The Alternative Investment Fund Managers Directive is a lesson in how not to legislate. The confusion of aims, huge number of amendments and unprecedented levels of criticism mean the original proposal is now widely accepted as flawed - even by the European Commission itself.
The essential problem lies with the directive’s mixed objectives. The creation of a level playing field within the EU, reversing the negative perceptions of hedge funds and private equity and trying to deal with the macro-prudential causes of the recent financial crisis would be challenge enough. But then there are the different priorities of the various players in the EU’s convoluted legislative process, such as the European Parliament and the European Council which have each proposed their own (often conflicting) version of the directive. Taken together, this accounts for the fudge and failure that is the AIFMD.
For the UK, these are difficult times. Besides being home to the vast majority of Europe’s hedge fund industry, this country also has a major share of other affected sectors. But despite Britain’s inside knowledge and accumulated experience, we have been outflanked by other member states.
The result is ill-thought-out, high-level regulation that has been forced on a major part of the market against the wishes of our own Government. Many of the complex issues have been unresolved and left to detailed level-two measures. There is also the risk of trade disputes and of EU funds being excluded from valuable markets.
The scope of the directive is much broader than its name suggests. The definition of an alternative investment fund takes in any professional or retail fund (other than those within the EU Ucits regime) irrespective of whether it is domiciled within or outside the EU. The term “fund” includes any collective investment undertaking, both open and closed-end.
An alternative investment fund manager is any EU-established manager that manages one or more AIFs.
All AIFs must have a single manager either internal or, if external, a separate management firm. There will be certain exceptions for banks and pension funds investing their own money, some at the member state’s discretion and some based on size, for example.
Such broad definitions catch a wide range of sectors. As well as hedge, private equity, real estate, infrastructure and commodity funds being captured, other sectors where co-investment takes place in assets such as art, fine wine and vintage cars may also come under the auspices of the directive. There is even uncertainty as to whether holding and joint-venture companies with a wide number of investors get caught.
This extensive scope means that would-be managers will have to assess on a case-by-case basis whether they are caught by the directive or not.
For a long time, the directive took a one-size-fits-all approach. Thankfully, there has been some movement away from this with differences in regulation applying according to the type of fund. For example, the parliament has indicated that managers of real estate funds, private equity funds and small, unleveraged funds with lock-in mechanisms could avoid some requirements.
The directive introduces a common authorisation requirement for AIFMs based on harmonised requirements. Although only the AIFM (that is, the external management company or the AIF itself where it is internally managed) is required to be authorised, the conditions for authorisation also affect the AIF that is being managed (both EU and third-country-domiciled).
Regulatory capital requirements for AIFMs start from £125,000. It could be that self-managed AIFs such as investment trusts will need an initial capital of at least £300,000 while for managers of large-value portfolios (of over £250m), the parliament has proposed a cap on the total capital needed at £10m.
There are also requirements for a separate risk management function and for liquidity management including stress-testing. Valuation of assets and calculating net asset value has been a contentious issue on the directive, with an initial proposal requiring independent external valuers being appointed (ultimately a further cost to investors in the fund). There are general requirements that distinguish between open-ended, closed-ended and listed entities but, as long as safeguards such as Chinese walls are maintained to ensure valuation is carried out entirely independently, both proposals will allow internal valuation to continue.
For EU AIFs, an independent depositary is required which must be an EU credit institution or one of the other categories of permitted, regulated firms. The depositary must be established in the home member state of the AIF and comply with broad requirements. These requirements are a clear example of the inappropriate application of the directive. The use of a depositary is not appropriate for every type of fund.
On the issue of depositary liability, only the council version of the directive allows the depositary to contract out of liability where it is reasonable to do so, although both versions allow depositaries to escape liability for losses caused by unforeseeable external events and hold them generally liable for the actions of sub-custodians. The increase in depositary liability is likely to have an impact on the fees they charge for their services, which again will ultimately be passed back to investors.
On remuneration, both council and parliament proposals require an AIFM to maintain detailed remuneration policies for members of staff whose professional activities have a material impact on the risk profiles of the AIF they manage. As this issue has been a political football during the financial crisis, it was perhaps inevitable these proposals found their way into later drafts of the directive even though the original draft was silent on the issue.
