Reforming Financial Markets I: Hedge Funds
Standard Note:
SN/BT/5588
Last updated:
21 January 2015
Author:
Timothy Edmonds
Section
Business & Transport Section
This is one of a series of notes which looks at actual or proposed reforms of either certain
parts of the financial services sector or reforms of certain activities.
The entire sector has received worldwide attention from regulators, governments, consumer
and intra-industry and professional groups following the financial crisis which began in 2007.
Whilst the financial ‘rescue and recovery’ phase of the crisis is (mainly) past, the legislative
response in many areas is now coming to a head. Regulatory and supervisory proposals
have been discussed at various national and international fora and new legislation is
proposed in many areas.
These notes attempt to describe the progress made on individual issues through these
phases. This note focuses upon the regulation of hedge funds by the Alternative Investment
Fund Managers directive.
This information is provided to Members of Parliament in support of their parliamentary duties
and is not intended to address the specific circumstances of any particular individual. It should
not be relied upon as being up to date; the law or policies may have changed since it was last
updated; and it should not be relied upon as legal or professional advice or as a substitute for
it. A suitably qualified professional should be consulted if specific advice or information is
required.
This information is provided subject to our general terms and conditions which are available
online or may be provided on request in hard copy. Authors are available to discuss the
content of this briefing with Members and their staff, but not with the general public.
Contents
1
What is a hedge fund?
3
2
The Directive
7
2
1
What is a hedge fund?
There are many definitions of what a hedge fund is. This one is taken from Investopedia
(part of a financial website). According to this a hedge fund is:
An aggressively managed portfolio of investments that uses advanced investment
strategies such as leveraged, long, short and derivative positions in both domestic and
international markets with the goal of generating high returns (either in an absolute
sense or over a specified market benchmark). Legally, hedge funds are most often set
up as private investment partnerships that are open to a limited number of investors
and require a very large initial minimum investment. Investments in hedge funds
are illiquid as they often require investors keep their money in the fund for at least one
year.
For the most part, hedge funds (unlike mutual funds) are unregulated because they
cater to sophisticated investors. In the U.S., laws require that the majority of investors
in the fund be accredited. That is, they must earn a minimum amount of
money annually and have a net worth of more than $1 million, along with a significant
amount of investment knowledge. You can think of hedge funds as mutual funds for
the super rich. They are similar to mutual funds in that investments are pooled and
professionally managed, but differ in that the fund has far more flexibility in its
investment strategies.
It is important to note that hedging is actually the practice of attempting to reduce risk,
but the goal of most hedge funds is to maximize return on investment. The name is
mostly historical, as the first hedge funds tried to hedge against the downside risk of a
bear market by shorting the market (mutual funds generally can't enter into short
positions as one of their primary goals). Nowadays, hedge funds use dozens of
different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact,
because hedge fund managers make speculative investments, these funds can carry
more risk than the overall market1
From the same source comes a definition of private equity – the other main sector covered
by the directive:
Private equity consists of investors and funds that make investments directly into
private companies or conduct buyouts of public companies that result in a delisting of
public equity. Capital for private equity is raised from retail and institutional investors,
and can be used to fund new technologies, expand working capital within an owned
company, make acquisitions, or to strengthen a balance sheet.
The majority of private equity consists of institutional investors and accredited investors
who can commit large sums of money for long periods of time. Private equity
investments often demand long holding periods to allow for a turnaround of a
distressed company or a liquidity event such as an IPO or sale to a public company.
The size of the private equity market has grown steadily since the 1970s. Private
equity firms will sometimes pool funds together to take very large public companies
private. Many private equity firms conduct what are known as leveraged buyouts
(LBOs), where large amounts of debt are issued to fund a large purchase. Private
equity firms will then try to improve the financial results and prospects of the company
1
Investopedia website at Investopedia.com Headlines
3
in the hope of reselling the company to another firm or cashing out via an IPO [stock
exchange flotation].2
A review of the Hedge Fund industry is produced annually by the pro-financial services
research group TheCityUK. Their summary of the state of the hedge fund industry as at the
end of 2012 can be seen in the latest edition of their review published in May 2013.
