatively low number of funds domiciled in both jurisdictions enables swift access to their regulators. Lasry admits this advantage will not last forever.
“Dublin exists because Luxembourg got too heavy, so the run-off work went to Dublin,” he said.
Delegates agreed that Ireland and Luxembourg are now well set up for fund launches, although the choice of jurisdiction might not always be because of the structures offered.
While choosing a jurisdiction based on what its regulatory system and structures offer makes the most sense, other factors – notably client wishes – also have
to be factored in. There may be cultural issues at play, and sometimes a jurisdicion is chosen simply because of familiarity rather than it being the most obvious domicile for a fund.
Client demand remains a key factor in the funds industry and it is something that many fund managers and lawyers are considering due to the capital waiting to be invested from Asia. Undertakings for Collective Investment in Transferable Securities (Ucits) funds, which are regulated onshore vehicles domiciled in the EU, are immensely popular with Asian investors and look to remain so, despite the introduction of the AIFMD.
Even Irish lawyers admit that Luxembourg has the edge over Ireland as the domicile of choice for Asian investors in Ucits. Dechert Dublin partner Declan O’Sullivan said more marketing needs to be done by Ireland to make up the gap.
But offshore jurisdictions are also still hugely popular in Asia.
“An awful lot of Asian investment still goes into Cayman and British Virgin Island structures,” commented Langan.
Quite how popular funds established under AIFMD will be for Asian investors remains very much up in the air.
“The reality today is that Ucits is the only passport we’ve got to sell funds,” remarked Lieven Debruyne, chief executive of Schroder Investment Management (Hong Kong). He added that he thought that Ucits still have a “great future” as a target for Asian capital.
EU – why?
In contrast, panellists pointed out that AIFMD could lead to managers questioning the benefits of an EU domicile. Depositary liability in particular is a concern, in terms of attracting Asian money and more generally.
According to HSBC Securities Services associate general counsel Stephen Lear, “the jury’s out on who ultimately will bear liability” in the case of, in Esma’s words, “a failure or negligence or in the event of loss of a financial instrument held in custody by the depositary itself or a sub-custodian”.
But Citigroup head of legal Nigel Kemp is sanguine about the liability issue.
“I think I could discharge the burden of proof that’s going to be put on me,” he said.
However, Kemp added that the “big issue” when it comes to depositary liability is defining what counts as an “external event beyond reasonable control”, as depositaries will not be liable for any loss in such circumstances.
He pointed out that it is not always possible to identify when a custodian bank or similar institution might be in danger of collapse. Referring to the recent insolvency of broker-dealer MF Global, Kemp said nobody knew the business was going to collapse until it did.
Although Esma’s advice refers to the segregation of assets, Kemp expressed some concern that regulators are still struggling with the concept.
“I’m still not convinced that the FSA can tell me what’s client money and what’s a client asset,” he told the summit. “Segregation of assets as a principle is only as good as the person who’s required to segregate the assets.”
Rules and regulations
Regulation was the focus of the speech given by Investment Management Association (IMA) chief executive Richard Saunders, who closed the conference. He highlighted a number of EU proposals, including the AIFMD, that he said concern the association. These include the European Market Infrastructure Regulation (Emir) that governs matters including the clearing of over-the-counter derivatives, proposals for a financial transaction tax and changes to MiFID.
Saunders told attendees that at present the IMA is spending “most time” lobbying on MiFID, but he expects some of the issues being raised in MiFID to rear their heads again in future versions of the Ucits directive. Among those issues, and connected with AIFMD, is the treatment of third countries.
“The default position of the European Commission is protectionist,” Saunders said, pointing out that it makes no sense to have different third-country regimes in AIFMD and MiFID.
“The challenge is to explain to politicians why this is a bad thing,” he added.
Saunders emphasised the importance of a healthy investment environment in the current economic climate.
“Growth requires people to invest and take risks, but if ordinary people aren’t going to be allowed to take risks where’s that growth going to come from?” he asked.
– M&A: avoiding culture shocks
Increased regulation in the investment funds industry is leading to consolidation. The UK’s biggest listed fund management company, Man Group, has acquired a number of businesses in the past few years, most recently hedge fund company GLG, at a cost of £1.1bn.
At a session looking at M&A in the investment management sector, Man Group head of legal Jasveer Singh said the key to a successful merger in the sector was to address both personnel and cultural issues.
He pointed out that acquiring another business, rather than growing organically, involves a manager’s record and investor base as well as his skills.
“The emphasis – and the tension – is on creating the right performing environment for the fund managers you’ve just acquired,” Singh said.
He added that another tension during deal negotiation is trying to identify a target’s investor base. This information tends to come late in the day, but it is crucial to find out where the synergies and overlaps are between investors.
Although Singh and fellow panellists, KPMG partner James Woolf and Freshfields Bruckhaus Deringer partner Jonathan Baird, agreed that many of the considerations involved in merging investment management businesses applied to other sectors too, they said the question of culture and individuality was key.
“Asset management is somewhat more ephemeral than many other businesses,” Baird concluded.
– Litigation funds: the issues
With litigation funding gradually growing in popularity there are several issues those wanting to launch a fund must grapple with. Unlike most other investment fund types, a litigation fund has little in the way of tangible assets. It is also still a relatively new form of investment, so not only do managers have to persuade investors to put money into a litigation fund, but they must also persuade a regulator that setting such a vehicle up is a good idea.
It is these problems that the founders of Argentum Capital and its advisers Bristows and Carey Olsen have been dealing with recently, culminating in the recent listing of the fund on the Channel Islands Stock Exchange (CISX).
As Carey Olsen of counsel Daniel O’Connor explained at the summit, preparing the fund for listing meant Argentum and its advisers spent a lot of time speaking to the Jersey regulator and putting across their “calm and believable message” about the asset class.
Bristows partner Iain Redford said the concept that the CISX and the Jersey Financial Services Commission (JFSC) struggled most with was that, due to insurance protecting against the loss of a case, a litigation fund had no downside.
The other tricky issue is valuing the fund, although as O’Connor said this would be even harder in an open-ended fund. Valuation is difficult because of the amount of cash held by a litigation fund. Argentum chief executive Louis Young told attendees that at any one time the fund could be holding up to 70 per cent of its capital as cash.
Young said the fund had developed a barrister panel to assess potential cases before agreeing to fund them. He said this raised the chance of providing good returns to investors.