EU and UK Regulatory Perspective:

Proposed hedge fund legislation

The International Funds Conference 2010

Stephen Ball, Partner

 A year of turmoil…
2008 -2009

• 1471 hedge funds

closed.

• $582 billion in assets

lost.

• Equal to the world’s

annual spending on
prescription drugs.

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…hedge fund assets growing again - up 9%
year-to-date as of Q3 2009
• Hedge fund industry assets reach $2 trillion - back to 2006 levels.

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On track to return their best year this
decade having returned over 19%

• $40 billion of
inflows in Q4
2009

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 Risk appetite has returned
• Hedge fund managers’ gross exposure is back to pre-Lehman
levels

Source: Bank of America Merrill Lynch Hedge Fund Monitor, Quarterly Market Analysis, November 30th 2009. Bank of America Merrill Lynch research is available at
www.mlx.ml.com

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 New fund activity is resuming
2009
• Quiet Q1 and Q2

• Q3 and Q4:
– 203 new hedge funds
launched.

– $12 billion assets raised.

– Most new launches from

existing managers
launching new products.

Source: Hedge Fund Research, Third Quarter 2009 Industry Report, Inc. © HFR, Inc. 2009,

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 Top 10 US fund launches 2009

Launched Assets by Strategy

Source: * As of November 2009 - Absolute Return, November 2009 database.

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 Top 10 European fund launches 2009

Launched Assets by Strategy

Source: * As of November 2009 - EuroHedge, November 2009 database

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 Top 10 Asian fund launches 2009

Launched Assets by Strategy

Source: * As of November 2009 – AsiaHedge and EurekaHedge, November 2009 databases.

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 Pensions increase share of global
hedge fund assets
• 2013 hedge fund assets will reach $2.6 trillion
• 2005 – 2013 pension fund weighting increases from 15-30%

Source: The Bank of New York Mellon and Casey Quirk Analysis 2009: The Hedge Fund of Tomorrow: Building an Enduring Firm, April 2009.

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 Largest funds still account for a
significant proportion of assets
• Top 10 fund of hedge funds manage $221 billion assets and
control $36% of the industry.
• Top 5 fund of hedge funds manage $147 billion assets and control
21% of the industry.

Source: InvestHedge, September 2009 issue (data as of June 2009) – N.B. The InvestHedge Billion Dollar Club List is published every 6 months.

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 Investor concerns drive structural
changes
• Alignment of interests

• A focus on greater transparency

• Liquidity remains a key issue for investors

• Managed accounts and UCITS III

• A call for a new and stricter regulation

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 Regulation: where are we?
• European Commission Draft Directive on
Alternative Investment Fund Managers (AIFM)
published on 30 April 2009 • UK Financial
Services Authority
– 60 consultation
• Highly controversial both in and outside European and discussion
Union papers, 32 policy
statements

• 12 November 2009, Swedish Presidency of the

European Council published revised draft Directive • UK Treasury
– 35 consultation
• papers
25 November 2009 Gauzes report published

• Huge rise in operational and regulatory • EU –

compliance costs 27 consultation
papers
• Consequential industry consolidation

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 Alternative Investment Fund
Managers Directive - Rationale
• Risk to investors

• Risk to counterparties

• Risk to creditors

• Stability of European financial

markets

• Integrity of European financial

markets

• Cross-border nature of risks

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 AIFM Directive - Objectives
• Ensure that all AIFM are subject to appropriate authorisation and registration
requirements.

• Provide a framework for the enhanced monitoring of macro-prudential risks.

• Improve risk management and organisational safeguards to mitigate micro-

prudential risks.

• Enhance investor protection.

• Improve public accountability for AIF holding controlling stakes in companies.

• Develop the single market for AIFM.

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Timeline

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 Response to the draft Directive
• Cost - $25 billion?

• 2% of investors in favour, 46% against.

• Major barriers on investing with EU fund managers who use offshore funds

• 32% increase in hedge fund compliance costs.

• 10% of hedge funds surveyed had delayed launch of a fund.

• Detrimental impact on tax revenues.

• Loss of choice for investors and resulting reduction in returns.

• Managers more likely to move their funds offshore.

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 Reaction to the draft Directive
“…the French dressing on what was “Regulatory overreaction.”
already a dog’s breakfast of a
Richard McIndoe, Head of Pensions,
directive.”
Strathclyde Pension Fund
The Economist

“…a very dodgy directive that’s been

“…badly thought out or thought out
with malign intent.”
Boris Johnson, Mayor of London
poorly constructed.
It’s a process that makes those who
support the European Union
embarrassed.”
Treasury Minister Lord Myners

“It really doesn’t work.”