Assets under management of the global hedge funds industry totalled over $2,050bn
at the end of 2012 (Chart 1). The 6% increase during the year was driven by
performance gains and follows a slight 1% reduction in the previous year. Industry
assets are close to the 2007 peak and have risen more than three-fold over the past
decade. Funds under management increased by a further $75bn in the first quarter of
2013 due both to positive returns and a net inflow of funds. Additional growth in 2013
will largely be dependent on the recovery in global financial markets.
The small net asset outflow seen during 2012 was more than offset by a 6.1%
performance return. This was only slightly below the average annual hedge fund return
of 6.2% seen over the past decade. Assets of fund of funds totalled $500bn, or around
quarter of global hedge fund assets under management. This was down 4% on the
previous year and more than 40% below the peak from 2007.
The number of hedge funds totalled 10,100, with new hedge funds launches outpacing
fund liquidations for the third successive year. Strong growth of UCITS-compliant
hedge funds has supplemented the fund population in Europe. The UK is the dominant
centre in this area and is the management location for nearly three quarters of UCITScompliant hedge funds’ assets.
Location of management The US is the largest centre for hedge funds, managing
close to 70% of global assets at the end of 2012, down from 83% a decade earlier.
Europe followed with 21% and Asia with most of the remainder. TheCityUK estimates
that around 42% of global hedge fund assets were managed from New York, down
from over a half a decade earlier. London’s 18% share in 2012 was slightly down on
the previous year, but nearly double its share ten years earlier. The breakdown of fund
of hedge funds by manager location shows that a quarter of global fund of funds’
assets were managed from the UK.
London remains by far the largest centre for hedge funds in Europe. Around 600 funds
located in the UK managed some 85% of European based hedge funds’ assets. The
largest seven hedge funds in Europe were all headquartered in London in 2012.
London retains its structural advantages which make it an attractive location including
its local expertise, the proximity of clients and markets and a strong asset management
industry. London is also a leading centre for hedge fund services providers such as
administration, prime brokerage, custody and auditing. Accounting for around a half of
European investment banking activity, it is a natural location for prime brokerage
services. The UK hedge fund industry employs around 40,000 people. Around 10,000
of these are directly employed by hedge funds and the remainder among the industry’s
advisers and service providers.
Asia also has an important role in the global hedge fund industry, both as a location for
management of funds and as a source of global hedge funds’ assets. Important
centres for management of hedge funds in Asia include Hong Kong, Australia,
Singapore and Japan.3
2
3
Investopedia website
The CityUK, Hedge Funds, March 2013
4
This sector was identified as posing a risk to the overall stability of the financial system in the
EU commissioned de Larosiere Report4 and in the Turner Review for the Financial Services
Authority (FSA) in the UK.5 It had previously come under fire for its activities in ‘short selling’
and (along with private equity companies) investment in, and restructuring of, companies, the
remuneration of its executives and the lack of transparency in its actions. As the financial
crisis worsened, the funds experienced dramatic withdrawals by investors (£22 billion was
withdrawn in November 2007 from US funds) such that many refused to allow further
investor redemptions. The argument that hedge funds provided liquidity to a market
appeared short of the truth at times.
Responding to criticism, in January 2008, under the Chairmanship of Sir Andrew Large, the
industry produced a set of standards covering themes such as:
 Disclosure
 Valuation
 Risk Management
 Fund Governance
 Shareholder Conduct
The Hedge Fund Standards Board (hfSB) oversees the code.6 Members (just over 120 funds
are signed up to the code) are required to follow the guidelines on a ‘comply or explain’
basis. The Standards can be found here.
Looking specifically at hedge funds, the Turner Review pointed out that although it regulates
UK-registered asset managers, hedge funds themselves are usually domiciled abroad and
thus are not subject to either capital or liquidity requirements. It cautioned that
…hedge fund activity in aggregate can have an important procyclical systemic impact.
The simultaneous attempt by many hedge funds to deleverage and meet investor
redemptions may well have played an important role over the last six months in
depressing securities prices in a self-fulfilling cycle. And it is possible that hedge funds
could evolve in future years, in their scale, their leverage, and their customer promises,
in a way which made them more bank-like and more systemically important.7
Accordingly, the Review argued that the appropriate approach to hedge funds would entail:
• Regulators and central banks in the performance of the macro-prudential analysis
role (Section 2.6 below) need to gather much more extensive information on hedge
fund activities (or on the activities of any other newly evolving form of investment
intermediation) and need to consider the implications of this information for overall
macro-prudential risks.
