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Alternative directive fails to make fund distinctions

The alternative investment fund managers directive is expected to be implemented in 2013 and, at present, the European Commission is waiting for a response from the European Securities and Markets Authority (formerly known as CESR) timetabled for September this year.

The directive aims to regulate collective investment schemes marketed principally to professional investors who are not already covered by the Ucits directive, in other words, private (or non-retail) funds.

However, the definition is so broad that it will cover retail funds that fall outside the scope of Ucits, in addition to regulating European managers of hedge funds, property funds and private equity funds.

Critically, the directive regulates the managers of private funds, not the funds themselves, because many funds are established outside the EU.

The directive’s objectives comprise improving investor protection; entrenching a single market for alternative investment funds; strengthening national and EU supervision; and providing market stability.

Increasing the accountability of AIF managers who hold controlling stakes in companies towards employees and the public is also specifically cited. This is a politically driven measure designed to counter the increasing effect of private equity funds on the EU labour market.

Overall, the directive is seen as a kneejerk political reaction. This can be contrasted with Ucits IV, a logical extension of the largely successful Ucits framework, which must be implemented by the beginning of July this year.

In respect of market stability, the directive fails to distinguish meaningfully between property, private equity and hedge funds, all of which have strikingly different

assets and risk profiles. In addition, other market participants who are involved in managing these types of funds will not be similarly regulated.

On investor protection, the directive does not take into account the institutional and sophisticated nature of the investor base as opposed to the type of investor who would invest in a retail scheme.

This is borne out by the absence of an avalanche of misselling claims despite the financial crisis and the considerable losses that some funds have suffered. Rather than run to a regulator, professional investors tend to enforce their rights or refuse to place money with the relevant investment house in the future.
It is likely that the drive for investor protection will come at a cost to the investor – additional regulation means additional administration.

Once all the secondary legislation is included, the cost of compliance will probably be passed straight through to the end-user.

More important, there will be a restriction on investment choice. This will occur because foreign managers and foreign funds will be discriminated against and because the regulatory burden will stifle innovation by driving up costs and deterring start-up managers.

With regard to start-up managers, the de minimis thresholds, which are intended to address this criticism, are so low that, on normal management fees, most fund managers would not be able to cover their costs.

AIFMs who manage assets which amount to less than €500m (for unleveraged funds with long “lock-in” periods) or €100m for other types of fund, will be exempt from the directive.

Such exempt funds will also only be able to take advantage of the passporting between member states offered under the directive if they opt in to full regulatory compliance. The passporting system will allow AIFMs to manage or market funds throughout the EU on the basis of a single EU authorisation. After a transition period of two years, the passport will also extend to the marketing of non-EU funds, which may be managed by EU AIFMs or AIFMs outside the UK.

The directive also imposes significant restraints on remuneration and port- folio management issues such as leverage.

AIFMs will be required to implement remuneration policies which follow sound risk management. They will also be required to set a limit on the leverage used; comply with that limit, and inform competent authorities about their use of leverage for the purpose of assessing systemic risk. This information will be shared with the EU Systemic Risk Board. The directive will also create powers for competent authorities to impose limits on leverage as advised by Esma.

The creation of Esma points to an increasing concentration of power with centralised EU regulatory behemoths as opposed to national regulators but it remains to be seen who will exercise the power in practice.

AIFMs will be required to manage and disclose conflicts of interest; implement adequate systems to manage funds’ exposure to risks and ensure the liquidity profile reflects the obligations towards investors. AIFs’ assets will have to be held by an independent depositary. The directive will also impose strict conditions on the delegation of functions to third parties.

In practice, the provisions that relate to service providers such as custodians and administrators are extremely onerous and will increase the cost to the fund of the provision of these services. Again, this cost is likely to be passed on to the investor.

Where is this likely to end up? Crucially, the existing private placement regime will remain in place in Europe until (most likely) 2018. As the vast majority of private funds are privately placed, this may mean that non-EU managers will have a regulatory advantage which may not necessarily be in the best interests of the EU fund industry.

Those foreign managers who want to use the AIFMD passport will be able to do so in the future provided their country has obtained equivalency. There will be a time delay of at least two years between the imp- lementation of the directive and the availability of this type of passport.

It will be interesting to see who gets equivalency. It is hard to imagine that the US will not. It will also be interesting to see how other jurisdictions, for example, Switzerland, an attractive relocation destination for managers, ends up being categorised.

Finally, one should not necessarily assume there will be lasting unity among the member states in the implementation of the directive as few will feel they can afford to lose a significant source of revenue and employment.

Dale Gabbert is a partner and Charlotte Stimpson a trainee at solicitors Reed Smith

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