The first Annex IV reporting season is nigh, and alternative investment fund managers subject to the obligation are busy gathering data from multiple sources, and working with administrators and technology providers to deliver what the regulators say they wish to see. As always, some are better prepared than others, but until a complete reporting cycle is over it is impossible to draw up a list of the ingredients of success.
When it was first proposed in 2009 in the aftermath of the financial crisis, the Alternative Investment Fund Managers Directive (AIFMD) was met with a mixture of incredulity and dismay. Some fund managers were concerned the Directive would effectively sever their relationship with European investors. They and their service providers warned that an unmodified Directive would banish the European private equity and hedge fund industries to Switzerland, or perhaps even further afield.
One reason behind these apocalyptic predictions was the level of disclosure demanded by the Directive, not only of the remuneration of senior staff and of assets and transaction flows to the depositary banks, but of intimate details of funds to the regulators themselves. The reporting requirements set out in Annex IV of the Directive are indeed demanding. They cover assets under management, trading and counterparty exposures, investment strategies, risk concentrations, financing, and liquidity.
Annex IV reporting leaves few managers alone. It is applicable to any AIFM managing or marketing an AIF into the European Union (EU) or the European Economic Area (EEA). The obligation also falls on any non-EEA AIFMs which are marketing AIFs to European investors via national private placement regimes. Only non-EU AIFMs not marketing an AIF into the EU or those running UCITS (Undertaking for the Collective Investment of Transferable Securities) strategies are exempt from Annex IV reporting.
Although they have to complete the comparable Form PF or Form CPO PQR, one factor behind the decision of a number of American fund managers to cease marketing into the EU is Annex IV. Lawyers have warned them that even the most mundane actions, such as distributing business cards at a conference held within the EU, or having a web-site that is accessible from an EU member-state, could constitute marketing and therefore render the fund subject to Annex IV reporting.
This has encouraged a binary approach from non-EU managers. Some have chosen to comply in full with AIFMD so as to circumvent any risk of being taken to task by regulators, while others have decided to avoid the EU altogether. “A number of firms are attempting to rely on reverse solicitation to avoid the reporting obligations and AIFMD more broadly,” says Gary Kaminsky, managing director for global regulatory and compliance at ConceptOne in New York. “It remains to be seen if that continues now the 22 July 2014 deadline has passed.”
Registered AIFMs must supply the completed Annex IV to their national regulator while non-EEA AIFMs adopting national private placement regimes must submit it to the regulators in all of the jurisdictions where they market. In terms of timing, the go-live date for the first Annex IV submission is the first whole quarter after which firms are authorised as AIFMs by their “national competent authority” or when they start to market their funds to EU investors.
Firms which had received authorisation as AIFMs from their home state regulators by 22 July 2014 were therefore required to file Annex IV reports no later than 31 October 2014. Other affected firms can expect to file Annex IV no later than 31 January 2015, or even April 2015. These dates are not far away. “It is critical that managers have a comprehensive solution in place to be ready to meet their regulatory responsibilities on time,” says Charles Bathurst, an advisor to the board of SuMi TRUST, a division of the Sumitomo Mitsui Banking Corporation.
The level of preparedness at managers for Annex IV is varied. A survey in January 2014 of 50 global fund managers by BNY Mellon in conjunction with FTI Consulting found 37 per cent of firms were uncertain as to how they would address Annex IV. Nine months on, Bobby Johal of compliance consultants Cordium reckons the majority of the managers his firm deals with are prepared for their Annex IV obligations.
However, non-EU firms seem less prepared. “The majority of the investment managers we deal with are based outside of the EU and when we speak to them about Annex IV or AIFMD more broadly, there seems to be a limited knowledge,” said Dermot Mockler, group head of regulatory affairs, compliance and anti-money laundering at TMF Custom House Group, a fund administrator in the summer of this year. “That is changing though but it would be fair to say the bulk of non-EU managers are not yet prepared for Annex IV.”