“Ill-conceived and badly drafted.”
Eddy Wymeersch, Chairman of the
Committee of European Securities George Osborne, Shadow Chancellor of
Regulators the Exchequer, UK Conservative Party

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 AIFM Directive - Key provisions

1. Application
2. Authorisation
3. Capital Requirements
4. Marketing Provisions
5. Limitations on leverage
6. Depositaries
7. Valuators
8. Delegation
9. Reporting and disclosure
10. Third Country Provisions

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 Application

• Introduces a legally binding authorisation and supervisory regime for all AIFMs
managing AIFs in the European Union.

• Covers hedge funds, private equity funds, commodity funds, real estate funds,
infrastructure funds.

• AIFM directive does not apply to:

– AIFMs managing AIF portfolios that have total assets of less than €100
million
– AIFMs managing AIF portfolios that have total assets of less than €500
million subject to the AIFs not being leveraged and which do not grant
investors redemption rights during a period of five years following the date
each AIF is constituted

• AIFM directive does not apply to UCITS, Credit Institutions covered by the Capital
Requirements Directive, Pensions funds.

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 Authorisation

• AIFM requires authorisation from Home Member State regulator.

• Must demonstrate suitability and provide information on:

– Identities of the AIFM’s shareholders
– Arrangements of governance, risk management and valuation
– Proposed delegation functions
– Liquidity management, short selling, custody arrangements

• AIFM directive gives member state regulators the power to

withdraw authorisation from AIFMs.

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 Capital Requirements

• As a minimum AIFMs shall have own funds of at least €125,000.

• Where the AIF portfolios managed by the AIFM exceed €125,000,

the AIFM will need to have an additional amount of own funds.
The amount will be equal to 0.02% of the amount by which the
values of the portfolios in the AIFM exceeds €250 million.

• Irrespective of the above provisions AIFMs shall not hold an

amount of own funds which is less than that required under the
Capital Requirements Directive.

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 Marketing Provision
• An AIFM authorised in its Home Member State will be entitled to market its
funds to professional investors (as defined in the Markets in Financial
Instruments Directive) in any member state.

• The cross-border marketing of the AIF is subject only to a notification

procedure, under which the relevant information is provided to the Host
Member State.

• The AIFM Directive does not provide rights in relation to marketing AIFs to
retail investors.

• “Passporting” of management services into another member state also

permitted subject to notification procedure.

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 Limits on Leverage

• The AIFM directive sets out specific obligations for AIFMs managing
leveraged AIFs.

• The provisions apply where an AIFM manages one or more AIFs that
employ “high levels of leverage on a systematic basis”.

• “High leverage” is defined as the combined leverage from all sources

which exceeds the value of the equity capital of the AIF.

• AIF’s employing systematically high leverage must make certain

disclosures to the AIF investors and also to its Home Member State
Regulator.

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 Appointment of Depository

• The Directive provides for the appointment of a depository which shall be a

credit institution.

• Must be EU domiciled, authorised and supervised credit institution.

• Must act independently and solely in the interests of the AIF investors.

• The depositary’s task shall include receiving payments made by investors,

safe keeping any financial instruments belonging to the AIF and verifying
whether the AIF has obtained ownership of all other assets the AIF invests
in
– Depositaries may delegate their tasks to other depositaries
– Depositary will be liable to the AIFM and the AIF’s investors for any
losses suffered

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 Appointment of Valuator
• Under the directive AIFMs will appoint for each AIF they manage an
independent “valuator”.

• Valuation of assets, shares and units should occur at least once a year.

• AIFM must ensure that the valuator has appropriate and consistent
procedure to value AIF assets.

• Rules applicable to the valuation of assets and the calculation of net

asset value per unit or share of the AIF shall be laid down in the law of
the country where the AIF is domiciled or in the AIF is domiciled or in the
AIF’s rules or incorporation documents.

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 Delegation of AIFM functions
• Delegation to third parties is provided for in the directive.

• Before an AIFM can delegate any functions it first needs prior authorisation
from its Home Member State Regulator and certain conditions need to be
complied with.

• An AIFM may not delegate to the depositary, valuator or to any other

undertaking whose interests may conflict with the AIF or its investors.

• Third parties may not sub delegate any functions that have been delegated
to them.

• AIFMs are not allowed to delegate their functions to such an extent that, in
essence, they could no longer be considered to be the manager of the AIF.

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 Reporting and Disclosure

• An AIFM must make an annual report available for each AIF it

manages.

• The Report should contain at the very least:

– a balance sheet or statement of assets and liabilities
– an income and expenditure account for the financial year and
a report on the activities of the financial year

• The annual report will be made available to investors and

regulators no later than 4 months following the end of the
financial year.

