This month I thought it would be appropriate to focus on the issues of asset protection that are necessary when considering fund investments. The AIFMD has approached this issue by requiring funds to have a depositary. The Pensions Regulator in the UK issued a discussion document at the end of January dealing with issues around asset protection in Defined Contribution Schemes in which a principal of Jaitly LLP played a role.
Of course alternatives and hedge funds in particular are becoming an important aspect of pension investment strategies as trustees and consultants consider greater exposure to these types of investments to manage their investment portfolios.
Asset protection means different things to different people – the AIFMD takes a relatively narrow approach requiring a depositary with risk management and liquidity requirements as part of the operating conditions for the manager. The UK Pensions Regulator in its discussion document recognises a much broader approach by considering the impact of wider issues such as fees, administration and record keeping, valuation methods, insurance, compensation schemes and security lending all of which can have just as significant an impact on the protection of investor assets as might the use of a custodian.
Hedge Funds can be viewed by some as riskier investments – but depending on the investment strategy they need not be. Indeed as absolute return vehicles one of the underlying principles of a hedge fund investment should be the preservation of capital and hence the protection of assets.
The analogy to houses in this month’s title is apt because of the use of leverage in investment strategies and their impact on asset protection. It is a concept that needs to be understood far better by investors. As with a house – financiers provide funds which are secured against the value of the house. This leads to financiers introducing margins of safety in case the value of the house should fall by requiring that amounts lent should not exceed say 70% of the current value of the property (a concept ignored by sub-prime lenders). With a business that borrows money – the principle is no different and the lending is secured by taking out fixed and floating charges on the assets of the business which the financiers assess as giving them a margin of safety in the event of a default.
In a hedge fund too the principle is similar but the nature of leverage and the deal that is negotiated with the financiers – the prime brokers – is important to understand, as that will have a significant impact on the safety of those assets for investors.
So lets take a simple long short equity fund that states that its gross exposure will normally not exceed 130%. Note this is only an intention – it does not prevent the fund from going beyond this limit. What does that mean? It means that the sum of its long and short exposures will not normally exceed 130% – but it could. For example its investments held long could be 100% of the value of the fund and its short exposures 30% or other combinations totalling 130%. It is able to do this by borrowing 30% of the value of its assets. Funds with little negotiating power may agree to the prime broker securing the value of all the assets against the borrowing. If the fund deals in risky transactions the prime broker may require wider margins of safety to take into account difficulties in asset valuation or fluctuating asset values. Others may negotiate that the assets secured cannot exceed say 140% of the level of borrowing. Others may provide for assets up to 200% of the borrowing and so on. The assets secured in this manner are referred to as encumbered or collateralised assets.
The prime brokers can then re-hypothecate the encumbered assets – this enables them to borrow from third parties and to put up the re-hypothecated assets as security for that borrowing as if it was their own asset. This is what caused such problems for funds that were financed by Lehmans because collateralised assets had been re-hypothecated and were being retained by counterparties when Lehman had defaulted on its obligations. Where the assets collateralised had no limits – i.e the prime broker treated all the funds assets as collateralised then the problem was exacerbated even further – and then there was of course the problems with record keeping that meant that tracing and differentiating between encumbered and unencumbered assets became a major problem.
How this will operate in relation to the depositary requirements of the AIFMD needs to be fleshed out by the EU and ESMA in accordance with Chapter III and Article 18 (a) 16 of the directive. The UK Pensions Regulator is also consulting on the issue through its discussion document. Both are also looking at risk management and liquidity.
It does seem therefore that there is a real need for certain basic principles to be clearly articulated so that investors interests are protected in relation to leverage:
- a requirement for disclosure of how leverage will operate on a fund and what impact this will have on liquidity and risk management
- a requirement to disclose what the manager of the fund will and will not be permitted to do in relation to leverage and what protections and controls will operate to ensure that the manager does not breach these parameters
- a requirement to provide an explanation of the circumstances in which rights against collateralised assets can be exercised by financiers and how collateralised security shall be managed
- a requirement to explain the types of recourse available (if any) to investors in the event that assets are lost
- a requirement to disclose how assets will be custodied, including sub custodial arrangements
- a requirement for custodians and depositaries to be adequately capitalised and to carry appropriate insurance or bonding in relation to those assets and possible loss
- a requirement for custodians and depositaries to segregate the assets from their own with adequate record keeping and regular disclosure .
It is only then that the regulatory environment within which investors make investment decisions will operate to protect investors assets and enable investors to make informed decisions relating to risks around leverage.
©Jaitly LLP