Navigating new priorities
15 April 2020
INDOS Financial’s Bill Prew discusses that while the industry has been readjusting priorities since the COVID-19 pandemic arrived, regulators have been equally busy
Image: Shutterstock
Business continuity planning (BCP) and maintaining operational resilience have been two of the overriding priorities for alternative asset managers since the COVID-19 crisis kicked off. However, regulators have been equally busy too. While a handful of regulatory deadlines have been pushed back by several months, a number of new proposals are being considered, which could have significant implications for alternative asset managers.
Tightening up on leverage
The ongoing market volatility and asset price fluctuations have prompted the European Securities and Markets Authority (ESMA) to launch a consultation on leverage risks in the alternative investment funds (AIF) industry. In a statement, ESMA confirmed its consultation was in response to the European Systemic Risk Board’s (ESRB) recommendations on liquidity and leverage risk at investment funds – a set of suggestions published back in mid-2018.
ESMA added that highly geared AIFs – including hedge funds and private equity – can increase systemic risk during stressed market conditions, especially when they are deleveraging. ESMA said deleveraging could potentially amplify the price impact of adverse market movements; cause contagion in the banking system; disrupt credit cycles and heighten the risk of asset fire sales. Consequentially, ESMA noted it was essential member states adopt a harmonised approach when assessing leverage and imposing limits around it.
Regulators will need to base their assessments on the Annex IV reports they receive from managers under the Alternative Investment Fund Managers Directive (AIFMD). The proposals not only focus on those AIFs that employ substantial leverage (defined by AIFMD as when an AIF’s exposure calculated using the ‘commitment method’ exceeds three times its net asset value’, but funds with greater than €500 million of ‘regulatory assets under management’, i.e. a gross exposure calculation of fund assets), as well as potentially other funds which fall below these thresholds. The proposals may apply to all AIF types, and not just hedge funds, but private equity and real estate too.
Cracking a nut with a sledgehammer
Leverage is often derided as being an inherently risky and destabilising activity, but this assumption is factually incorrect. The majority of hedge funds and some private equity firms deploy leverage to enhance their return generation, but it can also be used to offset portfolio risk, a point that has been made repeatedly by industry bodies. In addition, most hedge fund managers only use a modest amount of leverage, which is rarely ever more than three times their overall assets. Labelling individual hedge funds as being systemically important is therefore misjudged.
ESMA’s proposals also do not address the findings of the on-going IOSCO review on leverage nor any changes which may be implemented to the leverage measures as a result of the “AIFMD 2” review. We believe these should be tackled as soon as possible in order for regulators to compare apples with apples across funds and regulatory jurisdictions. The current AIFMD leverage measures are still, in several areas, subject to different interpretations across the industry-leading to inconsistent reporting to national regulators. Industry participants have also previously put forward recommendations for an alternative to the current gross and commitment methods on the basis these can distort the leverage numbers for funds using certain types of derivatives. They argue an alternative measure – which better reflects the actual market risk of a fund – should be used by regulators to assess risk.
Short selling under fire
The consultation on leverage comes amid other regulatory clampdowns, most notably the recent constraints being imposed on short sellers. In March, ESMA announced it would lower the threshold for reporting details about short sales to regulators although some markets including Belgium, Austria, Greece, France, Italy and Spain have introduced temporary bans on the practice. Spain’s regulator, for example, has prohibited short-selling altogether for one month although other supervisors such as the UK Financial Conduct Authority (FCA) has set the bar very high for imposing bans.
This patchwork approach is creating challenges for fund managers, as it is forcing firms to comply with different rules across multiple markets. Compounding matters further is that there is also a lack of regulatory clarity over what is banned. For instance, France introduced its short-selling ban when markets had opened for the day but simultaneously failed to clarify what securities the restrictions applied to. Moreover, there is limited evidence that such bans actually help markets, a fact that has been outlined by the FCA.