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 Third Country Provisions
• Marketing of third country funds (e.g. Cayman domiciled) in EU territory will be
permitted 3 years after the AIFM Directive comes into force (expected 2015).

• Third country AIF only marketable after the third country has:
– Signed a tax information exchange agreement with the relevant member state;
– Complies with stringent regulatory, supervisory and tax equivalence and
information requirements; and
– Allow EU AIF equivalent market access

• Until the three year period has elapsed AIFMs domiciled in a Member State will be
permitted to continue to market AIFs domiciled in a third country in other Member
States under the existing domestic private placement rules currently in force in
those Member States.

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 Implications for Cayman and other
offshore jurisdictions
• Hedge fund managers will
move offshore.
• Non EU funds prohibited
unless AIF’s domicile
complies with OECD Tax
and Exchange of
Information rules.
• Three year delay on access
to passport.
• Marketing Restrictions.

Estimated Fund Domicile Registration

Source: Charles River Associates Impact of the proposed AIFM Directive across
Europe

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 Current Position - Original Draft
Who is covered by Grants exemptions to managers of less than €100m of funds or
the directive unleveraged private equity funds of less than €500m. EU-based
managers of offshore funds are exempt, as are credit institutions, pension
funds, insurers and supranational institutions.
Limits on leverage The Commission will have the power to set pan-European limits on the
amount of leverage that different fund types and strategies may take.
Marketing EU-domiciled fund managers “approved” by national regulators may sell
Restrictions EU-domiciled funds in the EU. Offshore funds run by EU-domiciled
outside the EU managers must comply with OECD tax treaties and may be “passported”
after a three-year transition period. Non-EU fund managers will gain a
passport only if their country has equivalent legislation to the EU.
Pay Limits and Does not mention pay.
Disclosure
Requirements
Depositories: new Funds must use an EU credit institution as a depository and it would be
custodians liable for the actions of any subdepositories. This was a direct reaction to
the Bernard Madoff “Ponzi” scheme, in which it turned out that many of
the feeder funds had delegated custodial responsibilities to Mr Madoff.

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 Proposals for the new rules:
Swedish Version
Who is covered by Smaller managers must still be subject to national regulation. Removes
the directive exemptions for credit institutions, pension funds, insurers and supranational
institutions. Partly scraps the exemption for EU-based managers of offshore
funds.
Limits on leverage Leverage caps will be decided by national regulators, not the Commission,
and applied on a temporary basis only under exceptional circumstances.

Marketing Approved fund managers can market EU funds across the EU. Offshore
Restrictions outside funds or EU-domiciled funds that feed into offshore funds can seek approval
the EU on a state-by-state basis.
Pay Limits and Mandatory deferral of at least 40 per cent of variable pay over a three-year
Disclosure period. Managers would be banned from using money from profitable
Requirements businesses to subsidise poorer performers and total remuneration and
carried interest paid would have to be disclosed.
Depositories: new The depository may be an EU credit institution or an investment firm. Firms
custodians with no redemption rights in the first five years may also use a third party
that is subject to prudential supervision, such as a US bank. The liability
rules are less strict than those in the original draft.

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Proposals for the new rules: Gauzès
Parliamentary Version
Who is covered by Removes all size thresholds and scraps exemption for EU-based managers of
the directive offshore funds. Limits the exemption for credit institutions, pension funds,
insurers and supranational institutions to those investing only for their own
account.
Limits on leverage Fund managers themselves will set their own in-house leverage limits for
each of their funds. The Commission will have the power to impose temporary
leverage limits on specific funds in an emergency.
Marketing EU-domiciled funds eligible to be sold across the EU. Non-EU funds cannot
Restrictions outside raise money from investors in the EU unless the fund’s home authorities have
the EU an information-sharing and co-operation agreement with the country of the
investor.
Pay Limits and Pay policies must be consistent with principles laid down by the Group of 20
Disclosure nations and similar to rules applicable to credit institutions. Pay should be
Requirements linked to risk and manager interests should be aligned with those of
shareholders. Total remuneration and carried interest paid would have to be
disclosed.
Depositories: new The depository can be a credit institution or an investment firm. If it is located
custodians outside the EU, the Commission would agree that the depository is subject to
equivalent regulation and investor-protection rules.

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“Governments’ response the financial crisis has been
compared to that of rowdy drinkers in a bar brawl:
‘You wait until a fight breaks out and then take a
swing at the guy you have always wanted to hit.
Whether or not he had anything to do with starting the
fight is not the point.’
In Europe that is a pretty accurate description of how
policymakers are treating hedge funds and private
equity funds.”
The Financial Times

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