Dealing with disaster by transforming it into opportunity is an old adage, but talk of AIFMs repeating the success of UCITS funds as a global brand is more than premature. Even UCITS funds are still primarily a European domestic phenomenon.
It is not hard to recall the dismay that greeted the first drafts of the Alternative Investment Fund Managers Directive (AIFMD) in 2009. Private equity managers were astonished to find the Directive encompassed their activities at all, and blamed it at the time on the machinations of the former Danish prime minister and European socialist leader Paul Nyrup Rasmussen, who had described private equity as a “menace” which saddled healthy companies with debt, laid off workers and stripped assets.
Hedge fund managers were equally vilified by European politicians. Heinz Müntefering, the chairman of the Social Democratic Party (SDP) in Germany, had in 2005 described them as “locusts.” So news that AIFMs would have to constrain and disclose the remuneration of senior staff, appoint depositary banks to safeguard the assets of investors, monitor cash flows and insist on compliance with their prospectuses and report regularly on their activities to regulators was as unexpected as it was unwelcome. Fierce and sustained lobbying against the AIFMD began almost immediately, and a handful of managers headed for Switzerland and Hong Kong rather than put up with the interference.
Five years on, with the AIFMD at last becoming a reality, alternative fund managers are more than sanguine about the impact. Some even argue that AIFMD will actually help them raise capital. A survey of fund managers in 2013 by BNY Mellon Alternative Investment Services (AIS) found 54 per cent of respondents confident that the Directive would encourage investment in alternative funds. Chief among the reasons for that was the ability to distribute funds more widely as a result of being regulated under the AIFMD. There was talk for the first time that AIFMD could become a global brand comparable to that created by successive Undertakings for Collective Investment in Transferable Securities (UCITS) directives.
“A lot of the large pension plans and insurers in Europe do not invest in hedge funds because there has been an unfavourable regulatory backdrop,” says Donald Pepper, head of alternative sales at Old Mutual Global Investors in London. “There has also been political pressure from certain EU governments not to invest in hedge funds. At Old Mutual Global Investors, we are positive about the future of AIFMs and we feel allocators will warm to them, given the investor protections and safeguards now in place.” Others are less excited. A survey conducted in the summer of 2013 by alternative investment management industry data providers Preqin found only a third (35 per cent) of investors felt the AIFMD would have a positive impact on capital raising, while just one in five (22 per cent) felt the opposite. A Deutsche Bank Markets Prime Finance survey of hedge funds managing $325 billion found two out of three (61 per cent) sceptical about the ability of the AIFMD to open new sources of capital and the rest (39 per cent) unsure. Interest in AIFMD as a capital raising device is particularly low among American managers, with nine out of ten (90 per cent) telling the Deutsche Bank study they were unenthusiastic about complying with AIFMD even if the marketing passport was extended to funds based outside the EU.
The reasons for scepticism are multifarious. Europe is not a conspicuously large market for alternative investors, and there is considerable institutional and regulatory hostility to the alternative investment management industry as a whole. Most American managers that conducted an AIFMD cost-benefit analysis decided the costs outweighed the benefits, especially when their domestic market remains relatively buoyant. A Barclays Prime Services survey in early 2014 predicted that nearly two thirds of hedge fund assets (58 per cent) would originate in North America over the next year, compared to just 24 per cent from Europe.
Findings and projections of this sort make comparisons with the success of UCITS as a global brand look more than somewhat overblown. Since the first UCITS Directive became law in 1985, beginning the process of establishing a single European market for mutual funds, the UCITS market has grown remorselessly. The European Fund and Asset Management Association (EFAMA) put the net assets managed in UCITS funds at nearly three quarters (€7.261 trillion) of total net assets under management of €10.191 trillion at the end of April 2014. That is probably more than twice the size of the assets managed by the entire global hedge fund industry.
