EU’s New Rules on Hedge Funds Improve Earlier Draft—But Remain Controversial     Print

Perspectives: An Occasional Forum of the European Institute Reflecting Participant Views on Topical issues

By Anthony Luzzatto Gardner

After nearly two years of heated debate, the member states of the European Union have approved the Alternative Investment Fund Managers Directive which imposes strict regulatory requirements on a wide range of “alternative” investment fund managers, including those managing hedge funds, private equity and venture capital funds, listed investment companies, real estate and infrastructure funds.

The directive will apply not only to fund managers established in the EU, regardless of fund domicile, but also to those established outside of the EU if they market to EU investors. An exception is made for funds with assets under management of less than €500 million (for an unleveraged portfolio) or €100 million (for a leveraged portfolio). In practice, this means that most U.S. funds will fall into the regulatory net.

Although the directive will enter into force as EU legislation early next year, its real impact will only become apparent over the ensuing months during which working committees of the European Commission and European regulators elaborate more detailed rules: member states will be required to implement the directive into their national laws by January 2013.

Initial drafts of the directive were poorly conceived. Little wonder: most European legislators have never held private-sector jobs and come from countries with almost no asset-management industries. In the view of critics on Wall Street and in London, the draft was largely inspired by a desire in Germany and France to undermine the competitiveness of the UK’s financial services sector, which represents 80% of European hedge funds and 50% of private equity assets. Scapegoating private equity and hedge funds also served the purpose of European governments needing to appease left-wing critics who have called private equity and hedge fund managers “overpaid locusts.” Greece and other overly-indebted EU countries saw the directive as a convenient tool to punish hedge funds that dared question their financial solidity.

In this politically charged environment, it did not matter that private equity and venture capital had actually played an insignificant role in the crisis. See recent European Affairs article by Sebastian Mallaby on hedge fund virtues. True, some excessively leveraged hedge funds did contribute to the downward spiral of asset prices when they simultaneously unwound their positions. But this risk could have been averted by means short of a “one size fits all” directive.

Thanks to vigorous lobbying by the alternative investment fund industry, the final text is a dramatic improvement --particularly because it provides for valuable pan-EU marketing rights (“passports”) to approved fund managers, thereby eliminating the need to seek approval on a country-by-country basis. Nevertheless, EU fund managers of EU funds benefit from favorable treatment over non-EU (“third country” funds): the latter can only obtain “passporting” rights in exchange for meeting more stringent conditions. These rights will first be applied to fund managers within the EU as of January 2013, and two years later to fund managers outside the EU.

The existing system of country approvals will continue to operate subject to harmonized safeguards until January 2018, and then will be phased out if the European passport is fully operational. Although the requirements for third country funds obtaining a passport have not been finally established, they are likely to include the existence of cooperation agreements between a fund manager’s home state and the fund’s supervisory authority, as well as the existence of agreements on the exchange of tax-related information between the fund and the states where the fund is proposed to be marketed. Moreover, the countries where non-EU funds and fund managers are established must not appear on blacklists for money laundering or terrorist financing.

Some of the directive’s provisions seek to achieve appropriate objectives: fund assets must be safely kept by independent depositaries subject to a high standard of liability, that recognizes their responsibility only for losses within their control and ability to delegate to sub-depositaries; asset valuations must be performed properly and independently; fund managers must employ adequate systems to avoid or manage conflicts of interest and ensure sufficient liquidity to meet obligations to investors; strict conditions must be satisfied when delegating functions to third parties; and remuneration policies must be consistent with sound risk management by requiring that a significant part of variable compensation be deferred and in the form of shares.

However, the directive is more prescriptive than the package of measures passed by Congress in July under the Dodd-Frank financial reform legislation. It fails to differentiate between radically different types of fund managers and imposes burdensome compliance and disclosure requirements, and those costs may result in lower investment returns for sophisticated investors who have not requested additional protection.

Under the directive, fund managers will now have the obligation to disclose to their investors and regulatory authorities significant information relating to their major holdings and controlling stakes, including on planned investment strategy, fees and expenses, and concentration of assets. Fund managers will have to comply with minimum capital requirements of questionable value. They will have to disclose their use of leverage so that the appropriate authorities can impose limits in the event they detect risk to financial stability. Private equity managers will face an anti “asset-stripping” rule which imposes a 24-month post-acquisition ban on distributions, capital reductions, share redemptions and acquisition of own shares after the acquisition of control of a large company.  Private equity fund managers must supply employees and shareholders of portfolio companies with information on their future intentions and the likely repercussions on employees.

Approval of the directive is just the end of the beginning: it will require significant technical guidelines, rulemaking, interpretation and review in the coming months. In my view, the alternative investment fund industry should therefore continue to lobby as effectively as it has in the past to shape the directive’s practical impact.

Gardner, who is Managing Director in a London-based private equity firm, served as Director for European Relations in the National Security Council 1994-95.