AIFMD and the Law of Unintended Consequences

 

The Alternative Investment Fund Managers Directive (“AIFMD” or the “Directive”) has been on nearly every fund manager’s mind for quite some time now. It is a very complicated piece of European legislation with a long name, but its genesis and goals are clear.1 AIFMD is a direct result of the notion that hedge funds and other alternative investment funds (“AIFs”) significantly contributed to the 2008 financial crisis via shorting and other trading strategies that created large and uncontrollable market movements. This notion, coupled with several high‐profile hedge fund blow‐ups (e.g., Bear Stearns) and frauds (e.g., Madoff), led to a push at the EU level to create an EU-wide regulatory regime for AIFs, culminating in the initial implementation of the Directive in July of this year.2 Objectives of AIFMD include (i) providing European regulators with the tools to monitor fund-specific as well as systemic risks, (ii) creating a level playing field in which virtually all alternative fund managers are subject to strict regulatory oversight, and (iii) establishing a true EU passport that allows managers to freely market AIFs in the EU.3 As with all regulation though, there will be unintended consequences. This Viewpoint discusses some potential effects of the Directive on investors – negative and positive – that were likely not envisioned by the European legislators.

Potential Adverse Effects

Managers Leaving the EU or Deciding Not to Enter

A number of articles in the press this year have warned that managers may want to stay clear of marketing in the EU  because of the increasing regulatory burden. This avoidance behavior was generally expressed by smaller managers without a presence in Europe and managers with only a small part of their AUM sourced from Europe, but it’s an important issue. If managers indeed act on this sentiment, there will be a smaller pool of non‐EU managers marketing their funds to EU investors (although reverse solicitation – investors reaching out to managers – will likely remain an option). With the majority of hedge fund managers and funds based outside the EU,4 that is not an encouraging prospect: less choice is inherently bad for investors. As many EU-based institutional investors like to allocate to smaller and emerging managers,5the majority of which are based in the US,6 this development may affect the construction of the alternatives portfolios of many European investors. And it could impact performance as well: as the chart to the right shows, hedge funds managed by US-based managers (which encompass $1.74 trillion, or 73% of global hedge funds assets under management7) have outperformed the global HF benchmark on a rolling 12-month, three-year and five-year annualized basis.8

Increased Barriers to Entry

Over the past decade, the costs and complexity of setting up an investment management company and accompanying funds have significantly increased due to (i) rising expectations from investors (largely due to the shift in the investor base from individuals to institutions) and (ii) additional regulatory requirements introduced in the major hedge fund centers.9AIFMD will add to this trend in no small measure for managers falling within its scope by introducing, among other things, regulatory reporting (similar to Form PF, for those of you familiar with the US markets), additional investor reporting (including increased transparency), remuneration rules, increased capital requirements, and the need to have a “depositary,” which effectively acts as a hybrid administrator/auditor/manager/guarantor. These items may provide some benefit to investors, and several of these may already be common in certain national jurisdictions, but not to the extent envisaged by the AIFMD. Thus, this suite of additional requirements will lead to higher barriers to entry for managers wanting to set up shop or market to investors in the EU.10 This, in turn, could lead to fewer European fund launches and possibly to the consolidation of existing EU managers, again decreasing choice for European investors.

Potential Positive Effects

Increased Allocations to Alternatives

Not all potential unintended implications of AIFMD are an increased burden on fund managers. With a comprehensive European regulatory regime in place for AIFs, it is quite possible that investors that were previously uncomfortable with allocating to alternatives managers will start allocating, or increase their allocation, to AIFMD-compliant funds. Already there are signs of institutional investors preparing to move their allocations into AIFs.

Shift in Allocations Between Certain Types of Alternative Investment Funds

Up until the introduction of AIFMD, the only European regime for alternative funds was UCITS, which became a way for  managers to access the European retail markets.11 Over time, however, UCITS funds evolved to attract a large number of institutional investors who like the fact that UCITS funds are regulated. With AIFMD coming into effect, a new regulatory regime for alternative funds has been created that, compared to UCITS, imposes far fewer restrictions on the types of assets hedge funds can invest in and the trading strategies they can follow.12 In addition, it appears that ESMA, the European Securities and Markets Authority, may want to create a clearer demarcation between UCITS funds, meant for retail investors, and AIFs, meant for professional investors. The combination of these developments may very well mean that asset allocators who previously (only) allocated to UCITS will move part (or all) of their assets into AIFMD-compliant funds.13 For managers operating both AIFs and UCITS funds this may not mean much, but it could be a boon for the majority of AIFMD-compliant hedge fund managers as there are only a small number of managers that operate UCITS funds.14

