MiFID II: The Final Countdown

MiFID II has been a long time in the making, and the repeated delays may have led some to think that 12 months is plenty of time to get ready. However, this is a far-reaching directive with implications across trading, transaction reporting and client services, encompassing IT and HR systems. Firms need to get on the front foot now to ensure they can meet the requirements of the directive this time next year.

Fail to plan, plan to fail
Anyone relying on Brexit to create further delay, or to be repealed, should think again. While the Brexit timelines are not yet confirmed, MiFID II will pass into UK law this summer and will come into effect in January 2018. Even after it formally withdraws from the European Union, the UK is expected to follow the MiFID II regime.

So now is crunch time. There are a number of obvious challenges, as well as some that may have slipped under the radar. Some business changes may prove relatively straightforward, such as creating formal documentation for existing processes, but others could well involve sweeping changes to how managers run their business, interact with counterparties and even how the industry itself is structured.

Reporting obligations
In line with the overall goal of increasing transparency and improving market abuse detection, MiFID II will usher in sweeping changes around transaction reporting. Hedge fund managers have typically relied on the sell-side to fulfil both sides of the transaction reporting obligation on their behalf.

In Principle: 10 Things You Need To Know For 2017

On 23 June 2016, the UK shocked the world, and perhaps itself, when it voted in favour of a “Brexit” from the European Union. While the referendum result has brought significant uncertainty to the financial services sector, the Financial Conduct Authority (FCA) has made it clear that, from a regulatory perspective, it is “business as usual”. Indeed, it is clear that firms cannot afford to stand still in the wake of the referendum result, since financial regulation has, as always, continued to evolve.

In this publication, we focus on 10 key issues that authorised firms should be aware of going into 2017:

  • Brexit – key challenges ahead for financial services firms
  • FCA Mission Statement – a new mission for the FCA?
  • MiFID II – a whistle-stop tour for investment managers
  • extension of the Senior Managers and Certification Regime
  • Market Abuse Regulation – market sounding guidance for buy-side firms
  • mandatory clearing obligations under EMIR
  • AIFMD – ESMA advice on non-EU AIFM passports and proposed changes to Annex IV reporting requirements
  • increased regulatory scrutiny of the asset management industry
  • regulation of distributed ledger technology-enabled financial services
  • key takeaways from enforcement matters involving the FCA in 2016.

We begin by assessing the immediate challenges in the regulatory environment that Brexit would bring for financial services firms. We also examine the key themes in the FCA’s new mission statement, which we expect will form the foundation of the regulator’s 2017-2018 Business Plan.

Alternatives: A Traditional Fixed Income Replacement

As 2016 becomes less visible in the rear view mirror, investors are once again compelled to look forward as they construct durable portfolios. While markets may look uncertain to many sage investors, there have been some key uncertainties removed from the market including the US presidential election, crashing oil prices, Fed-direction uncertainty, and the positive/negative sign on global growth. Very significantly, one key driver of portfolios, global bond returns, appears to have come to the end of a 35-year bull run. The professional allocator is thus faced with the usual conundrum of how to position the portfolio differently, if at all, in 2017 and beyond plus the fiduciary pressure to replace bond exposure with another asset class. Despite the press widely reporting on the death or at least new paradigm of the hedge fund, it is again worth considering adding a lower-volatility, well-diversified hedge fund exposure to make up the gap left by traditional, long-only fixed income returns.

Editor’s Letter - Issue 119

Average hedge fund performance for 2016 was in line with the majority of institutional investors’ expectations, per Preqin; few now expect double-digit returns. EurekaHedge reckon the industry made 4.48%, the SS&C Globe Op Performance Index was up 5.11% and the HFRI Fund Weighted Composite Index advanced 5.6%. These returns are consistent with industry history, when defined as a spread over risk-free rates: still near zero in most OECD countries. Still, some event-driven, distressed debt, emerging markets and energy related strategies were well into double digits for 2016.

