Regulation of Alternative Investment
Financial Services briefing
The European Commission has published its politically charged proposal on regulating
Alternative Investment Fund Managers ("AIFMs")
The proposal has been drawn up hastily without proper consultation, and in many ways looks
like a classic EU compromise. It therefore satisfies neither side of the debate, by increasing the
regulatory burden on property, hedge and private equity funds (to howls of complaint in the City)
without directly regulating the funds themselves (to equally loud complaints from MEPs). The
Commission intends the proposal to become law in 2011.
• Managers of Alternative Investment Funds ("AIFs") must be authorised if their funds
under management exceed €100m (€500m for non-leveraged funds with at least a five-year
lock-in). The Directive does not contain any of the sensible exemptions contained in, for
example, MiFID that permit inter-group management without authorisation.
• AIFMs will be required to keep capital of at least €125,000, or, if greater, 0.02% of the
assets under management.
• Each Alternative Investment Fund (AIF) managed by an AIFM must appoint (1) a
valuer that is independent of the AIFM (2) a depositary (which must be a bank) to
receive payments from investors and act as a custodian. Delegation of these, and any
other administrative, tasks outside the EU is only permitted where that entity is locally
licensed by an equivalent regime, and where co-operation agreements between that regime
and the EU are in place.
• AIFMs can market AIFs to professional investors (using the MiFID definition)
throughout the EU. Where the fund is domiciled outside the EU, there will be a three year
delay to this right (i.e. 2014). Even then, marketing will only be permitted where reciprocal
arrangements are in place and tax information sharing with the EU has been agreed to by
the local jurisdiction.
• AIFMs will need to meet detailed investor disclosure requirements. Many of these
replicate existing practices, but there are new details on, for example, disclosing the precise
identity of investors that receive preferential treatment.
• Where AIFMs manage AIFs that employ leverage, there are new reporting obligations
where leverage exceeds the value of capital in two out of the past four quarters.
Regulators can limit the amount of leverage an AIFM can use.
• AIFMs are subject to new restrictions on short selling, as they will be required to operate
procedures that provide them with access to securities to meet their delivery obligations,
which will make naked short-selling more difficult.
• There are new requirements aimed at private equity funds who acquire stakes greater
than 30% in businesses that employ 250 or more people and either have an annual
turnover of more than €50m or a balance sheet of more than €43m. The AIFM must notify
the company and shareholders of details of their shareholding, their policies for managing
conflicts of interest, their development plans for the company, and on an annual basis
disclose further information including, for example, employee turnover.
There is a lot of work to do before this draft Directive is ready to be implemented. Much of the
existing drafting does not work, and even the explanatory notes released at the same time as
the Directive contain information from an earlier draft of the Directive. There is also a lot of
pressure from both sides of the debate to make major changes to the Directive. So where does
this leave us?
First, it is clear that managers of AIFs will need to comply with additional disclosure
requirements in the future. How much of a change this becomes will depend upon the final
version of the Directive and of the implementing legislation that will be issued under it. But the
administrative burden is certain to increase. Further, there can be little justification for
calculating capital requirements by reference to funds under management, given the different
legal nature of the fund and the manager.
On the plus side, the Directive does introduce a mutual recognition regime for funds that
are only marketed to professional investors. There will be a delay before funds established
off shore (for example, in Cayman or the Channel Islands) benefit from this regime, and they will
have to make do with the existing position until that date. But it seems likely that this step
forward may only be a small step in the Hedge Fund industry, given the number of high net
worth individuals who would not qualify for Professional status under MiFID.
One of the biggest legal gaps in the Directive is the lack of sensible exemptions. We can only
hope that the MiFID exemptions are replicated to enable, for example, managers not to require
authorisation where they are managing inter-group funds. Some of the recitals require much
closer examination too – Recital 5 suggests that AIFMs will be prevented from managing any
AIFs that fall outside the scope of the Directive, but that cannot be the intention.
The marketing rules on AIFs are also very confused. First, Recital 10 states that AIFs are
"complex instruments" for the purposes of MiFID. This means that all AIF investment is subject
to a suitability analysis by the AIFM, as there is no "execution only" service that can be
provided. Further, the definition of "marketing" is frightening, as it captures any investment,
"regardless of at whose initiative the offer takes place". This is totally different from the
approach taken by MiFID which recognises reverse solicitation and execution-only business as
legitimate models. Why such models should be permitted for retail funds but banned for
professional-only funds is a mystery.
The Directive also has a very definite view of the roles played by third parties in helping the
AIFM. Each AIF must have a depositary that is a Bank that is to be responsible for
custody and the receipt of investor funds. In the UK, the receipt of investor funds is typically
the role of an Operator, and those funds will be received into an Operator's account at a bank –
the Operator itself is not likely to be a Bank. Why funds need to be received by a bank, rather
than into an account held at a bank, is unclear. Further, the role of a third party valuer is set out
in more detail and where the valuer is to be outside the EU it must be regulated in an equivalent
manner. Many funds will need to re-assess the roles and responsibilities of the third
parties that they engage to provide services if these measures are enacted.
But enough of the broad policy considerations. The Directive also contains highly detailed
requirements that are not appropriate given the general nature of the Directive. For instance,
measures to potentially limit the use of naked short selling need to be subject to a much broader
consultation. A requirement that originators of securitised loan products retain 5% of their
books may have some attraction to regulators (and potentially to investors) but should not be
introduced in a law that applies to managers rather than originators.
Disclosure requirements relating to leverage, such as the identity of the five largest
sources of borrowed cash or securities, have not been subject to a cost benefit analysis that
demonstrates the additional stability that such disclosure may, or may not, bring.
The political nature of the directive is best illustrated by two points. First, the marketing of
non-EU domiciled AIFs within the EU is subject to tax co-operation requirements between
the EU and the non-EU member states. Such matters should not be the concern of legislation
aimed at properly regulating AIFMs. Second, disclosure requirements relating to the
intentions, and actions, of private equity funds are political rather than regulatory in
nature. Systemic risk in financial markets will not be improved by disclosing the employee
retention records of private equity funds, but valuable time may be taken up in trying to improve
these proposals at a time when it could be better spent working on matters of higher systemic