AIMA Journal Edition111Includes articles about:- Fees and beyond- Setting up in Hong Kong- US single family real estate- FED and the balance sheet- EMIR- Brexit..

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Contents

1Open Letter: Activist investors unlock valueBy Jack Inglis, CEO, AIMA

2Beyond the Fees: Key ConsiderationsBy Wendy Beer, William Saltus and JasmaerSandhu at Wells Fargo

3Federal Reserve May Shrink its BalanceSheet GraduallyBy Blu Putnam at CME Group

4Dreams of white picket fences: theinvestment potential of US single-family realestateBy Petteri Barman at Man GPM and a memberof the Man Group Executive Committee

5Should UK Investment Managers bedespondent about Brexit?By Peter Astleford at Dechert

6Launching a hedge fund in Hong KongBy Gaven Cheong at Simmons & Simmons LLP

7European Commission releases EMIR reviewproposalsBy Chris Bates, Jeremy Walter and WillWinterton at Clifford Chance

8Central Bank of Ireland publishes finalfeedback statement on Fund ManagementCompany Effectiveness Requirements(“CP86”)By Ken Owens at PwC

9“A riddle, wrapped in a mystery, inside anenigma”By Michael Beart and Marie Barber at Duff &Phelps

10SM&RC – reading the regulatory mind-setBy Gavin Stewart, Grant Thornton

11Progression in CaymanBy Deanna Derrick at Intertrust

12How The UK's SMCR Will Affect US FirmsBy Adele Rentsch at AIMA

13Hedge funds, Brexit and the EUBy Jack Inglis at AIMA

14The Panama Papers: A missed opportunity?By Paul Hale at AIMA

15Five things we learned at AIMA’s flagshipregulatory forumBy Jiri Krol at AIMA

Open Letter: Activistinvestors unlock valueBy Jack Inglis, CEO, AIMA

Jack Inglis

On behalf of The Alternative InvestmentManagement Association, which represents1,850 investment firms that collectively managemore than $1.8 trillion in assets in 57 countries.

Following the March elections, the DutchEmployers’ Association has made a number ofsuggestions to the political parties involved inthe negotiations on the formation of the newgovernment. There are some very sound andlaudable suggestions proposing that the Dutcheconomy remains competitive in terms of taxand the overall business regulatoryenvironment. However, there are also sometroubling proposals that, if implemented, would

move the Netherlands firmly into the camp ofcountries erecting new barriers to themovement of capital.

The proposals suggest that because the Euroand, by extension, Dutch assets and companieswill remain cheap and because some othercountries around the world are becoming moreprotectionist, the government should considerlegal remedies to ward against unhelpful hostiletakeovers and active investors.

This is nothing new. We have seen beforethat companies argued that active investingcould be harmful for the long term strategicprospects of companies that are their targets.These often self-serving arguments areusually based on a very few highly publicisedexamples which do not reflect the role andthe value of active investing in an economy.Also, these arguments are often strategicallyused to promote and support a position in aconcrete situation.

We at The Alternative Investment ManagementAssociation have undertaken comprehensive

research to assess the development andcurrent state of shareholder activism byalternative investors, investigated the impact ofsuch activism and identified certain trends andimplications for future developments. Weanalysed a unique dataset compiled withassistance from databases that recordcampaigns, reviewed the empirical research todate, and consulted both active and passiveinvestment managers.

The data shows a clear picture: activeshareholders produce long-termimprovements in companies’ performance.The empirical evidence to date indicates that,on average, engagement by active investors iscorrelated to improvements in the share price,operating performance and productivity oftargeted companies for several years followingthe engagement, including after the investorexits.[1]

Similar findings have been replicated by agreat number of studies across differentregions in the world. Most recently, a studyconducted by Bloomberg in early 2014 found

that stocks of companies with activeshareholder groups in the period 2009 to2013 – a period of 48 months – gained 48% onaverage, beating the S&P index byapproximately 17 percentage points.[2]

Active investors are relatively longer-terminvestors and are frequently structured toprovide ‘patient capital’. Large institutionalshareholders such as pension funds are alsobecoming increasingly supportive of activeinvestors by: investing ever greater sums inactive funds; supporting shareholder proposals;and, in some cases, joining forces with activeshareholders.

According to our data, proposals to improvegovernance of companies globally account formore than half of the objectives of activealternative investors. This suggests theconcerns that activism is primarily about shortterm goals and “financial engineering” andtherefore not in the benefit of long termstrategic performance are not well-founded.

By seeking higher standards of corporate

governance these investors improve thealignment of interest between management,shareholders and all other stakeholders. Thisultimately leads to improvements in theefficient allocation of capital and resources inthe economy overall. Governments shouldtherefore be wary of proposals that couldrestrict the manner in which shareholdersexercise their rights as the evidence suggeststhis ultimately leads to bad results.

[1] The AIMA study is availableat https://www.aima.org/educate/aima-resear…

[2] https://www.bloomberg.com/graphics/infog…

[3] A Dutch version of this letter was originallypublished in Het Financieele Dagblad on April25, 2017.

Beyond the Fees: KeyConsiderationsBy Wendy Beer, Director, Head of BusinessConsulting; William Saltus, Director, BusinessConsulting, and Jasmaer Sandhu, Analyst,Business Consulting at Wells Fargo

Wendy Beer

Intro

The Wells Fargo Business Consulting groupspoke to industry experts, investors, andmanagers this year, and has noticed an uptickof more complex term structures to better alignthe interests between managers and investors.Analysis of these recent discussions indicatesthat an increasing number of existing and newhedge funds are being pushed to explore suchstructures. The past three years of challengedhedge fund performance and muted capitalflows seems to have shifted the balance ofpower in negotiations to investors. As a result, itappears a growing number of investors have

Bill Saltus

been pushing managers to implement tools toensure that fees are paid based on alphageneration. In addition to reducing fees,negotiated investment terms includeperformance hurdles, multi-year performancecrystallization periods (multi-yearcrystallization) and claw-backs. Even though amanager may be incented to agree to some ofthese terms in order to attract capital, theyshould be well-informed of the tax ramificationsand any other implications of such terms.

Trends

Based on our discussions, hurdle rates are

Jasmaer Sandhu

becoming one of the most discussed topicsduring term structure negotiations. Theprocess of choosing an appropriate hurdle rateis complicated by the difficulty of separatingalpha from beta. Historically, investors werecontent with either a fixed hurdle rate or avariable hurdle rate tied LIBOR. More recently,however, there has been a push to selecting abenchmark that more closely matches thestrategy of the fund. An AIMA survey taken inearly 2016 showed that a third of respondentsemploy hurdles within their funds – noting that,in comparison to recent years, this was asignificant increase.[1] Brian Lahart, Head ofManager Research for Abbot Downing notes,

“Hurdle rates tied to alpha generation would bemore transformative to the industry.”[2]Investors view managers’ acceptance of hurdlestied to a benchmark as a vote of confidence bythe manager in their ability to generate alpha.

In addition to considering how the benchmarkmatches up with the manager’s strategy, themanager should back-test to determine howthe hurdle would have affected compensationin prior periods. “If a manager believes in itsability to perform, it may not negatively impactthe economics of the manager,” notes BensonCohen, a partner at Sidley Austin LLP’sInvestment Funds, Advisers and Derivativespractice. As managers look to better align theirincentive structures with investors’ interests,hurdles pegged to benchmarks that are alignedwith the investment strategy may become moreprevalent.

Less frequently employed than hurdles, multi-year crystallization and claw-backs ofperformance fees are another methodinvestors are using to increase investor/manager interest alignment. Anecdotally,

looking back at our investor and managerdiscussions as recent as a year ago, little wasspoken about multi-year crystallization. Basedon dialogue with legal practitioners and theresults of the AIMA survey, we infer that whilemulti-year crystallization adoption ratesremain low, discussions including it are on therise. Indeed, hedge fund lawyers we spokewith acknowledge an increase inconversations involving hurdles and multi-year crystallization calculations. “Given thetough performance environment, managershave been more willing to work with theirinvestors over the last few months onimplementing innovative commercial terms.Funds that employ longer-term strategies arebeginning to incorporate multi-yearcrystallization, while an even greater numberof managers are implementing benchmark-based hurdles,” notes Kelli Moll, a partner withAkin Gump Strauss Hauer & Feld LLP.

Performance crystallization periods delay thepayment of incentive allocations by a timelength often influenced by both the lock-upperiod and the investment strategy. For

example, some investors may request formanagers to implement a three-yearperformance calculation period, over which theinvestor would be able to “claw back” anyaccrued performance-related allocation duringa year of under-performance. Theimplementation of these terms can take placethrough the creation of new share classes,separately managed accounts (SMAs), orfunds- of-one. These can be created for bothnew and existing investors. During theformation phase of new hedge fund launches,investors may engage managers to considerthese terms as part of either a founders shareclass or as part of the standard terms.

The 1 or 30 model is an example of a newerinvestment structure which employs hurdlerates. Developed by Albourne and popularizedby a leading allocator, the model is designed toensure that over the long run the investor willreceive a greater share of alpha. In this model,the 1% management fee is an advance againstthe 30% incentive allocation. At the end of theyear managers will receive their 30%incentiveallocation, less the 1% management fee, if they

beat their benchmark hurdle. If that hurdle isnot reached, they only collect the 1%management fee. Making the management feean advance against the incentive fee creates aninherent hurdle on a gross performance basisof (1%/30%), or 3.33%. This implied hurdle is ontop of the benchmark hurdle that is used toensure the 30% incentive allocation is only paidfor alpha generation.[3]

Considerations

Though these terms can be effective inpromoting investor alignment, there are aplethora of considerations that need to bevetted. Implementing any of these terms,whether in an SMA, funds-of-one, or newshare class, can trigger Most Favored Nations(MFN) clauses. As Cohen from Sidley AustinLLP points out, once a manager commits tosuch an arrangement, existing investors mayneed to be offered access to the same terms.The manager may either be legally required toextend these terms to existing investorsbecause of an MFN or otherwise feelcompelled to extend the terms to existing

investors. The potentially broad reach of apoorly drafted or insufficiently understoodMFN provision can have unexpectedconsequences. Underscoring the importanceof drafting, Cohen notes that an MFN clauseagreed to in a specific feeder fund “may applynot only to new share classes of that feederfund, but to SMAs and funds-of -0ne thatpursue similar investment objectives.”Therefore, when agreeing to MFN clauses,managers should work closely withexperienced counsel to draft the MFN asnarrowly as possible to avoid it being appliedbeyond the specific circumstances that amanager would expect.Tax implications also need to be considered.For example, a scenario that could trigger taxquestions is when manager performance isbenchmarked to an index, but the index isnegative for the performance period beingmeasured. In this situation there is a possibilitythat the manager will beat the benchmark butstill have negative absolute performance.Because the incentive that is calculated is basedon negative absolute performance, it may notbe a profit allocation. A couple of different

ways this can be approached include: classifythe incentive as a guaranteed payment or delaytaking the incentive until the managergenerates profits. With a guaranteed paymentclassification, the manager may receive therevenue immediately but it could be taxed atthe higher ordinary income tax rate. In the caseof delaying the earning of the incentive, therevenue will be classified as an allocation ofprofits and potentially taxed at the lower long-term capital gain rates, but the manager willhave to wait until a year with positive absoluteperformance to receive this allocation[4]; thisapproach is not without its risks. “This methodcreates an economic risk because the managerwill forfeit the incentive if the fund shuts downbefore the manager is able to create positiveabsolute performance,” notes Joseph Heavey,Partner, of KPMG.

