European hedge fund advisors will soon be faced with the same challenges – and requirements – as their U.S. peers.

The European Commission wants them to disclose to investors – and regulators – a lot more about their trading strategies and risks when they register with the securities watchdogs in their home market.

Investment firms need to watch what the European Securities and Markets Association is hatching. The new regulator is ironing out the final touches on an Alternative Investment Funds Managers Directive (AIFMD), which may go into effect in 2013. ESMA is giving the securities industry until October 1 to comment.

Created in January, the ESMA is the successor to the Committee of European Securities Regulators and will play a greater role in how the European Commission adopts regulations. While the goal of the committee was to harmonize regulations across the European Union, the body did not have the power to issue guidelines. The new ESMA can develop standards and enforce their compliance.

Luxembourg has announced it wants to be the first to implement the AIFMD into law and has an upper hand over other markets because its regulations involving investment funds already parallel the directive.

The new European directive on hedge funds will affect all funds which do not fall under regulations called UCITS, which allow traditional investment or mutual funds to market themselves across Europe. The goal of European regulators has been to create a second category of funds – such as hedge funds, real estate funds and private equity funds – that would fall under similar guidelines to UCITS, aka the Undertakings for Collective Investment in Transferable Securities directive.

The AIFMD also affects U.S. hedge fund managers. Any hedge fund manager located outside the European Union – such as the U.S. – must get a “passport” to market the funds in Europe and would be required to comply with all of the provisions of the directive.

“Although regulations have not been finalized, what is known is that alternative investment managers must prove they have the resources – people and systems – to meet the AIFMD’s requirements and demonstrate their preparedness to clients,” says Jim Hamilton, Jim Hamilton, principal analyst with Wolters Kluwer Law & Business in Riverwoods, Illinois.

Compliance officers will likely take on a great role in ensuring their firms meet the AFIMD. The directive requires fund managers to implement and annually review adequate risk management systems in order to identify, manage and monitor appropriately all risks relevant to each fund investment strategy and to which each fund is or can be exposed. One area of contention is a list of specific safeguards the hedge fund manager should apply against conflicts of interest to ensure the independent performance of risk management activities.

Service providers such as fund administrators will potentially help out alternative investment managers with reporting requirements. “We are anticipating new client demands under the AIFMD in areas such as new investor disclosures which may end up being similar to what is required under UCITS IV,” says Ian Headon, senior vice president of product management at Northern Trust. UCITS IV is the latest iteration of the UCITS directive.

The Chicago-headquartered global custodian already helps funds fill out key investor documents – summary statements of important information to investors. Also under consideration: risk and liquidity reporting.

The AIFMD says that the funds should be expected to disclose to investors a description of their strategy and objectives, the types of assets the fund may invest in, and any procedures used to alter the investment strategy.

What about regulators? The AIFMD calls for broad disclosure about portfolio investments, trading activity, liquidity and leverage. The fund manager must, according to the AIFMD, rely on an appropriate liquidity management system and procedures. The fund manager needs to also regularly conduct stress tests to determine the liquidity of the fund under normal and so-called exceptional conditions.

“Reporting will become a lot more complicated and firms may need to implement a new system to aggregate data from multiple, disparate sources,” says Even Claussen, product marketing manager for SimCorp, a provider of software solutions and services for the investment management industry. Those sources include front-, middle- and back-office systems, particularly those that capture data needed for compliance. risk analysis and regulatory reporting.

Yet another key area of change: Valuation. Each hedge fund will have to calculate its net asset value on at least an annual basis. Open-ended funds will be required to carry out more frequent valuations based on the frequency in which they issue shares and redeem them while closed-ended funds will have to carry out NAVs each time the capital of the fund increases or decreases.

That’s the easy part. The more challenging part: Alternative fund managers can still do their valuations in-house but will be required to have an external valuation firm or auditor validates the internal calculations.

Fund managers must demonstrate that their valuation process is independent from the portfolio management function and the persons responsible for implementing the firm’s compensation policy. The goal is to avoid any potential conflicts of interest.

Although many of the requirements of the AIFMD do parallel those of the U.S.’ Dodd-Frank Wall Street Reform Act, Europe will differ in one key area – and a contentious one at that.

The AIFMD appears to be placing some of the onus for ensuring the European hedge fund operates safely with so-called depositary banks – the equivalent of U.S. custodian banks. Those custodian banks could be held accountable for the misconduct of European hedge fund managers. They could also be liable for the actions of subcustodians – local agent banks in multiple countries.

The ESMA has proposed that depositaries identify and monitor what it calls “potential loss events,” if it wants to avoid liability for any investor losses.

The proposal also says that depositaries must take additional steps to prevent those losses but does not define what they are. Still unclear is whether a prime broker could be considered a subcustodian when holding assets as collateral.

The new regulatory onus on depositaries could ultimately force custodian banks to implement a stricter segregation of duties between the depositary and fund administration activities performed by the same bank. Because one of the roles of depositaries will be to verify valuations, there will be a conflict of interest if it also performed the valuation and controlled it. As a result, fund administrators will likely do the valuation and have it reviewed by the depositary.


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