Yet the worst-performing strategy of 2016, managed futures (on average, with some notable outliers particularly among short-term traders) received the largest inflows, according to eVestment. This illustrates how many allocators are motivated by portfolio diversification rather than rear view mirrors. The search for uncorrelated returns remains the single most important reason for hedge fund allocations, as the 2016 EY Global Hedge Fund and Investor Survey (EYHFS) found.

Hedge fund industry assets remain at record levels of $3 trillion and the EYHFS finds that most institutional allocators intend to maintain stable allocations. After six consecutive years of asset growth, the industry paused for breath but we expect that the growth will resume. Liquid alternatives launches of high-calibre UCITS and ’40 Act funds continue, and are reaching out to wider audiences of investors. Meanwhile some vast asset management markets, such as the world’s fourth largest – Australia’s – are becoming easier to access.

A Measure of Certainty

International developments are giving fund managers and practitioners a lot of food for thought: Brexit, the US election, market volatility and an evolving regulatory landscape, particularly as the European Commission continues to consider third party passporting under the Alternative Investment Fund Managers Directive (AIFMD).

With so much international activity it’s understandable that managers, promoters, legal advisers and service providers to hedge funds are focusing on what it means for their operating models and how it might impact their fund structuring options.

As the sixth largest centre for hedge fund management globally, Jersey takes a keen interest in these developments, and the latest figures show that alternative funds business conducted through Jersey is holding up well. At the end of June 2016, for instance, the value of funds under administration in Jersey stood at just over $300 billion (up 2% from June 2015), with the number of funds established in the jurisdiction remaining stable.

For Jersey at least, the overall picture is one of stability. There has been very little volatility in Jersey’s funds figures over the past few years, in hedge or other classes. At the top end, some larger fund managers are continuing to raise significant funds, but there is also a trend for a growing number of smaller, new managers to use Jersey as a domicile for their funds.

ESG Under Scrutiny

Environmental, social and governance considerations continue to rise in importance among the investment community, across all asset classes. Yet, with ESG priorities and principles varying hugely from investor to investor, the fit between fund manager and allocator is by no means straightforward.

For this paper, we looked back at five very recent customised manager searches in public and private markets where ESG played a significant role. Two of these engagements - a Private Debt selection exercise for the UK Environment Agency Pension Fund and a Public Equity search for a European family office - are presented in detail. These asset classes sit at opposite ends of the spectrum in terms of the extent to which ESG has become embedded and marketed. The subsequent discussion draws on insights from other relevant searches in private equity, public equity and even renewable infrastructure during the past three months.

We hope that specific insights drawn from practical examples, as opposed to broad generalities, will be useful for both investors and managers involved in this sector. Many of these lessons relate to manager analysis, or how to dig beneath increasingly sophisticated window-dressing to assess actual practices. Whilst the number of ESG-branded offerings continues to rise across all asset classes, it has become increasingly challenging to distinguish between box-ticking and substance.

Overall, the universe of products and strategies continues to shift away from exclusions and screens, towards bottom-up factor integration and active engagement. Indeed, recent press from the likes of CalPERS on the underperformance caused by negative screens is likely to intensify the pre-existing trend. Yet each of these approaches, particularly integration, can take many forms.

Don’t Ignore the Start-Ups

In today’s world it’s fair to say launching a hedge fund is not as simple as it once was. Gone are the days of one or two people, in a room with a small amount of their own cash and some more from family and so-called friends, trading away with little or no infrastructure.

Prime brokers were willing to accept them as clients, there were no minimum revenue requirements, and the Regulator was at arm’s length at best, providing light touch regulation. Some of those firms have gone on to become the so-called “Titans” of the hedge fund industry. Winton Capital for example launched from a small office in Kensington in 1997 with $1.6m under management and now manages some $28bn.

What does the landscape look like now? Very different is the answer and it doesn’t appear to be getting any easier for the entrepreneur money manager.

Figures this year show a global trend which has seen the lowest levels of hedge fund launches in the opening quarter of a year since 2004. In fact, more hedge funds managed in Europe closed than opened during 2015 - a first. At the same time however allocations to hedge funds still increase year on year.

So where does the money go? Well typically it goes to the “Titan” managers whose assets under management are in the multiple billions and whose owners frequently feature in the Forbes or Sunday Times Rich Lists.

