Hedge fund managers are grappling with the ever-rising cost of compliance, as the waves of regulation from Europe and the US which followed the global financial crisis are implemented.
Uppermost in the minds of our investment manager clients is the Foreign Account Tax Compliance Act (Fatca), which the US is implementing on a global basis to require offshore funds to disclose information on investors and beneficial owners. This is being introduced alongside the European Union’s Alternative Investment Fund Managers Directive (Aifmd) which seeks to regulate managers operating in the EU and/or marketing their funds in the EU.
Under the Aifmd, EU managers promoting EU funds are subject to the directive from July next year. They will have access to a pan-European passport for marketing funds, once they have been authorised in one member state.
Managers with offshore funds can opt into the EU passport from 2015 with conditions broadly similar to those of the private placement regime.
Certain independent service providers must be in place, alongside various reporting requirements and non-EU managers must be authorised in the relevant EU member state of reference, with their home jurisdiction also meeting the prescribed requirements, including the required OECD-compliant Tax Information Exchange Agreements.
Under Fatca, or “the F-word” as many US lawyers have dubbed the initiative, both US and non-US investment fund managers have likely already begun the complicated and laborious task of performing due diligence on their investors to determine their status as US or non-US and as entities as opposed to individuals. The process is crucial because if the fund fails to provide the required information to the Internal Revenue Service then a withholding tax will apply to the entire fund with 30% charged on US source payments.
Particularly so for Fatca, where the fund is effectively operating as a tax collector for the US government, the cost of compliance with new regulation is a serious challenge and is making the start-up process for many either difficult or impossible. In order to make any progress, managers have to demonstrate a decent track record – which may work for those spinning out of former investment banking prop desks as a result of the Volcker Rule – however, that is not so straightforward for all new managers.
The previously ubiquitous hedge fund start-up example of two guys and a Bloomberg terminal has long since been replaced by managers working with a team of compliance personnel and, depending on their infrastructure, the outsourcing of significant compliance functions to third parties, which is keeping costs high.
The bottom line for investment managers is that without any seeding, the minimum assets under management required to launch these days is around $100 million (€77.5 million). We are seeing start-ups with less than that. However, sustainability is hard and to all intents and purposes, we have not seen a flood of new managers this year, notwithstanding gentle economic recovery.
Also conspiring to swing the pendulum further away from start-up managers and towards powerful institutional investors and sovereign wealth funds, is that business is increasingly being dictated by the investors with the biggest cheque books, who have the ability to negotiate preferential terms on issues like liquidity and access to information.
For the most part there is no easy capital out there anymore, regardless of the jurisdiction that funds are being raised, or deployed. Where capital is available, it typically comes with strings attached, providing one more headache for new managers as the cost of compliance keeps rising.
Ingrid Pierce is global managing partner at Walkers, and is based in the Cayman Islands
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