The UK hedge fund industry is divided over Brexit and its consequences, with high-profile managers donating sizeable sums of money to both sides of the debate. This fissure is mainly because a number of UK hedge funds do not solicit capital from Europe but rather the US and Asia-Pacific, while others are heavily reliant on inward investment from Europe. The divisions are laid bare by the fact the Alternative Investment Management Association (AIMA), the hedge fund industry group does not have an official position on the debate.
While a handful of hedge funds may profit from a depreciation in Sterling in the event of an exit, the long-term consequences are unlikely to be lucrative. The vote comes at a time of enormous macroeconomic uncertainty globally, which hedge funds have in the most part struggled to navigate. Many have failed to make profits in this low and occasionally negative interest rate environment, and outflows globally are at levels unseen since 2009.
A Brexit is likely to cause destabilisation in financial services and the real economy and could precipitate further redemptions from UK managers from global investors. Being shut out from European investors – who are the second largest hedge fund investor demographic after North America – in the event of Brexit is not an ideal scenario for capital-hungry managers.
On an operational level, Brexit has the potential to be painful. Assuming the UK remains a member of the European Economic Area (EEA), regulations such as the Alternative Investment Fund Managers Directive (AIFMD), European Market Infrastructure Regulation (EMIR) and the Markets in Financial Instruments Directive II (MiFID II) – by way of example – will continue to apply.
The only change is that the UK will have less influence at the bargaining table when these Directives are being framed. If we look back to the first iterations of AIFMD, there were genuine fears hedge funds in the EU would exit the single market altogether given its original mandate. Effective lobbying by the UK and a handful of like-minded European governments, industry associations, fund managers and service providers prevented this, and the AIFMD as a result is fairly palatable. Some managers even view AIFMD as an excellent commercial opportunity.
The alternative to EEC membership is for the UK to become a non-EEA third country. This will impact UCITS and AIFMs. UCITS and AIFMs would be forced to re-domicile to EU fund domiciles such as Ireland, Luxembourg or Malta. Gibraltar is notably absent as it too would no longer be in the EU should UK voters elect to leave, something which has caused consternation in the jurisdiction given its attempts to bolster its presence as a credible fund domicile.
Re-domiciling would not just result in legal costs at a time when operational and regulatory costs are on the rise. Hedge funds using a UK-based depositary or depositary-lite would have to switch to an onshore European provider in Ireland or Luxembourg. As most depositaries have an Irish or Luxembourg presence, this should not be too complex. UK-based custodians, however, would no longer be EC-designated credit institutions, and this could become messy. Attaining third country recognition could be time consuming for these credit institutions. The one redeeming factor is that any exit negotiations will take two years and this ought to be enough time for fund managers and service providers to address these operational issues.
All of this is hypothetical. If a Brexit occurred, some believe financial services – which are compliant with EU laws as much of it has been transposed by the UK government into national legislation – should qualify relatively easily for third country equivalence. But even this is far from guaranteed.
Guernsey, Jersey and Switzerland all received confirmation from the European Securities and Markets Authority (ESMA) that their regulatory regimes were equivalent with AIFMD. This was meant to result in the EC passing a Delegated Act three months after this ESMA confirmation but this has not happened. The UK could therefore be waiting a while before ESMA and the EC reached a conclusion, something that is unlikely to be abetted by the inevitable toxic environment post-Brexit should it occur.