Concerns over latest AIFMD draft

02 Apr, 2012

The hedge fund industry has reacted angrily to the European Commission's (EC’s) new draft text for implementation of the Alternative Investment Fund Managers Directive (AIFMD).

The EC’s draft appears to substantially diverge from the advice offered by the European Securities and Markets Authority (ESMA) thereby raising new questions about ESMA’s clout.  “We are concerned that this draft regulation appears to significantly and substantially diverge from the ESMA advice in a number of key areas, including third country provisions, depositaries, delegation, leverage, own funds, professional indemnity insurance, appointment of prime brokers and calculation of assets under management,” said Andrew Baker, CEO at the Alternative Investment Management Association (AIMA).

One of the biggest concerns surrounds EC proposals to force EU and non-EU regulators to sign legally binding co-operation agreements, which would require third country regulators to enforce EU law in their territories. It was reported that the Irish Funds Association had described this latest development as hugely disruptive. Such extra-territoriality would not only be unwelcome but very difficult practically to impose, according to one industry source familiar with the situation.

“This provision around forcing third-party regulators to enforce EU law strikes me as unworkable and it will be interesting to see what third-country hedge fund jurisdictions, such as the US and Hong Kong, will say about this. The biggest concern for managers in these jurisdictions is whether they will be able to access EU investors. Managers might just have to wait until EU investors drop them a phone call thereby causing serious damage to the EU private placement regimes,” said the source.

The proposals could also prevent the delegation of portfolio management outside of the EU.  “A lot of managers had hoped to delegate investment and risk management outside of the EU as managers did not want to be regulated under MIFID or AIFMD.  This looks like it won’t be allowed. I suspect some managers will shun EU investors and just move to the US or Far East. There is also confusion about making investments into European entities, and whether or not managers need a physical EU presence to do so. This is a major concern,” said Andrew Lowin, director at consultancy firm Kinetic Partners.

Nevertheless, the source highlighted he did not envisage an exodus of hedge fund managers, as has been reported elsewhere, because the third country provisions obviously impact non-EU managers only.

Reforms to depositary liability have predictably led to a chorus of opposition. The draft demands depositary banks holding hedge fund assets accept liability for those assets even if they are held in sub-custody. This will not come cheap. In September 2011, AIMA calculated depositary reform could cost the hedge fund industry up to $6 billion as depositaries shift the costs to end users. In a letter last fall, AIMA warned pension funds, charities, endowments and insurers would bear the brunt of this.  “Banks had originally thought there would be no sub-custody unlimited depositary liability. The EC has pushed the debate and progress back by 18 months on the topic of depositary liability,” said Lowin.

In regards to leverage, hedge funds will not be allowed to exceed two times leverage under Article 113. According to one expert, this reflected a very basic Ucits requirement but was not applicable to hedge funds although Lowin said leverage limits could impact only a few funds.

According to some reports, industry associations have found the EC’s draft disconcerting and demoralising. The source acknowledged he did not know why the EC had diverged from ESMA’s advice although could not rule out that political considerations had played a part.  Lowin was more sceptical though. “Ever since April 2009 when AIFMD was first proposed, it has been dominated by a political agenda. Some EU politicians want hedge funds out of Europe. It does not help much when, particularly over the Greek sovereign debt crisis when certain quarters publicly announced they were betting on a Greek default. Politicians will certainly have come across these statements and it would have led to renewed hostility against hedge funds,” commented Lowin.

The EC has given EU nation states and the European Parliament just two weeks to respond to the text. “It is impossible to know how this will pan out. What we do not want to see is another struggle between the Council, the Commission and the Parliament as this could create huge uncertainty. Everybody wants the rules to be workable but they also want to see them set in stone so they know how to move forward,” said the source.  However, the source conceded that while the latest developments on AIFMD were “worrying,” he said significant progress had been made since 2009 when the draft AIFMD was first published.

In effect, the EC is proposing hedge funds are more tightly regulated than Ucits funds despite not marketing to retail investors. This, highlighted Lowin, was ludicrous. “Hedge funds are facing bigger constraints than Ucits funds. Typical investors into hedge funds are highly educated, sophisticated institutional clients and not retail yet these institutional clients are being afforded much more protection. This does not make sense,” he said.