Likewise, there are tax considerations whenimplementing a multi-year performancecrystallization period. From the perspective ofgenerally accepted accounting principles(GAAP), a performance allocation needs to bemade to the general partner (GP) on an annual

basis, and will appear as accrued incentive tothe GP on the financial statements eventhough it has not been earned. Furthermore,the GP may receive an allocation of taxableincome and have to pay taxes on that incomeon an annual basis based on this accruedamount, even though the GP hasn’t earned adollar within the structure of a multi-yearperformance crystallization period. If thatperformance accrual needs to be clawed backin a subsequent year of under-performance, itcould be difficult for the GP to recover theamount of any taxes paid immediately becauseany losses allocated would generally be capitalin nature, and capital losses can only beutilized to offset other capital gains andgenerally cannot be carried back. Anyunutilized capital loss could be carried forwardinto future years, so the GP should not lose thebenefit.[5]In an era of challenging market conditions,investors are continuously pushing for a greateralignment of interests. Based on Wells Fargo’sdiscussions with its managers and investorswhich highlight the increasing adoption ofhurdles, this indicates that managers are

buying into this notion. As discussed, multi-year crystallization, a tool designed to alignliquidity of underlying investments and investorlock-up agreements with manager performanceallocations, is another tool being discussed as away to way to better align manager’s andinvestor’s interests . Today’s managers aredesigning terms to better align their funds withtheir investors, while remaining vigilantregarding all possible tax implications of thesestructures. Investors are always willing to paymanagers for alpha.

To contact the authors:

Wendy Beer, Director, Head of BusinessConsulting, WellsFargo: Wendy.Beer@wellsfargo.comWilliam Saltus, Director, Business Consulting,Wells Fargo: William.Saltus@wellsfargo.comJasmaer Sandhu, Analyst, BusinessConsulting, WellsFargo: Jasmaer.Sandhu@wellsfargo.com

Footnotes:

[1] AIMA paper “In Concert”, p. 9

[2] Abbot Downing, a Wells Fargo ownedcompany, is a wealth management company

[3] Albourne “Case Study: The Texas Teachers’“1 or 30 Fee Structure”, December 2016

[4] Note: Each situation may differ and youshould consult your tax expert.

[5] For illustrative purposes only. Each situationmay differ and you should contact your taxexpert.

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Federal Reserve mayshrink its balancesheet graduallyBy Blu Putnam, Chief Economist, CME Group

Blu Putnam

With U.S. unemployment at 4.3%, the FederalReserve (Fed) remains on track for more rateincreases in 2017 despite sluggish labor forceexpansion and wage growth barely stayingahead of inflation. And, the Fed now appearsready to start a long and drawn out process toreduce the size of its massive balance sheet.A bloated balance sheet is inconsistent withraising rates, but fears of possible marketimpacts have made the Fed very cautious.The Fed’s total assets are now $4.5 trillion,

including portfolio holdings of $2.5 trillion ofU.S. Treasury securities and $1.8 trillion inmortgage-backed securities (MBS). Thereinvestment activity implies the Fed is

currently a buyer of about $1 of every $2 ofnew Treasury debt, and remains a huge playerin the mortgage market. We anticipate thatthe Fed will stop reinvesting 100% of theprincipal received from maturing investmentsand switch to a staged policy of putting a capon reinvestment activity. The cap would beadjusted periodically over the next few yearsuntil the balance sheet had been reduced toroughly 12%-15% of GDP from about 25%currently.

Because the Fed anchors the short end of theyield curve with its target federal funds ratepolicy and the interest it pays on excessreserves, the market impact of maturingTreasury securities not being reinvested willprobably be very small, although it does implyless buying by the Fed at Treasury auctions. Ifthe Fed also steps back from reinvesting in theMBS market, the impact might be a little larger,in the range of 0.25% to 0.50% in terms ofpossible mortgage rate increases along thematurity curve, especially centered on the15-year and 30-year mortgages that the Fedbuys.

I. Inconsistency of Rising Rates and aMassive Balance Sheet

The asset purchase programs (aka QuantitativeEasing or QE) were instituted during a period ofnear zero short-term rates while the Fed wastargeting the federal funds rate at between0.00% and 0.25%. Before the financial panic of2008 and the institution of QE, the Fed’sbalance sheet was about $800 billion, or 6% ofGDP. Moreover, the mix of reserves held at theFed was roughly 80% required reserves and20% excess reserves. The massive assetpurchases created a huge overhang of excess

reserves – those deposits held by banks at theFed and not needed to meet reserverequirements. Total bank reserves are now$2.2 trillion (end-May 2017), of which 5% isrequired reserves and 95% excess reserves.

To provide a return to banks, the Fedinstituted a policy of paying interest onreserves, set at the top end of the targetfederal funds rate range. As the Fed raises itstarget federal funds rate range, it also raisesthe interest rate it pays on reserves, and thismeans the interest expense bill rises by $5.6billion annually for each 25-basis-point rise inthe target federal funds rate range, eating intothe Fed’s annual portfolio earnings. To beclear, raising rates means raising the costs offunding the Fed’s massive balance sheet andcreates an incentive for the Fed to reduce thesize of its balance sheet, in part to protect itsportfolio earnings that are running close to$100 billion annually over the last few years.[Note: After some accounting adjustments,the Fed contributes the bulk of its netportfolio earnings to the U.S. Treasury.]

There is another challenge created by the sizeof the Fed’s massive balance sheet – namely,the process by which the Fed controls thefederal funds rate so it stays within its targetrange. Prior to the financial crisis and QE, withexcess reserves representing about 20% of totalreserves, and amounting to only $2 billion, theFed was able to use security repurchaseagreements (i.e., repo and reverse repooperations) to add or drain reserves on atemporary basis to keep the federal funds rateat its desired level. While the Fed still doessome repo and reverse repo operations, withover $2 trillion of excess reserves, the size ofpotential reverse repo operations needed tokeep the federal funds rate in its target range isoverwhelming. Consequently, the Fed now hasa dependency on paying interest on excessreserves at the top of the target rate range asthe primary method of enforcing its desiredfederal funds rate range. This dependency onpaying interest on reserves is likely to remaineven as the Fed moves to shrink its balancesheet. Over the long term, though, reductionsin the level of excess reserves will give repoactivities a little more influence, although not

remotely as much in the old, pre-QE days.

II. Gradual Pullback from ReinvestingPrincipal

The reinvestment of principal makes the Fed avery big player in the market for U.S. Treasurysecurities and for 15-year and 30-yearmortgage-backed securities. We estimate thatover the next 12 months the Fed will see about$300 billion of its U.S. Treasury securitiesmature. This represents about half the U.S.budget deficit, or put another way, about $1 ofevery $2 of net new debt the U.S. Treasuryissues. MBS are self-amortizing, so principal isreceived every month, and some mortgages arepaid off as homes are sold or refinanced. Giventhe $1.8 trillion of MBS the Fed holds, as muchas $400 billion in principal might be receivedover the next 12 months; which compares tothe overall outstanding mortgage debt of U.S.households and nonprofit organizations ofabout $10 billion. Estimating the size of thenew issue mortgage market is complex, and notjust about rates. People pay off mortgages fora variety of reasons. While refinancing is

usually about rates, sales can be driven bydivorce, transferring to a different location for anew job, desire to downsize by retirees, anddeath. The Fed’s appetite for 15-year and30-year mortgages makes it the elephant in theroom for the new issue market for homemortgages as well as the secondary market.

The Fed’s plan to shrink its balance sheet isgoing to occur in very drawn out stages, mainlybecause the Fed does not want to disturb theTreasury or MBS markets. The plan is to put acap on reinvestment activity that initially makesonly a small dent in the reinvestment activity.Over time, as economic conditions allow, theFed would adjust the cap and reducereinvestment activity. Our estimate is that theFed would like to reduce its portfolio holdingsof Treasuries and MBS from $4.2 trillion inmid-2017, to around $2.8-$3.0 trillion by theend of 2021, with a target to get the balancesheet in line with about 12% of nominal GDP.This estimated long-term objective for the sizeof the Fed’s balance sheet is about half of whatit is now and about twice what it was before thefinancial crisis and when QE was instituted.

III. Market Impact

The market impact of the Fed slowly starting toreduce in reinvestment activity will affect theTreasury market differently from the MBSmarket.

The short end of the U.S. Treasury yield curve isanchored by the Fed’s target federal funds rate

range. So, the maturing of Treasuries is unlikelyto have any impact at all on short-term rates.

The impact on longer-term rates depends onhow the Fed targets its asset allocation alongthe yield curve, especially for the 10-year plusmaturities. Since the Fed’s maturity extensionprogram was announce in 2011 andimplemented in 2012, the Fed has beenholding about 22%-25% of its Treasuryportfolio in longer-dated securities. If thisasset allocation percentage is held constant,then there may be some incremental upwardimpact of a few basis points on 10-year orlonger yields, as the portfolio shrinks. The Fedcould decide to increase its asset allocation tolonger-dated securities to offset this smallimpact. We believe changing the assetallocation is unlikely, however, since otherinfluences on longer-term Treasury yields areexpected to swamp the tiny impact of the slowpace of balance sheet shrinkage. Weparticularly expect the U.S. federal budgetdeficit to rise over the next several years asinterest expense rises with rising rates. And, ifthe Republican Administration is able to enact

a tax cut as we expect it will eventually, deficitsare likely to rise even further. And, another biginfluence over the trend in Treasury yields willbe inflation, which is currently well anchored ataround 2%. A rise in inflation expectation,should it occur, would tend to push yieldshigher.The impact on the MBS market of shrinking thebalance sheet is much more complex. Whenthe Fed does decide to taper its buying of15-year and 30-year MBS, we estimate thatmortgage rates might rise about 0.25% to 0.50%relative to the Treasury yield curve. We note,though, that the Fed may decide to set adifferent time table for shrinking mortgagesversus Treasuries, and may be particularlysensitive to its impact on mortgage rates.

On net, we are expecting that as the balancesheet shrinkage process is implemented, anincremental upward increase in long-termmortgage rates of up to 25 basis points seemslikely, while the impact on Treasuries will bevery hard to find. In addition, Fed Watcherswill now have to think about the pace ofbalance sheet shrinkage as the Fed will

periodically adjust its cap on reinvestmentactivity. Changes in the reinvestment cap maynot be one-for-one aligned with rate increases,and may cause some confusion along the LIBORyield curve while markets and analysts come toterms with the pace of balance sheet shrinkage.

To contact the author:

Bluford Putnam, Managing Director & ChiefEconomist at CME Group:bluford.putnam@cmegroup.com

Disclaimer:

All examples in this report are hypothetical interpretations of

situations and are used for explanation purposes only. The views

in this report reflect solely those of the authors and not necessarily

those of CME Group or its affiliated institutions. This report and

the information herein should not be considered investment

advice or the results of actual market experience.

Dreams of whitepicket fences: theinvestment potentialof US single-family realestateBy Petteri Barman, Co-Head of Real Assets atMan GPM and a member of the Man GroupExecutive Committee

Petteri Barman

As returns across asset classes become evermore elusive, we believe it’s increasinglyimportant for investors to consider a widerrange of opportunities. Real estate investmentis an established part of many investors’alternative portfolios, but single-familyresidences (SFR) have received limited attentionsince the Global Financial Crisis (GFC). Whilst UScommercial property has risen 157% since itscrisis nadir – putting it 23% above its previouscycle peak – US SFR is still 7% below its 2006highs[1]. Currently, the ratio of house pricesagainst average income within the US marketare in line with historical averages, in contrastto the UK (where they are 30% higher versus

long-term averages), Canada (+46%), Australia(+50%) and Hong Kong (+50%).[2]

Moreover, the US has one of the biggest andmost liquid residential property markets inthe world, with more than 5.4 milliontransactions every year[3]. As a core tenet of‘the American dream’, we believe that thepersistent trends of home ownership may bea compelling investment story, and thatsingle-family residences could offerinteresting opportunities.

SFR supply and demand dynamics lookattractive

America is a relatively youthful nation. Its15-34 age bracket represents 27% of the totalpopulation. This is high compared to otherdeveloped markets such as France (where itmakes up 24%), Germany (23%), Italy andJapan (both 21%). For obvious reasons, thissegment drives a nation’s rate of householdformation. Even when accounting for the factthat headship rates are declining, thisdemographic structure is forecast to drive a

rate of family unit formation 30% above thelong term average[4]. The potential increase indemand for family homes that this couldentail may potentially provide a long-termstructural tailwind for SFR.