Private markets and leverage
Although hedge funds are the asset class most commonly associated with leverage, private capital strategies – namely private equity and private debt – could face some existential challenges as a result of the COVID-19 volatility and its impact on asset price valuation. Prior to COVID-19, private equity leverage stood at 6.5 times EBITDA, levels far higher than what we saw in 2007, according to McKinsey. Oliver Wyman, meanwhile, points out that 41 percent of all major leveraged buyouts (LBOs) and public to private transactions are exposed to companies vulnerable to COVID-19. While private capital is currently sitting on a lot of dry powder, many investments will face some large write-downs.
Are we focussing on the wrong issue?
As regulators enforce sporadic short-selling bans and initiate discussions which could lead to limits on fund leverage, they may do well at focussing on some other burning issues, namely liquidity. While regulators were initially very fixated on asset managers transacting in illiquid instruments post-Woodford, the extreme volatility being caused by COVID-19 is creating new, unexpected problems for the industry. In many instances, equity securities considered to be highly liquid, safe and revenue-generating at the beginning of the year – such as airlines, travel companies and hospitality services – are facing panicked, mass sell-offs and even potential defaults.
Since the crisis unfolded, the FCA and Bank of England have opted to push back their consultation on liquidity mismatches at daily dealing funds. Given that several daily dealing property funds have gated client assets, it is widely expected regulators will clamp down further on fund redemption terms. It is also possible regulators could demand that investors making short-term withdrawals from open-ended funds be given their assets back albeit at a discount versus someone who has given the manager more time to offload the securities. Swing pricing arrangements of this type are quite common in other markets. At the very least, it is likely managers will need to be more open about their fund liquidity terms and ability to meet investor withdrawal requests during periods of market stress.
What does the market need?
Regulators need to clearly communicate with the market about their intentions and the measures they are adopting. As we have seen with the recent short-selling bans, a lot of investors have been left confused by the conflicting regulatory policies being introduced. On leverage, there are potential challenges facing certain private capital strategies, but hedge funds are generally not that highly geared and certainly do not pose a systemic risk. Longer-term issues also need to be resolved quickly. Take Brexit, for instance. With the EU looking to potentially curb leverage, questions are now being asked about whether this will apply to the UK post-Brexit.
Tightening up on leverage
The ongoing market volatility and asset price fluctuations have prompted the European Securities and Markets Authority (ESMA) to launch a consultation on leverage risks in the alternative investment funds (AIF) industry. In a statement, ESMA confirmed its consultation was in response to the European Systemic Risk Board’s (ESRB) recommendations on liquidity and leverage risk at investment funds – a set of suggestions published back in mid-2018.
ESMA added that highly geared AIFs – including hedge funds and private equity – can increase systemic risk during stressed market conditions, especially when they are deleveraging. ESMA said deleveraging could potentially amplify the price impact of adverse market movements; cause contagion in the banking system; disrupt credit cycles and heighten the risk of asset fire sales. Consequentially, ESMA noted it was essential member states adopt a harmonised approach when assessing leverage and imposing limits around it.
Regulators will need to base their assessments on the Annex IV reports they receive from managers under the Alternative Investment Fund Managers Directive (AIFMD). The proposals not only focus on those AIFs that employ substantial leverage (defined by AIFMD as when an AIF’s exposure calculated using the ‘commitment method’ exceeds three times its net asset value’, but funds with greater than €500 million of ‘regulatory assets under management’, i.e. a gross exposure calculation of fund assets), as well as potentially other funds which fall below these thresholds. The proposals may apply to all AIF types, and not just hedge funds, but private equity and real estate too.
Cracking a nut with a sledgehammer
Leverage is often derided as being an inherently risky and destabilising activity, but this assumption is factually incorrect. The majority of hedge funds and some private equity firms deploy leverage to enhance their return generation, but it can also be used to offset portfolio risk, a point that has been made repeatedly by industry bodies. In addition, most hedge fund managers only use a modest amount of leverage, which is rarely ever more than three times their overall assets. Labelling individual hedge funds as being systemically important is therefore misjudged.
