However, the fact remains that unless it is considerably watered down, it could have a profound and lasting impact on the way the asset management industry does business in Europe.
The directive in its current form, also known as the ‘Belgian compromise version’, as it is based on a draft prepared by the current Belgian presidency of the European Commission, still leaves some massive questions unanswered. They fall into the following categories:
Remuneration principles
The reason remuneration is on the table is because of fears that the bonus culture encourages excessive risk taking. Where it was probably most abused was within the investment banks, and their remuneration activities are being covered in a different directive. The AIFMD seems to assume that hedge funds and their brethren in the world of private equity somehow also formed a systemic risk to the European and global financial system.
“Fund managers are not systemic institutions,” says Dan Waters, Director of Conduct, Risk and Asset Management Sector Leader at the Financial Services Authority (FSA). “We fundamentally don’t mind if they go bust. This all started with concerns about the systemic presence of funds and clusters of funds in the market.”
The directive focuses in on the way key personnel in risk-based decision making within a fund are remunerated. Much of what it requires is in all likelihood already common practise in larger funds, but the worrying point is that it assumes a role for hedge funds that was not and is not played in the financial system: funds become dangerous when banks lend them too much money, and the fund becomes too important to be allowed to fail. But the EC and the European Parliament are outwardly claiming a systemic role for hedge funds that is not recognised by regulators like Waters or by the financial services sector in general.
Passive marketing
The effort to include funds in the regime that indulge in so-called ‘passive marketing’ is also raising hackles, mainly because in this age of the internet, passive marketing has become so difficult to define. Funds outside Europe pick up business from Europe without actively marketing in Europe: what should a US fund of funds do if approached by a European family office? Turn them away?
“It is a non-starter to expect that, because of our domicile, we’re going to be restricted to investing in what is a pretty but increasingly economically less viable part of the world,” says Danny Truell, Chief Investment Officer at The Wellcome Trust.
This part of the directive could be an interesting one for regulators expected to police so-called ‘passive marketing’ on the part of funds in third countries. In this respect the AIFMD looks more draconian than anything that has preceded it. But what, in reality, can either fund managers or regulators do to implement this? Even the legal community seems baffled on how to proceed on a practical basis.
Foreign/third country managers
The EC would like to apply its directive to any fund manager, wherever he or she is based, that wants to market into Europe. Managing money in Hong Kong? If you want European investors on your books, you will need to comply.
“The third country chapter is integral,” says Chris Becher, Policy Officer for the Asset Management Unit of DG Internal Markets and Services, European Commission. “It is not enough to simply look at managers established in Europe…the single market should be available to all managers, but foreign managers must comply.”
The directive is creating consternation particularly in the US. In a way, it represents a mirror of SEC restrictions on the marketing of foreign investment funds to US persons. Some commentators fear a scenario where many talented US hedge fund managers will simply not accept European money. In addition, European investment managers may become too expensive, making it harder for them to raise money.
“European managers may not be chosen for sub-advisory mandates,” says Jennifer Wood, Partner at law firm Dechert. “US fund managers may choose not to establish European structures – I think there may be a flight away from the EU. Some of this may not be an issue, but these are the primary concerns of US managers and investors.”
At the time of writing, it did not look like the US regulatory regime would be considered equivalent: there would be no carve-out exemption for US-regulated funds or managers, no special treatment, unlike that being afforded to UCITS funds. There are dark mutterings of protectionism in the legal community in the US, and the Obama administration is known to have finally raised its concerns in Brussels.
“The US is not in a position to impose European rules on US investment advisors,” says Wood. “The SEC would have to regulate them, and the SEC would be in the hole imposing European provisions. It is an unlikely scenario.”
The US government and the Managed Funds Association are waking up to the fact that the directive could have serious transatlantic repercussions. There was still little or no interest in the directive in Washington DC in January of this year, and it has really only been in the last six months that US regulators and administrators have wised up to the issue. Now, of course, it may be too late: Brussels lawmakers are believed to be swamped by emails from US lobbyists, but have reached the stage where they’re are not prepared to consider them seriously.
There are also hidden dangers for the much-praised UCITS brand in all this. If the equivalence regime is too loose, there is a real risk of driving many funds offshore again. Eyes are already turning longingly to Switzerland and Singapore, where regulators are in the process of fine-tuning their regimes to make it easier for funds to migrate there. Singapore is consulting on a lighter touch regime for smaller funds, while Switzerland is allowing non-resident funds to register, possibly as a prelude to moving the bulk of their operations to the country.
“This is not about regulatory arbitrage, this is not about a race to the bottom,” says Ben Robins, Partner and Head of Funds at Jersey law firm Mourant Ozannes. “Regulatory uncertainty has added to the market jitters of 2008-09. In 2010 we’re seeing frustration with the regulatory stasis, and an increase in offshore formations. If you look five to 10 years in the future, the industry is not going to be all EU compliant funds.”
Depository regime
The directive’s proposed depository regime, which requires all funds marketed in Europe to deposit their cash and assets with an EU-based custodian or depository (usually a bank) is also taking flak.
