Make no mistake the AIFM directive is going to change the Hedge Fund industry forever. This legislation (now in advanced draft form) effectively marks the end of the free-wheeling unregulated years of the Hedge Fund. This excellent White Paper examines the main changes being proposed, what the likely effects will be for the industry and why this European Directive means that the traditional, secretive Hedge Fund model is now effectively dead.

1. A Global Perspectives White Paper
`
AIFMD & the Death of the
traditional Hedge Fund
By Shane Brett,
Managing Director
May 2012
Global Perspectives 1
www.globalperspective.co.uk
Email: Shane@globalperspective.co.uk
Phone: +353 (0) 42 9339951
Mobile: +353 (0) 87 115 2173

2. Contents
Introduction 2 Introduction
Background 2
“So the EU has closed its doors to the
AIFMD & the Hedge Fund Industry 3 US hedge fund industry”.
1. Domiciliation 3
Financial Times, Oct 2011
2. Reporting 3
3. Depository Requirements 4 Make no mistake the AIFM directive is going to
change the Hedge Fund industry forever. This
4. Leverage 5 legislation (now in advanced draft form)
5. Valuation policy 5 effectively marks the end of the free-wheeling
unregulated years of the Hedge Fund.
6. Remuneration 5
Conclusion 6 A new era of regulation is upon us and the
consequences of this EU Directive means the
traditional, secretive Hedge Fund model is
effectively dead.
Background
Rightly or wrongly Hedge Funds in mainland
Europe have an unenviable reputation. Despite
no Hedge Fund ever having required a public
bailout, the EU has used the current economic
crisis as a pre-text to increase regulation across
the industry in Europe.
Across the industry focus to date has been on
Dodd Frank (especially in the US) but the
Alternative Investment Fund Managers Directive
(AIFMD) is likely to have far greater affects on
the wider Hedge Fund Industry in the years to
come.
The third and final draft version of the AIFM
Directive was published recently (May 2012) and
unsurprisingly, against a background of extreme
Euro Zone turbulence, they have reintroduced
many of the more prohibitive requirements that
were first seen in the original draft but had been
successfully lobbied down in the second version.
Incredibly, this final version has even been
criticised by such unlikely sources as ESMA (the
EU’s own super regulator) and the ECB but still
looks likely to become law across the EU in July
2013.
We believe the adoption of AIFMD signals the
death of the traditional largely unregulated

3. alternative investment “black-box” which
pre-dominated the industry for so long.
Instead we are moving towards a more Likely Effects - There is a real fear that many
standard and invasive model of financial Hedge Funds may have to re-domicile their
regulation, similar to the UCITS regime funds within the EU in order to be able to market
in Europe. their products (or potentially “co-domicile” their
funds in EU/Cayman by setting up a mirror fund
This means Hedge Funds will be trying inside the EU - potentially operationally tricky).
to implement the required operational
reforms (including around leverage, Indeed some large fund of funds (like Amundi
reporting and depository liability) while Alternative Investments) have already changed
the outcome of the on-going Euro Zone their existing structure and moved their funds
saga is being played out in the fully onshore, re-domiciling within the EU
background. It will make for a regulated framework. We expect to see a lot
challenging environment to try and more of this in the future.
implement substantial regulatory
change. Hedge Fund friendly EU locations like Ireland
(which already has nearly half the global hedge
We will look at the main changes fund administration market) are pushing hard to
required under AIFMD and what the promote themselves as an alternative
likely (largely negative) effects of this domiciliation location (using their existing AIFM
will be on the Hedge Fund Industry. compliant QIF structure).
AIFMD & the Hedge Fund
Industry 2. Reporting
Like Dodd Frank in the US, AIFMD massively
1. Domiciliation increases the level of record-keeping reporting
required by Hedge Fund Managers.
One of the thorniest issues in the Managers will have to register with their national
AIFMD proposals is what will happen to regulator (essentially the FSA in the UK (itself
non-EU based managers who want to changing shortly) given that 80% of EU based
market and sell their funds inside the Hedge Funds are in London). Details will be
EU. required of investment strategy, the main
instruments funds will be trading and what the
To date the legislation has taken an likely level of exposure will be.
inside or outside of Europe view – i.e.
that the Hedge Fund either operated Similar reporting will be required on a frequent
fully within the EU or fully outside it. This on-going basis in relation to its exposure and
view also applied to Hedge Fund risk calculations. The stated aim of this is to
investors, Managers, Custodians and allow the regulators to determine if a systemic
the Hedge Funds themselves. threat is building up in the financial system.
Of course in reality this is nonsense. Likely Effects – Hedge Funds will have to
There is no such clear division. Funds invest heavily in their operational software in
(and their service providers) operate order to be able to access large volumes of data
across multiple jurisdictions just like quickly and flexibly for reporting purposes. This
companies in other global industries.
Global Perspectives 3
www.globalperspective.co.uk
Email: Shane@globalperspective.co.uk
Phone: +353 (0) 42 9339951
Mobile: +353 (0) 87 115 2173