As it happens, some alternative managers have tried to broaden their distribution by launching UCITS funds. Under UCITS III and IV, the range of asset classes and investment strategies open to UCITS managers was steadily broadened, making it possible to use derivative instruments in particular, and sparking a mini-boom in UCITS funds managed by Commodity Trading Advisors (CTAs) in particular. UCITS “hedge funds” are now thought to manage around €230 billion. But the European Securities and Markets Authority (ESMA) is now discouraging the adaptation of alternative investment strategies to mutual fund vehicles, fearful of exposing retail investors to losses large and conspicuous enough to have political consequences.
“There is a feeling that policymakers are intent on making UCITS a more conservative brand aimed strictly at retail while simultaneously creating a parallel AIFM brand which has greater flexibility aimed at more sophisticated investors,” says Ian Headon, a senior vice president at Northern Trust in Dublin. AIFs can certainly accommodate more daring asset classes and strategies than UCITS funds, and are not impeded by the liquidity constraints imposed on UCITS funds that must maintain daily liquidity. “Managers running strategies such as distressed debt or merger arbitrage will be able to run AIFMs,” explains Donald Pepper. “It allows hedge funds to be more flexible in what they invest in, and in the size of their positions they can take compared to strategies restricted by UCITS rules.”
Where AIFs might imitate UCITS is in broadening the appeal of hedge fund strategies among the Asian and Latin American allocators that have embraced UCITS funds as well regulated vehicles they can recommend to clients. “Inflows from Latin America have been nice, albeit incremental, while Asian allocators have also supported UCITS,” says Donald Pepper. “We do see some Asian allocators wanting to reduce the market risk in their portfolio by allocating to less correlated strategies and this could be done via AIFMs.” Ian Headon agrees. “We could see Asian and Latin American investors buying into AIFMD and we hope AIFMD will attain a UCITS status,” he says. “UCITS V and VI are going to change managers’ behaviour and we could see a lot of absolute return vehicles bypassing UCITS and becoming AIFMs.” Kumar Panja, global head of prime brokerage consulting at J.P. Morgan, is more cautious about the potential success of AIFMs as a brand.. “There is obviously the potential for an AIFMD brand to develop, although it is still too early to tell,” he says. “As a comparison, UCITS has been very successful in Europe, not to mention Asia and Latin America, but do I believe AIFMs will replace UCITS? No, I believe the two will continue to co-exist. It is important to note that UCITS took around 25 years to become a brand in its own right so an AIFM brand is not going to be an overnight phenomenon.” Ironically, as many people have pointed out, until UCITS V and VI bring the European mutual fund regulatory regime into line with that for alternative funds, investors in AIFMs will actually enjoy superior levels of protection. “Investors are protected through strict restitution for loss of assets under AIFMD which is not something UCITS currently affords,” says Mark Mannion, head of sales and client relationship management for Europe, Middle East, Africa (EMEA) at BNY Mellon AIS. “However, this is likely to change when UCITS V comes into play, so this arbitrage will be fixed soon.”
One market where nobody expects AIFMs to make an immediate impression is the United States, where alternative managers are forced by the Dodd Frank Act to register with the Securities and Exchange Commission (SEC) for the first time, and some alternative strategies are already being re-packaged for sale as funds regulated under the 1940 Investment Company Act which governs the $15 trillion American mutual fund industry. “We remain optimistic, but it is unclear if AIFs will take off in the United States just yet,” says Peter Townsend, head of hedge fund services at BNP Paribas. “AIFMD compliance has only recently entered the radar of the average US allocator’s watch list, and their due diligence criteria will likely remain `as is’ until AIFMD passporting for non-EU funds ramps up.”
Talk of AIFMs becoming a globally recognised brand comparable with UCITS are even more premature than that. After all, UCITS funds have existed for nearly 30 years, and have yet to develop much traction across borders within the EU, let alone overtake the domestic mutual fund markets in Asia or Latin America. Besides, the European Commission and ESMA are now working on versions V and VI of the UCITS Directive, while the AIFMD has only just reached version 1.0. An AIFMD II and III are more or less inevitable. ESMA is already committed to review the workings of the AIFMD between 2015 and 2018. At some point beyond that, if the new regulatory regime is seen to be stable and encouraging to capital flows, it might make sense to talk of an AIFMD brand. For now, it is enough for most managers that AIFMD did not mark the end of their world. Conquering the world can wait.