It will be a sobering start to a job. As George Osborne settles into his magisterial office overlooking St James’s Park this week, among the items at the top of the new UK chancellor of the exchequer’s in-tray will be one that gave his predecessor a major headache: the delightfully titled Directive on Alternative Investment Fund Managers.
After more than a year of wrangling, the European Union’s first effort to regulate hedge funds and private equity is reaching a critical phase. On Monday, a powerful committee of the European parliament will take the first vote on the proposals. The matter will also be top of the agenda at Mr Osborne’s maiden appearance at the monthly Ecofin meeting of EU finance ministers the next day, despite British attempts to postpone it.
It has not been an easy journey. Since the AIFM directive was mooted, it has drawn criticism from those in targeted industries – not only hedge funds and private equity funds but also investment trusts and funds that invest in venture capital, property and commodities. Many pension funds and institutional investors, though not directly covered by the legislation, are worried, too. They all say the legislation will drive up costs, reduce investor choice and burden corporates that have private equity investors with unfair regulation.
Tim Geithner, US Treasury secretary, in March warned bluntly that the legislation could cause a transatlantic rift, raising concerns that it “would discriminate against US firms and deny them the access to the EU market that they currently have”.
His words were echoed on Thursday in a letter to the European parliament from the Investment Management Association, the National Association of Pension Funds in the UK and the Alternative Investment Management Association, which warned: “There is a real risk that it would provoke retaliatory action in non-EU jurisdictions, which would damage the European financial services industry and the whole European economy.”
But Jean-Paul Gauzès, the French MEP steering the directive through the parliament, is dismissive of most concerns. “It is like criminal law, if you respect the law you have nothing to worry about, only if you are a hoodlum should you worry.”
Politicians in some EU states argue the legislation is too tame and does not do enough to rein in funds they believe prey on companies and could be the source of the next financial crisis. There is also a mandate from the Group of 20 leading nations to bring in rules to cover all players in the financial market.
At its core, the directive seeks to impose standards and regulatory oversight on a large swath of the shadow banking system that had largely gone unsupervised. There are several competing drafts but all require funds to seek government authorisation, hold adequate capital and make disclosures to regulators and their investors. Many of the proposals are relatively basic and already required by the UK.
But it has more contentious parts, including limits on fund borrowing, tougher standards for how and where fund assets are held, and – most controversially – new rules for how “third country” funds and managers based outside the EU can reach investors inside the bloc. Some versions also set rules for manager pay and require companies with fund investors to disclose their financial performance and strategy.
The language is technical and many of the concepts arcane and ill-suited to the parliamentary process, critics say. But the resulting legislation will likely set the boundaries for professional investors for years to come.
While aimed at London hedge fund and private equity managers, it has drawn squawks from a wider range of critics, who say it affects pension funds and endowments, too, potentially cutting investment choice and shrinking returns for ordinary investors and charities.
Lord Rothschild, chairman of RIT Capital Partners, one of the UK’s oldest investment trusts, wrote last month in the Financial Times: “The snag …is that the draft AIFM directive has cast its regulatory net so wide that it captures other investment vehicles, in Germany, the UK and elsewhere.”
The parliamentary draft envisages the notion of proportionality, giving national governments discretion over how to implement parts of the regulation.
Jarkko Syyrila of the UK’s IMA, says: “Anyone who has savings, anyone who has invested in a fund, an in- vestment trust, a real-estate fund, everyone who has a pension in Europe – a Greek or German pension fund – will be negatively impacted by this directive. It will drive up the costs of investing and drive down returns.”
In their letter, the IMA, the NAPF and AIMA warned the proposals were “unworkable”, and appealed to the European parliament to support a “pragmatic and workable solution”.
The directive would also add reporting requirements to many medium-size companies that happen to have private equity or venture capital investors.
Pierre Kosciusko-Morizet, of Price Minister, a French internet retailer backed by venture capital groups, says the directive would handicap start-ups as it would require them to disclose their financial performance, capital structure, research spending and strategy. They want “time below the radar” to get going, away from the attention of competitors. “You are paranoid about confidentiality, and with some justification,” he says.
The cost to a company of the extra reporting has been estimated at £30,000 ($43,880) a year by the British Private Equity and Venture Capital Association. Mr Kosciusko-Morizet says the new rules would also put start-ups such as his at a disadvantage against multinational competitors, which would not have to disclose as much detail about their French operations. The result would be the slowing of growth as start-ups delayed raising venture capital money to avoid the rules. “It just doesn’t make any sense, as VCs are not hedge funds, but they are being treated the same.”
