PAAMCO’s Max Rijkenberg reviews unintended consequences of AIFMD

Max Rijkenberg, legal counsel in PAAMCO’s London office and member of the Legal & Investment Structuring Group, has outlined key challenges created by the AIFMD, which could yet reduce choice for Europe’s investors seeking alternative strategies.

The Alternative Investment Fund Managers Directive (“AIFMD” or the “Directive”) has been on nearly every fund manager’s mind for quite some time now.

It is a very complicated piece of European legislation with a long name, but its genesis and goals are clear. AIFMD is a direct result of the notion that hedge funds and other alternative investment funds (“AIFs”) significantly contributed to the 2008 financial crisis via shorting and other trading strategies that created large and uncontrollable market movements.

This notion, coupled with several high‐profile hedge fund blow‐ups (eg, Bear Stearns) and frauds (eg, Madoff), led to a push at the EU level to create an EU-wide regulatory regime for AIFs, culminating in the initial implementation of the Directive in July of this year.

Objectives of AIFMD include (i) providing European regulators with the tools to monitor fund-specific as well as systemic risks, (ii) creating a level playing field in which virtually all alternative fund managers are subject to strict regulatory oversight, and (iii) establishing a true EU passport that allows managers to freely market AIFs in the EU.

As with all regulation though, there will be unintended consequences.

Managers leaving the EU or deciding not to enter

A number of articles in the press this year have warned that managers may want to stay clear of marketing in the EU because of the increasing regulatory burden.

This avoidance behavior was generally expressed by smaller managers without a presence in Europe and managers with only a small part of their AUM sourced from Europe, but it is an important issue. If managers indeed act on this sentiment, there will be a smaller pool of non‐EU managers marketing their funds to EU investors (although reverse solicitation – investors reaching out to managers – will likely remain an option).

With the majority of hedge fund managers and funds based outside the EU, that is not an encouraging prospect: less choice is inherently bad for investors. As many EU-based institutional investors like to allocate to smaller and emerging managers, the majority of which are based in the US, this development may affect the construction of the alternatives portfolios of many European investors.

And it could impact performance as well: hedge funds managed by US-based managers (which encompass $1.74trn, or 73% of global hedge funds assets under management) have outperformed the global HF benchmark on a rolling 12-month, three-year and five-year annualized basis.

Increased barriers to entry

Over the past decade, the costs and complexity of setting up an investment management company and accompanying funds have significantly increased due to (i) rising expectations from investors (largely due to the shift in the investor base from individuals to institutions) and (ii) additional regulatory requirements introduced in the major hedge fund centers.

AIFMD will add to this trend in no small measure for managers falling within its scope by introducing, among other things, regulatory reporting (similar to Form PF, for those of you familiar with the US markets), additional investor reporting (including increased transparency), remuneration rules, increased capital requirements, and the need to have a “depositary,” which effectively acts as a hybrid administrator/auditor/manager/guarantor.

These items may provide some benefit to investors, and several of these may already be common in certain national jurisdictions, but not to the extent envisaged by the AIFMD. Thus, this suite of additional requirements will lead to higher barriers to entry for managers wanting to set up shop or market to investors in the EU. This, in turn, could lead to fewer European fund launches and possibly to the consolidation of existing EU managers, again decreasing choice for European investors.

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