There are also shorter term catalysts fordemand. Mortgage availability in the US fell91% between June 2006 and February 2009, ascredit underwriting horror stories filled thecolumn inches. Although access has becomeless constrained since then, it remains over 80%below the previous peak[5]. Although we do notsee a return to the ‘Wild West’ days of 2006 –where some lenders were evidentlyirresponsible – we do think that the next movemay be skewed to the upside, especially ifTrump makes good on his promises to reduceregulatory oversight. We believe the average UShousehold is also in an increasingly betterposition to borrow: unemployment has fallenfrom the 10% peak it hit in December 2010 tolittle over 4.5% today, which has helped reducehousehold-debt-to-disposable-income ratiosback to the levels of the early 2000s[6]. In short,the pockets of the prospective US homebuyer

are potentially deepening.

If this potential demand comes to fruition itmay meet restricted supply. This is shown inFigure 1, which shows the number of single-family building permits since 1959, and forecastup to 2020 (indicated by the grey line). As canbe seen, activity collapsed after the GFC anddoes not appear set to return to its long runaverage this decade, in our view. So, whilstsupply is running below its long run average,demand may be structurally higher due todemographics, with the possibility of short termcatalysts. For us, this represents an attractivefundamental configuration.

Figure 1: US SFR permits[7]

Institutional investors have previously opted formulti-family over single-family residences

Since the GFC, multi-family apartment (MF)accommodation has been far more popularwith institutional investors than SFR, and thesegment is currently 244% above the post-crisis low, and 53% above the previous cyclehigh. Doubtless, investors have felt that whatthey perceived as superior liquidity andhomogeneity made the space more attractivethan SFR. Looking forward from today,however, given recent price appreciation andsignificant new supply we do not see the samerelative upside for MF.

Instead, we believe US SFR may experience arental yield compression until it is more in linewith other residential property marketsglobally. Why? Simply put, we believe that theUS is not historically a renting nation, and acore strand of the American dream is thehome-owning dream. We can see evidence ofthis in Figure 2, which shows that between 1995and the GFC, owners were in the ascendency.As the crisis forced a more hand-to-mouth

existence, this pattern was reversed, but webelieve a return to a more historical norm mayhave begun. We estimate that 9% of MF unitsare occupied by families with children, whilstfor SFR this figure rises to over 80%[8]. As thenumber of US households increase, and if theirfinances improve over the short term – as wehave discussed – the outperformance of MFover SFR could potentially be reversed.

Figure 2: US new owners and renters[9]

Active managers can help provide efficientaccess to SFR

We believe one of the things that has kept

institutional investors away from the SFR spaceis the perception of its operational difficulties:the challenges posed by idiosyncratic assetssubject to significant geographic dispersion.Today, however, the industry norm is for gross/net yield ratios of 60%, with 94-96% occupancyrates, figures which are comparable to USMF[10]. As investors consider their allocationsto alternatives, we believe that this may be anasset class worthy of attention – but the choicebetween ways to access these assets will be animportant one for investors.

Footnotes[1] Source: Morgan Stanley, RCA, Moody’s.[2] Source: The Economist, March 2017.http://www.economist.com/blogs/graphicde…[3] Source: Census data, National Association ofRealtors.[4] Source: Morgan Stanley.[5] Source: Mortgage Bankers Association.[6] Source: Bloomberg, OECD.[7] Source: John Burns Consulting, Census data.[8] Source: Man GPM research.[9] Source: Green Street Advisors, 06 June 2016.[10] Source: Man GPM research.

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Should UK investmentmanagers bedespondent aboutBrexit?By Peter Astleford, Partner and Co-Head ofthe Global Financial Services Group atDechert

Peter Astleford

For someone who voted against, Brexit can be ascary thought. In our area, how will UKmanagers maintain and improve their fee flowsfrom European investors post Brexit? Let’s lookat the facts. UK managers receive their feesfrom, broadly, managing UCITS and specialistfunds and individual investor accounts. Whatare the Brexit risks to these revenue streams?

Fees from European retail funds (“UCITS”) - UKmanagers generally target European investorsthrough UCITS established in Dublin andLuxembourg (the “EEA Gateways”). These fundshave an EEA marketing passport and aremanaged in the UK. This is set to continue afterBrexit.

Fees from specialist or alternative investmentfunds (“AIFs”) - Historically, many AIFs sold intothe EEA were based in tax havens. For variouscommercial, tax and legal reasons, Europeanbased funds are now in the ascendancy. Ingeneral, these AIFs have an EEA marketingpassport to sell to professional investors andare managed in the UK. This will also continueafter Brexit.

I should add that while the AlternativeInvestment Fund Managers Directive (“AIFMD”),provides a mechanism for non-EEA funds toaccess the EEA, this is likely a red herring for theUK. No implementation of this mechanism isexpected soon. Consequently, continuing towork through EEA Gateways is more realistic.

Fees from individual investor accounts –Lastly, UK managers access individualEuropean investors directly via segregatedaccounts utilising a further Europeandirective, the Markets in Financial InstrumentsDirective (“MiFID”). MiFID will be replaced by asecond version (MiFID 2) prior to Brexit.Thereafter, non-EEA managers will, for the

first time, be able to register with the new EUregulator (ESMA) to access Europeanprofessional investors.

As a result, the three routes to access Europeaninvestors should remain largely unchanged.

As ESMA could be slow to register UKmanagers, I recommend managers keep theirEuropean plans under review for future politicaldevelopments. For example, a new manager ormarketer could instead be established relativelyeasily elsewhere in the EEA assuring continuedinvestor access. My only concern here is that aperception of excess competition amongstsome EEA countries to attract UK businessesmay lead to tighter EEA rules; A firstpronouncement is already out there. Planningwill also be required to cover UK registeredsales staff that target Europe.

Other Incidental Issues – While fees shouldremain secure, some changes will be required.At present, UK managers can passport theiroperations into the EEA and vice versa. Thesereciprocal rights will disappear. As such, UK

managers should seek European authorisationfor any European branches and vice versa.

Equally, European based funds “operated” fromthe UK by a UK regulated manager will need toset up alternative arrangements. There aretried and tested routes to achieve this that willallow investment management fee income tocontinue to flow to the UK.

Conclusions - The next sixteen months (thelikely negotiation period if any agreement is tobe ratified in time) is probably insufficient todocument a comprehensive agreement. Morelikely is a transitional arrangement allowingmore time for definitive documentation whileavoiding a “cliff edge”. A transition process willmean that business can continue (albeit whilestruggling to cope with the welter of existingregulatory changes not to mention the latestFCA "final" asset management report).

As outlined above, a hard Brexit should onlyrequire change “at the edges”. Remember, USmanagers already have significant access to theEEA market on a similar basis. Wholesale

changes to those arrangements would be to thedetriment of the EEA Gateways, Europeanfinancial services businesses and investors.Meanwhile there are lots of opportunities forUK managers to find clients elsewhere.

In conclusion, the future looks good overall fora continuing UK and European industry that hasseen the value of its open-ended regulatedfunds rise from euro 6.2 trillion in 2008 to overeuro 14 trillion. Managers can get on withbusiness. Those frozen in uncertainty will haveonly themselves to blame.

To contact the author:

Peter Astleford, partner and co-head of theglobal financial services group at DechertLLP: peter.astleford@dechert.com

Launching a hedgefund in Hong KongBy Gaven Cheong, Partner at Simmons &Simmons LLP

Gaven Cheong

Introduction

So you want to launch your own hedgefund! That’s great – you’ve taken the firstimportant step in a challenging andcomplicated process that requires skilledconsideration to deliver success. But where tofrom here? If there’s one golden rule I wouldgive to any start-up manager, it’s this – speakto the right adviser! And by “adviser”, I don’tjust mean a funds lawyer – a lot of newmanagers may choose to speak with fundadministrators, prime brokers, Cayman Islandscounsel or any of the “Big 4” accounting firmsas a starting point before delving further into

conversations with other serviceproviders. The important thing is to identify anadviser who is well established and familiarwith the jurisdiction in which you want tomanage your fund, in terms of local norms,regulatory and tax requirements, and investorpreferences.Getting Started

What are some of the preliminary things youshould be thinking about once you havedecided that you want to launch a hedge fund?

Consider current employment situation

The existing employment documentationsshould be reviewed to consider whether thereare any restrictions in setting up a new hedgefund business. In particular, the focus shouldbe on complying with the existingemployment obligations. For instance, whensetting up the new fund, you must ensure thatyou continue to act in the best interests of theexisting employer and be aware of anyrestriction in soliciting any colleague to leavethe current company.

Choose and protect your brand identity

Before launching a new hedge funds business,it is extremely important to ensure that thenames or trademarks you propose to use foryour management business and funds do notoverlap with existing names which are in use orregistered trademarks. This is to avoid anyunnecessary future rebranding (or at worst,litigation for trademark or copyrightinfringement) which can be costly anddisruptive to your business. This exercise wouldinvolve performing checks on relevant registersin the country in which the fund entities will bedomiciled, to ensure that the chosen fundnames are available for use.

Decide on your management entity businessstructure

The most simple and common structureinvolves an offshore manager as it createsflexibility and potential tax benefits. However,some start-ups are established using morecustomised arrangements. Upon deciding onthe structure, the management entitles will

then need to be incorporated, followed by thepreparation of relevant operating agreements,such as a shareholders’ agreement for theoffshore manager.

Decide on your fund structure

The majority of hedge funds we have launchedfor our clients are domiciled in the CaymanIslands, which is relatively straightforward withgenerally less onerous ongoing obligations.Especially for managers looking to raise capitalin this region (ie Pan-Asia), the Cayman Islandsis a popular jurisdictional choice given investorfamiliarity with its laws and its structures, andthe well developed legal and operationalinfrastructure that has been built up in thisregion to support such structures.

While the Cayman Islands is most commonlyused, we are also able to advise start-ups usingother fund domiciles, including the British VirginIslands.

In determining the fund structure, you shouldconsider your prospective investors, tax

positions, investor expectation, cost andoperational factors. Common fund structuresinclude standalone and parallel funds,segregated portfolio companies (SPCs) and themaster-feeder structure, each with distinctadvantages and shortcomings depending onthe need of the individual hedge fund. We have,in addition to the above, extensive experiencewith alternative approaches to fund structures,including, for example, the use of additionaltypes of feeder funds, dual master funds, andthe use of ‘hybrid’ structures (for example,structures that can accommodate closed andopen-ended sub-funds, or that can deal withpockets for illiquid assets).

Prepare SFC application

Certain activities require regulation by the HongKong Securities and Futures Commission (SFC)if carried out in Hong Kong. These activitiesinclude, for example, dealing and advising insecurities. These activities are widely defined inthe SFO (the Securities and Futures Ordinance)and will most likely affect the operation of ahedge fund business. Carrying out these

activities without obtaining an SFC licence is acriminal offence. The process of applying for anSFC licence, which generally takes about 20weeks, requires the proper completion andsubmission of certain prescribed forms.

Agree seeding arrangements

It is important for a start-up hedge fundmanager to be able to raise sufficient capital forthe new fund to invest either at launch orshortly afterwards in order to optimise theinvestment strategy, meet the costs ofincreased compliance and provide comfort topotential investors. Seed capital is an up-frontinvestment from a third party investor, whichallows a hedge fund manager to deal with theconcerns above and to launch a fund with anamount of capital that demonstrates to otherpotential investors and the market moregenerally that it is a business of substance.

It is, therefore, important for a start-up hedgefund manager to secure a seed deal. In recentyears, due to the reduced availability of seedcapital, it has been very competitive for start-

up hedge fund managers to secure a seed dealon favourable terms. Ideally, a good seed dealthat works for all parties involves carefulbalancing of the need to provide the seedinvestor with a sufficient economic interest andcontrol over the business in order to providethem with comfort as to how it is being run,against ensuring that the hedge fund managerdoes not cede too much control or interests inprofit streams or capital for what will hopefullybecome a successful hedge fund managementbusiness in the future.

Launch

Now that you’ve attended to the preliminaries,the next step is to consider the key workstreams to actually launching your fund,understanding the documents and agreementsthat are required to be put in place andchoosing service providers for the fund.

