The European Parliament has been calling upon the Commission to tightly regulate private equity and hedge funds. The Internal Market Commissioner, Charlie McCreevy has been refusing to legislate on these issues. But, he has changed his mind. The European Commission has recently adopted a Proposal for a Directive on Alternative Investment Fund Managers.
The proposal is part of the Commission programme to introduce a harmonised regulatory and supervisory framework for the alternative investment sector. The proposal focuses on obligations to be imposed on Alternative Investment Funds Managers (AIFM), submitting them to a common set of rules.
Presently, the AIFM activities are regulated by national financial and company law regulations and general provisions of Community law. According to the Commission, some of the risks associated with AIFM are not sufficiently addressed by the existing rules. The Commission has therefore proposed the draft directive establishing regulatory and supervisory standards for hedge funds and private equity.
The alternative funds industry has heavily criticized the Commission's proposal. The hedge fund and private equity industries are concerned about the costs and red tape that the draft directive entails. According to Kinetic Partners the implementation costs of the Commission’s proposal will be around £3 billion to the UK hedge fund industry. Moreover, it will cost “several hundred million pounds annually” to an UK manager to comply with the new rules.
For the purposes of the proposal, Alternative Investment Funds (AIF) are defined as all funds that are not harmonised under the UCITS (Undertakings for Collective Investment in Transferable Securities) Directive such as hedge funds and private equity, as well as real estate funds, commodity funds and infrastructure funds. The proposal puts therefore all AIF in the same bag.
According to the Commission “It would be disproportionate to regulate the structure or composition of the portfolios of the AIF managed by AIFM and it would be difficult to provide for such extensive harmonisation due to the very diverse types of AIF managed by AIFM.” Hence, the draft Directive will regulate the way in which AIFM manage alternative investment funds (AIF) under their responsibility rather than the funds themselves. Consequently, the management and administration of any AIF in the European Union must be authorized and supervised in accordance with the requirements of the Directive.
It is important to mention that the president of the Party of European Socialists, Poul Nyrup Rasmussen, and the chair of the European Parliament's economic committee, Pervenche Berès, attacked the Commission proposal stressing that it would be "highly ineffective." In a letter addressed to José Manuel Barroso they said "As it stands now, any funds, be it off-shore or on-shore, would then be allowed to market their products in the EU as well as operate in European markets, in reality without effective regulation or registration." They will seek a proposal which regulates the funds themselves.
The Commission wants to ensure that all AIFM operating in the European Union are subject to effective supervision and oversight consequently the draft proposal introduces a legally binding authorization and supervisory regime for all AIFM managing AIF in the EU. All AIFM that operate in the EU will be required to obtain authorisation from the competent authority of their home Member State. Such authorization would cover the services of management and administration of AIF throughout the Community. They would be required to show that they are suitably qualified to provide AIF management services and they will be required to provide detailed information on the planned activity of the AIFM.
It was difficult for the College of Commissioners itself to decide the thresholds above which the directive provisions would apply. An initial proposal put the hedge fund threshold at €250 million. Nevertheless, the Commission has yielded to the Socialist group in the European Parliament pressure to lower the threshold under which managers would not be subjected to the new rules. The Commission has therefore exempted all AIFM managing AIF portfolios with total assets of less than €100 million from the provisions of the draft Directive. The Directive will not also apply to AIFM managing portfolios of AIF with less than €500 million of assets in case of AIFM managing only AIF which are not leveraged.
The directive will apply, therefore, to all AIFM managing hedge funds above €100 million in value and private equity funds of €500 million or more not using leverage.
According to the Commission having a threshold of €100 million entails that around 30% of hedge fund managers, managing almost 90% of assets of EU domiciled hedge funds, would be covered by the Directive.
Under the proposal all AIFM that operated in Europe would have to meet reporting, governance and risk management standards. The AIFM will be required to hold and retain a minimum level of capital. They will have to report on their activities and their structure. The AIFM will be required to notify national authorities about their investment strategy as well as their plans on how to manage risk. The draft directive will therefore impose further costs on managers since they will be required to implement new fund reporting and risk management systems.
If the AIFMs comply with all the proposal requirements they will be allowed to market their funds throughout the EU. Under the draft proposal authorisation as an AIFM will entitle the manager to market the AIF to professional investors only. The AIF cross-border marketing is subject to a notification procedure, under which relevant information is provided to the host Member State.
Consequently, if the AIFM fail to comply with the new rules they would not be allowed to operate in the EU.
The Commission has stressed that the AIF management and administration activities are reserved to EU domiciled and authorised AIFM, with the possibility for AIFM to delegate administration (but not management) functions to offshore entities subject to stricter conditions such as depositaries nominated to take custody of money and assets must be EU established credit institutions and valuators appointed in third country jurisdictions must be subject to similar regulatory standards.
The draft proposal provides the requirements that must be fulfilled in order to a member state to allow an AIFM to delegate administrative tasks to an entity established in a third country as well as to allow the appointment of a valuator established in a third Country.
