Recent amendments to the Investment Company Act (ICA) of 1940 have compounded regulatory hurdles for Europe-based hedge funds that conduct business in the United States. Although hedge funds are typically able to avoid registration with the ICA under 3©1 exemptions, where the fund has less than 100 accredited investors, or 3©7 exemptions, where there are less than 499 qualified investors, a transformative U.S. regulatory regime presents new obstacles.
Accredited investors meet the following thresholds:
- Make $200,000 a year or $300,000 a year jointly with a spouse
- Have a net worth of $1 million individually or jointly with spouse
- The Securities & Exchange Commission is considering higher limits
Qualified investors are defined as:
- Persons with $5 million in investable assets
- Public and private pensions funds with $25 million in investable assets
- Nominees investing solely on behalf of qualified purchasers.
The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act epitomizes the new reporting and supervisory regime. This piece of legislation has also closed key exemptions and now forces hedge funds with more than $150 million in regulatory assets under management (RAUM) in the United States to register as investment advisors, according to a 2016 report by accounting firm, Grant Thornton.
As an SEC registered investment advisor, hedge funds must also comply with the following requirements:
- File disclosures on Form ADV
- Designate a chief compliance officer
- Maintain financial records to facilitate SEC examinations
- Keep client assets with a qualified custodian
While European managers may think that adhering to the European Union’s Undertakings for Collective Investment in Transferable Securities (UCITS) law assures the compliance of their equity strategies with the ’40 Act, the U.S.’ tightening regulatory regime challenges that notion.
Due to new reporting requirements announced by the Securities and Exchange Commission Chair Mary Jo White in 2014, foreign hedge funds must now deploy more compliance analytics, monitoring and disclosure resources to address a myriad of new risks perceived by U.S. regulators. Instead of designating non-bank institutions as systemically important to the financial system, U.S. regulators are implementing more reporting mandates to make sure firms are properly managing risk, according to April 2016 guidance from the Financial Stability Oversight Council (FSOC).
In a 2015 SEC press release, Chair White articulated the goals of her reforms by saying that “investors will have better quality and greater access to information about their fund investments and investment advisers, and the SEC will have more and better information to monitor risks in the asset management industry.”
These ’40 Act amendments have also adopted several elements of European regulatory models and prioritized the following risk categories:
- Portfolio composition and operational risks
- Counterparty risk
- Derivative exposure
- Portfolio liquidity
- Leverage exposure
As a result, UCITS-compliant fund managers may find that ’40 Act limits on position concentration and demands for enhanced portfolio diversification may invalidate certain equity strategies. To circumvent these regulations fund managers may seek designation under the Securities Act of 1933, which regulates closed-end funds, or vehicles that typically issue a fixed of number of shares, and are implicitly more illiquid.
More commonly, however, hedge fund managers will seek the 3©1 or 3©7 exemptions, which enable their alternative investment vehicles to allocate capital with significant leverage and make exotic and high-risk wagers. But, given that pensions are a primary institutional investor segment for alternative asset managers, particularly for larger AUM funds, these vehicles also fall under strict Employee Retirement Income Security Act (ERISA) legislation, magnifying reporting demands for European funds with American assets.
And further complicating matters is the recent Memorandum of Understanding, signed by the U.S. Commodities Futures Trading Commission (CFTC) and the U.K. Financial Conduct Authority (FCA) in October. The MOU aims to enhance transparency and the exchange of information between certain alternative asset managers with cross-border operations.
While the MOU only covers 20 firms registered with the CFTC as swap dealers, the internationalization of fund compliance is a growing trend that is certain to scale in its restrictiveness and scope, according to a July 2016 Boston Consulting Group report. Advanced EU reform initiatives like UCITS and the Alternative Investment Fund Managers Directive (AIFMD) may position European managers at an advantage relative to their peers in the U.S., with regards to stress test and audit compliance, but inevitable regulatory disruption demands an even more proactive compliance strategy.
Look no further than the BCG study, where one-third of their respondents answered that they were seeking better consolidation in risk reporting. Another 40 percent said that their information systems were deficient and required upgrades.
Regulatory transformation has been a trend in the European investment industry since before the financial crisis and, in many ways, is more advanced than its counterpart in the United States. But, with an increasingly global crusade to improve pre-trade compliance, analytics and reporting, transparency, IT system integrity and investor protection, it is clear that regulatory technology, or regtech, will assume a role of central importance.
To capture AUM in a lucrative American market, European alternative asset managers must embrace a secure and leading edge cloud solution that automates the supervision, capture and reporting of all position and portfolio data. In a challenging market that pushed high-profile fund managers like Bain Capital, Fortress and others to liquidate certain funds or permanently shutter their operations in 2015, the right regtech asset is the best hedge against risk from the markets and SEC examiners as well.