EUROPE - Most hedge fund and private equity managers are unlikely to benefit from the passport provisions of the European Commission's Draft Directive on Alternative Investment Fund Managers (AIFM) before 2014, even though they will have to meet its requirements as soon as it becomes law.
The majority of hedge and private equity funds are domiciled in offshore centres such as the Cayman Islands or Bermuda, and these "third-country" funds will only enjoy the marketing rights conferred by the Directive three years after the directive comes into force.
Meanwhile, if their managers come under the scope of the Directive (which covers all managers of non-UCITS handling EUR100m or more, or EUR500m or more if they are un-leveraged, estimated to be 30% of all hedge fund managers), they will have to be authorised by and provide detailed information for their local finance regulator, as well as meeting minimum capital-adequacy requirements, which is at least EUR125,000, and, where portfolio value exceeds EUR250m, an additional 0.02% of the excess.
Kinetic Partners, a hedge fund regulatory consultancy, estimates the cost of compliance to the UK hedge fund industry to be £2-3bn in the first year and "several hundred million pounds annually thereafter".
"We can't help but be skeptical," said Julian Young, lead partner for the Ernst & Young European hedge funds practice.
"The proposed benefits of unencumbered cross-border marketing of funds is not sufficient to outweigh the burden of compliance, particularly when viewed in the context of the practical issues of cross-border marketing of UCITS funds."
Ben Blackett-Ord, CEO of UK-based financial services regulatory consultancy Bovill, also said: "The passport provisions potentially represent real progress. But it is not immediate."
The Directive proposes only funds domiciled in Europe will be eligible to be marketed across the EU by EU-authorised AIFM.
It "recognises that the management of offshore funds is an important feature of the hedge fund and private equity business models" and will provide a passport for third-country funds which "comply with stringent requirements on regulation, supervision and cooperation, including on tax matters", but sets aside a three-year period for the "necessary preparation and groundwork to make this a success".
"Whatever the type of fund, if it is located outside Europe it will not have the right to be marketed across Europe before the expiry of three years," said a senior official at the Commission involved in drafting the proposal.
"But there is a ‘stand-still' period during those three years allowing those Member States that already accept the marketing of third-country funds in their territory to continue to do so."
Even if the draft Directive gets approval from the European Parliament and European Council by the end of this year, the Commission does not think it will come into force before 2011 - which means offshore hedge funds and private equity funds would not benefit from the EU passport until at least 2014. Furthermore, it is not clear that a fund-of-funds, even if it is domiciled in the EU, can be marketed across the EU if its underlying investments include third-country funds or funds managed by non-EU authorised AIFMs.
"A fund-of-funds will be able to market across Europe only if it is investing in underlying funds whose marketing is also allowed in Europe," the official at the Commission confirmed.
A non-EU manager can opt-in under Article 39 of the draft Directive, subject to some conditions of equivalence, but according to Young "non-EU AIFMs face considerable challenges to conducting business within the European Community".
Representatives of the European pensions industry, including APG, the Shell Pension Fund and Spain's Inverco, had warned of the inefficacy of a non-global approach to hedge fund regulation in earlier consultations, as well as downplaying the systemic risk presented by AIFMs and emphasising the quality of their risk management provisions.
Roderick Munsters, current chief investment officer of APG, pointed out, for example, that more than half its hedge fund portfolio has little or no leverage.
"Apart from providing liquidity to financial markets, hedge funds also enhance diversification possibilities of institutional investors," said the European Federation for Retirement Provision (EFRP). "These advantages should in the opinion of EFRP not be put into jeopardy by over-regulation of the hedge fund industry."
The proposal has been met with anger from the alternative investment industry, with hedge fund managers complaining it overstates their systemic risks and private equity managers taking exception to the impracticality of requirements for independent valuations and to being grouped with hedge funds, because they present no systemic risk at all.
Responding to criticism, an official at the Commission said: "Systemically-relevant entities are indeed a big part of what we are trying to achieve with this Directive, but there are other risks that we want to tackle, as well: issues such as transparency into the activities of private equity businesses and investor-protection.
"But we also felt that it would be too difficult to define a hedge fund, because they have such diverse investment policies, and that any attempt to do so would make it too easy to circumvent the regulations. And we have tried to incorporate some differentiation into how the rules are applied to AIFMs using leverage or those with controlling interests in companies, for example," he continued.
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