The Commission proposal would allow an EU AIFM to market AIF domiciled in third countries to professional investors throughout Europe, three years after the transposition period but it is subject to those conditions. Until then, the member states may allow AIFM to market AIF domiciled in third countries to professional investors on their territory subject to national law.
Moreover, three years after the transposition period the Directive will allow AIFM domiciled in a third country to market their funds in the EU provided that the third country has a similar regulatory framework and supervisory arrangements to those proposed in the draft Directive, and EU operators enjoy equivalent access to that third country market.
The Commission will decide through the comitology procedure on the equivalence of the relevant third country legislation and on comparable market access.
According to the Financial Times lawyers have said that the proposal requirements “(…) will make it more expensive to run funds from offshore centres (…)” According to Michael Newall, lawyer at Norton Rose “If the costs rise it might make more sense to domicile your funds onshore.”
The Commission pointed out that AIFM employing high levels of leverage in their investment strategies may contribute to the build up of systemic risk however the information needed to detect and respond to those risks, according to the Commission “has not been collected in a consistent way throughout the Community, and shared across Member States so as to identify potential sources of risk to the stability of financial markets in the Community.” The Commission wants, therefore, to remedy this situation. Hence, those AIFM would be obliged to disclose information regarding their use and sources of leverage which would be aggregated and shared with other authorities in the Community in order to facilitate a collective analysis of the impact of the leverage of those AIFM on the financial system in the Community.
The Commission has considered necessary to impose limits on the level of leverage that AIFM could use. Thus, the Commission would set leverage limits through comitology procedure.
Under the draft proposal an AIFM will be required to provide all companies over which it can exercise a controlling or dominant influence with the information necessary for the company to assess how this controlling influence may impact on its economic and social situation. The draft directive provides, therefore, for a list of information that AIFM managing AIF which are in a position to exercise controlling influence over a company will have to supply to shareholders. They will be required to disclose their intentions with regard to the future business development and other planned changes of the controlled company. The AIFM would be required to issue an annual disclosure on the investment strategy and objectives of its fund when acquiring control of companies as well as general disclosures about the performance of the portfolio company.
Such requirements will apply to acquisitions of control in companies that employ more than 250 persons, have an annual turnover exceeding 50 million euro and/or an annual balance sheet exceeding 43 million euro.
According to the financial times, Luke Johnson, Chairman of Channel 4 Television and Risk Capital Partners has said that under the Commission’s proposal “companies in general” will have to spend “tens of thousands in compliance costs” and they “(…) will have to publish data compromising their competitive position, giving a completely unfair advantage to privately owned businesses [that will] not be subject to these rules.”
Moreover, Member States would be required to lay down rules on sanctions applicable to infringements of the provisions of this Directive.
The draft directive is based on the Lamfalussy process for regulating financial services. Detailed implementing measures would be adopted through comitology procedures. The Commission has left a lot of room to comitology which will diminish Member States control over the content of such measures.
Whereas Charlie McCreevy said the proposal responds to the G20 calls for regulation and oversight to be extended "to all systemically important financial institutions, instruments and markets” according to Florence Lombard, Executive Director of Alternative Investment Management Association (“AIMA”), the directive “(…) conflicts with the G20’s global plan for recovery and reform which calls for regulators and supervisors to “reduce the scope for regulatory arbitrage” and to “resist protectionism.”
Moreover, Florence Lombard said “(…) many of the provisions will disadvantage European hedge fund managers against those outside of Europe, which could prove an incentive for them to move business elsewhere – negatively impacting badly-needed tax revenues for Member States.”
The proposal is going through the co-decision procedure with QMV required at the Council. It remains to be seen what will come out of the negotiations. It is important to mention that the Socialist Group in the European Parliament have been calling for tougher measures. According to Poul Nyrup Rasmussen, the socialist group “will not accept such an ineffective regulation." Moreover, the French MEP, Jean-Paul Gauzès, from the EPP has said that “(…) the proposal is a good step in the right direction but perhaps not enough.” It seems very likely that the MEPs will vote for a directive even more burdensome than the Commission’s proposal. Most hedge funds and private equity that are marketed within the EU are based and registered in the UK. However, the UK government cannot veto the proposal.
Simon Walker, Chief Executive Officer of the British Private Equity and Venture Capital Association, has said that the Commission’s proposal “It is especially counter-productive for Britain as 57% of the European Private Equity industry is located here (and hence the UK has the most to lose if firms choose to relocate) and it would effectively override a domestic disclosure procedure under the Walker regime which is widely regarded as working extremely well (…).”
Julian Korek, founding Member of Kinetic Partners, has said: “This ill-considered directive would be disastrous for the UK hedge fund industry, and prove hugely costly to the industry for almost no apparent benefit." Moreover he recalled that “Two years ago, hedge fund invested heavily to comply with Europe’s Markets in Financial Instruments Directive (MiFID) which this new directive threatens to supersede. The UK-based hedge fund industry spent tens of millions of pounds to comply with MiFID, which now looks like money down the drain.”