“The depository regime is heavily influence by Madoff,” says Andrew Baker, Chief Executive of the Alternative Investment Management Association. “It is riding roughshod over the desires of investors. It is telling them that they can’t be trusted to do their own due diligence.”
But can they be trusted? This writer knows of one Austrian private bank that, while publicly recognising that it ought not to allocate more than 10% of its assets to one manager, had over 40% of its private client managed fund portfolio exposed to Madoff via various feeder structures. These were allegedly professional investors making these allocation decisions.
The investment community is not trumpeting its enthusiasm for the directive by any means, even though Brussels considers them to be among the beneficiaries of the new legislation.
Take The Wellcome Trust, the largest charitable foundation in Europe: “We are concerned about the directive,” says CIO Danny Truell. “For us, the biggest threat is inflation, and thus we need a diversified portfolio. We have no home country bias.” He reckons his foundation requires approximately 25% allocated to Europe. “I have more transparency now than I will ever want. Bits of the [alternative investment industry] were part of the cause of the financial crisis, but very few of the big asset holders had any problems with their funds. The middle and small foundations saw the real disasters. The concentration of power in the hands of the investment banks was the problem, and hard code legislation would not have helped that. Regulation has not been one of the great success stories of the past five years, and I don’t think it is productive to tell sophisticated investors what to invest in.”
He is not alone. Kathryn Graham, Director of BT Pension Scheme Management Limited, says institutional investors are able to do their job without hand holding from the regulator. “We always assess the risk in our investments. Our concern is when someone puts in place legislation which does not allow us to do our jobs properly. We feel hedge funds, and particularly the Hedge Funds Standards Board, can contribute significantly, and the majority of the trustees on the HFSB are investors. Regulation cannot protect you from bad managers; the crisis arose from bad supervision by regulators.”
The issue is also worrying some within the Irish financial services industry. Under the directive, the assets of a fund must be calculated by a valuator that is wholly independent of the fund manager. They may be based outside the EU, but only if the valuation standards are equivalent to those prevailing in the EU. Considering that there are no accepted universal valuation standards inside the EU, this represents a challenge. Not only that, but many Irish administrators have been able to keep their costs down via outsourcing to cheaper centres outside the EU. Will they still be able to do this?
Politics
What is surprising is that the EC has chosen to scope out an entirely new directive, and that the commission’s political masters gave it so little time to draft the first version of the directive (two weeks, one insider told UCITS Hedge recently). The directive is being driven by politicians keen to humble hedge funds and private equity firms. Fig.1 shows how many of a sample of 100 MEPs believed hedge funds to be responsible for the financial crisis. It is interesting to note how far down that list the investment banks come.
There is a perception in European political quarters that hedge funds are a ‘bad thing,’ that they were responsible for the crisis, and that they must be reined in. Activist investing in the EU has not gone down well in some quarters, and left wing politicians want revenge for what they perceive as attacks by hedge funds on the European body corporate.“The process here is a cautionary tale of how regulations should not be written,” says the FSA’s Dan Waters. “Focus on the facts, write something that works. The authors have had to address a wide range of fund structures. We are in favour of global, competitive markets and active choice, and we hope that the EC’s vision of that is delivered.”
There is also a very high risk that the directive, when it does come into force, will simply cause fund managers to pass on any additional costs to the investor: ultimately, the investor will have to bite the bullet on this.
“Having $10 million sitting around doing nothing is a significant issue for funds of funds,” says Peter Coates, Head of the European Office at fund of funds Lighthouse Partners. He sees the directive’s requirements imposing massive new running costs on alternative fund managers which, ultimately, will be passed onto investors. “It represents a huge barrier to innovation as well,” he observes.
The cost of managing a pension fund is therefore likely to go up, and the amount of money available to Europe’s growing pool of retirees will go down. There is no way the fund management industry will simply swallow the cost. While lawmakers may not realise this, regulators do. “To take 40 or 50 basis points out of a fund of funds would be catastrophic,” says Dan Waters at the FSA.
Conclusion
At the time of writing, the European Parliament was scheduled to vote on the directive in October. The vote had already been delayed from September, largely, one suspects, due to quiet opposition from certain ‘vested interests’ within the EU. One also suspects the EC does not want to risk having that opposition more openly manifest, or the directive in any way watered down or de-railed.
Ultimately, the EC wants to make this directive work. However, it is one thing to pass a directive, and quite another to enforce it. One senior EU regulator I spoke to for this article said: “On the retail funds side, the EU is setting the standard. There is a lot of commonality between regulators. On the institutional side, no one is doing what the AIFM [directive] proposes.”
Take the plan to monitor short positions: while such transparency on shorts already exists in Canada, for example, the financial regulator there simply does not have the resources to properly monitor the positions of individual funds. What is more, how will the regulator intervene with funds that it feels are becoming systemically dangerous? Will it force them to unwind that position? And what will be the legal implications for the regulator if this causes severe economic loss to investors?
“The hedge fund community needs to get out there, and have a more concerted and public voice,” says The Wellcome Trust’s Truell. “The asset owner community has not been a particularly coherent voice either. Our own governance criteria are not exactly transparent. This directive misses the opportunity to level the playing field, instead of which it is trying to impose a consumer-based solution.”