• And regulators need the power to apply appropriate prudential regulation (e.g. capital
and liquidity rules) to hedge funds or any other category of investment intermediary, (or
4
5
6
7
High Level Group on Financial Supervision in the EU (the Larosiere Report), February 2009, p25
FSA, Turner Review: A regulatory response to the global banking crisis, 18 March 2009
An overview of the hfSB Code can be found here.
FSA Turner Review, p72
5
to otherwise restrict their impact on the regulated community), if at any time they judge
that the activities have become bank-like in nature or systemic in importance.8
While the Commission did not ‘blame’ the sector for the financial crisis they remained
concerned about aspects of their activities:
While AIFM were not the cause of the crisis, recent events have placed severe stress
on the sector. The risks associated with their activities have manifested themselves
throughout the AIFM industry over recent months and may in some cases have
contributed to market turbulence. For example, hedge funds have contributed to asset
price inflation and the rapid growth of structured credit markets. The abrupt unwinding
of large, leveraged positions in response to tightening credit conditions and investor
redemption requests has had a procyclical impact on declining markets and may have
impaired market liquidity.
Funds of hedge funds have faced serious liquidity problems: they could not liquidate
assets quickly enough to meet investor demands to withdraw cash, leading some
funds of hedge funds to suspend or otherwise limit redemptions. Commodity funds
were implicated in the commodity price bubbles that developed in late 2007.
On the other hand, private equity funds, due to their investment strategies and a
different use of leverage than hedge funds, did not contribute to increase macroprudential risks. They have experienced challenges relating to the availability of credit
and the financial health of their portfolio companies. The inability to obtain leverage
has significantly reduced buy-out activity and a number of portfolio companies
previously subject to leveraged buy-outs are reported to be faced with difficulties in
finding replacement finance.9
8
9
Ibid., p73
Alternative Investment Managers directive EC Com 2009 (207)’ p3
6
The Commission identified the following specific risks:10
Risk
Source of risk
Macro-prudential
sytemic risks
Direct exposure of systemically important banks to the AIFM sector
Pro-cyclical impact of herding and risk concentrations in particular market
segments and deleveraging on the liquidity and stability of financial
markets
Micro-prudential
Weakness in internal risk management systems with respect to market
risks
risk, counterparty risks, funding liquidity risks and operational risks
Investor protection Inadequate investor disclosures on investment policy, risk management,
internal processes
Conflicts of interest and failures in fund governance, in particular with
respect to remuneration, valuation and administration
Market efficiency Impact of dynamic trading and short selling techniques on market
and integrity
functioning
Potential for market abuse in connection with certain techniques, for
example short-selling
Impact on market Lack of transparency when building stakes in listed companies (e.g.
for corporate
through use of stock borrowing, contracts for difference), or concerted
control
action in 'activist' strategies
Impact on
Potential for misalignment of incentives in management of portfolio
companies
companies, in particular in relation to the use of debt financing
controlled by AIFM Lack of transparency and public scrutiny of companies subject to buy-outs
Source: EU Commission
2
The Directive
2.1
Introduction
The EU Commission produced a draft directive on the regulation of hedge funds, - the
Alternative Investment Fund Managers (AIFM) Directive in April 2009.11 The directive would
apply to hedge funds and private equity funds, as well as real estate funds, commodity funds,
infrastructure funds and other types of institutional fund. The directive has been subject to
intense scrutiny and lobbying particularly by the industry with the support of both the previous
and current UK governments. Some of the debate has had nationalistic tones; since 80% of
the industry affected is based in London, the proposals would affect the City more
extensively than the rest of the EU. The broad elements of the directive were summarised in
an EU press release of April 2009.12
The initial text of the directive was heavily criticised, and the Internal Affairs Commissioner
later acknowledged that ‘the original text was far from perfect’.13 However, there has been
strong support for the directive from some countries, for example France and Spain, who
10
11
12
13
Alternative Investment Managers directive EC Com 2009 (207)’ p3
Alternative Investment Managers directive EC Com 2009 (207)
Europa press release 29 April 2009
See Alternative Visions, Financial Times 14 May 2010
7
both had citizens with substantial investments in Madoff owned investment funds, and in
Germany, where established manufacturing companies were bought and the ‘restructured’
by hedge fund and venture capital funds.