Plan your launch

Given the complexity of starting a new fundbusiness, we advise start-up hedge fund

managers to plan the launch of the new fundcarefully so that things will not fall through thecracks. The launch plan should include differentwork streams, including manager set-up, fundset-up, marketing requirements, tradingdocumentation and seeding. We offer our start-up clients access to a centralised documentrepository where documents may be storedand shared, which will be particularly useful inorganising the documentation of the fund.

Negotiate a lease for your business premises

In parallel with setting up the hedge fundmanagement entities and preparing thedocumentation for the fund launch, thenegotiation of a lease agreement will likely takeplace when looking for business premises. Asthe landlord and the tenant have differentpriorities, the negotiation exercise seeks tobalance the conflicting interests of the two.Start-up hedge fund managers should beaware of the key terms of the lease agreement,including, for example, payment of rent, rentreview and break clause.

Staff

Your team of analysts and portfolio managerswill need to be employed by the regulatedentity in Hong Kong. This means needing tohave employment agreements in place, andwork visas (if they are not already Hong Kongresidents).

Decide on directors and service providers

The choice of directors and service providersare important as they play significant roles inthe fund. The decision will depend on thespecific needs of the fund and we haveextensive experience in advising in thisregard. Independent offshore directors havenow become an indispensable part of anyfund launch, especially one that is focused onraising genuine third party capital frominstitutional investors. Having anindependent board is important not only froma corporate governance perspective, but alsofor tax reasons (to avoid having your offshorefund brought onshore!).

We can assist with not only referrals toprofessional independent third parties thatoffer directorship services, but can also assistwith reviewing and negotiating your directorappointment agreements.

Prepare fund offering documents andagreements

The key legal documents required for a newcorporate hedge fund include:

• Prospectus or Private PlacementMemorandum (PPM)

• Articles of Association• Subscription/Redemption Forms• Investment Management Agreement• Management Agreement• Distribution Agreement• Administration Agreement• Prime Brokerage Agreement• ISDA Documents

These documents are important and requirecareful drafting as they govern the relationshipsof different parties to a fund.

Negotiate prime brokerage agreements

The documentation under which a primebroker is appointed is complex and often veryfavourable to the prime broker – precisely howone sided is a matter for negotiation.

While bearing in mind that product-specificadditional documentation may also berequired, the key terms documenting the fund’srelationship with its prime broker will be foundin a prime brokerage agreement.

Negotiate administration agreements

Administration agreements document theprovision of fund administration services to thefund by an administrator. The administrator isone of the fund’s most important serviceproviders. Start-up hedge fund managersshould ensure that the appropriate services arebeing provided to the fund and that the fundagrees to terms that are market standard anddo not expose the fund to greater liability thanis essential. The typical services provided by anadministrator include transfer agency services,

anti-money laundering services, services inrelation to the calculation and publication offund net asset value, tax services and thepreparation of unaudited financial statements.

Launch Day

The big day has arrived! Once your funddocuments have gone through their variousrounds of comments and input from yourvarious service providers, and you havefinalised versions on hand, here are some ofthe other things you need to think about beforeyou finally press the launch button:

• Have you secured all the licences /regulatory approvals to operate yourfund?

• Are your PB accounts / bank accountsopened and operational?

• Have you registered your fund with CIMA(including your directors)?

• Do your fund documents have all thenecessary disclosures to ensure that theycomply with local private placementrequirements?

• Have you got your board minutes andlaunch resolutions (both Cayman Islandsand Hong Kong) in order?

Conclusion

We have looked briefly at the various things astart-up manager should consider whenlaunching a new hedge fund.

Launching a new fund is indeed a complexprocess as the planning and preparation ofdocuments require a lot of negotiation,knowledge and care. Key decision points haveto be identified and triggered in a way that isoptimal from both a cost and timingperspective.

To contact the author:

Gaven Cheong, Partner at Simmons &Simmons: gaven.cheong@simmons-simmons.com

Company website:http://www.elexica.com/en/resources/micr…

European Commissionreleases EMIR reviewproposalsBy Chris Bates, Partner; Jeremy Walter,Partner and Will Winterton, Senior Associateat Clifford Chance

Chris Bates

On 4 May 2017 the European Commissionpublished a legislative proposal to amend theEuropean Market Infrastructure Regulation(EMIR), reflecting the outcome of its review ofhow EMIR has worked since its adoption in2012. Rather than fundamental reform, theproposals set out a limited number of changesaiming to address specific issues identified inthe review, although many of these will havesignificant impact on market participants. TheCommission also issued a communicationindicating that it would propose legislation inJune 2017 to enhance the supervision of centralcounterparties (CCPs). Framed in the context ofthe UK's exit from the EU, this includes

Jeremy Walter

proposals for enhanced EU supervision andpossible location requirements for third countryCCPs that play a systemic role in EU markets

Timing

The Commission proposal will now make itsway through the EU legislative process beforebeing finalised and published in the OfficialJournal, likely during 2018. Most of the changeswould take effect immediately the regulationenters into force (20 days after publication),without any transitional arrangements orconformance period.

Will Winterton

However, some requirements would not takeeffect until six months later, such as thechanges to the clearing threshold, the changesto insolvency protections and the newtransparency obligations of CCPs. Otherchanges would take effect 18 months after thedate of entry into force, including the newobligations on clearing firms, many of thechanges to the regulation of trade repositoriesand the changes

to the technical standards on margin. TheEuropean Securities and Markets Authority(ESMA) would be required to draft technicalstandards to give effect to some of the changes

by the date nine months after the date of entryinto force.

Scope: expanding the definition of "financialcounterparty"

The Commission proposal would amend theEMIR definition of "financial counterparty" (FC)to include:

• All alternative investment funds (AIFs) asdefined in the Alternative InvestmentFund Managers Directive: This wouldextend the scope of the definition toinclude AIFs registered under nationallaw that are currently considered to benon-financial counterparties (NFCs). Thechange could also be interpreted tomean that all third country AIFs shouldbe considered to be third country entitiesthat would be FCs if established in theEU, regardless of whether they aremanaged by an AIF manager authorisedor registered in the EU.

• Securitisation special purpose entities(SSPEs): Currently, many SSPEs are not

subject to the clearing and marginingobligations under EMIR because theirown positions do not exceed the clearingthreshold and they are not part of agroup whose non-financial entities havepositions exceeding the clearingthreshold. The proposed change willpotentially bring all SSPEs into the scopeof clearing and margining obligations,with only some relief from clearing (butnot margining) for SSPEs that are able totake advantage of the new clearingthreshold for FCs discussed below. Thereis no proposal to extend the existingrelief from margining for covered bondissuers to cover SSPEs, even thoughSSPEs would face many of the samepractical issues in margining theirhedging transactions, as they do nothave access to liquid collateral withoutadditional liquidity facilities.

• Central securities depositories. Thesechanges would take effect as soon as theamending regulation enters into forceand the Commission proposal does notinclude any conformance period or

transitional provisions. Therefore, firmswould need to carry out areclassification exercise on theircounterparties even before thelegislation is officially published. It is alsounclear how these changes affectexisting contracts with entities that willbecome subject to margin and clearingobligations for the first time. In addition,entities that become subject to theclearing obligation for the first time mayhave to wait for six months before theycan benefit from the new clearingthreshold for FCs discussed below.

Changes affecting the clearing obligation

Per-class clearing threshold for NFCs

The Commission proposes to narrow the scopeof the clearing obligation for NFCs, so that NFCswould only be subject to the clearing obligationfor those classes of OTC derivatives for whichthey exceed the clearing threshold (revisedArticle 10(1)). However, it appears that an NFCthat exceeds the clearing threshold for any

class of OTC derivatives may still be treated asan 'NFC+' for all other purposes, including themargining of uncleared transactions. Therefore,this change may only provide limited relief forthose corporates with large positions incommodities derivatives that wish to be able tocontinue to conduct normal treasury operationswithout margining costs. In addition, firms willneed to build systems that can classifycounterparties as NFC+ for some purposes andnot for others.

New clearing threshold for smaller FCs

The Commission also proposes to introduce aclearing threshold for FCs with a low volume ofOTC derivatives activity (revised Article 4(1)(a)and new Article 4a(1)). This threshold will be setat the same level as the clearing threshold forNFCs. However, where an FC's positions in OTCderivatives exceed the clearing threshold forone class of OTC derivative, the FC wouldbecome subject to the clearing obligation for allclasses of OTC derivatives (as is currently thecase for NFCs). In addition, unlike the treatmentof NFCs, an FC's hedging transactions would

count towards the clearing threshold and FCswould continue to be subject to margin andother risk mitigation obligations whether or notthey exceed the threshold.

Clearing threshold calculation

Instead of carrying out clearing thresholdcalculations on a rolling basis, counterpartieswould instead need to calculate, annually, theiraggregate month-end average positions forMarch, April and May (new Article 4a(1) for FCsand revised Article 10(1) for NFCs). This isbroadly in line with the current process forcalculating relevant thresholds for the marginobligations. However, the calculations are notidentical and counterparties may need to buildadditional processes for this revised clearingthreshold calculation (e.g., to calculate positionsby asset class).

Removing barriers to clearing

The Commission proposes amendments toaddress concerns that counterparties with alimited volume of OTC derivatives activity may

face difficulties in accessing central clearing.Clearing members which provide clearingservices (and their clients which provide indirectclearing services) would be required to provideclearing services on "fair, reasonable and non-discriminatory commercial terms" (new Article4(3a)). This goes further than the currentrequirement for clearing members to facilitateindirect clearing on reasonable commercialterms. The Commission would be empoweredto adopt a delegated act to specify whencommercial terms are to be considered fair,reasonable and non-discriminatory.

The proposal also provides that the assets andpositions recorded in the separate accountsmaintained by a CCP for its clearing membersor a clearing member for its clients are not tobe treated as part of the insolvency estate ofthe CCP or clearing member (new Article39(11)). The Commission hopes that this willimprove access to clearing by providing greatercertainty that assets are protected in a defaultscenario, at least where assets are held with aCCP or clearing member. However, CCPs andmarket participants will need to analyse how

this new rule interacts with national insolvencylaws. In addition, the proposal does notspecifically address the insolvency treatment ofthe 'leapfrog' payments made by CCPs to clientsof insolvent clearing members or the positionsheld by clients of clearing members providingindirect clearing services.

In addition, the proposal aims to improve thetransparency and predictability of CCPs' initialmargin requirements. It would impose newduties on CCPs to provide their clearingmembers with a simulation tool allowing themto determine the amounts of initial margin thatwould be required by a new transaction andwith details of its initial margin model (newArticle 38(6) and (7)). The Commission wouldneed to take these new requirements intoaccount when evaluating the equivalence ofthird country regimes regulating CCPsrecognised or seeking recognition under EMIR.

Extending the exemption for pension schemearrangements

In the absence of a technical solution to allow

pension scheme arrangements to participate incentral clearing, the Commission proposes toextend the current exemption of pensionscheme arrangements from the clearingobligation (revised Articles 85 and 89(1)). Theextended exemption would apply until threeyears after entry into force of the amendingregulation. The Commission would have thepower to extend this exemption by a furthertwo years. The Commission hopes that theextended exemption will allow CCPs andpension scheme arrangements to worktogether to bring pension schemearrangements within the clearing obligationwithout negatively impacting pension returns.

However, the amending regulation might nottake effect until after the current exemptionexpires on 18 August 2018. One potentialsolution to this timing issue might be to amendthe RTS imposing the clearing obligation tocreate an extended phase-in period for pensionscheme arrangements to bridge the gap untilthe amending regulation enters into force.

Removing the frontloading requirement

The proposal would repeal the existing'frontloading' requirement under EMIR (currentArticle 4(1)(b)(ii)). Currently, contracts couldbecome subject to the clearing obligation fromthe date when the CCP is authorised orrecognised to clear a class of contracts eventhough ESMA has yet to consider whether topropose RTS mandating clearing of that class(although the RTS adopted to date haveincluded provisions obviating this requirement).