Conclusion

AIFMD is coming into effect in phases with final implementation scheduled for 2018. The Directive allows national regulators, at their discretion, to implement transitional periods during which their private placement regimes (“PPR”) remain available to managers. Most EU jurisdictions relevant to fund managers that have an existing PPR have established such transitional periods of one year or longer.15 In addition, the regulators in a number of jurisdictions with existing PPRs that have not yet implemented the Directive have indicated that their PPRs will remain available at least until AIFMD is transposed into national law. Both developments mean that it may take a couple of years to actually see the impact of the various unintended side-effects, as managers have additional time to become fully AIFMD-compliant. However, European asset allocators would do well to keep these issues in mind when deciding on how to approach the potential changes that AIFMD brings along. Furthermore, AIFMD may provide a good sense of the direction in which fund regimes in other parts of the world are heading: it appears that APEC (Asia-Pacific Economic Cooperation) may model the Asia Region Funds Passport after AIFMD with a view to facilitating the easy cross-border offering of investment funds in the APEC region.

 

1 For a comprehensive overview of AIFMD and easy access to key documents, see the website of the Alternative Investment Management Association at http://www.aima.org/en/aifmd/index.cfm.

2 AIFMD applies to various types of non-UCITS alternative investment funds. Aside from hedge funds (and their managers), AIFMD regulates private equity, real estate, infrastructure and venture capital funds.

3 See the Executive Summary of the European Commission’s Proposal for a Directive on Alternative Investment Fund Managers, April 2009, available at http://ec.europa.eu/internal_market/investment/docs/alternative_investments/fund_managers_executive_summary_en.pdf.

4 Approximately 23% of the 5,000 hedge fund managers globally are based in the EU (source: Preqin Hedge Fund Analyst database, September 2013), and approximately 25% of hedge funds are incorporated in an EU jurisdiction (see HFR Global Hedge Fund Industry Report – Second Quarter 2013, July 2013, p. 36).

5 See Deutsche Bank’s Eleventh Annual Alternative Investment Survey, February 2013, p. 103.

6 The US is home to approximately 3,000 hedge fund managers running roughly 8,500 hedge funds, out of about 12,000 funds globally. See Preqin Special Report: US Hedge Fund Industry The Leading Player in Hedge Funds, September 2013, p. 2 and Preqin Quarterly Update: Hedge Funds, Q2 2013, July 2013 p. 5.

7 See Preqin Special Report: US Hedge Fund Industry The Leading Player in Hedge Funds, September 2013, p. 2.

8 Ibid., p. 4.

9 For example, in the US, the Dodd–Frank Act was signed into law in 2010, requiring virtually all managers based or doing business in the US to register with the SEC.  And Singapore changed its fund manager regime in 2012 to require most managers to obtain a Capital Markets Services License from MAS, the national securities regulator.

10 KPMG recently estimated the total cost for hedge funds in meeting AIFMD rules at around $6 billion. See Financial Times, Regulatory glut hampers fund market growth, June 23, 2013 (http://www.ft.com/intl/cms/s/0/1f3b7c7a-d8e2-11e2-a6cf-00144feab7de.html#axzz2fi78ATZ9).

11 The UCITS regime (“Undertakings for Collective Investment in Transferable Securities”) has been around since the mid-‘80s and quickly evolved into a way for retail investors to access alternatives.

12 Limitations imposed on UCITS funds include the amount of leverage they can take, the way they can take short positions, how far they can deviate from their investment objective, diversification obligations, gate size and no less than fortnightly liquidity.  This may work for certain long/short equity funds, but many hedge fund strategies can’t easily be shoehorned into a UCITS product.

13 UCITS funds have been particularly appealing to investors in France, Spain, Italy and Germany.  See: Preqin Special Report: UCITS Hedge Funds Growing in Prominence, June 2013, p. 3.

14 UCITS funds make up only about 7% of the hedge fund universe.  Ibid., p. 6.

15 As of the writing of this Viewpoint, the following countries have implemented AIFMD into national law: Austria, Cyprus, Czech Republic, Denmark, France, Germany, Gibraltar, Ireland, Latvia, Liechtenstein, Luxembourg, Malta, Netherlands, Slovak Republic, Sweden and the UK.

Max Rijkenberg, LLM is Legal Counsel in PAAMCO’s London office. As a member of the Legal & Investment Structuring Group, Max is responsible for the structuring and negotiation of investments with underlying managers, the oversight and design of PAAMCO-structured vehicles, and the ongoing monitoring and advice with respect to restructurings, compliance with applicable laws and regulations and other legal matters. Max also oversees compliance for PAAMCO’s London office. Prior to joining PAAMCO, Max was an associate in the investment funds group of Akin Gump in New York. Max graduated from the University of Amsterdam with JD-equivalent degrees in Dutch Law and European & International Public Law, and received his LLM from New York University School of Law. Max also spent time at Columbia University Law School and at the École de Droit of the Sorbonne. He is admitted to the Bar in New York.

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