Following the lobbying campaign, supported by the UK government, substantial changes
were made to the directive.
The main areas of contention remaining were:
 Restricting the scope of the directive to active AIFM firms
 Clarification of application of the directive where the fund has no responsibility for
aspects of the work
 Optional exemption from the directive where the funds in any one fund is below €100
million and all funds collectively are less than €500 million
 Allow Member States to apply stricter rules to overseas funds operating in their
country than domestic ones
 Reductions in capital requirements for non-leveraged funds
 Obligations surrounding the safe keeping of client monies
 Remuneration policies required to reduce risk taking consistent with similar proposals
to banks
 Information on fund leverage gathered by domestic regulators should be shared with
other Member States
The Association of Investment Fund Managers (AIFM) have produced an internal document
outlining their remaining concerns.14 These include:
 Overly restrictive and ‘onerous’ rules regarding depositaries
 “Unprecedented level of interference in the ability of managers to outsource activities”
 Leverage controls are disproportionate to the risk posed by hedge funds and, as
worded, “make very little sense technically”
 Third party controls are impossible to enforce in the European Parliament text of the
directive. Third party countries have access to the EU without meeting the whole of
the directive’s conditions.
 Remuneration rules have been copied over from banking guidance and are not
applicable to fund management
 Short selling – “it seems like the hedge fund industry could be the only one affected by
various restrictions and bans on short selling”
The directive, was also examined by the House of Lords, European Union Committee.15 It
published its Report in February 2010. Its summary and conclusions are shown below:
8
204. We concur with the conclusions of the Turner Review and the de Larosière group
that AIFs did not cause the recent financial crisis. However, we note the aggregate
activity of hedge funds could increase market instability (para 64).
Key aspects of the AIFM Directive
205. We welcome EU regulation of Alternative Investment Fund Managers. We support
the principle of harmonising regulation of AIFMs across the EU on the basis that a
robust legal framework at EU level can strengthen the single market and benefit
investors. AIFMs we spoke to recognised that some regulation would increase their
integrity and public perception of the worth of their activities. We welcome also the
elements of the Directive that provide for coherent oversight of AIFMs across the EU
by requiring the registration of, and the collection of appropriate data from, managers,
in line with the conclusions of the G20 (para 71).
206. We urge the Government to negotiate a solution that will avoid penalising smaller
entities without encouraging managers to attempt to avoid the Directive through
threshold manipulation. Thresholds that reflect the differences of the private equity and
venture capital industries should also be identified (para 80).
207. A one size fits all approach will not work. We recommend that the Government
seek to tailor the Directive in a way that respects the differences between the types of
funds it covers. A possible solution could be to establish broad principles in the
Directive (para 91).
208. We agree that it is appropriate for the Directive to regulate the manager rather
than the fund, as the latter is merely a vehicle in which assets are held. Targeting
AIFMs will ensure that the risks of AIFs are effectively monitored, irrespective of the
domicile of the fund, whilst leaving AIFMs with the flexibility they need to operate. In
reality some provisions of the Directive will also have the effect of regulating the funds.
We urge the Government to ensure during negotiations that the focus of the Directive
is kept on the regulation of the manager rather than the fund (para 98).
209. We agree that AIFMs should be the subject of appropriate regulation. However,
the retail level of protection offered by the Directive as drafted is not required by the
informed and experienced institutional investors and high net worth individuals who
invest in Alternative Investment Funds, who are able to carry out their own extensive
due diligence. We recognise that the success of these Funds has an impact on those
not directly involved in the investments industry, including through pension funds (para
102).
