Following FBI investigations in 2008, a number of Swiss banks were accused of helping wealthy Americans evade US taxes via offshore accounts, by not applying required withholding taxes. One high profile case resulted in UBS agreeing a settlement of $780m in unpaid taxes and the release of the names of thousands of offshore account holders. This focused the attention of the US government on the prevalence of offshore tax abuse.

More generally, the behaviour of financial institutions is under unprecedented public scrutiny, exemplified by the recent Occupy Wall Street movement, which has now spread to other cities around the world. Tax avoidance and the ability of so-called elites to avoid their fair share of the tax burden have received much media attention in the post-2008 environment. Legislators around the world have started to look at ways to address this problem; partly to fill their hollow exchequers and partly to be seen to publicly tackle inequity and perception of regressive taxation regimes.

The Foreign Account Tax Compliance Act (“FATCA”) legislation is the US government’s attempt to address these issues by forcing foreign financial institutions to disclose the holdings and income of US citizens or face a 30% withholding charge on all US originating payments (e.g. dividends). The act is far reaching and will have a significant impact to the financial services industry globally. Many commentators have focused to date on the opaque nature of implementation and the confusion over how it will be interpreted. In addition, there is the intriguing prospect of financial institutions facing a catch-22 of either complying with FATCA, or the incompatible EU Data Protection law. Whilst such observations are interesting and important, they somewhat miss the point when it comes to addressing a key question for asset managers – what should I be doing right now?

Focussing on FATCA’s ambiguities and complexity induces fear in some organisations of the consequences and implementation requirements that FATCA will impose. This anxiety in some cases translates to intensive, up-front programme activity, an approach favoured by many consultants and advisors. In other cases, firms face organisational paralysis resulting from the need to digest uncertain, complex requirements.

We believe that neither predicament is correct approach to FATCA compliance. Whilst there is substantial work to be done, no major programme needs to be initiated within the next quarter. Rather, the existing sense of urgency should be channelled into a streamlined and limited ‘flash diagnosis’, which will help to clarify the known impacts and planning proposals for programmes to commence in Q1/Q2 2012.

‘Flash Diagnosis’ – not ‘Programme Rush’

An immediate ‘flash diagnosis’ would entail the following key elements, and would set the scene for a well-planned and controlled implementation programme in 2012/13:

• An up-front strategic decision on fund compliance vs. non compliance
• A detailed impact assessment to identify gaps in current processes and infrastructure, and ability to adhere to disclosure requirements
• Assignment of appropriate resources to drive through change; FATCA is an organisational change initiative and not just a Finance change
• Development of a coherent communications strategy to manage commercial tensions that may arise from increased investor requirements, particularly among investors based outside the US
• Maintenance of a close watching brief on lobbying and engagement efforts on-going with the IRS on behalf of the industry, which are aimed at clarifying points of contention and minimising the ultimate compliance burden

The critical outcome for asset managers is an early and clear identification of key plans and organisational impacts, and a sense throughout the organisation that FATCA compliance is a known and planned quantity. We believe that too much industry emphasis currently focuses on the (admittedly important) complexities and ambiguities of FATCA compliance. These will be clarified in time, and can be handled in a controlled fashion once contingent plans are in place based on the above steps.

Nevertheless, any such analysis will need to be cognisant of the key provisions, complexities and pitfalls that FATCA presents, a number of which are recapped below.

FATCA – the background

FATCA was passed into US law on 18th March 2010 as part of the Hiring Incentives to Restore Employment (HIRE) Act, and is intended to counter US tax evasion through the use of offshore accounts and foreign management companies by US investors. The act requires Foreign Financial Institutions (FFIs) to identify whether or not investors are US persons; if they are US persons then FFIs will be required to submit certain information about the financial assets held by these persons with an aggregate value of $50,000 or more.

Who is impacted?

It is important to note that asset managers or promoters are not themselves FFIs – funds themselves are. Although it is the responsibility of the fund to report to IRS, they may delegate this to administrators, which means that the issue of FATCA compliance is a critical consideration for all administrators as well as their clients’ funds.

Custodians will also be FFIs, but Fund Accounting and Transfer Agency functions may not necessarily be. The large global custodians have therefore taken an industry lead in initiating programmes of change within their organisations to ensure they are best placed to meet FATCA requirement and also advising their clients on potential change.