Suspension of the clearing obligation

The proposal would also give the Commissionpowers to suspend the clearing obligation inspecific circumstances, including where clearingmay have an adverse effect on financial stability(new Article 6b). Suspension would be effectivefor a period of up to twelve months.

Changes affecting reporting of derivatives

Changes to reporting requirements

The Commission has proposed various changesto the EMIR reporting requirements. Some ofthese changes are likely to be helpful to marketparticipants:

• CCPs would be responsible for reportingdetails of exchange-traded (non-OTC)derivatives transactions on behalf of bothcounterparties and for ensuring accuracyof the details reported (new Article 9(1a)),although this would not relievecounterparties from their obligation toreport back-to-back transactions ortransactions cleared on non-EU CCPs;

• firms would no longer need to reportintragroup OTC derivatives transactionswhere one of the counterparties is anNFC (revised Article 9(1)), although theexemption would only apply where thetransactions meet the conditions for anintragroup transaction under EMIR,including the condition requiring an

equivalence determination fortransactions with third country entities;

• firms would no longer have to report('backload') transactions entered intobefore 12 February 2014 that were notstill outstanding at that date (revisedArticle 9(1)), although backloading willcontinue for other contracts entered intobefore 12 February 2014.

However, FCs would become responsible forreporting details of OTC derivativestransactions with NFCs not subject to theclearing obligation (NFC-s) on behalf of bothcounterparties (new Article 9(1a)).

As with the similar requirements under theSecurities Financing Transactions Regulation(SFTR), this would impose a direct regulatoryobligation on the FC to report transactions onbehalf of its counterparty, even if the FC hasbeen unable to obtain all the requiredinformation from the counterparty.

Therefore, FCs will need to put in place new orrevised agreements with all their NFC-

counterparties, including any that currentlyreport their own trades, to address this newregulatory obligation and accompanying risk.Managers of UCITS and AIFs would also becomeresponsible for reporting trades on behalf oftheir funds.

These changes appear to apply when theamending regulation enters into force, with notransitional provisions. Therefore,counterparties might need to put in place thenecessary agreements with clients and othersystems changes before the legislation isofficially published.

The proposal imposes new specific obligationson ESMA to draft implementing technicalstandards covering data standards, includingentity, instrument and trade identifiers, and themethods and arrangements for reporting(revised Article 9(6)).

Registration and supervision of traderepositories

The proposal would impose new duties on

trade repositories to ensure the effectivereconciliation of data between traderepositories, to ensure the completeness andaccuracy of reported data, to facilitateswitching by transferring data to other traderepositories when requested by their clientsand to give counterparties access to datareported on their behalf by a CCP or FC (newArticles 78(9) and Article 81(3a)).

The Commission has proposed increasing theupper limit of the basic amount of fines ESMAcan impose on trade repositories, with the aimof increasing the deterrent effect of thesanctions system (revised Article 65(2)).

The proposal also introduces a simplifiedapplication process for the extension ofregistration for trade repositories that arealready registered under SFTR (revised Article56).

Access to trade repository data

The proposal would give regulators in non-EUcountries with their own trade repositories

direct access to data held by EU traderepositories where certain conditions arefulfilled (new Article 76a).

One of these conditions is that under the legalframework of the third country, traderepositories are subject to a legally binding andenforceable obligation to provide EU regulatorswith direct and immediate access to data.

This addresses the Financial Stability Boardrequest for authorities to remove barriers toregulatory access to information. Currently,authorities in these third countries only haverights to direct access to data held by EU traderepositories where there is an internationalagreement in place between the EU and therelevant third country, although this wouldremain a condition for recognising a thirdcountry trade repository for the purposes ofmeeting the EU reporting requirements.

Changes affecting the margin rules

The Commission proposal would expand thescope of the RTS on risk management

procedures for uncleared OTC derivatives toinclude supervisory procedures relating to thelevel and type of collateral and segregationarrangements, to ensure initial and ongoingvalidation of counterparties' risk-managementprocedures (revised Article 11(15)(a)).

This would allow the RTS to include provisionsrequiring the prior regulatory approval of riskmanagement procedures, including initialmargin models.

Supervision of CCPs

The Commission's accompanyingcommunication on responding to challenges forcritical financial market infrastructures andfurther developing the Capital Markets Union(CMU) indicated that the Commission wouldpresent a further legislative proposal in June2017 to address the supervision of CCPs thatare of systemic relevance in the EU. Thisproposal was published on 13 June 2017.

The Commission's May 2017 communicationstated that there is a need to enhance EU-level

supervision by ESMA of systemically importantEU CCPs and the role of the central bank ofissue of the currencies used by EU CCPs.

It also stated that there is a need to subjectnon-EU CCPs to safeguards under the EU legalframework where they play a systemic role inEU financial markets and directly impact theresponsibilities of EU and Member Stateauthorities. The Commission acknowledged theneed to avoid fragmentation of the globalsystem but notes that, following the UK exitfrom the EU, a substantial volume of euro-denominated transactions would not be clearedin the EU and would no longer be subject to EUregulation and supervision.

In summary, the Commission's subsequentproposal published on 13 June 2017 grantsincreased supervisory powers andresponsibilities to a new 'CCP ExecutiveSession' within ESMA and provides for closercooperation between the supervisoryauthorities and central banks responsible forEU currencies.

For non-EU CCPs, the proposal introduces a twotier system, whereby systemically importantCCPs (so-called Tier 2 CCPs) will be subject tostricter recognition requirements, includingdirect supervision by EMSA.

It also gives the Commission power to decidethat a Tier 2 CCP is so systemically importantthat it must be established in the EU andauthorised under Article 14 EMIR in order toprovide services in the EU. However, thislocation requirement is presented as a "lastresort", if enhanced supervision is insufficientto mitigate potential financial stability risks.

Conclusion

The legislative proposal does not respond toall the requests made by market participantsto simplify and enhance the EMIR framework,for example, the request for single-sidedreporting or to allow market participants tomeet their clearing obligation by indirectclearing on recognised third country CCPs.However, more changes may be introducedduring the legislative process. In addition, the

proposal would require the Commission toproduce a new report reviewing the effect ofEMIR three years after the amendingregulation comes into force.

To contact the autors:

Chris Bates, Partner at Clifford Chance:chris.bates@cliffordchance.comJeremy Walter, Partner at CliffordChance: jeremy.walter@cliffordchance.comWill Winterton, SeniorAssociate: will.winterton@cliffordchance.com

Central Bank ofIreland publishes finalfeedback statementon Fund ManagementCompanyEffectivenessRequirements (“CP86”)By Ken Owens, Partner, PwC

Ken Owens

On December 19th 2016, the Central Bank ofIreland (the “CBI”) published the feedbackstatement to CP 86 – third consultation.Marking the end of a consultation processwhich started in September 2014, the CBI alsopublished the finalised guidance for fundmanagement companies on managerialfunctions, operational issues and proceduralmatters and also published details of new rulesfor fund management companies on aneffective supervision requirement and on theretrievability of records.

This feedback statement has been long awaited,with the main area of contention being the

location rule for directors and designatedpersons, which the CBI had proposed in theirJune 2016 third consultation. In this regard thefeedback statement brings some welcome reliefwhich will make the location rule much moreworkable for all concerned.

Location Rule

The finalised rule on effective supervisionstates that a management company shallconduct a preponderance of its managementin the EEA. The CBI then differentiatesbetween management companies based onPRISM rating.

Management companies with a Low PRISMrating which will require at least:

(i) 2 directors resident in the Ireland,

(ii) half of its directors resident in the EEA, and

(iii) half of its managerial functions performedby at least 2 designated persons resident in theEEA.

Whereas management companies with a PRISMimpact rating of Medium Low or above shallhave at least:

(i) 3 directors resident in the Ireland or, at least,2 directors resident in Ireland and onedesignated person resident in Ireland,

(ii) half of its directors resident in the EEA, and

(iii) half of its managerial functions performedby at least 2 designated persons resident in theEEA.

The feedback statement goes into somedetail to explain how the CBI has reached thisposition and is reflective of the level offeedback and engagement which the CBIreceived from the industry in the consultationperiod. The feedback statement also explainsthe CBI’s focus on the EEA from a locationperspective which is something which wasnot evident from the third consultation whenit was issued.

One important lesson for all of us from this

lengthy process is that strong engagement inthe consultation processes with the CBI can,and in this case, has made a difference to theoutcome of the process. In the feedbackstatement the CBI states that the outcome wasswayed, to a certain extent, by argumentsconcerning expertise and the need to facilitateorganisational models which drawappropriately on the expertise of thepromoter/investment manager.

Transition Period

The other notable point from the feedbackstatement is that the CBI has provided atransition period of 18 months for existingfund management companies giving themuntil 1 July 2018 to be in compliance. Thesenew rules relate to the streamlining ofmanagerial functions to 6 managerialfunctions, the Organisational Effectivenessrole, the retrievability of records rule and theeffective supervision requirement.

For organisations looking to establish newmanagement companies the CBI has said that it

will only approve applications for authorisationsubmitted on or after 1 July 2017 where thefund management company will be organisedin a way which complies with the new rulesintroduced by CP 86.

The new rules will be included in the amendedCentral Bank UCITS Regulations and in theforthcoming Central Bank AIF Regulations.

Other Points to Note

Most of the proposals outlined in the thirdconsultation have been retained as follows:

• The CBI has concluded that it isappropriate that where a director isappointed as a Designated Person, he/she should receive two separate lettersof appointment – one for the role ofdirector and one for the role ofDesignated Person.

• The CBI will look to receive a copy of eachDesignated Person’s letter ofappointment to be submitted as part ofthe fund management company

authorisation process.• The CBI has deleted the proposal which

stated that Designated Persons shouldbe employed by the same group ofcompanies where such persons were notgoing to be working in the same location.

• The draft managerial functions guidancedoes not prohibit the appointment of anindividual as both director andDesignated Person.

• The CBI does not consider theappointment of an individual to the roleof director and as Designated Person willautomatically give rise to a conflict ofinterest.

• The CBI considers that appointees mustbe sufficiently senior in their roles tomeet these expectations.

• Management companies will be requiredto have their own documented policiesand procedures in each instance with thisis required by regulation and will not beable to rely on delegate’s policies andprocedures to satisfy this regulatoryobligation.

• The CBI is of the view that exception-only

reporting does not demonstrate asufficient level of oversight andengagement by a Designated Person.

• Regular meetings between DesignatedPersons and delegates should be held toallow Designated Persons properlyperform their role.

• Notwithstanding the establishment ofany committees, the CBI obliges aDesignated Person to be responsible forthe performance of his/her managerialfunction.

• Regarding alternate Designated Persons,Designated Person is classified as a Pre-Approved Control Function in accordancewith the CBI’s Fitness and Probity regime.

• There is no ‘alternate Designated Person’role under that regime. Stakeholdersshould refer to the Fitness & Probitystatutory requirements, standards andregulatory guidance in relation to theappointment of a ‘temporary officer’.

• A management company shall keep allof its records in a way that makes themimmediately retrievable in or fromIreland.

• The CBI has clarified its expectations asregards its minimum requirements forrecord retention, archiving andretrievability of the relevant documentsof a fund management company.

• The CBI has reiterated that it placessignificant importance on proper andadequate recordkeeping and thatprocedures and processes should be inplace which seek to avoid manipulationin so far as is possible.

• The CBI considers that a fundmanagement company, notwithstandingthe delegation of activities or the mannerin which documentation is stored, mustbe able to produce records on requestfrom the CBI.

• The CBI expects that fund managementcompanies will subject their recordretention policies to an annual audit. Thisreflects the level of importance which theCBI places on a fund managementcompany’s recordkeeping.

• The CBI has clarified that such an auditmay be undertaken by an external partyor internally, for example by the internal

audit function of the fund managementcompany.

• Annexes I and II of the managerialfunctions guidance allocate internal audittasks to the Organisational Effectivenessrole. However the CBI goes on to notethat the precise allocation of regulatoryobligations amongst managerialfunctions is a matter for each

• fund management company and it maybe that, for any particular company, theparticular regulatory obligations shouldbe attributed differently.

