The Alternative Investment Management Association (AIMA) is the global hedge fund industry association representing, amongst others, the managers of more than 70% of the world’s hedge fund assets, and including fund of hedge funds managers, prime brokers, legal and accounting firms and fund administrators. On 27 July 2009, AIMA issued a warning that the European Commission’s draft directive on alternative investment fund managers would be damaging both to fund managers and investors globally, if enacted into European law. This warning also marked the first time that AIMA, which has 1,100 corporate members in 40 countries, has felt the need to coordinate a global press release. Why is AIMA so concerned?
While the image of hedge funds as a service industry for the world’s yacht-dwelling rich may linger in the minds of tabloid journalists, the reality is more prosaic. The factory worker’s retirement fund is likely to include hedge fund investments. The underprivileged youth given the opportunity to study at an Ivy League university is being funded by the fruits of hedge fund investment. Ordinary families saving a few hundred dollars a month into an insurance savings scheme will have hedge funds contributing to their nest eggs. Hedge funds have become core building blocks in the business of safeguarding and growing the world’s capital.
The attraction of alternative investment strategies to such a broad range of portfolio investors lies in its diversity. The myriad investment strategies represented by the portmanteau term “hedge funds”, in aggregate, add up to a unique opportunity set of different alphas, risk profiles, and diversification; whose flexibility is immensely useful to investors of all types globally. And here’s the rub. A professional investor sitting in, say Paris, wants to be able to access expertise not only in La Defense, but also in St James Place, Fifth Avenue, Club Street and Jardine House. That diversity is core to the hedge fund premise. Likewise to build a stable client base, the hedge fund manager sitting in Nihonbashi or Darling Harbour needs to be able to market her services to that investor in Paris, as well as to others around the world and across Europe from Amsterdam to Zug. This is, with no hyperbole, an utterly global industry that respects no geographic boundaries. The industry has structured itself by osmosis to deliver on that promise, with the overwhelming majority of products established in offshore jurisdictions so that they can be available and marketed equally to professional allocators in any jurisdiction.
The EU includes some of the most important centres of hedge fund excellence and investor demand, including France, Spain, the Netherlands and the UK. In addition, Switzerland, a major nexus of private wealth management, is increasingly aligned with EU financial policies and protocols.
However, the recent draft EU directive creates potentially insurmountable difficulties for non-EU domiciled funds and non-EU established managers in accessing the EU market. Managers will only be allowed to market their funds with a special marketing passport that the directive creates. But that passport will not be available for three years, and in any case will require managers to jump through some formidable, and possibly impassable, hoops.
Some of the specific provisions are as follows. First, the manager must be in a jurisdiction in order for the EU judges to have a comparable level of regulation and supervision to that of the EU – a requirement that is ambiguous and clearly beyond the control of the manager. Secondly, there must be reciprocal access for EU managers to market into the manager’s own jurisdiction; while this is at first glance fair, it is not only again outside the manager’s control, but also hints at the “protect our companies” agenda of the directive. Thirdly, there must be a bilateral agreement between the regulatory agencies in the EU country and the manager’s home country to exchange information – yet again, beyond the manager’s control. There is an uncontentious requirement to disclose the major owners of a manager wishing to market into the EU. Finally, though there is a requirement that there should be a bilateral tax disclosure agreement between the EU member state and the manager’s home country – given that most countries’ revenue services have little, if anything, to do with their financial regulatory agencies – this is likely to be a deal-breaker in a number of jurisdictions and is clearly unreasonable.
Finally, although the EU appears to be in an unholy rush to finalise the directive (by the end of this calendar year), no “passports” will be granted for three years. The draft directive allows EU managers to continue to market under private placement rules, but is silent on the treatment of non-EU managers. This potentially imposes a massive handicap on non-EU managers.
While larger managers may be able to pay for the restructuring potentially needed to comply with the directive, multi-billion dollar managers are a small, albeit visible, part of the alternative investment management ecosystem. The majority of the industry’s expertise and skill set sits within the thousands of small boutiques that exist because of their investment excellence and nothing else. These may not have the financial or management resource to deal with the requirements of the directive, which may therefore exclude the backbone of the industry.
The directive would make it so difficult and costly for non-EU funds and managers to access the EU market that it is clearly protectionist in effect, if not in intent. Managers (particularly in North America, South Africa and the Asia Pacific) are likely to face a major loss of business from the EU, while investors will face loss of choice, increased costs and diminished returns.
More importantly for the ordinary person in the EU, this will have a massive impact on how effectively and efficiently their savings can be managed. EU investors are likely to face a situation where they can use only EU-domiciled funds, using an EU-based custodian and managed by EU-based asset managers – a tiny sub-set of the current opportunity set. The resulting necessity to have separate structures for EU investors will destroy economies of scale and add compliance costs, thus driving up expense ratios and depressing returns to investors.
AIMA believes that the provisions of this protectionist draft directive will not only damage an industry that is at the cutting edge of the financial world, but also hurt ordinary savers, investors and all beneficiaries of institutional pools of capital globally. It will, incidentally, weaken the competitiveness of the EU in investment management and make the EU a less attractive destination for international investment. AIMA’s objective is to raise awareness of this issue with some urgency, and rally a coordinated and rational response in defence of the industry.
To that end, AIMA has drafted a detailed guidance note on the potential effects of the draft directive. Please contact Peter Douglas at firstname.lastname@example.org if you would like to receive a copy.