Knitting together the EU quilt
Europe requires private placements. Iain Morse reports on how this can be achieved
Europe needs private placements. Certainly, UCITS III codifies the requirement for passportable, cross border investment funds that can be sold to the retail as well as to the institutional market. Previously long-only funds are now permitted to use derivative and future contracts but within a tightly controlled risk framework. "It creates a retail regime where managers can try to mimic or replicate some of the features of hedge funds," judges Robert Mellor, a partner at PricewaterhouseCoopers. Rapid growth in demand for access to absolute return strategies and alternative asset classes such as private equity, commodities and currency is meanwhile creating a real headache for regulators. These asset classes need to find their way into the distribution system for financial products while as much consumer protection is preserved as possible. Hence the private placement regime which has evolved with each new version of UCITS. The use of private placement is best seen in contrast to that of UCITS as a means of distribution; it covers the regulated parts that UCITS does not reach.
The current call for evidence by the Commission marks a round of industry consultation intended to further refine the private placement regime. To the extent that it exists in member state law and regulation, private placement has proved a very useful concept. This is the case with securities that are placed under rules and codes of practice based on the Prospectus Directive. But when it comes to the placement of investment funds, matters are far more complex; it is here reform is needed. "We need greater transparency and clarity," says Lorin Gresser, head of product strategy at Threadneedle Asset Management. The main barrier lies in the EU-wide lack of regulatory harmonisation. Only a few EU member states have a clear legal definition of private placement. This lack of consistency has created a patchwork quilt in which some countries have incomplete or ambiguous legislation and some ask for the prior registration or publication of a prospectus.
Despite some heroic resistance by national regulators it is becoming fairly easy to market UCITS across borders, but the same is not true of private placements. In practice, this means that many firms now have broad product ranges which include UCITS and non-UCITS. They need to take legal advice before selling non-UCITS products to intermediaries such as private banks, never mind to individual investors. This is so costly and cumbersome that the European Fund and Asset Managers Association estimates the average cost per firm for reviewing private placements at in excess of €400,000 per annum. In individual cases it can run much higher. The outcome is that many private placements are not advertised outside of their country of origin and restrictions are put on the range of permitted investors. Cross border investment certainly takes place, but in a semi-covert manner.
A glance at the varied treatment of private placement hedge funds across Europe helps make this point. In Belgium the minimum permitted investment is €250,000 unless they are sold to an institution acting on their own account. In France, a rather more complex set of rules exists. So called ARIA funds (those regulated by the Autorité des Marches Financiers, the French regulator) fall into three groups. The first may leverage up to 200% of net assets, with a low minimum investment of €10,000. But these are only open to investors with an aggregate net worth of €1m or more, and one year of relevant work experience. Investors without this work experience must invest at least €125,000. The second group are "leveraged funds" and follow identical rules but can leverage up to 400%.Thirdly, funds of alternative funds may leverage up to 200% and must be diversified across at least three sub-funds with a minimum €10,000 required investment.
In Germany, the Investment Act of 2004 introduced a new regime for single manager and funds of hedge funds and is designed to go places others do not. Much time and attention has also been given within it to the role of prime brokers. A non-domestic fund of funds can be registered with the federal agency for financial services supervision, BaFIN, but only as long as BaFIN considers that the home state regulation of the fund in question is effective and that the relevant regulator is prepared to co-operate with BaFIN. There is much more detail in the German regulations and reading them would surely take up a slow train journey from Berlin to Rome.
In Italy, no public marketing of hedge funds is permitted, a minimum investment of €500,000 is required and no more than 200 shareholders are permitted per fund. Given Luxembourg's role as a cross border financial centre its treatment of hedge funds also deserves scrutiny. A new law passed in February this year introduced Specialised Investment Funds (SIFs), ideal as vehicles for placements. The minimum investment is €125,000 but SIFs have the appeal of flexibility and can be set up before gaining regulatory approval. "This flexibility is what the market wants" thinks Gresser, "at the top end of the market investors are now very sophisticated."
The types of private placement investments most in demand, as mentioned, lie in absolute return strategies and alternative asset classes. Funds of hedge funds are an obvious example, likely to be focus when the Commission regulates. But there are very strong arguments for including single strategy hedge funds in "plain vanilla" strategies such as European equity long/short. Indeed some of these, particularly funds of funds, are already available via investment trusts listed on the London Stock Exchange. Private banks with high net worth clients are also permitted to distribute existing private placements via the issuance of notes linked to the underlying performance of the relevant placements.
This formula has been widely used in Germany to give institutional and retail investors exposure to hedge fund type products. On this model the bank buys the placement, then blends this into a risk adjusted portfolio of similar investments before distributing notes that replicate their price movement. Needless to say this is a potentially expensive arrangement, good for the banks, much less so for consumers. "New regulations should aim to open a less expensive route to the same underlying investments," thinks James Freeman, head of strategy at Key Asset Management.
Another key area for the new private placement regime lies in how it will define eligible counterparties or investors for such. At present it seems likely that the definition to be used will be that adumbrated in MiFID, Article 24(2). This defines eligible counterparties as investment firms, credit institutions, pension funds and insurance companies, all competent to perform due diligence on the relevant placements. It includes pretty much all other EU or nationally regulated investment firms, potentially extending the range to include a motley of privately owned banks, as well as private banks, family offices, financial advisers and sundry brokers. If adopted this would recognise the varied national regimes and practices for the giving of financial advice and distribution of investments to private investors.
However MiFID 24(2) extends much further to include persons and undertakings exempted under Article 2(1)(k) and (l), a catch all which includes such as "persons whose main business consists of dealing on their own account in derivatives". In some EU member states this status is easier to establish than in others.
So-called "professional investors" are also included in Annex 11 to MiFID Article 24(2). This defines a professional investor as a client who possesses the "experience, knowledge and expertise" to make its own investment decisions and properly assess the risks incurred. This becomes interesting when extended to include individual investors, who would otherwise be treated as requiring the protection of UCITS. Exemption from this depends on a number of possible criteria, which include the overall value of the assets owned by the investor, the minimum amount permitted as an investment into a private placement and the disclosure of relevant information concerning the investors understanding of risk.
At present, MiFID stipulates that at least two of the following conditions be met for any individual to be permitted to invest in a private placement. First, that they carry out an average of 10 transactions or more which are comparable to the private placement. Second it requires that the individual's financial portfolio is worth at least €500,000 or third that they have worked or work for at least one year in the financial services sector, which requires knowledge of the transactions or services envisaged.
There is certain to be lobbying for these conditions to be varied because they are hard to justify. Ignore the first. There is no a priori justification for the €500,000 limit. One possible alternative, already widely used in member states, is a minimum cash investment varying from €50,000-100,000 to $50,000-100,000.
Very oddly, quite a few hedge funds impose the same 100,000 cash minimum in UK pounds, although this is roughly equivalent at current exchange rates to $200,000. The work experience based restriction also seems unsatisfactory; a bank clerk might qualify while a professor of economics might not. Local regulators use voluntary self disclosure and this system needs to be extended to establish the required status.
"Surely we could have a low cost regime where investors are asked to self certify their competence," argues Freeman. Whether this simple solution is adopted remains to be seen. It will also be unpopular with the banks and distributors who want to retain their advisory and distributory role in this fast growing and lucrative market.