Supervision of AIFMS
210. We agree that disclosure requirements could enable supervisors to identify where
AIFMs pose excessive risk to financial stability, which should enable steps to be taken
to reduce this risk (para 110). We welcome the work of the FSA to date on their survey
of hedge fund managers and prime brokers to build up an overall view of the UK
alternative investment industry. We also agree with the Government’s support for the
Swedish Presidency’s compromise to help ensure that only systemically relevant data
is collected (para 111).
14
15
The report is not generally publicly available, however, Members wishing to request a copy should apply to
dtonner@aima.org in the first instance to request access.
Directive on Alternative Investment Fund Managers, House of Lords EU Committee, HL 48 2009-10
9
212. The Government should ensure that national supervisors take on the role of data
analysis and intervention. National supervisors, including the FSA in the UK, are likely
to be most effective at analysing systemically relevant data and taking action to reduce
risk. The Government should also work to put in place systems to require national
supervisors to provide relevant data to the ESRB and bodies at a global level (in
particular the Financial Stability Board) to help ensure that these bodies can identify
systemic risks at an EU and global level respectively (para 112).
213. Transparency requirements could in principle help provide protection to investors
in AIFs and increase public understanding of the industry. However, the Government
must ensure that such requirements set out in the Directive reflect the variations of
different types of alternative investment funds to prevent them placing companies
owned by private equity funds at a competitive disadvantage (para 116).
214. We agree with the Financial Services Authority and the Government that
supervisors should have the power to impose leverage caps where appropriate, based
on the aggregated information they receive from fund managers. We welcome the
Swedish compromise on this issue and the Government’s support for this proposal
(para 125).
215. We agree that if capital requirements are set in the Directive, they must
differentiate sufficiently between different types of funds covered by the Directive. The
Government should also consider whether it will be more appropriate to enforce capital
requirements through the Capital Requirements Directive (para 128).
Towards an EU Passport regime for AIFMS?
216. We support the principle of an EU passport extended to non-EU funds, managed
by both EU and non-EU managers. However, we believe that as originally drafted the
proposal for a passport for these funds would impose significant obstacles in the way
of managers wishing to market non-EU funds in the EU. EU managers should be able
to continue to invest in non-EU funds and fund managers located outside the EU
should be able to invest in Europe (para 160).
217. We agree with the Minister that if equivalence is an assessment of whether a third
country operates an identical regulatory regime to the EU as in the draft Directive, then
it will be hard, if not impossible, to achieve. We therefore support the continuation of
national private placement regimes to maintain options for investors, whilst efforts are
made to achieve the principles-based equivalency with third-country regimes that is
required for the EU passport to operate effectively (para 161).
218. The Government should continue to negotiate a solution that does not penalise
the marketing of non-EU funds which will eventually have negative repercussions on
the UK and European financial markets (para 162). The Government should ensure
that EU regulation is in line with, and complements, global arrangements. We believe
that the Government should not agree the Directive unless it is compatible with
equivalent legislation with regulatory regimes in third countries and in particular in the
United States, in order to avoid a situation in which EU AIFMs lose competitiveness at
a global level (para 174).
Depositary and valuation
220. We urge the Government to press for an amendment to the Directive which would
enable AIFMs to use non-EU depositaries, and to sub-delegate custody functions so
long as they are suitably regulated and supervised (para 185).
10
221. We do not support the Directive’s provision that depositaries should be liable for
risks and losses of sub-custodians that they cannot control. We recognise the
improvements included in the Swedish compromise and we urge the Government to
support this aspect of the compromise during the negotiation under the Spanish
Presidency (para 186).
222. In this respect we agree with the suggestion made in the Gauzès Report whereby
private equity funds would be exempt from the requirement for an independent
valuation agent. We urge the Government to negotiate a valuation mechanism which is
consistent with the operational reality of AIFs, such as that proposed by the Swedish
Presidency (para 193).
Better regulation
223. Had the Commission followed its own Better Regulation principles, the
shortcomings of the Directive could have been dealt with at a much earlier point or
might not have been there in the first place. The Government must put pressure on the
Commission to ensure that future proposals are subject to the better regulation agenda
(para 202).