What FATCA means in practice – and when

The deadline for FATCA compliance has been delayed from the original date of 1st January 2013 and will now be 1st January 2014. FFIs will need to identify new and pre-existing US account holders (including certain ‘high-risk’ accounts, typically those above $500,000, where more extensive due diligence requirements apply). As a first key interim deadline, each FFI must subsequently enter into an agreement with the IRS by 30th June 2013 to adhere to certain disclosures and provide ongoing reporting – this will result in a classification as a ‘Participating’ or ‘Good’ FFI.

If an FFI does not enter into an agreement with the IRS, it will be classified as a ‘Non-Participating’ or ‘Bad’ FFI, and will be subject to a 30% withholding tax on all US source income. Withholding on US source dividends and interest paid to Non-Participating FFIs will begin on 1st January 2014.

‘Participating’ FFI’s will be required to withhold 30% of any US source income and gross proceeds from the sale of assets generating US source income from all ‘recalcitrant’ investors – those who have failed to provide adequate information about their residency status. Whilst this sounds simple enough, this requirement has implications for both managers and investors:

In the above schematic, Client 1 consents to the residency disclosures required, and his FFI is registered as ‘participating’. He receives his full allocation of income from US-registered stock dividend. However, whilst Client 3 is similarly compliant, his FFI has not registered as ‘participating’, and therefore 30% of his US-sourced income, to which he is entitled, is collected by the IRS directly from the custodian. Clients finding themselves in this scenario could well represent the industry’s biggest headache following implementation.

Client 2 is recalcitrant, and has not provided the requisite disclosures. He forfeits 30% of all US-sourced income; and the collection point for the IRS depends on whether his FFI participates or not.

The basic premises of FATCA compliance are clear enough. Firms are highly incentivised to get their compliance strategies right – customer demand will see to that. But how easy is this to implement in practice? The fear of many firms is – not easy at all.

The first challenge lies in classifying customers as compliant or not. Identifying recalcitrant account holders should be no more than an administrative headache. But the 30% withholding also applies to foreign entities with ‘undeclared substantial US owners’; meaning that, for example, any offshore trust where ownership of the assets is not entirely declared must be treated as effectively a recalcitrant investor.

Secondly, participating FFIs must also be fully aware of which FFIs are non-participating, since any US-sourced income due to them (e.g. through fund-of-fund structures) will need to be similarly withheld.

It is therefore clear that the categorisation of investors and institutions, and the controls and procedures required to administer the correct withholding treatment, are going to be onerous in aggregate. And the burden imposed on the industry does not end there.

For example, under the current ‘Qualified Intermediary’ regime only accounts holding US securities need to be documented as to their US tax status; under FATCA all account holders will need to be documented regardless of whether or not they are a US citizen and hold US securities. This switch from negative to positive evidencing of tax status entails another major piece of administration.

A further important principle of FATCA is the calculation of a Payment Pass-through Percentage (PPP), which is based on an assessment of the proportion of US assets in a fund. The PPP will denote the degree of withholding of payments based on the proportion of US assets held by a particular fund, and this is where the current lack of clarity and resolution becomes a real headache for the industry. For example, will the PPP be calculated at a legal entity (SICAV) level or sub-fund level? The answer to this question will have significant implications; e.g. would investors in a Japanese sub-fund be impacted if US assets are held in a different sub-fund?

To make the situation yet more interesting (or confused), the FATCA reporting requirements are in contravention of the EU Data Protection law, which forbids the transmission of personal information to jurisdictions with lower standards than the EU’s own (which includes the US). Compliance will therefore break EU law as it stands, and clarification of this situation is urgently being sought.

What of UCITS funds?

Current FATCA compliance requirements do not provide any exemptions for UCITS funds. Controversially, this means that whilst UCITS funds are not allowed to sell to US citizens, under current FATCA interpretation they would still have to provide proof to the IRS that they do not have US investors.

The provisions above are examples of the features of FATCA which have infuriated the European Fund Industry. There are likely to be further debates and compromises reached before the final requirements become clear.

More onerous than complex

The implications of FATCA therefore extend right through from the new account due diligence processes and the information required to be captured at this point, to the maintenance and administration of withholding tax by entity category, to compliance disclosure and reporting requirements - all of which demands substantial operational, procedural and organisational change.