ESMA’s proposals also do not address the findings of the on-going IOSCO review on leverage nor any changes which may be implemented to the leverage measures as a result of the “AIFMD 2” review. We believe these should be tackled as soon as possible in order for regulators to compare apples with apples across funds and regulatory jurisdictions. The current AIFMD leverage measures are still, in several areas, subject to different interpretations across the industry-leading to inconsistent reporting to national regulators. Industry participants have also previously put forward recommendations for an alternative to the current gross and commitment methods on the basis these can distort the leverage numbers for funds using certain types of derivatives. They argue an alternative measure – which better reflects the actual market risk of a fund – should be used by regulators to assess risk.
Short selling under fire
The consultation on leverage comes amid other regulatory clampdowns, most notably the recent constraints being imposed on short sellers. In March, ESMA announced it would lower the threshold for reporting details about short sales to regulators although some markets including Belgium, Austria, Greece, France, Italy and Spain have introduced temporary bans on the practice. Spain’s regulator, for example, has prohibited short-selling altogether for one month although other supervisors such as the UK Financial Conduct Authority (FCA) has set the bar very high for imposing bans.
This patchwork approach is creating challenges for fund managers, as it is forcing firms to comply with different rules across multiple markets. Compounding matters further is that there is also a lack of regulatory clarity over what is banned. For instance, France introduced its short-selling ban when markets had opened for the day but simultaneously failed to clarify what securities the restrictions applied to. Moreover, there is limited evidence that such bans actually help markets, a fact that has been outlined by the FCA.
Private markets and leverage
Although hedge funds are the asset class most commonly associated with leverage, private capital strategies – namely private equity and private debt – could face some existential challenges as a result of the COVID-19 volatility and its impact on asset price valuation. Prior to COVID-19, private equity leverage stood at 6.5 times EBITDA, levels far higher than what we saw in 2007, according to McKinsey. Oliver Wyman, meanwhile, points out that 41 percent of all major leveraged buyouts (LBOs) and public to private transactions are exposed to companies vulnerable to COVID-19. While private capital is currently sitting on a lot of dry powder, many investments will face some large write-downs.
Are we focussing on the wrong issue?
As regulators enforce sporadic short-selling bans and initiate discussions which could lead to limits on fund leverage, they may do well at focussing on some other burning issues, namely liquidity. While regulators were initially very fixated on asset managers transacting in illiquid instruments post-Woodford, the extreme volatility being caused by COVID-19 is creating new, unexpected problems for the industry. In many instances, equity securities considered to be highly liquid, safe and revenue-generating at the beginning of the year – such as airlines, travel companies and hospitality services – are facing panicked, mass sell-offs and even potential defaults.
Since the crisis unfolded, the FCA and Bank of England have opted to push back their consultation on liquidity mismatches at daily dealing funds. Given that several daily dealing property funds have gated client assets, it is widely expected regulators will clamp down further on fund redemption terms. It is also possible regulators could demand that investors making short-term withdrawals from open-ended funds be given their assets back albeit at a discount versus someone who has given the manager more time to offload the securities. Swing pricing arrangements of this type are quite common in other markets. At the very least, it is likely managers will need to be more open about their fund liquidity terms and ability to meet investor withdrawal requests during periods of market stress.
What does the market need?
Regulators need to clearly communicate with the market about their intentions and the measures they are adopting. As we have seen with the recent short-selling bans, a lot of investors have been left confused by the conflicting regulatory policies being introduced. On leverage, there are potential challenges facing certain private capital strategies, but hedge funds are generally not that highly geared and certainly do not pose a systemic risk. Longer-term issues also need to be resolved quickly. Take Brexit, for instance. With the EU looking to potentially curb leverage, questions are now being asked about whether this will apply to the UK post-Brexit.
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