Revisions to the Directive and significant discussion between the Commission and the
European Council took place throughout the summer of 2010. One of the main debating
points was the treatment of AIFMs originating outside of the EU. Under the original
proposals AIFM could only be sold in the EU if the originating country had equivalent
legislation to the EU’s. This provoked protests from an alliance of American based hedge
funds (the world centre for funds) and EU government development agencies that use
overseas funds in their development work.16 An agreed Council position was reached in
October 2010, European Parliament approval was given to the revised document in
November 2010 followed by final Council approval in May 2011. The final version of the
Directive was published in July 2011.
The proposed changes to the regulations provoked some intense activity in the hedge fund
sector. The Financial Times reported in July 2010 that “bank traders rush to launch spin-offs
before rules change”. It continued, “in the first quarter [of 2010] there were 254 fund
launches, the largest quarterly number since the financial crisis”.17 The industry also began a
period of analysis of the rules and how they would affect them. In the media this was
crystallised in the number of hedge funds leaving the City for extra-EU jurisdictions. In a
report in October 2010, a consultancy calculated that “one in four hedge fund employees has
left London for Switzerland”.18 The tax revenue impact of which was put at £500 million. In
March 2011 a report suggested that Malta was becoming an alternative venue for “dozens
rather than hundreds” of hedge funds all “at the expense of London”.19 It should be noted
that this movement was not ascribed purely due to the directive. Also cited as reasons were
the 50% tax rate, “political attacks and regulatory uncertainty”.20
16
17
18
19
20
AIFMD Rules to be diluted, Financial Times 12 July 2010
Financial Times , 14 July 2010
Financial Times, 2 October 2010
Financial Times, 4 March 2011
Financial Times, 2 October 2010
11
2.2
Details & implementation
The Directive document itself is 73 pages long, the directive itself about 60 pages long.
Broadly the Directive divides into four main parts:
 general provisions, authorisation and operating conditions
 measures regarding the depositary of funds
 Transparency Requirements and Leverage
 measures regarding supervision
A more accessible guide to the provisions can be had from the Commission’s Europa
website which has a ‘Frequently Asked Questions’ page about the Directive. Parts of this are
shown below:
What are the objectives of the AIFMD?
The overarching objective of the AIFMD is to create, for the first time, a comprehensive
and secure framework for the supervision and prudential oversight of AIFM in the EU.
Once the AIFMD enters into force, all AIFM will be required to obtain authorisation and
will be subject to ongoing regulation and supervision. In this way, the AIFMD will:
Increase the transparency of AIFM towards investors, supervisors and the employees
of the companies in which they invest;
Equip national supervisors, the European Securities Markets Agency (‘ESMA’) and the
European Systemic Risk Board (‘ESRB’) with the information and tools necessary to
monitor and respond to risks to the stability of the financial system that could be
caused or amplified by AIFM activity;
Introduce a common and robust approach to the protection of investors in these funds;
Strengthen and deepen the single market, thereby creating the conditions for
increased investor choice and competition in the EU, subject always to high and
consistent regulatory standards; and
Increase the accountability of AIFM holding controlling stakes in companies (private
equity) towards employees and the public at large.
Have the United States introduced new rules for this sector?
Effective regulation of the financial markets requires consistent and effective action to
be taken in all major jurisdictions. In this and other areas, the commitments made by
the G20 leaders provide the framework for this action.
In accordance with these G20 commitments, as in Europe, the United States have
acted to strengthen regulation in this area. New rules on hedge funds and private
equity were adopted in July as part of the Dodd-Frank Act. These rules will require the
registration of managers of private equity and hedge funds with the Securities and
Exchange Commission. Managers will be subject to substantive regulatory
requirements and will be required to report regularly to supervisors for the purposes of
systemic risk by the newly-created Financial Stability Oversight Council.
The objectives and approach of these reforms are consistent with those of the AIFMD.
How do the rules adopted differ from the Commission's proposal?
12
The rules adopted by the Council of Ministers and European Parliament fully respect
the objectives and structure of the Commission's proposal.
The 'all-encompassing approach' of the proposal is retained, covering all the major
types of AIFM and alternative investment fund. This will ensure a level playing field and
will help to minimise the risks of regulatory arbitrage. Strict rules have been included
on, inter alia, transparency, the valuation and safekeeping of assets, risk and liquidity
management, the use of leverage and the acquisition of companies.