What is clear is that the changes and operational enhancements required will impact almost every participant in the asset management value chain, including asset managers themselves, transfer agents, custodians, administrators, clearing organisations, distributors and investors.

But crucially, we see this work as being more onerous than complex. Requirement ambiguities will be clarified in due course, and managers who have prepared early and thoroughly have no reason to fear the implementation ahead. 

Getting prepared should start with an assessment of the level of US exposure of their products and investors. This will lead to a range of critical decisions on whether particular entities can and should comply, which must be taken on a fund-by-fund basis and will be driven largely by the type of clients, and the degree of US exposure of each fund.

If you can keep your head whilst all around you are losing theirs…..

There is still a lack of complete clarity around the precise provisions of FATCA compliance and implications for implementation, which does create uncertainty for the industry. The deadline for compliance has shifted once already (no-one should count on it shifting again); and (by way of an example) the details of the new reporting requirements must be developed through treasury regulations that have not yet been issued - further guidance will be issued in 2012 which may clarify the situation.

Despite the extensive lobbying underway to try and protect the asset management industry, asset managers will receive no special exemptions under FATCA. It must also be a strong possibility that where the US legislature leads, the EU will follow; and FATCA might well precede similar regulations originating in Europe and/or the Far East.

FATCA compliance will entail far reaching impacts to all financial organisations, and all key participants in the asset management value chain. But volume of work should not be confused with complexity. As clarity emerges (and it surely will), asset managers need to be ready with clear strategies, impact assessments, communication plans, and implementation approaches. But what this means is that it’s now time to be ‘on your marks’, rather than for a headlong rush into a full-scale programme. Clear, streamlined up-front analysis will lay the groundwork for successful implementation in 2012/13.

It’s time to act now – but it’s time to act smart. Planning cannot wait. Implementation must.

For further advice on how best to manage the impact of FATCA on your business, and on Alpha’s implementation approach and capabilities, please contact Luc Baque: luc.baque@alphafmc.com or Matt Bacon: matt.bacon@alphafmc.com

During October, Alpha FMC hosted its inaugural Private Equity discussion forum. Attended by leading global GPs, LPs and Family Offices, as well as high profile administrators and software vendors, the forum focussed on current industry hot topics - notably outsourcing and technology.

Trends in Outsourcing

The panel and attendees were unanimous in their agreement that there is an increasing trend towards the outsourcing of ‘non-core’ functions within the Private Equity (PE) market. The key drivers of this trend are the topically urgent search for cost savings, a regulatory environment that is becoming more intrusive and onerous, and the pressure exerted on PE managers through increasing investor discretion.

These trends largely mirror those that drove, and continue to drive, outsourcing across the wider asset management industry - and they now provide the imperatives for PE managers to focus on core activities, whilst de-risking and driving efficiencies from non-core activities by leveraging the scale and expertise of third party administrators (TPAs).

The Development of PE Administrator Capability

Historically, bespoke PE administrators have struggled with the scale and breadth of service offering required for them to be seen as plausible partners for GPs. Conversely, larger traditional TPAs have been perceived as trying to deliver the administration of PE assets through their core service functions, without fully accounting for the inherent idiosyncrasies of complex asset classes or fund structures.

In recent years, however, the administrator landscape has evolved considerably. Bespoke administrators are reaching a level of maturity and scale that establishes them as genuine potential partners to the PE powerhouses - witness the numerous recent wins by such administrators of established PE brand names. Concurrently, global TPAs have understood that PE administration is fundamentally more complex than their traditional asset coverage, and that administration on hybrid long-only systems and processes will not suffice as a credible service offering.

Naturally those TPAs who developed a more bespoke capability earliest, (or who grew through acquisition into the alternatives space), have enjoyed a head start on their rivals, benefiting from the direct domain expertise of their targets whilst also leveraging their significant balance sheets and service offerings.

A Positive Sales Message

Like their traditional asset manager forerunners, GPs increasingly see the value of the positive marketing message associated with independent administration. Such an arrangement demonstrates transparency and rigorous asset servicing in an environment of increased scrutiny by investors and regulators, particularly on those organisations managing alternative asset classes. Indeed the use of an independent administrator is becoming a key checklist item for some investors when considering where to allocate their capital. As we move into 2012 and beyond, regulatory scrutiny and consequent investor pressure are only likely to become more acute – a challenge that outsourcing may prove the most effective means of addressing.

