The latest twist in the ever popular AIFMD story is that the EU Commission recently released draft regulation implementing the Directive 2011/61/EU on Alternative Investment Fund Managers (AIFMD) which diverges significantly from the technical advice provided to the Commission by The European Securities and Markets Authority (ESMA).
I don’t want to get too hung up on the detail, as I want to save some of my space for some comment, but it’s worth a brief pause to recap on how we got to this point in the story. In April 2009, the European Commission proposed a Directive on Alternative Investment Fund Managers (AIFMs) with the objective of creating a comprehensive and effective regulatory and supervisory framework for AIFMs at the European level. The proposed Directive was aimed at providing harmonised regulatory standards for all AIFMs within scope. The final agreement on the framework Directive (Level I) was achieved in November 2010 and the text entered into force on 21 July 2011.
ESMA was requested by the Commission to provide technical advice on the implementing measures of the AIFMD (Level 2). ESMA’s final advice was submitted to the Commission on 16 November 2011 and the Commission was expected, by most, to adopt implementing measures based on ESMA's advice in the course of 2012.
It is clear that the significant divergences referred to in the opening paragraph are not the result of tweaking the ESMA recommendations into legal language in order to provide greater legal clarity or certainty. The latest twist in the tale introduces new policies which have not been recommended by ESMA, leaves out ESMA’s advice completely or changes the parameters which ESMA put forward following extensive consultation with industry experts, market participants and industry trade organisations.
Perhaps this latest development shouldn’t come as a complete surprise. AIFMD has been controversial from the start and was widely seen as a rushed, fundamentally flawed knee jerk political response. The AIFMD has been subject to constant political interference and lobbying and there remains uncertainty as to what the final legislation will look like and what the impact will be. Small wonder then that closure rates of AIFMs in the EU remain high, and start ups are subdued, whilst new firms open at record rates in Hong Kong and Brazil.
I think this is just one of the unintended consequences of this legislation; the high level objectives of the directive are fully supported by the industry – investor protection, higher standards of governance, improved transparency / reporting and liquidity requirements aimed at reducing systemic risk. Has the Commission really achieved any of this by the AIFMD, however?
Let’s consider investor protection. Most investors in alternatives are sophisticated investors. Do they need protection forced on them to a similar extent that retail investors need protecting? I’d argue not. If you don’t know what you are buying, how it fits within your existing portfolio, what your exit plan is and how to risk manage it then simply do not invest. The AIFMD could become the emperor’s new clothes - it creates the perception of protection for those who should know better.
What about reducing systemic risk? Most recent research into the liquidity crisis has concluded that AIFMs were a positive factor providing liquidity to the market when no one else would or could. The threat is that the cost implications of AIFMD compliance will result in less small, niche AIFMs, which could reduce investor choice – with less choice one could argue that the investor is less able to diversify its portfolio which arguably increases systemic risk.
Surely increased transparency and requirements re independent valuations is a must have? Well yes, but as above with investor protection, does the sophisticated investor need this to be dictated to them through regulation? Most AIFM’s are desperate for assets so if you are investing significant sums you should have a relationship with the manager and should be able to negotiate reporting that suits your own risk management and reporting needs. I’d also expect that you understand the valuation procedures applied by the fund and can satisfy yourself that these are relevant and appropriate. Relevance is an issue in implementing the AIFMD requirements - are the same rules really appropriate for a private equity or real estate fund as for a long short equity fund? Clearly not, but such funds will have to incur huge costs nonetheless which will no doubt be passed onto the investor in many cases.
It’s interesting that a recent survey of French experts was very pro AIFMD and concluded that it will boost investor confidence in hedge funds and pave the way for potentially significant asset growth. I have to disagree – capital raising and investing opportunities are fewer in Europe than in many other jurisdictions and I just can’t see how, in its current form, the AIFMD can be good for Europe, the alternative industry or its investors.