Joseph Henkel, head of global solutions at SEI, also found EU firms better prepared than their non-EU counterparts. “Many EU managers had, for example, submitted their Variation of Permission (VOP) applications with the FCA on the original 22 January 2014 deadline, or shortly thereafter. The larger, non-EU managers running European institutional money were also quite prepared.” The managers that seemed less prepared were the mid-sized and smaller managers. He thought most of these firms had delegated the work to AIFMD management companies, or Mancos.
Reporting frequency for Annex IV is determined by assets under management (AuM). Firms running between €500 million and €1 billion are expected to file Annex IV on a semi-annual basis, while managers in excess of €1 billion must submit the report quarterly. Those managing between €100 million and €500 million must file annually. Even hedge and private equity funds managing sums below these thresholds and marketing in Europe, must also supply some detail to regulators in those jurisdictions where they are marketing.
The reporting frequency and scope is also subject to leverage calculations. A firm managing €500 million that is leveraged is expected to file Annex IV reports semi-annually or even quarterly, rather than annually, as regulators incorporate leverage into the AuM calculation. Unleveraged private equity funds must provide Annex IV annually irrespective of AuM. As if that was not enough, regulators are allowed to arbitrarily ask certain AIFMs to increase their reporting frequency if they feel it is necessary.
Firms are expected to submit Annex IV 30 days after the end of each quarter, although funds of hedge funds and funds of private equity funds can provide the report 45 days after the quarter end. This can cause a mismatch with valuation cycles. “Annex IV is a challenge for fund managers, and the 30 day turnaround is likely to prove very difficult,” says Mike Megaw, global head of regulatory solutions at SS&C GlobeOp. “The majority of people in the hedge fund industry will strike their net asset value (NAV) on a monthly basis, so there is a risk that up-to-date data will not be ready for some Annex IV filings. Some strategies, depending on their complexity, take longer to strike a NAV and this too will be a challenge for filers, especially with the 30 day turnaround.”
There are also complications surrounding the formatting by which AIFMs supply Annex IV to regulators across the EU. A briefing by the Financial Conduct Authority (FCA) in the UK in June 2014 outlined the two formats by which managers can submit the report. Managers were advised to upload the form into XML and then format accordingly into GABRIEL (Gathering Better Regulatory Information Electronically), the online regulatory reporting system run by the FCA. Firms were also permitted to supply the XML formatted report by email, at least until October 2014. Alternatively, firms were told they could upload the XML file via a B2B methodology. The FCA also said it will only accept the XML version 1.1 schema laid down by the European Securities and Markets Authority (ESMA), even though ESMA released version 1.2 on 25 May 2014.
The FCA is only one of multiple regulators active in Europe, and there is little uniformity across the EU in how Annex IV is supplied. “Other member-states are allowing email with on-line capabilities but there is no single platform being utilised across all EU member-states,” says Joseph Henkel. Fortunately, regulators are not going to add to managers’ workload by demanding Annex IV be submitted in languages other than English. "At present, member-states have said it is acceptable to provide an English-only version of Annex IV, which is not the case in the UCITS IV Key Investor Information Document (KIID)," adds Henkel.
A further potential challenge could arise if different regulators start tinkering with the Annex IV and force managers to make additional disclosures. Unlike a regulation, a European directive such as AIFMD does afford member-states some leeway to interpret the rules as they see fit. "This is a possibility,” says Henkel. “If the fund is not passported – for example, a non-EU manager utilising national private placement regimes to market into a number of competent authorities - there is a risk that national regulators could amend Annex IV according to their own markets. At present, we do not know of any reporting differences in Annex IV but that is not to say it will not happen in some member-states in the future." A particular concern is that some jurisdictions will make voluntary components of Annex IV mandatory. In fact, this is already happening, according to Pete Townsend, head of hedge fund solutions at BNP Paribas Securities Services in Ireland. “Some jurisdictions, such as Ireland, are asking AIFMs to supply the optional data points. Each country may have variances on the Annex IV reporting regime for managers and funds. Member states have a right under national regulations to demand more details and data from AIFMs,” he says. “However, it is unlikely different national competent authorities will alter the calculation methodologies contained within Annex IV. I believe regulators will be pragmatic about this. In addition, ESMA has provided guidance on the technical details of the calculation methodologies and member states probably will not want to deviate from that,” adds Townsend.