The strong single market dimension of the proposal has also been preserved,
introducing a single market passport for European managers and funds, as well as a
'third country passport', which will in due course become a single harmonised regime
for third country access to investors in the EU.
The Commission has worked closely with Council and Parliament throughout to refine
the detailed rules where necessary. In some areas, such as remuneration, new rules
have been introduced by the Council and Parliament. These are consistent with the
regulatory objectives and are welcomed by the Commission.
What is the 'passport'?
The AIFMD introduces for the first time a genuine ‘single market framework’ for this
sector, which will allow AIFM to ‘passport’ their services throughout the EU on the
basis of a single authorisation.
Specifically, once an AIFM is authorised under the AIFMD in one Member State and
complies with the rules of the directive, this manager will be entitled upon notification to
manage or market funds to professional investors throughout the EU.
By creating a single regulatory and supervisory regime for all AIFM active in the EU,
the AIFMD will help market participants to overcome the barriers and inefficiencies
created by the current patchwork of national regulation. This will help to increase
choice and competition, to the benefit of European investors.
When will the passport be made available to non-EU managers and funds?
Alternative investments are a global industry and it is important that European
investors have access to the best that the global market has to offer. At the same time,
it is imperative that all AIFM active in the EU are subject to the same high standards of
transparency and conduct, irrespective of where they, or the funds they manage, are
located.
Following a limited transition period of two years, and subject to the conditions set out
in the AIFMD, the passport will be extended to the marketing of non-EU funds,
managed both by EU AIFM and AIFM based outside the EU. In accordance with the
principle of ‘same rights, same obligations’, this approach will ensure a level playing
field and a consistently high level of transparency and protection of European
investors.
The phased introduction of the third country passports will allow European supervisors
to ensure that the appropriate controls and cooperation arrangements necessary for
the effective supervision of non-EU AIFM are operating effectively.
Before the third country passport is introduced and for a period of three years
thereafter, national regimes will remain available subject to certain harmonised
safeguards. Once this period has elapsed and on the basis of conditions set out in the
AIFMD, a decision will be taken to eliminate the parallel national regimes. At this point,
13
all AIFM active in the EU will be subject to the same high standards and will enjoy the
same rights.
Will the Directive limit leverage in the hedge fund sector?
Leverage employed by a wide variety of actors throughout the financial system has
contributed to the fragility of the financial markets and amplified the effects of the
financial crisis. It is therefore necessary to ensure that leverage is used responsibly
and that the associated risks are understood and managed prudently.
The AIFMD introduces a range of transparency requirements and robust safeguards in
relation to the use of leverage by AIFM. Each AIFM will be required to set a limit on the
leverage it uses and will be obliged to comply with these limits on an ongoing basis.
AIFM will also be required to inform competent authorities about their use of leverage,
so that the authorities can assess whether the use of leverage by the AIFM contributes
to the build-up of systemic risk in the financial system. This information will be shared
with the European Systemic Risk Board.
The AIFMD will also create powers for competent authorities to intervene to impose
limits on leverage when deemed necessary in order to ensure the stability and integrity
of the financial system. ESMA will advise competent authorities in this regard and will
coordinate their action, in order to ensure a consistent approach.
How will the AIFMD protect investors?
Investor protection is one of the core objectives of the AIFMD. The financial crisis has
highlighted the range of risks to which investors in investment funds – both retail and
professional – are exposed. The AIFMD introduces safeguards to ensure that investors
in alternative investment funds are well-informed and adequately protected.
In particular, the AIFMD will increase the transparency of AIFM and the funds they
manage and market. This will help investors to perform better due diligence. In
addition, a variety of operational and organisational requirements will help to ensure
that investors are appropriately protected. For example, the AIFMD will require that:

conflicts of interest are avoided or managed and disclosed;

AIFM employ adequate systems to manage risks to which the fund is exposed,
and to ensure that the liquidity profile reflects the obligations towards investors;

a fund's assets are safe-kept by an independent depositary subject to a high
liability standard;

valuation is performed properly and independently; and

strict conditions are met when AIFM delegate functions to third parties.
