This INDOS Financial article was first published in HFM Week and can be read here (subscription required).
Many alternative investment fund managers have not traditionally subjected themselves in their fund offering documents to specific investment restrictions unless required to by regulation or other rules. Managers prefer this approach since it provides them with maximum flexibility to manage the fund as they deem appropriate.
Despite the introduction of AIFMD, which requires managers to make prior disclosure of a range of information to investors, including a description of the investment strategy, fund objectives and investment restrictions, there has not been a noticeable change in practice. Some investors suggest there is a trend towards disclosing less rather than more restrictions, which they feel is not a positive industry development.
Regulators are also placing more emphasis on mandate compliance. In its 2015/6 Business Plan, the FCA stated it would focus on whether UK authorised investment funds are operating in line with their marketing materials and investment mandates. Whilst this review focusses on UK authorised funds, it sends a message to all managers to ensure they monitor their mandate compliance. In the US, there have been several cases of SEC enforcement action against registered investment advisors for failure to comply with or disclose changes in investment strategy.
Some investors would no doubt welcome more specific restrictions which are tailored to a fund’s strategy. These would include restrictions around the types of products and markets in which the fund normally expects to trade, counterparty risk management restrictions and portfolio concentration restrictions. This would result in reduced potential for scope creep which is a specific area of concern to them. In this respect, the conditions for listing a fund on the Irish Stock Exchange offer an example of a sensible starting point. These include concentration limits of 20% in a single issuer, as well as counterparty exposure limits of 20% to a single counterparty. There are also requirements to ensure counterparties are appropriately regulated and hold minimum financial resources.
Arguably, more specific disclosure would also enable better oversight over a fund’s compliance with its mandate. Fund boards and depositaries would be able to more effectively discharge their duties and protect the interests of investors. A key role of a fund board is to ensure the investment manager operates within its mandate. For many alternative funds, it has traditionally been the board of the fund and the manager itself overseeing a fund’s compliance with its mandate since administrators do not to take any contractual responsibility for doing so and auditors generally rely on representations from the fund board. AIFMD introduced the role of the depositary for non-EU alternative investment funds being marketed in the EU. One of the more valuable duties performed by depositaries is oversight over a fund’s compliance with its investment restrictions.
When it comes to funds which contain restrictions, there are a wide variety of approaches taken. Some funds include a list of several specific restrictions but it is more common to see documents refer to ‘guidelines’ rather than restrictions. In some respects guidelines are neither fish nor fowl and could be difficult to enforce were a manager to stray outside of them. We have also seen instances where language could be tightened up to avoid ambiguity or to accommodate practices such as placing unencumbered cash into money market funds, which can inadvertently lead to a breach in counterparty limit restrictions.
Even when there are restrictions in place, they need to be appropriately monitored. A good example is the Weavering Macro Fund fraud. Its offering memorandum contained a number of representations, investment guidelines and restrictions including that all counterparties to the fund would be ‘major banks’ and no more than 20% of the fund’s gross assets would be exposed to the creditworthiness of any one counterparty. At the time of the fund’s collapse, exposure to a related party counterparty had increased to over 90% of the net asset value. We have often argued that, had a depositary been in place, the whistle would have been blown on the fraud a long time before the fund’s eventual collapse.
More specific disclosure may also be beneficial to defend any claims against breach of mandate. One leading insurance broker noted that claims for breach of mandate are low-frequency (around 5% of claims by volume), but they account for over 30% in value of all claims. There are different views as to whether managers would be in a stronger position to defend claims if they had published very clear restrictions which they can demonstrate they have subsequently complied with.
In summary, now may be a good time for managers to review their documentation and strategy for defining and disclosing investment restrictions and looking at their controls and procedures for ensuring on-going mandate compliance, given the current increased regulatory interest and investor transparency demands.