THE Alternative Investment Fund Managers Directive took a significant step towards becoming law last week after being approved by the European Council. While a lot of commentary has focused on the high profile hedge fund sector, the directive will regulate all European managers of private funds irrespective of the underlying asset class. In addition to the managers of hedge funds, it will also regulate all property fund managers as well as the managers of private equity funds, and even retail funds that do not qualify as UCITs under the existing European retail funds regime. It is an astonishing regulatory land grab.
What is even more astonishing is that there is not a convincing rationale for this unprecedented legislation. The two most plausible rationales of “market stability” and “investor protection” don’t stand up to scrutiny.
There has been little convincing evidence that the activities of managers of private funds caused the financial crisis. Another major flaw in the market stability argument is that the directive does not distinguish meaningfully between different asset classes such as property, private equity or hedge funds.
These all have strikingly different assets and risk profiles. And to the extent other market participants such as banks are not regulated in a similar way to private fund managers, the “market stability” measures won’t really work, they will just put private funds at disadvantage to other market players. The proposals on leverage and pay restraint are currently so vague that they are meaningless and may end up being counterproductive.
Perhaps surprisingly, there is not a tidal wave of investors alleging that private fund managers hoodwinked them. The reason for this is that private funds are sold to professional investors, not the general public. In the absence of fraud, professional investors don’t tend to come crying to the regulator, they simply enforce their rights or refuse to place money with the relevant investment house in the future.
The current proposals are going to have some unintended consequences that will be hard to reverse. Firstly and most importantly, there will be a restriction of investment choice. This will occur both because foreign managers and foreign funds will be discriminated against and secondly because the regulatory burden will stifle innovation by driving up costs and deterring 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.
Secondly, the costs of investing in private funds will go up. Make no mistake, we are facing a paper mountain here once all the secondary legislation is included. Someone is going to have to bear the cost of compliance, and history suggests that that someone will be the end user. Your pension may well invest in private funds – in fact it probably does. The cost of those investments is going to rise, reducing the return.
So, how is this going to play out? The provisions relating to marketing non-EU funds are going to be crucially important. It is hard to see “Fortress Europe” working with respect to the US, where many of the biggest private fund managers are based.
Assuming that the US gets equivalency status, so that US managers may sell their funds into the EU, managers may simply relocate to the US. The EU will want to limit the number of foreign jurisdictions that qualify. It will be fascinating to see how Switzerland, an attractive relocation destination for managers, ends up being categorised.
Another key test will be the extent to which there is lasting unity among the member states in the implementation of the directive. Although somewhat bloodied, the private funds industry is still a significant source of revenue and employment. Many countries would like to have a share of that in these difficult times. This is likely to be a significant source of tension.
Dale Gabbert is a partner at Reed Smith