AIFMD: No Alternative to Harmonization

Following delays throughout 2012, the European Commission (EC) published the eagerly awaited Level 2 measures of the Alternative Investment Fund Managers Directive (AIFMD) on December 19. The directive is an effort to regulate the non-Ucits (Undertakings for Collective Investment in Transferable Securities) fund sector. It aims to harmonize the way alternative investment funds (including hedge funds, private equity funds and real estate funds) operate in Europe, improve competition and protect investors.

As in most other regulations being developed, increased transparency is at the heart of the AIFMD. Alternative investment fund managers will be required to report to regulators and investors on their assets under management (AUM), asset types, leverage, risk and liquidity, at both a portfolio and investor level. All of this will require sound underlying data management capabilities.

As part of their internal processes, fund managers currently calculate performance metrics such as AUM, leverage and liquidity using a variety of methods. However, under the AIFMD, they will have to adopt methodologies prescribed by the regulators. In its summary of the Level 2 measures, the EC says total AUM should be calculated "using the value of all assets managed by the [fund manager] without deducting liabilities and valuing financial derivative instruments at the value of an equivalent position in the underlying assets." It says the best way to calculate leverage is a combination of the gross method, which excludes the value of any cash and cash equivalents, and the commitment method, where derivatives positions are converted into the equivalent positions in the underlying assets.

Standardized Methods

Paul Ellis, Dublin-based European head of product solutions at HSBC Securities Services, says some fund managers are better prepared than others to adopt the calculation methodologies described by the EC. "If you are familiar with Ucits and how such funds calculate risk and leverage, then you will be able to apply similar methodologies for AIFMD compliant funds," he says. "If, however, you are a hedge fund manager who has predominantly operated offshore funds, you will need to assess the calculation methods defined by the regulations. It may well be the case that the regulatory requirement will be different to that currently utilized for portfolio management purposes. That being the case, it is likely that dual calculations will be needed, which will naturally lead to some additional overhead."

To do the AIFMD calculations accurately, fund managers need a strong reference data infrastructure. "To value an asset correctly according to what alternative investment fund managers are doing, you need to have the right reference data connected to the particular holdings in your products," says Ronan Brennan, Dublin-based chief technology officer at Moneymate, a data management services provider. "This will show whether an instrument is a derivative. And if it is a derivative, it will make it clear that you can't use the mark-to-market value-you have to use the underlying related securities value. If your reference data infrastructure doesn't have the data stored in that way, you won't be able to calculate the AUM in the way the regulator wants."

Third-party service and pricing providers believe they will play a key role in helping fund managers assemble the data needed for reporting. Because the alternative fund managers targeted by the directive are often small firms, it may not be profitable for them to set up their own internal pricing team. Bob Cumberbatch, London-based head of industry and regulatory affairs at Interactive Data, a pricing and data vendor, says the number of instruments in scope makes it impractical for firms to value them all internally.

"Previously, if you were looking for a value for an instrument that was thinly traded, you would potentially have to go out and call a number of brokers and ask them what they might trade that instrument for, and then perhaps mechanically average those quotes," says Cumberbatch. "It sounds feasible for a small number of instruments, but when you consider doing that on a daily basis and across the average size of the portfolios these firms manage, it really is unfeasible to take that approach, both from a cost and resource perspective." The fact that fund managers must demonstrate that their valuations are independent also favors the use of third-party providers.

Consolidated View

With data coming from many sources, the fund managers are going to need robust data normalization capabilities. Ellis says the fund manager is in the best position to draw together all of the data that must be reported, but emphasizes that service providers can make it easier for them to do so. "For Form PF [the US regulation requiring enhanced disclosure for private funds], we have created files that are configured by reference to the regulations so that the client receives the data in a way that eases the regulatory burden for them," says Ellis. "We expect to do the same for AIFMD. Given this reporting is ultimately a regulatory obligation on the manager, I think managers will always want to retain the ultimate sign-off on the data."

Taken as a whole, Brennan says the AIFMD has implications for the front, middle and back office. In the back office, fund managers have to ensure they get the right type of reference information from the valuations process; in the middle office, they have to ensure their security masters have the right reference data to provide the necessary transparency reports on the portfolios; and in the front office, they have to ensure they have systems which can deliver the information to the investors. He says larger firms probably have many of these capabilities in place as part of their internal risk management procedures, but smaller firms may need to invest in basic data management tools to bring all of the data together in the right place and deliver the necessary reports.

Under the AIFMD, fund managers will also be required to appoint a depositary, which will act as an auditor of the activities of the fund manager and fund. Among the most challenging duties of the depositary is monitoring the cash flow of the funds.

It had been suggested that depositaries would only be required to verify that the fund managers have procedures in place to reconcile the cash flow of funds and to monitor the outcomes of these reconciliations. However, in the Level 2 measures, the EC concluded that depositaries should themselves reconcile cash flows of the funds and identify cash flows that are inconsistent with the stated investment strategy of a fund. This will require the depositaries to manage a large amount of data relating to assets and cash.

Tooling Up

Northern Trust is one of the custodian banks preparing to operate as a depositary under the new regime. Ian Headon, Dublin-based head of product development at Northern Trust Hedge Fund Services, says the bank is analyzing whether it needs more data technology in order to execute its responsibilities as a depositary. "We believe we already have most of the data elements we need for the cash flow monitoring because, in our capacity as a fund administrator, we already collect huge amounts of data, in terms of assets and cash," he says. "How we need to process that data, given our new obligations as a depositary, is an open question. We may still need some extra data tools to help us to manipulate more skilfully some of the data elements we have."

Headon says Northern Trust has been keeping a close eye on the development of the directive and, as part of its IT planning, has introduced changes that will help it comply. In particular, he says Northern Trust's acquisition of Omnium, a fund administration services provider, will help it comply. "We acquired Citadel's third-party administration business Omnium in 2011. It provides state-of-the-art hedge fund middle-office capabilities, such as strategy and asset tagging, trade affirmation, splitting the portfolio into multiple books, multiple strategies, multiple trading desks, and so on," he says. "This new hedge fund business, Northern Trust Hedge Fund Services, gives us a material step-change in hedge fund technology-and we are working through the extent to which we will be able to leverage the capabilities for AIFMD reporting."

The next milestone in the development of the AIFMD is July 22, when the directive must be transposed into national law across the European Union. However, with the Level 2 measures now in the public domain, fund managers and the third parties hoping to assist them can began to finalize their AIFMD solutions.