Technology – Economies of Scale

One of the key benefits to working with outsource providers is the opportunity to leverage their significant investment in advanced technology and reporting platforms. All leading TPAs have invested heavily in these platforms, driving service and efficiency improvements across both traditional and alternative asset classes. Investment on such a scale, and the service and efficiency improvements that result, are the sine-qua-non for TPAs, in precisely the same way that asset managers are increasingly reluctant to undertake the scale of in-house investment required on non-core functions, just to keep up with more sophisticated investment techniques, asset classes, and regulatory requirements.

With all TPAs boasting impressive platform credentials, (some of which are more real and tested than others), the system and technology offering promoted has become an increasingly central selection criteria for clients selecting an outsource partner. However, the consensus appears to remain, in the PE market at least, that whilst the utopian vision of a “light touch” front end system interfacing seamlessly with a robust, complex administrator platform is edging closer, it is still quite some way off.

A Compelling Case?

With such a compelling array of factors pushing the PE market towards an outsourcing model, it is almost hard to believe that such a significant number of GPs continue to run their operations in house. The forum revealed a clear sense that, despite the significant advances made by the TPA providers in terms of servicing capability for alternative asset classes, and the efficiencies that result from their wider service propositions, there is still some way to go before many GPs would feel comfortable relinquishing the control and direct oversight they have over their own administration. The most common deterrents to outsourcing remain:

• A belief that administration can be performed cheaper in-house; and that the ‘all-in costs’ of outsourcing still remain comparatively high. Such costs include:
  • The maintenance of extensive and expensive administrator oversight functions
  • ‘Hidden Fees’ arising from the evolving complexities of the business
• Operational risk arising from the complexities associated with migrating funds
• The constraints that may be imposed on PE firms through having to adhere to standard models, and the limitations on TPA adaptability to business change
• Cultural differences between nimble PE firms and global TPAs

So whilst TPAs have created a far more compelling outsourcing proposition for PE clients in recent years, there is still work to be done before they are viewed by a number of their potential clients as genuine partners in this market.

Administrators, for their part, are responding to this challenge head on, targeting mandates for start-up funds, and adapting their value proposition and service capabilities to a level that they hope will open up opportunities for a wider outsourcing trend across the PE market. After all, with the continued squeeze on profit margins experienced in most large legacy asset manager outsourcing arrangements, it is precisely these sorts of new markets and opportunities that present TPAs with the most promising route to new, profitable business.

The Challenge and Prize Ahead

All market participants face challenges as the PE outsourcing market develops. For the GPs, it is about evaluating the real cost of running their business, anticipating the impacts of changing regulatory and investor requirements, and choosing an effective end-to-end operating model that best serves their future business needs. For bespoke administrators, the challenge is to maintain the momentum they are already building, in developing platforms, and a credible service proposition to take to the wider market in order to bridge the gap between niche provider and global partner. Larger, international TPAs must demonstrate that they can be flexible, client-focused and accommodating – which is always a tough balance to strike in a business which fundamentally demands scale and standardisation. However, their continued development of sound alternatives processing alongside their broader service offering is likely to prove an increasingly compelling proposition for GPs.

For further information about Alpha’s work and capabilities with Private Equity clients, please contact Ben Lucas: ben.lucas@alphafmc.com

Alpha completes first Fund of Hedge Fund Manager Benchmarking Study

Alpha has just completed the inaugural Fund of Hedge Funds (FoHFs) Operations Benchmarking Study. The study, (which is the first of its kind in the alternative investment space), assessed costs, capabilities and service levels for the Investment and Investor Operations functions at leading FoHFs managers. It uses the same proven approach as Alpha’s long-running studies for long-only Asset Management and our soon-to-be-launched study for Private Wealth Managers.

As the long-only and alternative investment management industries continue to converge, and more transparent and demanding requirements from institutional investors and their advisors, (such as investment consultants), are adopted, there is an increased demand for these kinds of external evaluations. The study has been widely praised for its approach and findings by our participants, as well as a number of industry bodies and actors.

The study is highly confidential and no data is shared with or sold to external parties. The objective is to allow participants to compare their own business models against those of their peers and industry ’Best Practice’, and to make any required changes to operating models to improve capabilities. Whilst studies of this nature are new to the alternatives industry, Alpha has been conducting benchmarking studies in the long-only industry for 10 years, with participants using them as valuable management tools and an agent for efficiency enhancements.