Annex IV is by and large considered to be a more prescriptive and granular document than the Form PF reports submitted by managers to the US Securities and Exchange Commission (SEC) and the Form CPO PQR reports submitted to the Commodity Futures Trading Commission (CFTC). “It is a very prescriptive format, and requires an enormous amount of data aggregation,” says Mockler. “Not only do European regulators expect information submitted on aggregate basis from AIFMs, but they also expect to see reporting done on an individual fund-by-fund basis.”
Annex IV, which consists of 301 data fields to populate, requires managers to provide information on instruments traded, borrowings, exposures, stress test results and leverage. “Annex IV is a lot of work and the questions and data sets are very detailed,” explains Ben Pugh, chief operating officer at Ovington Capital in London.
Paul Clement, partner and director of operations at Castilium Capital, a recently launched hedge fund based in London, agrees. “Annex IV is extremely thorough and requires managers to go into enormous detail,” he says. “For example, a firm with country-level exposure to Greece will be required to list its positions, break them down into sectors and percentages, and even NAV percentages in those sectors, which is similar to CPO-PQR. It is exhaustive.”
One area which caused immense confusion and frustration was the calculation of leverage and “Regulatory” AuM (RAuM). A legal briefing by Dechert pointed out that AIFMs were required to determine leverage as a ratio of exposure to NAV, with exposure calculated in accordance with a “gross” and a “commitment” method. The briefing added the “commitment” method would lead to a similar result as that derived from the application of the guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risks for UCITS funds (CESR/10-788) devised by the Committee of European Securities Regulators (CESR), the predecessor body to ESMA.
The “gross” method obviously does not permit a manager to take netting or hedging arrangements into account. AIFMs adopting the gross method will therefore appear more leveraged than they believe they are. As leverage is included in RAuM, some firms will also appear far larger in terms of assets than the standard AuM figures they publish in their prospectuses indicate. “The assets managed by some fund managers will look far higher in Annex IV than what they would report to investors,” says Megaw. “RAuM under Annex IV includes a gross leverage calculation, which requires managers to convert certain derivatives in their portfolios to the market value of the underlying securities. The RAuM in Annex IV can be much greater than the traditional calculations.”
This could have unintended consequences, particularly if regulators come to believe some fund managers are systemically more significant than they actually are. “The Form ADV and Form PF definition of RAuM in the United States looks to gross assets on an audited balance sheet,” says Gary Kaminsky. “The EU definition of RAuM incorporates gross assets but also requires AIFMs to notionalise the value of derivatives, so the results will be skewed. The result could be that AIFMs may appear much larger, and therefore more `systemically important,’ due to their EU AuM. It is quite possible these institutions could find themselves unwittingly appearing on the regulators’ radar and subject to greater scrutiny and oversight.” Ben Pugh agrees. “I worry whether managers could in some way be deemed systemically important financial institutions (SIFIs) because of the data reported in Annex IV’s leverage exposure calculations,” he says.
Consistency in reporting, and duplication of data across reports, also present potential problems. Some firms, typically those that have filed either Form PF with the SEC or Form CPO PQR with the CFTC, were warned that attempting to replicate the data sets in those reports into Annex IV would be a mistake. “I have heard anecdotally that there is about 50 to 60 per-cent overlap between Form PF and Annex IV,” says Bobby Johal. “Managers have to be cautious though, as the interpretations within the reports are not identical and Annex IV has a number of different fields to Form PF.”
