EU moves the regulatory goal posts for alternative managers: Prepare for the UK versus Europe

Today the European Commission is due to publish its draft text for the Alternative Investment Fund Managers Directive. A late draft is relatively easy reading, but masks a huge range of complexities, offers retrograde steps in regulation rather than progression, and will require significant rewriting of current FSA rules. But, as with all EU directives, today’s publication should be seen only as the start of a time consuming process which will see extensive lobbying from the UK, where 80% of the European Alternative Investment Fund Managers are located. Indeed, the commission has stated that it expects the earliest date that member states could implement the directive would be the end of 2011.

The concern with the lobbying process that will now start is that some of the other powerful voices in Europe are motivated by political posturing and home country protectionism, and the UK, the dominant home for the Alternative Investment Fund business, and Ireland – the home of their back offices, may be lone voices.

So what does the proposed regime look like?

First we need to consider who it applies to. There are two very important issues here.

1.      The directive establishes a different regulatory regime in Europe for the Alternative Investment Fund Managers (AIFM) and their Alternative Investment Funds (AIF) in the same way that the UCITS directives have for retail fund managers. So, AIFM business is proposed to be outside of MiFID, and the important and progressive steps made by firms in responding to that regulatory framework will potentially be lost. More surprisingly, and somewhat counter intuitively in the current climate, the current draft text means that the requirements for AIFM managers to hold risk based capital (the ICAAP process) potentially drop away.

Why only potentially? Well, the way that it appears this directive will work is that it creates a regime only for managing AIF’s. As soon as the AIFM undertakes other business, perhaps running a managed account alongside the AIF, that business activity will continue to attract the requirements of MiFID and the CRD, and therefore reintroduce the need for an ICAAP.

2.      Within the UK regulatory framework there are already too many paths through regulation. Rules and requirements apply very differently to groups of firms who fundamentally do the same thing, but structure themselves differently. For example, regulatory requirements apply very differently to an AIFM who makes investment decisions in the UK, to those who only make recommendations in the UK which are ratified by an off-shore committee. Nothing in the draft directive seeks to address this hugely important anomaly and this is indicative of European Lawmakers who don’t understand the industry they are presiding over.

So, as things stand today it looks like we will have more paths through regulation, and more complexity. This is hard to justify when the UK AIF industry, and regulation, has not been the subject of any significant market failure. The idea of a progressive, proportionate, and risk based set of regulations for the AIF industry, to protect against systemic risk, is a concept that is hard not to accept. But what is proposed today isn’t it. This is a significant lost opportunity and is a political knee jerk reaction to a crisis that doesn’t exist. For years regulators have delivered piecemeal regulation for investment managers, often asking them to fit into bank and sell-side regulatory frame works, rather than properly considering what regulations they really need. This directive is another lost opportunity.


The directive in some more detail

Who does it apply to? Any firm that manages a fund other than a UCITS fund. So not only does the directive cover Hedge, Private Equity, Commodity and Real Estate funds, but also any other fund, of any legal construct, not covered by the UCITS directive. There is a proposed exemption where the total AIF under management are less than €100million (or €500million if no leverage is employed and investors are subject to a 5 year lock-in), though it is not clear whether in those circumstances the firm would default into mainstream FSA supervision.

Where can business be undertaken? The proposals allow for European passports to be provided for investment management activities, as is currently the case. The current draft also proposes that off-shore AIFs will be able to be marketed across European borders to professional investors in a further 3 years, giving EU regulators time to determine whether off-shore supervision arrangements are sufficiently robust. EU domiciled funds can, under the draft directive, be marketed across the European territory. The Directive allows member states to decide to allow marketing to retail investors, though it is not clear that any state has the appetite to take advantage of this.

Capital Requirements: A greatly simplified capital regime is proposed by Europe that requires firms to hold capital equal to the higher of;

• ¼ of one years operating expenses (less certain variable costs); or
• €125,000 plus 0.02% of AIF portfolios managed in excess of €250 million.

For smaller firms this will be a significant increase in regulatory capital, for larger firms who are currently required to hold individually calculated risk based capital, potentially a significant decrease. Private Equity firms currently on £5,000 capital face the biggest impact.

General Organisation Requirements: These appear to mirror the principles that UK regulated firms will already be used to. Documented procedures, and appropriate systems and controls are expected. It remains to be seen whether the FSA will adopt the existing common platform (CRD and MiFID based requirements) when it implements the AIFM directive.

Valuation: Independent valuations, by an on-shore and independent valuator must be undertaken at least once a year. This is a strengthening of existing requirements which stem largely from industry practice and guidance rather than rules. This is likely to promote growth in independent valuation and administration companies but may in turn increase costs for the AIFM.

Depositary arrangements: Every AIF managed by an authorised AIFM must have an independent depository. The depositary must be a bank which is subject either to European regulation, or regulation which the EU regulators deem to be equivalent to their own. This could have significant implications for funds which have independent depository arrangements in offshore jurisdictions and places extra burden potentially on private equity firms who self custody their unlisted securities.

Conduct of Business: The directive only specifies at a very high level how AIFM’s must conduct their business, requiring arrangements to manage conflicts of interest, and AIF liquidity. Risk management arrangements must be kept separate from the role of portfolio management, which may be a stretch for smaller firms, and the directive appears to ban all side letters unless they are allowed for in the funds offering documentation. Almost as interesting however, is what is not covered. A notable exception is any requirement to achieve best execution, an issue which UK firm’s have been making significant steps to implement for the past 18 months.

Transparency: The AIFM must take responsibility for publishing annual audited accounts of the funds it manages and the directive restates the standard information that must be disclosed in the fund’s offering documentation, and AIFMs will be used to this. However a new requirement is the need for the AIFM to provide periodic disclosure to investors in the fund which covers:

• The percentage of the AIF’s assets which are hard-to-value, illiquid and in side pockets.
• Any new arrangements for managing the liquidity of the fund;
• The current risk profile of the AIF and the risk management systems used.

All of these details must also be provided to the AIFM’s national regulator each year.


Leverage: AIFMs will be required to disclose high levels of leverage to both investors and national regulators. High is defined as 100%, though the details of the disclosure are less defined. What is known at this stage is that the descriptions must differentiate between borrowings, and leverage embedded in financial derivatives.

Controlling Interests: New rules are proposed to ensure that when significant stakes (over 30%) are taken in non-listed companies. These detailed requirements, which appear similar to the agenda laid down for Private Equity by the Walker Report in 2007, may impose significant additional burdens on Private Equity AIFMs.

Issues for the regulator: The proposed directive also lays down some requirements on national regulators. Perhaps not the most interesting part of the directive but the FSA will have, if the Directive is passed in its present form, only two months to consider a request for authorisation from an AIFM. A significant reduction on the current six. Firms who operate across borders will probably also be interested to understand the directive gives national regulators clear rights to undertake, or request, investigations of AIFM’s actions across national borders.

This directive is a curious mix of detailed requirements cobbled together to target AIFMs. It is however just a starting point and there is scope for CESR to add many and various requirements over and above the detail already here.

Which of the detailed regulations will survive the lobbying and horse trading that is about to start is hard to forecast. But due to the political will behind this directive it is probably naïve for us to expect significant movement. More interesting to watch may be how the FSA weaves these requirements into the already too complex system of regulation that exists in the UK. It is difficult to see the benefit of many of the provisions, some of which smack of protectionism. We are disappointed the Commission did not take the opportunity to look at the regime for investment managers as a whole rather than this piecemeal attack. Will this opportunity be taken to simplify the regime for AIFMs, or make it even more complex?

29th April 2010

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