• The CBI is proceeding with therequirement that fund managementcompanies should maintain a dedicatedand monitored email address.

A post Brexit roadmap for managementcompany substance

Coming just 3 weeks after the CBI issued itsthird consultation on fund managementcompany effectiveness, the UK’s decision toleave the EU featured in many of theresponses received by the CBI. A number of

respondents raised the issue of how theproposed exit of the UK from the EU wouldaffect the CBI’s approach.

As regards the CBI's perspective on the UK'sposition post Brexit, the CBI gave a nuancedresponse saying that in formulating theirfeedback statement and the final rules "wehave been cognisant of this aspect". Thefeedback statement goes on to say that, assubsequent arrangements for the UK postBrexit remain the subject of major negotiations,it is was not possible for the CBI to predict theoutcome of those negotiations. Interestingly theCBI then states that they have set out in somedetail the factors which are relevant to theirassessment of the extent to which anauthorised entity can be considered to besubject to effective supervision (feedbackstatement page 12 paragraph c) and that thesefactors should allow interested parties to assessthe likely impact, if any, of different forms ofBrexit on the application of the CBI's rules.

Now that the rules and guidance formanagement companies have been finalised,

managers and promoters have the ability toconfidently plan for the implications of Brexitwith a clear roadmap from the CBI of theirsubstance requirements for Irish UCITSmanagement companies and AIFMs.

To contact the author:

Ken Owens, Partner,PwC: ken.owens@ie.pwc.com

“A riddle, wrapped in amystery, inside anenigma”By Michael Beart, Director and Marie Barber,Managing Director at Duff & Phelps

Michael Beart

For those acquainted with the topic, WinstonChurchill’s now famous words taken from his1939 BBC broadcast provides a more thanfitting description of the Disguised InvestmentManagement Fee (DIMF) legislation. More thantwo years after coming into force, manytaxpayers (and also a great number of advisors)remain confused as to the full implications andintentions of the DIMF legislation despiteexposing investment managers to potentiallycrippling personal tax liabilities.

The complexity of the DIMF legislation,combined with its staggered introduction andkey amendments, has left many managers

Marie Barber

unsure about how and when it applies.Furthermore, the potential to cut throughtypical non-domicile protections, corporatestructures and transfer pricing positions isperhaps one of the most fundamental andmisunderstood areas to the legislation. Put itsimple terms, it can operate such thatindividuals are taxed as if they personallyreceive their share of management andperformance fees directly in the UK regardlessof the commercial position and interveningcorporate realities. With new guidanceanticipated in 2017 we would expect HMRC tostart to use the new legislation to its fullpotential and raise additional tax revenues

from the asset management industry.

Legislative background

The DIMF legislation is a piece of targeted taxavoidance legislation focused on the assetmanagement sector and first came into force inrelation to fees arising from 6 April 2015. Thelegislation is part of a wider overhaul of thetaxation of investment managers in the UK andextends equally to the hedge fund industry.

The legislation imposes an income tax chargeon fees that are deemed to arise to anindividual performing investment managementservices in a tax year from an investmentscheme and/or managed account. The deemingprovisions operate such that a fee arises to anindividual if they receive it directly or if certain‘enjoyment conditions’ are met. Theintroduction of the enjoyment conditions is oneof the key amendments that widened the scopeof the legislation. Should the enjoymentconditions be met, the legislation provides forsome exemptions, however the exemptions arethemselves barred in certain situations, for

example where the fees are used to reinvestback into the fund. As such it is paramount tostep through the legislation from start to finish.However, on undertaking the analysis manytaxpayers may find themselves uncertain as tohow to interpret the legislation and are leftguessing as to the intention behind certainprovisions. The net result in some cases willhave a considerable impact on commerciallydriven business models.

Despite DIMF issues stemming from thecorporate structure adopted, the responsibilityto disclose and pay any tax liability rests withthe individuals providing investmentmanagement services, not the business. Therisk is that addressing the legislation could fallbetween the gaps in the relationships betweencorporate and personal tax advisors. Quiteunderstandably many personal advisors whoshould be including DIMF disclosures in theindividual’s tax returns will not have the fullunderstanding of the corporate structurerequired in order to undertake the analysis.

Additionally, the existence of a potential

personal liability, requires individuals toexercise their judgement as to whether thelegislation applies when completing their ownpersonal tax returns. This creates an extracomplication that different individuals workingalongside one another in the business could filedifferently, i.e. one could make a disclosure andthe other may not. There is no mechanism toensure consistency across all such individualswith respect to what is disclosed to HMRC.

HMRC Guidance

HMRC first published guidance on the DIMFlegislation in 2015, however despite numerousamendments to the legislation it has yet to beofficially updated, even though HMRCacknowledge it does not cover material pointsamended (e.g. the enjoyment conditions). Draftguidance covering the amendments wasinformally published for comment on 21October 2016 but cannot be relied upon and afinal revised version of the guidance isexpected to be released towards the end ofSummer 2017.

What it is possible to infer from the guidance isthat HMRC consider that a wide range of factorsare relevant to determining when a fee arises toan individual, such as equity ownership, votingrights, the use offshore structures and trusts.The original guidance suggested some ‘safeharbours’ for genuine corporate managementvehicles with sufficient substance butdisappointingly these have not been retained asthe legislation has been amended. Instead theyprovide more indication as to their views ontopics such as when it is reasonable to assumean amount would have arisen to an individual.Rather ominously it states that HMRC will payparticular attention to structures which rely onclaiming that investment management activitiesare partially performed by a vehicle outside theUK in a low (or no) tax jurisdiction and closelyexamine the substance of the purportedoffshore activity, in other words, the transferpricing of the transactions in place.

Interaction with other legislation

It is important to note that the DIMF legislationoperates independently to a number of other

key pieces of tax legislation applicable to theindustry. Managers with internationalstructures may be required to consider bothtransfer pricing and diverted profits tax (DPT).However, both transfer pricing and DPT havesmall and medium sized enterprise (‘SME’)exemptions, but DIMF does not have anequivalent protection. Nor for that matter doesthe investment management exemption (‘IME).

Equally the non-domicile regime that many inthe industry benefit from provides noprotection from the DIMF legislation as it treatsall amounts arising to individuals as part oftheir UK trade. Furthermore, it is not clear howthis interacts with the new tax rules for non UKdomiciled individuals. DIMF also has thepotential to apply to non-resident individuals ifthey are providing services in the UK.

Similarly, it is unlikely that protection from aDIMF charge will be available under thevarious double tax treaties that the UK is partytoo. Where part of the structure is based inother EU countries, an argument may beconsidered under the EU treaty freedoms and

in particular, the free movement of capital, asthe DIMF legislation may impede non-residentinvestment management companiesattracting capital from the UK and vice versa.However, making such an argument could bea long and costly affair and is more likely tofail than succeed.

Action to be taken

Given the wide and complex implications of theDIMF legislation investment managers need toreview their arrangements and assess whetherthe legislation applies. Seeking the support of aspecialist tax QC in reaching a conclusion on thelegislation is an increasingly popular theme andprovides additional support for the conclusionsmade. However, taxpayers shouldn’t necessarilythink the conclusions reached will be positive.

As best practice, it is important for managersto review the position annually, at the end ofeach accounting period, and understand howto practically manage the tax risk for theirbusiness and individuals involved inperforming investment management

functions. A plan of action should bedeveloped at both the corporate andindividual level, as consultation may be vitalfor achieving a consensus. Where thelegislation has a material impact and isinadequately covered in the guidance,taxpayers may consider approaching HMRC toconfirm the position. In a world of increasedscrutiny and transparency, it is important formanagers to take prompt action, review theiraffairs and consider the implications of theupdated guidance once it is released later thissummer.To contact the authors:

Marie Barber, Managing Director:Marie.barber@duffandphelps.com

Michael Beart,Director: Michael.beart@duffandphelps.com

SM&CR – reading theregulatory mind-setBy Gavin Stewart,Head of Strategy Execution of FinancialServices Group, Grant Thornton

Gavin Stewart

Driving cultural change will require morecollaboration between firms and the regulatorsdue to the extension of the Senior Managers &Certification Regime (SM&CR)

We are approaching a decade since the marketsfroze in August 2007 and Northern Rockcollapsed, signalling the start of the financialcrisis. SM&CR, due to come into force in 2018,originates in these events.

Understanding this context, in particular itseffect on the mind-set of regulators and ofParliament, will be critical to making a successof the new regime. The Parliamentary

Commission on Banking Standards (PCBS)report was not subtitled “changing banking forgood” by accident. Its core purpose was tochange firms’ culture, and we should thereforeview SM&CR as a means to that end.

In the first wave covering banks and insurers,both regulators and firms tended to focus onimplementing the detail of the regime as anend in itself. This ensured accountability mapswere clear and the rollout was as smooth aspossible. However, this approach focussed toomuch on the implementation process, partiallyobscuring the outcome. The second wave,covering all remaining regulated firms – morethan 50,000 - including hedge fund managers,alternative credit managers and funds of funds,is now looming, and regulators’ attention isstarting to shift. Two forces are driving this – ayear’s practical experience of the regime, andthe much larger and more diverse nature of thesecond wave of firms.

Practical experience will drive behaviour

Unsurprisingly, operating the new regime on

the ground is posing challenges to both firmsand regulators. For firms, accountability maps,by their nature, are often too neat to representaccurately what happens in practice,particularly when there is a problem. Forregulators, there will be some tension betweenrecognising that each firm is different and thedesire to compare different approaches.

The sheer spread of firms also makes thesecond wave of SM&CR a challenge. The newregime will encompass everything from largeasset managers to dentists and therefore willdemand a different approach, with far moreproportionality built in.

The first time the regulator sets a precedent bytaking action against a senior manager, a newtone will be set for what happens thereafter.Firms are already wary of this and regulatorswill likely feel under pressure to show theregime works as intended by holdingindividuals to account successfully. In addition,this will play out against the background ofsome senior managers retiring or moving role,and new ones being appointed and approved.

This too will influence the future behaviour ofboth firms and regulators.

The framework for regulatory relationships

One school of thought is that SM&CR will havelittle effect on regulatory relationships and that,if it does, this will be confined to banking, itsoriginal focus. However, this ignores the factthat the regime will produce accountabilitymaps that purport to cover the entireorganisation, a significant departure from theApproved Persons regime it replaces. It alsounderestimates SM&CR’s symbolic importance,with the Prudential Regulation Authority, forexample, already declaring its success as a keycomponent of the revolution in regulation thathas taken place since the crisis.

Given all this, the new regime will probablyprovide the de facto framework for theregulators’ relationships with firms. Inparticular, their perception of SM&CR is likely toshape how they make two of their keyassessments of the inherent risk a firm poses,namely the firm’s openness with the regulator

and the quality of its systems and controls.

If both these assessments are consistently high,regulators are likely to view firms much morepositively, through thick and thin. Historically,many firms have struggled to understand whatopenness means in practice, and so have reliedpredominantly on their systems and controls.However, these can never be fool proof, whichleaves firms exposed when a problem occurs.SM&CR creates a set of expectations aroundopenness, perhaps for the first time, and socould lead to a better mutual understandingabout what it means in practice.

Implementing for the long term

Changes in culture and in firms’ openness withits regulators will not happen overnight, butfirms should still carefully consider themthrough their implementation of SM&CR. Thisis because, even if only sub-consciously,regulators will begin to look at firms throughthe lens of the new regime even as it is beingput in place.

Business change, communications and thefuture measurement elements of theseprogrammes are all therefore likely be moreimportant than ever. Testing the newarrangements against potential adversescenarios should also be a core part of theapproach and their design should containenough flexibility to allow firms to reflect howthe regime works under the pressure of futureevents.

Risks and opportunities for firms

Firms can find the regulators, particularly theFinancial Conduct Authority due to its wideremit and complex structure, quite siloed, andas a result can receive mixed messages. This issometimes compounded by the fact that firmsusually deal with regulators on a transactionalbasis, often reflecting their own silos. SM&CRwill challenge this status quo on both sides byapplying a single lens across firms’management and governance.