The study covered the following functional areas:

The participating group, which includes a range of leading players in the market, (and who jointly manage more than 10% of global FoHFs AUM), highlighted some interesting trends in this rapidly changing market. The success of managers, now more than ever, depends not only on performance but increasingly on having a strong handle on all components of the business and their related costs.

The last few years have seen an increased focus on the quality of operational capabilities in the alternative investment market in general, and the FoHFs sector in particular.

Historically, the back offices of alternative investment managers have taken a back seat to the total focus on investment returns. Many operations departments have been highly manual and lacked in many of the areas that would be considered to be ‘best practice’.

However, following the credit crunch and the Madoff scandal, both investors and regulators have been placing greater emphasis on the operational capabilities of FoHF managers. One reflection of this trend was a shift in investment allocations to the ‘larger scale’ managers. Such managers are often part of broader financial groups who have invested in infrastructure (whether IT, operations or other) on an on-going basis - and who have sound balance sheets.

To be able to compete for allocations from the main providers of assets, managers must increasingly be able to prove the robustness of their operations in a transparent manner. Benchmarking provides an extra level of independent due diligence and demonstrates to pension fund consultants and investors alike that participating managers are challenging themselves to enhance the management of their businesses, along with associated costs and risks.

Evaluating an operating model at a high level can immediately point to potential break points and areas of concern for both managers and investors.

Operating models are maturing, but the market is still fragmented

The operational models found in the FoHF industry are more heterogeneous than those in the more mature long-only industry, and may reflect the ‘cottage industry’ beginnings. There exists in some areas almost a “pick and mix” approach to outsourcing, with individual functions, rather than coherent blocks of the back office, being managed by Third Party Administrators. However, we are seeing a clear trend towards consolidation of providers and movement toward the type of standardised model prevalent in the more mature long-only market.

Concurrently, the number of software solutions targeting this market has ballooned in recent years, with more than 30 vendors targeting the core ‘shadow NAV’ space, maintained in-house alongside outsourced full NAV services. This has resulted in software costs falling and license terms becoming more flexible. However, it has also introduced further risks in the selection process as some providers do not have critical mass and may struggle to survive in the medium term.

For a number of reasons, the market infrastructure to support the FoHFs trade lifecycle still has a number of weaknesses

Some processes are still very much manual and will almost certainly impact operational risk levels and costs for all managers. For example, we estimate that only 60-70% of hedge fund share classes (i.e. units) have an ISIN code. In the experience of several major hedge fund database vendors, most manager clients do not request the ISIN code in their downloads, instead using internal proprietary instrument identifiers with a resultant impact on operational risk.

Other missing infrastructure includes the lack of a central market repository for hedge fund prices and terms and conditions, which is forcing managers to run this function in-house, thus needlessly duplicating the task and keeping costs high. Market initiatives are targeting the FoHFs’ trade STP process with some software vendors building automatic trade connectivity between managers and administrators, albeit using proprietary technology.

The lack of a market-wide approach to issues such as these acts as a drag on the market as a whole. We predict that due to investor demand, further regulation and business opportunity, the OTC nature of the market is set to shrink over time.

Managers who are able to leverage parent company infrastructure have an advantage

FoHFs managers that are subsidiaries of traditional asset management and/or investment banking parents that are able to leverage their parent companies’  operational and IT infrastructure have an advantage from organisational structure, cost, control and efficiency perspectives.

Business functions where such successful leverage is evident include systems pre- and post-trade compliance checking, client reporting, performance measurement and attribution/contribution and data repositories as well as core IT infrastructure, such as IT networks, e-mail and web browsing.

The 2012 study will launch in Q1 of next year and we are starting to recruit the participants for next year’s study now. If you are interested in further information, please contact Bo Lantorp, Alpha FMC’s Benchmarking Director, on bo.lantorp@alphafmc.com or +44 (0) 7958 304053  or Alpha Associate Sunil Chadda on sunil.chadda@alphafmc.com or +44 7967 687756.

The Alpha Benchmarking Function is a separate, “Chinese walled” part of the company with its own dedicated team, management structure, completely segregated benchmarked client data and a strong, proven methodology.