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The Silicon Valley Bank (SVB) meltdown has caused stock markets to fall across Europe and triggered US stock market volatility early this week. The pan-European Stoxx 600 index dropped nearly 2.5%, with all sectors and major bourses in negative territory.  

Over the past 2 decades clients have asked us, “Our investors seem to be happy with our fund performance. What is the worst that can happen to us in practice if our fund performance suffers due to exogenous factors (such as a stock market drop) and clients become disgruntled? If we breached local fund marketing regulations during our fundraising process because we chose to take some business risk in order to take the ticket, what’s the worst that can happen to us when markets fall?”     

When general investment market performance is positive, as indicated by buoyant stock markets, everyone is happy. After all, both fund managers and investors like it when everyone is making money. 

But what happens when stock markets drop (or crash), your fund performance suffers and investors lose money in your fund? 

In this blog, we explore the potential correlation between stock market drops resulting in a negative impact on fund performance and the 5-Key Distribution Risks as well as the potential consequences (“blowback”) to AIFMs and Asset Managers.   

Is cross-border fund marketing risk-free?   

No. Marketing funds cross-border constitutes a regulated activity in each jurisdiction. This is why there are regulations in each country governing the promotion of financial products or services to investors in that country.

So fundraising cross-border (overseas) inherently entails RISK.

We advise clients to mitigate their distribution risks as much as possible by investigating each country’s laws in advance of marketing and complying with local regulations on the marketing of funds or financial services to investors in each country. Read our Blog: Cross-Border Marketing Compliance: What you Need to Know.

What are the 5-Key Distribution Risks? 

Any marketing of AIFM/Asset Managers’ funds in any country could potentially incur the 5-Key Distribution Risks including: sanctions, investor litigation, investor rescission rights, business franchise and reputation risks. Each of the 5 risks are explained below:    

1. Sanctions Risk

• The country regulator could impose sanctions for unlawful activity carried out in their jurisdiction. Many AIFMs/Asset Managers don’t realise there are criminal sanctions including imprisonment as well as administrative sanctions (fines) in many jurisdictions for breaches of fund marketing and/or licensing rules.
• In other jurisdictions, there are administrative sanctions, i.e., fines ($/EUR/£ MM) that could apply for breaches of local laws.
• Sanctions could apply to the entity carrying out the breach (i.e., salespersons) and/or management of the entity carrying out the breach.
• In practice, tough criminal sanctions are generally a “bellwether indicator” of the local regulator’s willingness to enforce their rules.

Read more about enforcement in our Blog: Punitive Fund Marketing Regulations Sanctions: Enforcement indicator?

2. Litigation Risk

• Investors can sue the AIFM/Asset Manager on the basis that the AIFM/Asset Manager broke local laws and regulations for the marketing of funds or financial services to the investor in their country.
• Clients say to us, “Investors can sue us anyway for any reason, so why is litigation risk important?” Our response to clients is: “Don’t give investors any reason or claim to sue you based on your (AIFM/Asset Manager’s) breaches of local fund marketing laws.”

3. Investor Rescission Rights Risk

• • Litigation and investor rescission rights risks frequently go together.
  • When AIFMs/Asset Managers breach local marketing laws, in practice it is the equivalent of the AIFM/Asset Manager handing out free put calls (“free puts”) to the investor.
  • Investors could have legitimate claims against the AIFM/Asset Manager to get their money back, requesting rescission rights if the AIFM/Asset Manager has breached local regulations on marketing the fund to the investor, effectively, a “free put”.
  • “Free Puts” to the investor are so not free to the AIFM/Asset Manager; they are in fact very costly (“expensive puts”) as investor rescission rights claims could potentially:
  • • negatively impact the performance of the AIFM/Asset Manager’s fund
    • investors could file lawsuits in court against the AIFM/Asset Manager
    • result in an AIFM/Asset Manager incurring large legal costs to defend the lawsuit
    • require the AIFM/Asset Manager to hire in-house lawyers (more headcount) to defend the lawsuit (and/or)
    • cause the AIFM/Asset Manager’s reputation and business franchise to suffer due to bad publicity.

4. Business Franchise Risk: AIFM/Asset Managers generally do not want to subject their business franchise to unnecessary risks. However, breaches of local marketing regulations can indeed do just that. Why would fund managers want to subject their precious and growing business franchise to excessive risk of failure?

5. Reputation Risk: AIFM/Asset Managers generally do not want to have an industry-wide bad reputation triggered by any of the 5-Key Distribution Risks. As part of their own Request for Proposal (“RFP”) processes, investors actually care about the AIFM/Asset Manager’s business practices and choose to invest with AIFM/Asset Managers with good reputations. Reputations are hard-earned, and a bad one could negatively impact the AIFM/Asset Manager’s ability to fundraise from investors overseas. 

Read our Blog: 5-Key Distribution Risks for Cross-Border Marketing.

Is there a correlation between stock market drops and AIFM/Asset Managers’ 5-Key Distribution Risks?

In practice, the answer is YES: Your distribution risk could substantially increase if you are non-compliant with country marketing regulations.

The 5-Key Distribution Risk “trigger” is when investors lose money due to stock market drops: It’s like throwing a lit match on fire accelerant.

When this happens, your fund investors can become disgruntled and take the following action:

• file a complaint against you with their local regulator if you breached their country’s laws while marketing & selling the fund to them;
• sue you in court and request rescission rights (demanding their money back);
• declare all fund contracts null and void (contract dissolution).

These risks could trigger your business franchise and reputation risks.

5-Key Distribution Risk Blowback in practice: KUWAIT

Here is a “real life” example of what can go wrong when AIFMs breach country laws on selling their funds to investors in foreign jurisdictions and the resulting “blowback” (5-key distribution risks) when markets crash (drop) and investors lose money:   

National Industries Group (NIG), a company controlled by one of Kuwait's biggest merchant families, invested $25 million in a fund launched by a well-known US private equity AIFM in 2006. The fund, which raised over $1 billion, collapsed during the 2008 credit crisis after defaulting on $16.6 billion in debt.

In 2009, NIG filed a fraud suit against the US AIFM in Kuwait, seeking to recover its investment, alleging that the private equity firm had misrepresented facts while marketing the fund. NIG claimed its investment contract with the US AIFM was null and void because the US firm did not have a securities license from Kuwait’s regulator CMA to offer investment products in Kuwait. Apparently, the US AIFM’s sales team flew to Kuwait and sold shares in their fund to NIG while onshore in Kuwait, clearly in breach of Kuwait’s licensing and private placement regime.

What ensued was lengthy and very costly litigation, fighting over which courts of jurisprudence applied to the case (Delaware, US vs. Kuwait). We understand Kuwait’s regulator CMA got involved. This US AIFM’s business franchise and reputation, especially for fundraising from Middle East investors, suffered greatly.

Summary

The way AIFM/Asset Managers can mitigate their 5-Key Distribution Risks when fundraising overseas, especially during stock market drops (or in times of market volatility or even stock market crashes), is to comply with country marketing rules at all times.

As the saying goes, “One needs only a single match to start a fire”, one that could send your business up in smoke.

Since all 5-Key Distribution Risks are related to each other, the last thing AIFM/Asset Managers want to do is give investors a valid reason for them to seek retribution because you broke the laws in their jurisdiction when marketing and selling your fund to the investor.

Your precious business franchise, not to mention your P&L, is worth protecting. It’s just not worth sacrificing your hard-earned reputation.

SRMO is here to help.

Begin exploring SRMO now

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