Yet performance for most of the world’s hedge funds hasn’t been great and some of these managers have succumbed to the pressures of it all, returned capital to outside investors and turned themselves into quasi family offices, essentially running their own monies and those of their partners. This trend is likely to continue for the next few years at least or until the regulatory pendulum swings back, but that does not look likely to happen.

Investment Funds On Hook For US Pension Liabilities

Funding shortfalls have been growing in recent years for reasons including greater longevity and lower interest rates. Most pension funds do not have any hedges against rising life expectancy. Meanwhile, lower interest rates and tighter corporate credit spreads reduce the discount rate at which pension liabilities are calculated.

Additionally, many companies and pension fund sponsors around the world, including private equity firms, have been closing pension funds to new members, seeking to reduce benefits, and have ceased funding. Investors in distressed companies may have a particularly strong need to reduce costs in order to turn around firms and ensure they can survive post-bankruptcy, or possibly avoid going bankrupt in the first place. Defined benefit pensions, open to new members, are almost extinct outside the public sector.

But some recent US legal rulings are moving in the opposite direction of market and economic forces. Owners of US companies – including some private equity funds – could become more frequently liable for making extra contributions to remedy pension fund deficits, after a legal judgment in response to a case brought by a trade union. Sun Capital Partners was found liable for pension liabilities at bankrupt Scott Brass Inc. (Sun Capital Partners III, LP, Sun Capital Partners III QP, LP, and Sun Capital Partners IV, LP, v. New England Teamsters and Trucking Industry Pension Fund in 2013). This was despite Sun Capital following widely used structuring techniques to avoid liability.

Post-Brexit Aftershocks on the Horizon

The Brexit vote on June 23 came as a massive shock to financial markets, especially the British pound, which fell from 1.50 to the US dollar to 1.29 within a matter of days. Across the English Channel, however, the euro took the news with remarkable equanimity, and remained firmly in the upper half of the narrow 1.04 to 1.15 to the US dollar range where it has been trading since February 2015.

The aftershocks of Britain’s decision to leave the European Union are only just beginning. The first came in late September when Prime Minister Theresa May announced a date to set Brexit in motion: March 2017, for invoking Article 50 of the European Union that deals with a member-nation wishing to leave the economic and political grouping of 28 countries, including Britain. Markets perceived the setting of a date as increasing the probability of a “hard Brexit” in the absence of an agreement to extend Britain’s current relationship with the EU after a two-year withdrawal deadline in March 2019. More aftershocks may be on the way, and the pound may not be the only one reeling from the tremors.

Editor’s Letter - Issue 118

Hedge fund managers espouse diverse political views. Managers, including George Soros, Renaissance Technologies’ Henry Laufer and Paloma Partners’ Donald Sussman, donated far more money to Hillary Clinton’s campaign than to Donald Trump’s. Managers advising Trump include SkyBridge Capital founder, Anthony Scaramucci, Paulson founder John Paulson, and distressed investor Wilbur Ross, while activist Carl Icahn also supports Trump. What might Trump - and triple Republican control of the Presidency, Senate and Congress - mean for the industry? At this stage, only broad brush signals can be gleaned.

Trump transition team member Paul Atkins often opposed new regulations during his time as an SEC Commissioner. He also opposed escalating fines imposed on many parts of the financial services industry, arguing that these penalties unjustly punish shareholders - who are virtually never culpable. Republican proposals to apply a cost/benefit analysis to regulation make sense, but can they tame the regulatory leviathan? Though very few Republican lawmakers voted for Dodd Frank in 2010, talk of a wholesale repeal now looks unlikely. Trump’s “moratorium on all new financial regulations” seems even less probable, partly as over 100 Dodd Frank-related rules are still being shaped. Instead, new Treasury Secretary, and former hedge fund manager, Steve Mnuchin, aims to roll back particularly complicated parts of the gargantuan statute and those that hamper bank lending. Similarly, Mnuchin wants to address the complexity and subjectivity of the Volcker Rule. The objective seems to be selectively rescinding, streamlining, and rationalising, rather than revoking, these regulations.


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