Regulating Hedge Funds:
The EU Alternative Investment Fund Managers Directive

Introduction

Over the last 20 years alternative investment funds have moved from being niche providers to being part of the mainstream of financial services.  The banking crisis of 2008 magnified already developing concerns that this part of the sector was under-regulated.  The G20 Summit in April 2009 expressed the view that these investment funds needed to be regulated and the European Commission subsequently published a draft directive.

In this paper, following the adoption by the European Parliament and the Council of Ministers of an agreed text for the directive, we explain the background, consider how the directive will operate in practice and assess the implications for the sector.

Background

There are broadly several different kinds of alternative investment funds (AIFs), some overlapping, including:

• hedge funds – these are privately owned companies who invest funds on behalf of wealthy individuals or professional investors, such as pension funds or insurance companies;
• private equity funds – private equity is money invested in companies that are not publicly listed on stock markets;
• venture capital firms – they help entrepreneurs to raise money from investors;
• commodity funds – they invest in particular commodities such as gold or coffee; and
• real estate funds – who invest in property.

As hedge funds are the best known AIFs, the directive has commonly been referred to as the “hedge funds directive” but it is important to note that its scope is wider than that, to ensure that AIFs do not evade regulation.  The sector currently manages around €2 trillion of assets within the EU.

Before the 2008 financial crisis concerns had been expressed about AIFs in many countries.  European Parliament reports had highlighted the growth in size of the sector and its movement from the fringes to the mainstream of the financial services sector.  Some hedge funds were perceived to act aggressively and critics objected to the practice of “short-selling”, a form of dealing that relies on the value of an asset falling rather than rising, which they believed damaged the real economy.  Private equity funds were criticised for buying up entire businesses and taking them private, thus reducing their public accountability and, it was argued, making it easier to cut employment in the process.  There was a general concern that AIFs, not being publicly listed companies themselves and subject to relatively light regulation in most countries, operated largely in secret and often appeared to pay their senior executives exceptionally large salaries and bonuses.

In the immediate aftermath of the banking crisis there were criticisms of hedge funds in particular for short-selling bank shares and claims this had contributed to the crisis.  In fact, both the Turner Review of financial services regulation and the EU’s own review of high-level regulation found that although AIFs had been short-selling bank shares, so had other investors and AIFs had not contributed to financial instability more generally.  But nonetheless, they both recommended that AIFs be subject to regulation because of the risk that the size of the sector could pose to stability.  These recommendations were shared by the governments of the world’s largest economies and the EU, meeting in the G20 in April 2009.

The Commission’s Proposals

The European Commission tabled its proposals for a directive on AIF managers in April 2009.  The proposed directive was intended to:

• provide a comprehensive and effective regulatory system for AIF managers;
• regulate not the funds but the managers who run them;
• ensure that regulators have sufficient information to enable to maintain effective oversight;
• exempt smaller AIFMs – those managing a portfolio €100 million or more (€500 million if they do not use leverage) would be regulated;
• permit AIFMs to operate throughout the EU on one set of regulatory rules;
• allow third country AIFMs to operate within the EU after a transitional period of three years during which the regulatory arrangements in their home countries would be assessed.

These proposals were controversial, partly because some in the AIF sector objected to any regulatory framework but also because many critics felt the proposals were hastily drafted, did not reflect sufficient understanding of the diversity of the sector and would impose excessive regulatory burdens.

Whilst the FSA, the CBI and the Alternative Investment Managers Association (AIMA) all agreed on the need for a single system of regulation for AIFs, there was considerable concern about other aspects of the proposed directive, perhaps not surprisingly when 80 per cent of EU hedge funds and 60 per cent of private equity funds are based in Britain.  In evidence to a House of Lords Committee inquiry, the AIMA said that:

without significant revision, the Directive will lead to less choice and greater costs for investors within the EU – without achieving the stated objectives of the Directive.

The UK Government and the FSA were both concerned, in particular, that an effective ban on third country funds would have adverse consequences for investors in the EU as they would no longer be able to choose the best performing global AIFs but be restricted to EU-based ones.  Such a measure, many critics argued, was protectionist.

Although most of the criticism of the Commission’s proposals came from those who felt that the directive would damage AIFs, there were those who argued that the proposals did not go far enough in eliminating the risks posed by AIFs and others who wanted stronger controls on remuneration.

The Adopted Directive & its Impact

The main points of the finally agreed directive are:

• that an alternative investment fund manager is any legal person who manages one or more AIFs;
• that AIFMs managing AIFs with a total value of less than €100 million are exempt from the regulations;
• that AIFMs managing non-leveraged AIFs with total assets of less than €500 million, where the investors have no redemption rights for five years following their initial investment, are also exempt;
• there are other exemptions, including pension schemes;
• that an EU-wide passport will enable authorised AIFMs to operate across the EU;
• there will be far greater disclosure to regulators by AIFs – including of their borrowing;
• investor protection measures include a fund’s assets being kept safe in an independent depositary;
• after two years, third country funds will be able to be marketed in the EU provided the AIFs and their managers satisfy the requirements of the directive;
• a Member State will continue to be able to allow third country AIFs to market their products in that Member State under national regulations for five years from when the directive comes into force but it is intended to adopt a harmonised system for third country AIFMs at that point;
• the directive will come into force in 2013.

The most difficult issue to resolve was the position of third country AIFs operating in the EU.  The third country rules outlined above were a compromise and one that should protect the position of AIFs in London.  The longer-term position, however, will depend on agreeing a common regulatory framework for third country AIFs beyond 2018.  One of the arguments against the original proposals was that they would take the EU AIF market out of the global market.  The Commission argues that the regulatory approach taken by the final directive is compatible with that adopted by the US following the passage of the 2010 Dodd-Frank Act, thus avoiding the danger of regulatory conflict between the EU and the US.

The remuneration rules are designed to discourage fund managers from taking risks that are incompatible with the risk profile of the fund.  They reflect rules on remuneration adopted in other parts of the financial services sector since the banking crisis.

The muted response to the adoption of the final text of the directive shows that the major concerns with the initial proposals were addressed.  It remains to be seen whether the introduction of the “passport”, enabling an AIF to be registered in one Member State and operate through the EU without further approval, will in fact lead to a single market in this type of investment because of the differing tax rules operated by Member States.  Nonetheless, some AIFs may take advantage of this opportunity in the future.

The difficult passage of this directive demonstrates the importance of the Commission tabling sound proposals which, in particular, reflect the realities of the market place and of ensuring that proposed regulation will be proportional to the risk.  It also shows the capacity of the European Parliament to improve initially flawed Commission proposals.