Kaminsky reckons the overlap is lower than 50 to 60 per cent. “I would say maybe one third of the enriched data in Form PF is overlapping with Annex IV,” he says. “The data sources may overlap, but the calculations and interpretation of a number of different data points is quite different. Nonetheless, managers should leverage the process of identifying the data sources and aggregating the data used for Form PF and apply it accordingly to Annex IV.”
Simply copying and pasting a Form PF filing into Annex IV is therefore unacceptable and likely to lead to managers making errors or risk being in non-compliance. “Borrowing from Form PF would be dangerous. Annex IV, unlike Form PF, breaks down the portfolio by geography, sectors and concentrations. There are too many differences. For example, the methodology to calculate leverage and liquidity is not the same,” says Mockler.
That said, the expertise and experience gained from filing Form PF and CPO-PQR is proving useful in completing Annex IV, provided managers proceed cautiously. “Fund managers which have experience in filing Form PF will probably have a better understanding of Form PF but Annex IV is more detailed,” says Clement. “It is like an enhanced version of Form PF, with a few extras thrown in for good measure- for example, the addition of the remuneration policy and NAV calculations. While the questions in the two documents are similar, Annex IV goes into more depth and will ask for more granular level reporting.”
Although managers retain ultimate responsibility for the accuracy and timeliness of their Annex IV submissions, managers can get some help from their fund administrators and technology providers. “The big challenge is having to collate all of the necessary data,” says Clement. “We are outsourcing it to a consultancy firm and they are going to collect and collate the data and report it. We are a small manager and we simply do not have the manpower to spend the time to do Annex IV, among other regulatory reporting, ourselves, internally. Conversations with other fund managers indicate most are adopting a similar approach. It is more cost-effective for the smaller managers to outsource this work than internalise it and build information technology systems and re-jig the infrastructure to deal with the Annex IV requirements, although larger managers with 30-plus employees and in-house IT staff and top tier portfolio management systems may have the manpower to do this internally.”
Consolidating multiple data sets from different providers is challenging, but it is proving manageable. “If a fund manager client has multiple fund administrator or prime broker relationships , we can import the necessary data,” says Mockler. “In addition, managers can provide data which service providers do not possess or they can input it themselves. It is a challenge but it is by no means an impossible one.” Townsend of BNP Paribas agrees. “Annex IV requires a collaborative effort with managers and their service providers, so identifying which party provides what data can be challenging. The manager will have to agree timelines and protocol with the service provider on the delivery and validation of that data. The service provider will have to source the data from the manager. Another challenge is where managers use multiple administrators and it is essential the data is consolidated so it can be inputted into Annex IV,” says Townsend.
Predictably, it tends to be the larger managers which are choosing to internalise their Annex IV, along with other regulatory reporting obligations. It is detailed and requires time and effort to get right. In fact, the costs of Annex IV reporting are likely to be on a par with those imposed by Form PF in the United States. Most hedge funds reckon quarterly filers will be paying an outsourced provider around $100,000 per annum to handle the work.
This cost is non-trivial, especially as returns have diminished while operational and other regulatory overheads have grown. It was therefore unsurprising to read in a joint BNY Mellon/FTI Consulting survey in January 2014 that 46 per cent of managers were still assessing how to absorb the extra cost. However, a survey – also conducted by BNY Mellon and FTI Consulting – published on the eve of AIFMD’s implementation found that 13 per-cent of managers would offset all of their AIFMD regulatory costs to the fund itself. A further 29 per-cent of managers told the survey they would charge some of the costs to their funds.
The real, long-term risk is that managers do not devote enough resources to the entire Annex IV process. “Annex IV is not a form managers can put together in a couple of weeks or even months. There is a substantial amount of data to compile and collate,” warns Gary Kaminsky. “Firms will need to collect an enormous amount of disparate data, aggregate it, enrich it and populate the form. A huge amount of work still needs to be done. One cannot just take the raw data and put it into a form. Managers need to transform that data, and enrich it prior to turning it into XML.”