The wave of regulations that have washed over the financial services industry since the great crisis have left many participants dazed and confused, with many rules yet to be finalized and their overall impact as yet unclear. The description certainly applies to Europe’s hedge fund industry.
The Alternative Investment Fund Managers Directive entered into force in the 27-nation European Union last week, and many alternatives managers are still scratching their heads wondering how the rules will affect their businesses. At best, the reaction to the new regulation is one of resignation, at worst, hostility.
The directive, which came into effect on July 22, aims to establish an EU-wide framework for supervising the risks posed by alternative investment fund managers, specifically hedge funds and private equity funds. So far, only seven EU member states have put the directive into effect with their own legislation: Denmark, Germany, Ireland, Luxembourg, Malta, Sweden and the U.K.
In the U.K., Europe’s biggest hedge fund market and second only to the U.S. globally, managers are playing a wait-and-see game before committing to the directives. The U.K. government has adopted a one-year transition period in implementing the new rules, which gives managers time to make their preparations.
Most anger has been directed toward the directive’s remuneration clause, which seeks to align fund managers’ incentives with the interests of their investors. In the current draft, by the end of the year, funds may have to defer 40 percent to 60 percent of pay for a minimum of three to five years. There are also suggestions that at least 50 percent of remuneration is paid in fund-linked instruments.
Although few in the industry disagree with the principle of greater regulation for hedge funds, many European hedge fund managers contend that the rules will harm their ability to compete with managers in other jurisdictions.
“People don’t understand in a liberal economy why, if you are not a publicly quoted company, this should be relevant to them,” says Jerome Lussan, chief executive of Laven Partners, a hedge fund consultancy. “It is putting a lot of people off setting up hedge funds. Hedge fund salaries are misunderstood. It is a risk propagated by populists.”
The regulators have effectively adopted the kind of compensation rules that have been applied in banking, which managers say is an unsatisfactory approach for what is a private industry.
“If you are generating alpha in different market conditions, and as a fund your return is in excess of the market return, then you have every right to charge two and twenty,” says Steven Mitra, partner at LNG Capital, a London-based credit-oriented hedge fund. “Even during the crisis a significant proportion of hedge funds have outperformed the market, so that warrants you getting remunerated at your terms.”
The new EU rules are also supposed to apply to foreign subsidiaries of European-domiciled funds, as well as foreign managers looking to distribute their services in Europe. That means that U.S. alternative funds looking to sell in Europe would have to disclose and control their remuneration policies according to the AIFMD. Many industry executives believe such provisions are anticompetitive and will diminish the attractiveness of working in Europe.
According to guidance from the European Securities and Markets Authority, “the remuneration provisions should apply to all delegates of EU AIFMs,” says Jiří Krόl, deputy chief executive and head of government and regulatory affairs at the Alternative Investment Management Association, an industry lobby group. “So you are potentially in a situation under which European managers will have to contractually apply the EU remuneration provisions to those outside the EU. This, apart from not being in line with [the spirit of] the directive, isn’t attractive to anyone outside the EU. It could cut off certain managers from using outside talent.”
The precise details of the remuneration rule are yet to be worked out. For example, it is still unclear how the rules will apply to partnership distributions or dividends passed on to the owners of the management business. Similarly, industry executives express concern about how the new rules will interact with other EU regulations. Either way, the confusion is proving an irritant.
“The remuneration preparations have been pretty badly thought out,” says one manager, who asked to remain anonymous. “We were waiting for the ESMA guidelines and [in February] they came up with an 87 page document — it is not easy to understand.”
The AIFMD principles cover a wide range of governance issues in the alternative investment industry, from product marketing to operational efficiency to custodian functions. Implementing the new rules will be costly and resource intensive.
Custodians will now be responsible for safeguarding assets and must monitor fund cash flows — an activity that will lead to more costs for fund managers. The U.K. Treasury chose to have a one-year transitional period to give the industry time to adjust to the rules; however, many industry executives feel this may serve merely to prolong the agony.
“Even if you have got an extension of time — at the moment it is very grey,” says Lussan. “People are generally bad at dealing with this. I don’t think people are ready for this. They don’t know how it will pan out.”
Other European states have until September 4 to confirm compliance with the guidelines or explain why they cannot do so.
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