4. will obviously favour larger, more Under the AIFMD proposed regulations
established managers who should have Depositories (Custodians/Prime Brokers) will
deeper pockets. have a much higher degree of liability for any
losses that are incurred – even losses that are
It will also favour larger Administrators. outside of their control (i.e. delegated to a third
As they are holding the official books party).
and records of the fund and can easily
access and report this data, many In many ways this regime will be even tighter
Managers may decide to fully outsource than the existing UCITS requirements. This is a
the AIFMD reporting requirements to huge change whereby hedge funds are
them. effectively more tightly regulated than the
existed onshore regime.
Administrators themselves will likely
have to invest in their existing reporting Non-EU funds must have a Depository either
capabilities in order to satisfy their within the EU or in their “home country” (main
clients. Smaller administrators will find location) or country of domiciliation. However the
this more difficult, reinforcing the catch here is that non-EU Depository must be
process of consolidation already subject to the same level of EU regulation in the
underway in this part of the industry. “home” jurisdiction as they would be in the EU
(including mutual tax and regulatory co-
Additionally these reporting operation agreements).
requirements will feed down pressure to
the industries main software vendors; to It is completely unclear how this will work in
make their software more malleable and practice and is a source of much concern in the
dynamic for reporting purposes, right industry. Our view is that this requirement is
across all aspects of the fund. There is close to unworkable.
likely to be a year or two lag once the
Directive is finalised, while many
vendors built out the required Likely Effects – We would expect to see some
enhancements in their applications depositories withdraw completely from perceived
risky markets. Additionally we would also expect
Hedge Funds using proprietary software to see them offer less coverage for markets
will likely have to make substantial which they deem are in any way inherently risky.
investments to bring their systems up to
the new required standard. They may Many existing Depositories will be reluctant to
decide the gap is not worth trying to continue to offer coverage in certain Emerging
bridge and opt to migrate to an off-the- Markets. This could have a huge effect on these
shelf platform which will do this for them. countries. If Hedge Funds are effectively unable
to allocate their investment capital to the assets
in these countries, it serves to undermine
investment in the markets that most need it.
3. Depository
Requirements Non-EU funds will have to spend the next couple
of years (the Directive becomes law in July
2013) working with their national regulator to
All Alternative Investment Funds will ensure that their home regulations satisfy the
have to appoint a single independent Directive’s requirements. The real issue will be
Depository to safeguard the fund’s when the gaps are identified.
assets.
Global Perspectives 4
www.globalperspective.co.uk
Email: Shane@globalperspective.co.uk
Phone: +353 (0) 42 9339951
Mobile: +353 (0) 87 115 2173

5. The Directive is mandating that the
“home” regulator must itself introduce
regulation to bring itself up to the EU
level. This, of course, will be close to
impossible politically. The EU will be 5. Valuation policy
seen as trying to supplant other
countries sovereignty.
AIFMD mandates that all assets of a fund will be
independently valued. The valuation of the
We expect many countries (including
Funds assets must either be performed by an
the US) to lodge official objections to
independent entity (i.e. an administrator) or they
these rules (perhaps at the WTO level)
can be performed by the Hedge Fund - as long
and if this is not resolved satisfactorily,
as it is not valued by the Portfolio Management
then reciprocal rules will be imposed on
function or the area that sets remuneration
EU resident Hedge Funds.
policy for the fund.
Likely Effect - Funds will be required to use
4. Leverage administrators (as all EU managers do now) but
further restrictions on the valuation of hard to
As well as stricter rules on the use of mark assets by Hedge Fund Managers may
leverage, the current draft proposals mean some may start to steer clear of potentially
contain an unusual and very strict illiquid investments.
methodology for calculating leverage.
Firms will need to document their valuation
This proposal has raised many procedures, valuation committee processes and
eyebrows right across the industry. The pricing policies carefully, ready for external
EU actually rejected the more common regulatory inspection or submission.
leverage methodology recommended by
ESMA (its own markets regulator). The best managers do this already, however the
focus of the regulators will be squarely on the
Likely Effect – If this calculation is hard to value, illiquid securities which they will
adopted it will further limit the amount of be concerned (in aggregate across the industry)
leverage a Hedge Fund can adopt in its may cause a systemic risk in the future.
investment strategy and could be a
major change from the model of the
traditional hedge fund.
6. Remuneration
Furthermore adopting these new
calculations will be an operational
Under the directive company remuneration must
nightmare for smaller firms, as they
be published in detail in the Fund Managers
struggle to change/add existing leverage
annual reports. Also, salaries and bonuses must
calculations to their risk analysis
be weighed towards long term rewards and
reporting and software.
away from short term payments.
Service providers such as
Likely Effect – The industry will have to become
Administrators and the industries
use to a new level of transparency and
system vendors will have to move
openness in some of the most sensitive areas of
quickly to ensure they are compliant
any business – how much its staff are
with these calculations if they are in the
remunerated. This will be a major cultural
final treaty text (as currently looks
change.
likely).
Global Perspectives 5
www.globalperspective.co.uk
Email: Shane@globalperspective.co.uk
Phone: +353 (0) 42 9339951
Mobile: +353 (0) 87 115 2173

6. Like in investment banking, Hedge
Funds are likely to increase their basic
salaries to staff, in order to mitigate
unfavourable reporting in the press (this
will be the first time mainstream media
will ever have access to Hedge Fund
remuneration).
Conclusion
It is clear from the draft AIFMD Global Perspectives offers the
proposals that these new EU regulations
will change forever the way Hedge following services to the Asset
Funds operate. Management industry:-
The industry will have to reconcile itself  Consulting,
to a far more open, more invasive and
more regulated operating environment  Bespoke Research,
in Europe. This is likely to become the  Product Design,
de-facto standard globally, bringing the  Service Provider Reviews
era of the traditional, secretive Hedge  Operational Due Diligence
Fund to an end.
reviews.
The question in the years to come is
whether this is in fact only the start of a
pipeline of future regulation designed to
bring Alternative Investments tightly
within the regulatory net.
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Global Perspectives 6
www.globalperspective.co.uk
Email: Shane@globalperspective.co.uk
Phone: +353 (0) 42 9339951
Mobile: +353 (0) 87 115 2173