Planned exemption for companies with fewer than 50 staff may also prove ineffective. “We reached 50 people in our first year, so the threshold should definitely be higher,” he says.
Rules requiring venture capital firms to hold minimum levels of regulatory capital and hire a bank to safeguard assets, while designed to protect investors, could make it harder to start new funds, he fears. “We already lack VC funding in a place like France,” he says.
The directive arises from long-standing concerns raised by the European parliament’s Socialists, and other critics of hedge funds and private equity. They say they are trying to crack down on trading that destabilises the financial system and on buy-out funds that load companies with debt. “We want to avoid activities that are purely speculative and have no economic or social benefit,” says Mr Gauzès, the sponsor. “I know that most of private equity and hedge funds are perfectly respectable, but there have been some problems, such as in Germany where companies were bought and broken up, which have been very traumatic,” he says.
Historically, while the UK has welcomed, and regulated, alternative investment managers, other countries have not. That did not stop their citizens and institutions from investing in alternative funds based elsewhere, nor halt the spread of private equity-financed buy-outs of EU companies.
The financial crisis exposed the cracks in this arrangement – French and Spanish citizens lost billions of euros through hedge funds that channelled money to disgraced US financier Bernard Madoff – and galvanised critics. By January 2009, José Manuel Barroso, Commission president, was promising more immediate action.
In Brussels, officials scrambled to draw up coherent rules to cover a diverse, complex group of market players – without the usual extensive preparatory work, from industry consultations to impact assessments. Today, it is widely accepted the drafting was flawed. “I agree the Commission’s original text was far from perfect,” conceded Michel Barnier, internal market commissioner, a few weeks ago.
A bad situation was made worse, in the eyes of the industry, by problems in the UK. The collapse of several British banks undercut London’s claim to leadership in financial services; the Labour government was initially distracted; and the Conservative party, then in opposition, lacked influence in Brussels since withdrawing from the main centre-right coalition.
Alternative drafts from the Swedish and Spanish EU presidencies fixed some sticking points but introduced wrinkles that have also drawn opposition, including rules on manager pay.
So far, no draft has solved what many investors, and US officials, see as its central problem, the “third country” rules blocking funds based outside the EU from raising money from investors inside the bloc.
Mr Gauzès says under the latest version, any hedge fund or private equity group will be able to gain an EU “passport” if it complies with new rules and its home country abides by global standards on, for example, tax and data sharing. “The Americans can easily come into Europe, they just have to join the club,” he says. “Some speculators will be eliminated from the game, that is my goal, but the rest will carry on as usual.”
Investor and industry groups do not agree. Danny Truell, chief investment officer of the Wellcome Trust, a UK charity that finances medical research, says more than £5bn of its £14bn portfolio is invested principally in private equity, venture capital and hedge funds outside the EU. If these investments were blocked by law, its performance would suffer, he says, and the charity would have less to invest in medical research.
Critics say funds that invest in emerging markets would find it hardest to comply, making it harder for EU investors to back fund managers in fast-growing nations. “Africa is hugely reliant on capital from Europe,” says Cora Fernandez of Sanlam Private Equity, a South African fund. Those “who can least afford it are bearing the brunt of the cost of this directive”.
No matter how next week’s votes turns out, the AIFM debate offers crucial lessons for both politicians and the financial services industry they are seeking to tame.
The first is the danger of starting out with ill-prepared draft legislation. Brussels seems to have taken that on board; consultations over planned rules for the derivatives markets, another potentially contentious area, have been extremely extensive.
The second is the power of lobbying. The episode has shown how effective well funded and well co-ordinated campaigning can be. Private equity has already secured several important exemptions, and more lobbying is expected when parliament and the Council of Ministers merge their versions of the text later this year.
But the ferocity of the industry’s efforts have left an unpleasant taste in Brussels, where the campaign is being scrutinised by transparency advocates. Parliamentarians seem almost winded by the experience: “Normally, there are different interests involved,” says Mr Gauzès. “Here it was in one direction only.”
Above all, the debate has underlined how crucial Brussels has become to the financial services sector as regulators try to reassert their grip and find a balance between two different visions of the financial system – a markets-based, Anglo-American model, and a more regulated, bank-focused approach familiar in Continental Europe.
“It’s pretty unfortunate the way things have turned out. Influencing Brussels has become increasingly important,” says one senior UK regulator. But he expresses optimism that future tussles may be less wearing: “This was a reflection of a very extreme set of circumstances.”
Additional reporting Kate Burgess
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