This will put a premium on firms’ ability tobuild a consistent overall relationship that

encompasses all their regulatory touchpoints.If firms continue with a transactional approach,they might therefore be running increasedregulatory risk, particularly if they encounter aproblem and SM&CR does not operate asintended.

However, building such a relationship will be amajor challenge for most firms. Even wherethey have a single focus point for regulatoryaffairs, these departments can easily becomeoverly defensive to regulators’ scrutiny. Thiscan mean they try to present a shield toprotect senior management from regulatoryoverload, while they often also find it hard tomaintain their knowledge of the firm’sbusiness and the risks it is running. Thesechallenges are likely to be especially acute forsmall/medium sized firms providingalternative finance, who do not have a namedFCA supervisor and so will have littlecontinuity of experience with the regulator.

Firms should therefore consider carefully whatsort of overall regulatory relationships theywant to have in the longer term. For many

firms, this is likely to involve a greater degree ofinternal coordination and forward thinking.

Contact the author:

Gavin Stewart, Head of Strategy Execution ofFinancial Services Group, Grant Thornton:Gavin.B.Stewart@uk.gt.com

Progression in CaymanBy Deanna Derrick, Business Unit Director,Hedge Funds, at Intertrust Cayman

Deanna Derrick

“In the Cayman Islands, we have seen anincreasing number of separate classes beingcreated in funds to specifically accommodate theincreasing demand for SRI strategies.”

Sustainable Responsible and Impact Investing(SRI) has been gaining increased focus globallyas investors give greater consideration toenvironmental, social and governance (ESG)factors despite ESG factors being widelyconsidered non-financial in nature.Independent directors offer investors andmanagers increased confidence regardingadherence to the ESG programmes by virtue ofthe directors’ impartial oversight. Independent

directors need to grasp the strategies andactivities of a SRI focused fund to help providethe appropriate checks and balances neededto ensure the fund’s ESG monitoringprogrammes are effective.

When and how did it all begin?

From the 1960s, mostly through political unrest,SRI gained in popularity. Arguably, significantadvances and the growth of SRI started uponthe formation of the United Nations-backedPrinciples for Responsible Investment (PRI) inearly 2006. In the first year, PRI had 100signatories with $6.5trn of AuM. PRI has avoluntary and aspirational set of six investmentprinciples. One principle is the incorporation ofESG factors into investment practices, and otherprinciples address good governance, integrity,accountability and transparency. PRI signatoriesaccount for approximately half of globalinstitutional assets ($62trn) with over 1,700signatories including both investors and assetmanagers.

The Sustainable Accounting Standards Board

(SASB) noted that over half of the almost 300policy instruments established in the 50 largesteconomies to encourage investors to considerlong-term value drivers, including ESG, wereestablished between 2013 and 2016 despitelimited sustainable investing concepts(primarily negative/exclusionary) being aroundsince the late 1800s. SASB was established in2010 to address the need for ESG related datathat is relevant, reliable and comparable. Theincreased number of policy instruments alignswith the growth of PRI signatories and investorasset allocation to SRI.

What market share is currently attributed toSRI investments?

As detailed in the Global SustainableInvestment Review 2016 (GSIR), released by theGlobal Sustainable Investment Alliance (GSIA)at the end of March 2017, global sustainableinvestments accounted for approximately$22.9trn of AuM at the start of 2016. Globallysustainable investments grew 25.2% over 2014.SRI in the United States alone represented$8.72trn of the AuM, representing an increase

of 33% over 2014. Unsurprisingly, 53% of theAuM is attributable to Europe butencouragingly the relative US contribution hasincreased to 38% of the global sustainableinvestments. As expected, the report indicatedthat asset allocation remained weightedtowards the institutional investors; however,the relative growth of retail investors inCanada, Europe and the United States hadincreased to 26% with over 33% of the SRI AuMinvested by retail investors in the US.

What are the definitions and how are theymeasured?

GSIA used an inclusive definition for sustainableinvesting which encompassed screening(negative /exclusionary, positive/best-in class ornorms-based), ESG factor integration,sustainability themed investing, impact/community based investing and corporateengagement/shareholder action.

Negative/exclusionary screening representedthe largest sustainable investing strategyglobally ($15trn in assets) as well as the largest

sustainable-themed strategy in Europe. ESGfactor integration ($10.4 trn) and corporateengagement/shareholder action ($8.4trn) werethe second and third largest SRI activities, withthe US being the biggest contributor towardsESG factor integration.

GSIA acknowledges that increased disclosure byPRI signatories is enhancing ESG transparency.Given this, the GSIA report notes that severalfactors including market penetration of SRIproducts, development of new products thatincorporate ESG criteria and the incorporationof ESG criteria by large asset managers acrosswider portions of holdings are driving theincreased growth in ESG.

What are you seeing from a Cayman fundsperspective?

In the Cayman Islands, we have seen anincreasing number of separate classes beingcreated in funds to specifically accommodatethe increasing demand for SRI strategies.Unique classes are created in ongoing fundsthat include SRI strategies and activities. In

addition, a number of separate fund entitiesthat specifically integrate SRI themes andstrategies, including screening and theintegration of ESG factors, have been launchedas either funds of one (similar to a managedaccount) or as collective investment funds.

To a lesser extent, we still see side letterprovisions that integrate SRI themes; however,notably the side letters more frequentlyaddress negative/exclusionary activities ratherthan a comprehensive SRI programme. ESGfactors have become increasing topical withcredit and emerging markets managers.

What role do independent directors play insupporting SRI strategies?

The oversight by the board of Cayman fundsencompassing SRI needs to include anunderstanding of the strategies and activitiesbeing employed in order to develop aneffective monitoring programme. Given thevariety of activities and factors that SRI canincorporate, the board will want to considerpoints relevant to the strategies and activities

to effectively monitor the specific aspects ofthe SRI programme.

For example, if a fund intends to deploy positivebest in class screening to accomplish the SRIstrategy, it is important that the fund does notdrift to a negative/exclusionary methodology;therefore, the board meetings of the funddirectors should include monitoring points thatconfirm that best in class screening has beenused as the fund’s SRI programme is executed.The fund’s board of directors needs tounderstand the programme so that they canappropriately monitor adherence andapplication. Knowledgeable independentdirectors can provide the objective oversight asan unbiased check and balance for investors.

We also see independent directors beingappointed to advisory committees. Advisorycommittees are formed by the boards of thefunds and can assist with independentoversight of the SRI programme to helpmitigate conflicts that arise when the fundboard members are part of the investmentmanagement team.

What lies ahead for SRI?

Despite the recent delay in the US Departmentof Labor (DOL) fiduciary rule anticipated in April2017 and Trump’s executive orders andproposed budget cuts affecting environmentand social programmes, the future of SRIappears to be increased AuM commitment byboth institutional and retail investors. At theend of 2016, DOL updated their guidance forERISA plans regarding statements of investmentpolicy (including proxy voting policies). This newguidance confirms that material ESGconsiderations are permissible when a trusteedevelops its statement of investment policies[i];a clarification which may result in even greaterERISA plan asset allocation to SRI.

Independence on the board of funds holdingPlan assets provides oversight that is removedfrom the day-to-day deployment of the ESGprogram. Given independent directors provideconflict-free governance in the best interest ofthe investors, plan trustees will gain valuablecomfort in discharging their fiduciary dutiesbecause they have independent monitoring of

not only the fund’s performance but also theadherence to investment policies integratingESG factors.

To date, SRI and ESG factors continue to betopical with increasing inflows. Globally, anumber of managers are launching SRI fundsintegrating ESG factors. We believe SRI growthin emerging markets will continue as emergingmarkets embrace ESG factors and improvereporting. We also anticipate a growth inanalysis regarding the impact of incorporatingESG factors to investment performance.

Recently, PRI has launched a due diligencequestionnaire for the practices for responsibleinvesting as a tool for investors and managers.PRI’s six principles will continue to encouragegrowth in SRI related funds. As SRI continues togrow, investors and managers both benefitfrom the conflict free oversight provided by theindependent directors on funds boardsdeploying SRI strategies.

How The UK's SMCRWill Affect US FirmsBy Adele Rentsch, Associate, MarketsRegulation at AIMA

Adele Rentsch

Post financial crisis, U.K. banks were hit withtough new senior manager accountability rules,allowing the regulator to vet their senior staffand defining new levels of personalresponsibility for management. Asset managersare next in line, with the rules being rolled outto the rest of the U.K. financial services industryfrom 2018. As we know from the experience ofthe banks, non-U.K. staff is also in the firing line.

What are the new rules in the U.K.?

The U.K. Senior Managers and CertificationRegime currently applies to U.K.-regulatedbanks and insurers. The regime focuses the

U.K. regulator’s attention on the very toplayer of management of U.K. firms. Thosemanagers can only be appointed if approvedby the regulator. The rules also make it easierfor the regulator to hold individualspersonally responsible for failings within theirremit. This has caused a lot of angst amongsenior banking staff.

The new rules also push the onus back ontofirms to verify the fitness and propriety of asignificant proportion of their staff, includingsalespeople and traders. When the rules getextended to the asset management community,this is likely to cause huge headaches for H.R.and compliance teams in terms of revisingrecruitment processes and annual performanceassessments.

There are also new conduct rules that apply toall staff members, except for the few identifiedas ancillary staff (e.g. cleaners and securityguards), with firms having to provide trainingon what those rules mean in the context ofindividual roles. Firms have to report breachesof the conduct rules to the U.K.’s Financial

Conduct Authority (FCA) each year.

Why is this of interest to staff in the U.S.?

While the rules apply directly to U.K. firms,U.S. staff involved in the U.K. business mayvery well be captured by the new rules, forexample, global business heads (e.g. the headof I.T.) or managers of the U.K. businesslocated offshore. A U.K. firm will also have tothink carefully about how it outsourcestrading and other functions to U.S. affiliates tomake sure this doesn’t blur accountabilitylines. Overall, this may lead to a lot of verydifficult conversations and decisions aboutreporting lines and potentially costlyrestructures for global asset managers.

Likewise, traders and other staff located in theU.S. aren’t safe either. If they’re involved withthe clients or business of the U.K. entity, theymay well be caught by the regime. This meansthe firm will have to sign off on their fitness andpropriety when they’re hired and annuallythereafter for them to continue in their role.

What is the deadline for the new rulescoming into force?

The rules are being extended to all U.K.-regulated firms from 2018. However, the exacttiming and arrangements to transition to thenew rules are yet to be announced. Butoverall, this doesn’t really give firms muchtime to assess how the rules impact them andget ready.

Is there still time to influence the finalrules?

The FCA has committed to designing the newrules to apply proportionately across firms ofdiffering size, type and complexity, but we don’tyet know what this will look like in practice.

AIMA has engaged directly with the FCA overthe last year to raise particular challenges withextending the rules to asset managers. Wecontinue to encourage our members to raisespecific issues or questions with us, so we canchannel these through to policy makers orsupervisors at the FCA.

While there may still be some scope to raiseparticular concerns with the FCA, a word ofcaution: for the banks, the final rules were notmaterially different from the draft rules. Theremay also not be much time between releasingthe final rules and their go-live.

The clear message for firms is not wait for thefinal rules to start on implementation.

How can you start getting ready?

The U.K. Government has already told us thatthe rules for asset managers will look verysimilar to what is already in place for banks. Onthis basis, AIMA has already started rolling outan education programme for our members.

In advance of the draft rules coming out, wewould encourage firms to look at reportinglines and delegations, and start mapping outwho has overall responsibility for the differentparts of the U.K. business.

U.S. senior managers who are potentiallycaptured should fully understand their personal

responsibilities under the regime, and maywant to carefully review their insurancearrangements and indemnities.

At the staff level, the new regime may meanthat firms have to change employmentcontracts, including for in-scope individuals inthe U.S. Firms will also need to ensure that anychanges to, for example, staff training andannual performance assessments are extendedto non-U.K. staff, as necessary.