There are general requirements and limitations for delegation and outsourcing, including the need for prior regulatory approval and co-operation agreements between EU regulators and regulators in non-EEA countries where risk or portfolio management is to be delegated.
Indeed, the parliament version of the directive would effectively prevent such delegation outside of the EU, something that would even affect intra-group outsourcing which is fairly commonplace.
The council and parliament are also at odds concerning the question of whether member states have the power to impose leverage limits on AIFMs. The parliament wants to allow AIFMs to set their own leverage limits, which would then be monitored by home regulators. It has also given the European Securities and Markets Authority the power to cap fund leverage if it considers the levels inappropriate. But under the council’s version, it is the national regulator that can impose caps to avoid systemic risk.
The parliamentary version has greater disclosure requirements on AIFMs, requiring them to inform investors and national regulators periodically of maximum and total levels of leverage. Specific requirements for private equity funds will have an impact on the levels of leverage these funds would be allowed to employ and oblige them to disclose information relating to control of non-listed companies.
Many of these requirements appear to have been introduced to address political concerns about the activities of private equity companies and it is difficult to see how they represent any real attempt to tackle systemic risk.
Further disparity is found in the requirements for reporting short selling.
The council text requires only the reporting of short selling. The Parliament has gone much further, proposing that controls over short selling, and possibly even a ban, should be included in the directive. Given the upcoming changes to the market abuse directive, one can only hope that a joined-up approach on short selling is developed outside of the AIFMD.
One of the few positive things to come out of the directive so far has been the introduction of two distinct passports for AIFMs. The first, to market EU-domiciled AIFs to professional investors in other member states. The second, to pursue permitted activities (such as AIF management) in other member states on a cross-border services basis or though a local branch. However, there will be no EU passport permitting sales of AiIF to retail customers.
However, no consensus has yet been reached on the marketing of third-country funds in the EU and the management of EU funds by third-country AIFMs.
Again, the council approach differs from that of the parliament here, as it effectively permits a continuation of the private placement regime and allows an EU AIFM to market funds located in third countries to professional investors in the EU as long as the relevant member state permits it and it complies with certain provisions of the directive. Co-operation arrangements will also need to be in place between the regulators of the AIFM and the third country in which the fund is located.
However, parliament says to market non-EU-domiciled AIFs, the third country must comply with certain money laundering, terrorist financing and tax information exchange obligations. In addition, there must also be an information exchange agreement between the AIFM member state and the national regulator of the non-EU AIF. Finally, there must be equivalent market access. If these conditions are fulfilled in relation to a given non-EU AIF, it will also benefit from the EU marketing passport, although one can argue it is highly unlikely many non-EU jurisdictions will meet these criteria and they are effectively being used as a barrier to entering the EU market.
Similarly, marketing by non-EU AIFMs of non-EU AIFs in any member state appears to be condoned by the council if sufficient information is provided to investors and the national regulator and co-operation arrangements exist between the member state and the AIFM’s home country.
This contrasts with the parliamentary approach, which requires non-EU AIFM to comply with the full directive regime, including requirements for the marketing of third-country AIFs and requires the home country regulator to act as an agency of the EU regulatory authorities in policing compliance with the directive.
Again, it seem sees likely these criteria are being used as a barrier to entry rather than to facilitate effective investor protection.
There have also been criticisms about the practicalities of each third country having to have a "co-operation arrangement" with each member state. Some third countries (including the Cayman and British Virgin Islands) have said they can, in principle, comply with the requirements if sufficient time is available for the requisite but co-operation agreements, there are now considerable doubts about some other countries - including the US, which has been highly critical of the third-country provisions in the directive.
Whether the EU's proposals trigger a tit-for-tat protectionist approach in other jurisdictions remains to be seen.
The three way negotiations between the council, parliament and commission will continue, as they seek to agree on a final text in time for the first reading vote in parliament.
Whether the UK can use this period effectively to achieve any improvements in the areas of concern remains doubtful, and time is running out.
The parliamentary vote will take place in September or October and the directive is likely to take effect in 2012.