Two of the most important considerations for any hedge fund manager under AIFMD are deciding on who to appoint as an external AIFM (or "Management Company") and also who to appoint as a depositary; the latter of which is discussed later in this report.
As registered AIFMs, European hedge fund managers are required to separate out their portfolio management and risk management functions. That is fine for established managers with well-developed front to back teams.
But for smaller managers, who only just qualify as AIFMs by exceeding the EUR100m, they may not have sufficient capital and may not be able to adequately separate key management functions to ensure good governance is in place.
Show me the way
This is why the third party AIFM solution has become such a vital solution; not just for start-ups but also for non-EU managers looking for the most cost- and operationally-efficient route into Europe. Often they need guidance on the most appropriate fund structure, whether to set the fund up themselves or establish a sub-fund on a platform, and so on.
"For us, the starting point is determining where the divisions are going to lie," says David Hammond, General Counsel at ML Capital, who operate the MontLake UCITS Platform and MontLake QIAIF Platform out of Dublin. "Let's assume they want to go down the full outsourcing route. The manager would need to design the product, and depending on the strategy decide whether it would best work under a UCITS wrapper or an AIFMD wrapper. We would check to see whether there is investor appetite for the product, which could depend on pricing, fee structures, etc.
"Then you've got to consider the distribution framework: what kind of investors is the manager hoping to attract with the fund? Which EU markets will they be targeting? This is a key consideration because you could spend a lot of time on the operational side of the fund, getting it launched, but if you overlook the marketing considerations, all that work in the early stages might be wasted."
Deciding on whether to use an AIFM's fund platform, or to set up a standalone fund depends on the will of the individual manager. "It may depend on factors such as branding, what the expected fund AUM will be, whether the manager wants to benefit from economies of scale by running a sub-fund on the platform. The point is, we can cater for managers in all scenarios," says Cyril Delamare, CEO of ML Capital.
The AIFM’s track record
Andrew Frost is Director, Investment Solutions at Lawson Conner, a London-based specialist fund manager platform providing FCA license coverage as well as AIFM hosting services. He says that a key criteria when selecting an external AIFM is that they are tried and tested and have a demonstrable track record; one that has made a meaningful impact for its clients.
"In my view, one needs to look at the type of managers and strategies the AIFM has hosted, which in turn should dictate whether they have the right operational infrastructure in place to effectively carry out the role of a third party ManCo.
"I think it's prudent to look for an AIFM with a four- or five-year track record of outsourced compliance and regulatory umbrella services. Lawson Conner has a team of 26 people including legal and regulatory experts, structuring experts, compliance experts. That's all we do, 24/7.
"Finally, one point that is advantageous is to look for an AIFM whose teams have practitioner experience. Our team has worked previously for hedge funds, custodians and administrators so we have an innate knowledge of what our clients are looking to achieve and how we can provide that.
"Operational infrastructure, track record, experience of the senior management team: these are all extremely important aspects that need to be considered," outlines Frost.
Other less obvious considerations might include: Can the AIFM provide capital introduction support? Can they assist on tax/VAT, staff payroll and accounting? Are they able to provide premises for the investment manager to run their fund? These can all help sway the manager one way or the other when it comes to narrowing down their short list.
Cost considerations
One of the biggest fears that new managers have is the cost of getting to market given the breadth and complexity within the hedge fund industry. New talent is vital; it is the lifeblood. To help break down the perceived cost barriers to entry, Cordium provides a unique pathway to becoming, should the manager wish, their own AIFM, without having to wait months on end to receive their regulatory license.
"Our customer base tends to be people who are looking for an institutional quality product. They want to make sure they can pass institutional investor due diligence, and that the firm providing the regulatory and AIFM hosting service has a strong reputation; not financial skin in the game but reputational risk in the game. We do this by providing a flat monthly fee. Some UCITS ManCos which have evolved to become `Super ManCos' under AIFMD have continued to use a basis point fee model, which doesn't necessarily make sense within the AIFM world," explains Joe Vittoria, Chief Executive Officer, Mirabella Financial Services. Mirabella is a regulatory hosting platform that enables managers to get their strategies up and running in quick time, by availing of Mirabella's FCA license.
Managers then have the choice to remain on Mirabella for as long as they feel comfortable once they have received their FCA license, and avail of its AIFM services, or take the next step forward and establish their own AIFM. This is made possible using the Cordium Total AIFM Solution (`CTAS'), where the manager owns the AIFM outright and Cordium operates it on their behalf, in full compliance with AIFMD.