Hedge funds, Brexitand the EUBy Jack Inglis, CEO, AIMA

Now that the UK has begun to negotiate theterms of its exit from the European Union, thehedge fund industry has once again been citedin the process. At a speech in London in June,the former Liberal Democrat Leader and‘Remain’ campaigner Nick Clegg said thatBritain’s Brexit strategy was being shaped by an“elite” of hedge fund managers, right-wingpoliticians and newspaper proprietors. Mr Cleggwent on to suggest that hedge fund executivesin Britain regarded “EU-wide regulations [as] anoverburdensome hindrance to their financialaspirations”.

The remarks, made at an event at ChathamHouse, echoed speeches that we heard in therun-up to the referendum itself and were areminder that the myth of an industry opposedto official oversight and regulation persists, atleast in some quarters.

We have said this many times before, but let’sbe clear: the hedge fund industry as a wholewas (or is) neither definitively pro- nor anti-Brexit. No hedge fund management firm took acorporate position. Some individual hedge fund

business owners did publicly express a view butthese were on both sides of the debate.

The over-riding concern from Brexit , then andnow, is ongoing access – to investors and totalent. In terms of regulation, from the EU andelsewhere, the industry (as reflected in AIMA’sPolicy Principles) has always supportedregimes that treat investors fairly, promotetransparency, protect shareholder and creditrights, detect systemic risk and combatmarket abuse.

Yes, the EU Directive on AlternativeInvestment Fund Managers over-reached andhas been problematic. But with it in place weat AIMA have continued to want to make itworkable. There may be differences of opinionwithin our industry on the rights and wrongsof Brexit, but we can all agree that good andworkable regulation reassures investors,promotes financial stability and helps theindustry to grow.

The Panama Papers: Amissed opportunity?By Paul Hale, Global Head of Tax Affairs, AIMA

Paul Hale

Joe Ware in his recent piece for Reaction marksthe anniversary of the leaking of the Panamapapers. He sees this as a catalyst for themeasures to be enacted in the CriminalFinances Bill and an opportunity to forcegreater transparency onto offshore jurisdictionssuch as the British Virgin Islands.

I see the Panama Papers rather as a missedopportunity, in the UK at least, which couldhave put the public debate on much betterinformed ground. As Joe notes, the PanamaPapers revealed the dubious dealings of “a hostof senior politicians across the world fromBashar al-Assad to Vladimir Putin, and led tothe resignation of the Prime Minister of

Iceland”. Instead the UK public remembers thatour Prime Minister had owned shares in acollective investment scheme registered withHM Revenue & Customs as thousands of othersuch funds are and that Emma Watson used anoffshore company to hold a property.

It is easy for the press and campaigning NGOsto conflate “criminality, corruption andterrorism” – and tax evasion - with taxavoidance, but they are very different. Theformer indeed rely on secrecy and the solutionlies in the enactment and enforcement ofproper measures against money launderingand other financial crimes. This includes thedisclosure of beneficial ownership informationbetween government authorities. The focusinternationally at the EU, the OECD and the UNis on non-cooperative jurisdictions which donot collect and provide the information.

It is worth noting that there were few (if any)Cayman Islands companies identified in thePanama Papers. Cayman has for some yearsrecognised that its future lies as a financialcentre that can offer high-value services,

particularly in markets such as investmentfunds and securitisation vehicles. Offshorefinancial centres provide a tax neutral venuewith appropriate regulation where funds canbe raised from institutional investors andused for investment across the world. To dothat, offshore financial centres must meetinternational standards and be seen asreputable. Cayman, for example, is a leadingmember of the OECD’s Global TransparencyForum and meets FATF and otherrequirements. It, like the other Crowndependencies and overseas territories, isentering into arrangements for theestablishment of a central registry and theimmediate exchange of beneficial ownershipinformation on demand with each other andthe UK.

Joe and other campaigners want to go furtherand require that the offshore financial centresadopt public registers of beneficial ownership,something that few developed nations apartfrom the UK have instituted (and so MissWatson’s walk-on role in the Panama Papers).Public availability of this information, contrary

to Joe’s argument, has little relevance to theefficient functioning of the markets. This is aclash between the public interest and the rightof the individual to privacy. In the absence ofcompelling reasons otherwise, the latter shouldwin.

The tax rate that a country chooses to adopt isa distraction in this debate. By holding assetsoffshore a person cannot escape the obligationto pay taxes in accordance with domestic laws.In any event, most developed countriesincluding the UK impose little or no tax onforeign investors and even exempt domesticholding companies from tax on dividends andcapital gains from overseas subsidiaries.Onshore investment funds and securitisationregimes are not subject to tax - tax neutrality isas relevant to these as to the offshore financialcentres. Once again, it is a matter of disclosureof information and the offshore financialcentres are compliant with FATCA and theCommon Reporting Standard.

It is no less true for being a truism that any taxavoidance by a multinational enterprise in the

countries where it is operating must haveoccurred before the profits arrive offshore. Infact, it is a bit more complicated than that.

The structures used by the multinationals tooperate in the countries in which they operatehave been enshrined in domestic andinternational tax law. They arose in the high taxera thirty years or more ago when the USaggressively used transfer pricing rules andcontrolled foreign companies legislation toforce its businesses to declare profits in the UStax net. Since then, corporate tax rates havefallen outside the US but successiveadministrations, rather than following thatpath, instead relaxed the requirement to bringprofits into US tax. That reduced the effectivetax charge but the position was reached whereother jurisdictions were taxing the profitsproperly allocated to them under internationaltax laws and feeling short changed, while theUS was not fully taxing the balance. So, in largepart it was not overseas taxes but US tax thatthe multinationals were not paying.

The BEPS project and unilaterally introduced

diverted profits taxes are addressing the issueof profit allocation. However, the effect may beto shift tax payments from the US to otherjurisdictions, since the tax paid there potentiallybecomes a tax credit in the US. This is animportant part of the rationale behind thecompeting tax reforms being promoted byPresident Trump and the Republican party.They both wish to cut US tax rates so that theUS tax system no longer acts as an inducementto US multinationals to invest abroad.

This brings us to the (Republican) elephant inthe room. Delaware’s closed corporate registeris far larger than that in Cayman. The US hasnot adopted CRS and the IRS is not able to meetits obligations to make reciprocal exchanges ofinformation under FATCA – which a Republicanelement wishes to repeal. How will the EU facethe prospect of labelling the largest economy inthe world a non-cooperative jurisdiction?

Five things we learnedat AIMA’s flagshipregulatory forumJiri Krol, Deputy CEO, Global Head ofRegulatory Affairs, AIMA

Jiri Krol

By Jiri Krol, Deputy CEO, Global Head ofGovernment Affairs, AIMA

Representatives of more than 20 regulatoryagencies as well as dozens of asset managersgathered in Paris in April 2017 for one of ourflagship global events, the AIMA Global Policyand Regulatory Forum 2017, and affiliatedworkshops. The event came just days after theUK Government invoked Article 50, triggeringthe country’s long, two-year farewell to theEuropean Union. It came only a few weeksbefore the French presidential elections, which

could be as seismic as either the Brexitreferendum in the UK last June or the USpresidential elections last November. And theevent also came during the extraordinary first100 days of Donald Trump’s administration. Allthree events cast a long shadow over theproceedings.

The events over the two days were conductedunder the Chatham House rule, meaningparticular comments or opinions can’t beattributed to specific speakers. But I would liketo reflect on some of the core themes.

Brexit cannot lead to a ‘race to the bottom’in the EU 27

For the delegates from the UK, accustomed toa very UK-centric perspective on Brexit in theBritish media and at dinner parties, theconference provided a European and globalview. A recurring message from the EUpolicymakers and regulators we heard from,and to whom we spoke, was that the “EU 27” –the post-Brexit European Union MemberStates – will need to work even harder in future

to ensure a level playing field within the bloc.One speaker said that Brexit posed the 27 aprofound challenge and one that the MemberStates needed to quickly face up to andprepare for. There was also general agreementthat the EU’s capital markets union project willneed to continue and possibly acquire agreater urgency given the relatively higherreliance on banking by the 27.

Speakers agreed that regulations will need tobe implemented with greater consistency.Discussions touched on the AIFMD review andissues around delegation. More than onespeaker referred explicitly to the threat of a“race to the bottom” as EU states compete overthe City of London’s market share. There wasalso much talk of London’s importance to theEU economy, particularly in terms of assetmanagement, and of the need to strengthenthe already powerful partnership between theUK’s asset management sector and EU markets.

As AIMA sees this crucial issue, we believe thereare currently four key unanswered questions:

• The willingness of UK legislators andregulators to place asset management atthe front of their thinking as a UK growthindustry post-Brexit;

• The willingness of the EU to grantequivalence and thus access to the UK asa third-country under various pieces ofEU financial services legislation;

• The future of policy direction of existingand future EU financial serviceslegislation, in particular the maintenanceof private placement regimes underAIFMD and the Capital Markets Unionproject; and

• The degree of access in the UK to skilledemployees from the EU and beyond.

The Trump administration may notderegulate the financial system

A number of speakers at the conferencespoke about the inconsistency betweenpolitical rhetoric in the US currently and thelikelihood for substantial financial regulatory

reform. There was a consensus among ourpanellists that much of the Dodd-Frank Act,including those aspects relating to reportingand swaps, will not be repealed. As onespeaker put it, repealing the Act wholesalewould severely damage US asset managersseeking access to the EU and other marketson the basis of regulatory equivalency.

Areas that our speakers felt might be looked at,however, include the Volcker rule – the post-crisis crackdown on prop trading and on banksowning stakes in alternative asset managers –and the role of the US in internationalregulatory and supervisory bodies.

Asset managers are helping to makemarkets more stable

A number of speakers reflected on the fact thatthe asset management industry has beenrelatively stable in the near-decade since thecrisis. There clearly is now much morerecognition than ever before in Europe of the

usefulness of market finance and of thefundamental differences between banking andasset management. AuM is not a balance sheetand redemption requests to a fund are verydifferent to a run on a bank, as one speakernoted.

A recurring theme was whether the hugevolumes of data now being routinely disclosedto regulators by market participants aroundthe world are helping regulators betterunderstand risk concentrations. Somespeakers clearly believe that regulators areswamped and still lack the tools to analyse theinformation accurately.

There was also a recognition that the largefinancial markets continue to be heavilyinfluenced by the actions of central banks.Questions were posed as to whether theseinterventions were making markets more orless stable. One speaker acknowledged thatEurope’s financial system may still be too fragileto withstand a major shock.

Costs of compliance will be thoroughlyassessed

There were welcome utterances from severalregulators on both sides of the Atlantic aboutthe need for thorough impact assessments tobe carried out into the costs of compliance andthe unintended consequences brought by post-crisis regulatory reforms such as the AIFMD.Regulators said they will be seeking not onlyindustry-wide views but feedback fromindividual firms.

In terms of reporting requirements, there wererenewed promises by regulators in differentjurisdictions to work together more closely inorder to avoid unnecessary duplication and toseek to make the disclosure of data lessburdensome. But regulators also spoke aboutthe need to improve the quality of data theyreceived from fund managers. As one put it,“the data is very messy, it’s incomplete andwe’re still trying to fill in the gaps”.

Alignment of interests keeps growing

A new feature of the GPRF this year was a paneldevoted to hearing from institutional investorsin hedge funds. As we know, most investors inhedge funds and private credit funds today areinstitutions. More than half of all pensions, two-thirds of all foundations and four-in-fiveendowments allocate to hedge funds. Given thedominance now of this constituency, it is vitalthat their voice be heard more frequently inpolicy and regulatory discussions.

Speakers opined on the active/passive investingdebate, on the differences between institutionaland retail products, and, above all, on fees.There was general agreement that the days of“2&20” as a standard fee structure werenumbered and that therefore the medianarrative is increasingly divorced from reality.The panel also touched on the increasinglysophisticated and tailored structures designedto create ever-closer alignment between fundmanagers and investors.

Earlier, policymakers spoke about the need for

costs to come down and for transparency,particularly around fees and expenses, toincrease. AIFMD and MiFID in Europe andDodd-Frank in the US have already substantiallyincreased disclosure, but clearly additionalpolicy prescriptions are being considered, inorder both to increase investor protection andto increase the competitiveness of the EU assetmanagement sector.

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