AIFMDs Annex IV Are Hedge Fund and Private Equity Funds Prepared?

Investors may have heard rumblings lately in the hedge fund and private equity communities about something called Annex IV. If you a US based investor you may not even have come across the term yet or know why it is being discussed. Complicating the matter further is an alphabet soup of regulatory abbreviations surrounding the term. Here is a quick primer on the issue and why it is important for both US and non-US investors to know about this issue.

Is Annex IV the Same As Form PF?

Annex IV is a regulatory filing that is part of the Alternative Investment Fund Managers Directive (AIFMD). Under the AIFMD regime, if you are a fund manager looking to market a fund, referred to as an Alternative Investment Fund (AIF) in the AIFMD world, in Europe then you most likely need to fill out some variation of Annex IV.

The form must be filed with a so-called Nationally Competent Authority (NCA) in each EU country  where marketing is conducted, such as with the Financial Conduct Authority (FCA) in the UK.  It is also worth nothing that investors are not alone in confusion surrounding Annex IV. To provide some clarity, the FCA recently published a guide for fund managers for reporting under Annex IV. Further complicating the matters is that the actual process of filing the form out is also still being finalized. In the UK the FCA is anticipated to allow filing electronically via its GABRIEL system beginning this month. Filing may also be completed by completing the European Securities and Markets Authority (ESMA) Annex IV reporting template .

From the perspective of largely US based funds, many have compared Annex IV to the US SECs Form PF. Indeed there are many similarities between the two including varying levels of form completions based on asset under management eligibility criteria, sometimes known as Regulatory Assets Under Management (RAUM). Also similar to Form PF there have been reports of fund managers grumbling about how a firms use of leverage can distort the RAUM figure and make them seem larger than they actually are. Why do funds care about this? Wouldnt showing higher asset levels be considered a good thing? Not necessarily from a regulatory perspective as there are more robust filing requirements for larger institutions, referred to in AIFMD speak as Systemically Important Financial Institutions (SIFIs).

Another similarity between Annex IV and Form PF are different filing deadlines for different institutions. Some firms have to begin filings this month and eventually all eligible firms have to report by January 31, 2015.

The types of data collected is also somewhat similar including details of :

• Markets traded by the funds
• Portfolio diversification including details of large concentrations and top holdings
• Investment strategies and markets traded

Based on these similarities some managers have sought to take short cuts and simply copy the data from Form PF into Annex IV. This article from COO Connect outlines however, that this should not be done on a wholesale basis and due to issues such as the way data is grouped differently on the forms only approximately 60% of the information overlaps.

Also similar to Form PF, once the initial Annex IV filings are complete there are also ongoing filing requirements. Putting the technicalities aside here is general summary of the ongoing filing deadline:

• Between €100 million and €500 million annually ongoing filings
• Between €500 million and €1 billion: semi-annual ongoing filings
• Over €1 billion quarterly ongoing filings

Annex IV Operational Due Diligence Considerations

From an operational due diligence perspective some questions investors may want to ask your fund manager relating to Annex IV include:

• Are your required to fill out Annex IV? If not, why?

• If yes, what is your plan to handle to the initial Annex IV filings?

• Have you worked with domestic and European legal counsel or a compliance consultant to assist in completing the Annex IV filings?

• Have you discussed any increased data collection and reporting requirements necessary to complete the filings with fund trading counterparties and third-party service providers such as  prime brokers and administrators?

• Have you begun to collect any data, static or otherwise, for the filing so far? If not, when do you plan to start?

• Have you gone through the exercise of comparing what data from Form PF you may be able to use for Annex IV?

• What is the plan for ongoing Annex IV filings?

• How much do you estimate the time and resources spent on the initial Annex IV filing will cost?

• Are you working with any third-party firms to assist in completing the filings?

• Will the expenses for initial and ongoing Annex IV filings, sometimes referred to as offsetting. be passed onto investors as a fund expenses or will they be a management company expense? Is this consistent to the way other compliance expenses such as Form PF have been handled?

  Annex IV is simply the latest development fund managers operating in a global environment must navigate. With the steady growth of global financial regulation and compliance requirements through efforts such as AIFMD, it increasingly important for investors to take measures during the due diligence process to learn not only how fund managers are meeting these challenges but also whether investors are sharing the bulk of the expenses for fund compliance.

  Are More Hedge Funds Expensing Private Jets and Salaries At the Fund Level?

  A recent Financial Times article opened with the following salvo against hedge fund managers, Some hedge fund managers are taking salaries, private-jet expenses and entertainment costs directly out of the funds they manage So what? Is this necessarily a bad thing? Particularly if the funds are profitable.

  To play devils advocate for a moment we could raise two points. Firstly hedge funds, in a variety of different ways, make a variety of fee disclosures. This generally includes disclosures about certain types of marketing and employee remuneration fees. While most prudent investors would likely agree that it is often not in the best interest of the funds, and therefore themselves, to have expenses such as employees salaries and private jets passed through to them, its not as if they hedge funds dont disclose what types of expenses they can, and are charging, through to the funds.

  Should hedge funds be criticized if investors perhaps arent performing due diligence on these expense disclosure language to properly vet the situation? Instead, it seems, some investors may be crying wolf because they trusted a hedge fund to be what they might  deem to more prudent in the managing of these expenses, without doing enough homework up front. Furthermore, why is this even a surprise to anybody? Hedge funds have a number of discretionary rights, such as the creation of reserves, when it comes to the management of expenses and contingencies. If a manager feels expenses are in the best interest of the funds then arent investors a bit late to raise criticisms after they have been incurred since they knew the hedge fund managers rights in this area prior to investing?

  Wait just a moment, some investors might argue. Expense disclosures are too vague to be effective in preventing such lavish expenses, the agreement might continue. Such a line of reasoning may indeed be correct. This bring us to the second point. While there may be a lag involved between the actual incurring of a fund expense (i.e. paying the private jet bill) and it showing up in an area that investors could have insight into such expenses, such as in the audited financial statements, its not as if the expenses are never disclosed. Of course,  investors may argue that such delays are too long to be useful. In reference to the audited financials in particular, investors may not have the necessary granular detail to fully vet these types of expenses. Some of this may vary based on the domicile of the hedge fund itself. For example, the details of fund expenses including marketing costs such as printing are typically detailed more clearly under standards such as UK GAAP versus US GAAP.

  So what is an investor to do? Well perhaps a good start would be to perform some actual operational due diligence (ODD).  Even better, how about ODD  both prior to investing and ongoing operational due diligence after an allocation has been made? Joking aside, ODD can help investors become informed about how funds approach expenses in general. With this general understanding in place, investors can then dive into areas such as audited financial statements and conduct interviews with fund personnel regarding the types of fees charged to funds.

  Of course, this initial ODD is not a guarantee that a hedge fund will not deviate from seemingly reasonable expense policies and begin charging expenses such as private jet flights, entertainment and salaries to fund. This is where ongoing monitoring comes in. To be clear, an investor performing ongoing ODD monitoring may not even be able to detect such expenses before they occur, but they are increasing the likelihood of being more informed about such changes once they happen. Whether or not an investor agrees with such lavish expenses being charged to the funds in which they invest, and likely most dont and for good reason, ODD can help to ensure that investors are more informed about the expense policies of the hedge funds in which they invest. Articles such as the above referenced Financial Times article are good reminders of the need to conduct ongoing monitoring of funds in these areas, otherwise investors may end up paying for more than they bargained for.