"We work in some respects like an octopus where the tentacles cover everything, giving us control so we can see what's going on. But the minute the manager becomes licensed, we can disappear without causing disruption. It's important to us that that transition is done as smoothly as possible. Using CTAS, Cordium can then maintain all of the risk and operational processes, governance processes, on an ongoing basis," says Vittoria.
"Clients can start with Mirabella, set up their own AIFM with CTAS and everything they've enjoyed, operationally speaking, under Mirabella continues as normal. It is a proper partnership approach," emphasises Adam de Domenico, Chief Executive Officer, Cordium (Malta).
Taking control
The above arrangement helps to address another concern that managers have – moreso established managers – and that is the issue of control. In Europe, under the UCITS regime, EU-based managers have long had time to understand the concept of appointing an external ManCo. But in the US, the concept of handing over control of the management entity is anathema. It just doesn't happen.
"There is an optical consideration among SWFs and big pension schemes who may like someone's strategy but need them to be fully authorised in their own right, and have their own AIFM. We have onboarded numerous clients who, at the same time, have asked us to help them get authorised as their own AIFM. We can provide a lot of efficiencies with our technology in terms of helping the manager get licensed by the FCA. If we can onboard someone, get them up and running, and then six or seven months later they become fully authorised, that's a great result," says Frost.
He confirms that Lawson Conner has in excess of 50 fund manager relationships, of which it acts as the appointed AIFM to approximately 30 of them.
Risk management
Risk management is one of the most important roles of the AIFM under AIFMD and this ties in closely with the issue of control. Again, for those established managers that are considering an EU AIF, the last thing they want is for the appointed AIFM to interfere with their risk processes and procedures. As one administration specialist points out, it is a case of the AIFM understanding what the fund manager's risk processes are "to ensure we can properly segregate the risk management function from the portfolio management function under AIFMD. For some it might even be an enhanced risk management process, depending on the amount they've spent internally, so this is potential value-add that we can offer as the AIFM."
Typically, the AIFM would engage with the client at the time the fund prospectus is being put together to get a clear understanding of the investment strategy. This then allows them to put together the appropriate risk management policy.
"Everything gets documented in a risk management policy for the AIF which is shared with the client so that they have a clear view as to how we, as the AIFM, will monitor risk and report it. Depending on the asset class there might be a higher risk weighting depending on the currency risk or credit risk. Regardless, everything is shared with the client before the fund is launched," said the administrator specialist, who asked not to be identified.
Over at Mirabella, Vittoria stresses the point that they simply police the risk management rules that the fund manager has written. "We do not unilaterally dictate how they risk manage their fund. It is a partnership methodology," says Vittoria.
"The way we integrate our risk management sets us apart and ensures that we can do everything we need to from a regulatory and governance perspective. Our risk team can see everything they need to see, without significant intrusion into the client's way of running their business. Most clients will put language in the fund documentation along the lines that Mirabella will be the initial AIFM to the fund until such date that their own firm gets its own appropriate regulatory license. In other words, the documentation is written such that the day they get regulated, we disappear."
Distribution support
Some managers will want help from a distribution perspective when launching their fund into Europe, others less so. As such, it is worth considering whether the hosted AIFM is able to support distribution activities. At ML Capital, for example, the team offers both active and passive distribution. According to Delamare, active distribution will be offered for one of the three QIAIFs it is currently launching. Typically, this applies to managers who do not have a well-established distribution network of their own in place in Europe.
"We work with high-profile fund managers who have their own sales teams and often don't need help with distribution. However, what they really like is our passive distribution service where we make sure that for every market into which their funds are marketed, they are fully compliant, they are visible on the relevant databases in each EU market, and we make sure they are open for investment through different platforms and that investors can efficiently allocate to them," confirms Delamare.
To conclude, the seeding environment has started to pick up again with a major US seeder expected to make a big splash. In Vittoria's view, this could result in a number of large hedge fund managers losing some of their star performers as the carrot is dangled for them to run their own hedge funds.
"There's a perceived barrier to entry and an actual barrier to entry. The perceived barrier to entry is that traders sit around and think they'll never be able to afford to run their own hedge fund business. When they go out and actually meet with service providers, the actual barriers to entry come down. Platforms like Mirabella are making it easier for new talent," concludes Vittoria