Due to their complexity and risk, investment in many types of alternative investment
fund is limited to professional investors. Consequently, the AIFMD creates rights for
marketing to professional investors only. Member States are not prevented from
making certain types of alternative investment fund available to retail investors.
However, in this situation, competent authorities will be able to apply additional
safeguards at national level to ensure that retail investors are adequately protected.
What is the purpose of the rules on pay?
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An important lesson of the financial crisis has been to ensure that remuneration
practices in financial institutions do not create incentives for excessive risk-taking.
While bonus payments in banks have dominated the headlines in recent times, it is
essential that sound remuneration principles be applied consistently throughout the
financial services industry. Failure to do so may result in excessive risk-taking by
individuals in certain sectors and may create opportunities for arbitrage as employees
move between sectors.
Rules on remuneration practices are therefore being introduced in all major financial
services sectors, including in the AIFMD. Specifically, AIFM will be required to
implement remuneration policies that are consistent with and promote sound risk
management and do not encourage risk-taking which is inconsistent with the risk
profile and fund rules of the funds managed.
Will smaller managers be covered by the AIFMD?
A comprehensive approach to regulation is necessary to ensure that standards are
consistently high and to allow regulators to monitor risks wherever they arise in the
financial system.
However, in order to avoid imposing disproportionate requirements on the very
smallest AIFM and to allow supervisors to focus on those AIFM whose activities are of
greatest relevance to financial stability, the AIFMD incorporates a system of ‘de
minimis’ thresholds.
Depending on the type of fund they manage, AIFM whose assets amount to less than
€500 million (for unleveraged funds with long 'lock-in' periods) or €100 million for other
types of alternative investment fund will be subject to a tailored regime. These AIFM
will be required to register with national authorities and to comply with harmonised
transparency requirements, as well as additional requirements applied at national level.
The AIFMD also provides for the possibility for these AIFM to ‘opt-in’ so as to avail of
passporting rights in return for full compliance with the AIFMD.
How will the depositary rules help investors?
The functions of the depositary are critical for investor protection. When the entities
charged with safeguarding the assets of the fund do not perform their duties effectively,
investors stand to lose all or part of their investment. The experiences of Madoff and
Lehman have highlighted the potential weaknesses in this area and the pressing need
to clarify and strengthen investor protections.
Under the AIFMD, all AIFM will be required to ensure that the funds they manage
appoint an independent and qualified depositary, which will be responsible for
overseeing the fund's activities and ensuring that the fund's cash and assets are
appropriately protected. Depositaries will be held to a high standard of liability in the
event of a loss of assets and the burden of proof will reside with the depositary.
The AIFMD will also introduce a robust mechanism for the delegation of depositary
functions and will regulate carefully the circumstances under which liability can be
transferred to a sub-depositary, including when the sub-depositary is located outside
the EU. This will allow investors to benefit from investment in third countries without
compromising the level of investor protection.
The Commission is currently examining the corresponding depositary rules in the
UCITS Directive with a view to producing proposals for their revision in 2011. This will
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ensure that the standard of protection afforded to investors in UCITS does not fall
below that of the AIFMD. The rules adopted in the AIFMD will serve as a clear
benchmark for this work; however the Commission will also assess whether additional
safeguards are required to reinforce further the protection of retail investors.
How does the AIFMD regulate private equity buy-outs?
Private equity and venture capital investment can play a crucial role in restructuring
and financing companies in the EU.
The objective of the AIFMD is to introduce safeguards to increase the transparency of
this type of investment towards the employees of the companies acquired and the
public at large and to address potential risks to portfolio companies acquired by private
equity funds, while minimising any competitive distortions that may result.
In particular, the AIFMD introduces rules relating to the disclosure of significant
holdings by private equity funds. In the event of acquisition of control, the AIFMD will
require the AIFM to ensure that the fund discloses relevant information in relation, for
example, to the intentions with regard to the future business of the company and to the
financing of the acquisition. The AIFMD also includes specific rules to mitigate risks to
the long-term health of companies linked to 'asset stripping'.
Detailed implementation of the Directive is with the European Securities and Markets
Authority (ESMA) which has held consultations upon the detailed rules and national
implementation.
Industry responses to the directive can be found on the hfSB website here.
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