By Barry Cohen and Amanda Cantrell
Hedge fund managers in the U.S. may think the new rules being contemplated in Washington are tough, but perhaps they should take a look across the pond. For if lawmakers in Europe have their way, it will soon be harder to run a hedge fund in Europe than ever before, and it will be tougher than ever for managers of funds based outside the European Union to market those funds to European investors.
The European Commission, which is responsible for proposing new legislation for the 27-nation bloc, proposed a draft piece of legislation, the Directive on Alternative Investment Fund Managers, in April 2009. The AIFM directive was designed to govern hedge fund operations throughout the EU.
Two entities within the Commission—European Parliament and the Council of the European Union—are hammering out a final version right now, in a process similar to the reconciliation of draft legislation in the U.S. House of Representatives and the Senate. A deadline for passing a final draft has been set for July 6.
When the first draft of the directive was released, it landed like a bomb in the laps of European hedge fund managers, who felt it was extremely onerous and that it had come out of left field—a feeling exacerbated by the fact that the European Parliament failed to engage with the European hedge fund industry while working on the legislation, according to hedge fund managers.
These managers said at the time that the proposed directive was so draconian that it would—if passed in that form—make life incredibly difficult for managers of hedge funds domiciled outside of the EU, which includes U.S. and most U.K. hedge funds.
The original version proposed setting low limits on the amount of leverage a manager could use, requiring new levels of disclosure, significantly raising capital requirements and making it all but impossible for managers of non-EU funds to market to EU investors.
While some compromise amendments have been added and changes have been made since the original draft, the various versions being shuttled around Parliament and the Council still contain several proposals that industry insiders are finding hard to swallow.
“We would be cutting Europe off from capital that could flow from countries outside the EU,” says Wolf Klinz, chair of the Special Committee on the Financial, Economic and Social Crisis of the European Parliament, of the way one of the proposals from Parliament is now written. “At the same time, we would make it almost impossible for European investors, such as pension funds, to invest outside the EU. This would be a bad outcome.”
The antipathy to hedge funds may seem out of proportion with the amount of money these funds manage in Europe—assets in the European hedge fund industry stood at $382 billion through the end of 2009. But in truth, the relationship between continental European governments and hedge fund managers has been strained for years.
One major reason may be that some leaders on the Continent tend to lump hedge funds together with private equity—one group these leaders almost certainly hate more than hedge funds.
In 2005 a number of buyout funds including Kohlberg Kravis Roberts (KKR), Apax Partners Worldwide, the Blackstone Group International, Permira Advisers and Providence Equity Partners bought TDC A/S, a former telephone company monopoly in Denmark, for $15.3 billion—at the time, the largest leveraged buyout since KKR’s takeover of RJR Nabisco in 1989.
The deal was highly controversial and deeply unpopular with socialist leaders and labor unions. The buyers financed the purchase price with debt, sending the company’s debt-to-asset ratio skyrocketing to 90% from 18%, according to the IUF, an international federation of trade unions. More than half the company’s assets were then paid out to shareholders in the form of $7.6 billion of special dividends, according to reports. The buyout burdened TDC and its employees with debt obligations just as the world’s economy started to take a turn for the worse, and almost 10,000 employees lost their jobs, the IUF argued.
One of the most outspoken critics of the deal was Poul Nyrup Rasmussen—Denmark’s former prime minister, a former president of the Party of European Socialists and a member of the European Parliament until last year. Rasmussen is also considered to be the driving political force behind the draft directive.
The animosity some of the more left-leaning European politicians felt toward private equity funds eventually began to spread toward hedge funds—particularly the shareholder activist funds, such as London’s The Children’s Investment Fund, which took big stakes in sacred-cow companies that played a major role in the economies of their home countries.
One of these companies was the Deutsche Börse, Germany’s stock exchange. The TCI-led shareholder revolt resulted in the ouster of several Deutsche Börse executives and let a German leader to call investors such as private equity and activist hedge funds “locusts.”
Three years later, with political animosity still simmering, the Madoff scandal broke. Bernie Madoff orchestrated a multi-billion dollar Ponzi scheme through his firm, Bernard L. Madoff Investment Securities, and when the scandal came to light, it was revealed that many so-called sophisticated investors, including funds of hedge funds, were invested.
These included the aristocratic French banker René-Thierry Magon de la Villehuchet, who invested $1.4 billion on behalf of himself and clients in the Madoff fraud. Just days after the scandal broke, de la Villehuchet killed himself. Apart from the fact that many European investors lost money in Madoff, de la Villehuchet’s suicide shook the French establishment.
The draft version of the directive was produced just a few months after the Madoff fraud, and industry professionals claim the draft was rushed out as a result of political pressure. They argue that it was sloppily written and contained several proposals that were unworkable.
Also, the directive was designed to encompass all alternative investment funds, not just hedge funds, managing assets above a yet-to-be determined threshold. That includes private equity and real estate funds. Taken as a group, these various funds have vastly different strategies and liquidity levels, making it that much more difficult to write intelligent legislation, industry leaders argue.
On May 17, the European Parliament approved its version, and the Council approved its own version the following day. The texts both differ from and contradict each other and sometimes diverge from the original draft.
Parliamentarians believe they are reflecting the wishes of the voters in their constituencies. But the hedge fund industry views Parliament’s version as less amenable to their interests.
The Council’s finance ministers represent the interests of the member states, which means they are closer to the concerns of their respective financial sectors and are more likely to listen to objections. The European Commission is expected to act as a referee by coaxing everyone involved to merge their proposals into a final version in the process known as “trialogue.”
Many European hedge fund managers and investors say the toughest anti-hedge fund rhetoric comes chiefly from France and Germany. These two countries comprise little of the European hedge fund industry and therefore have much less to lose with the proposed regulation than the United Kingdom, which controls 76% of the hedge fund assets managed out of Europe.
One of the most hotly contested areas of the proposals concerns whether investors in the EU can access funds based outside the EU. The Parliament and Council versions differ in terms of exactly how non-EU funds would be able to market themselves to European investors.
The Parliament version of the draft contains so-called passport provisions, which stipulate that only managers authorized by the EU and whose own country regulators meet a number of conditions can market their funds freely throughout the EU. The passport concept stipulates that any managers of funds based outside the EU who want to attract EU-based investors will need to obtain a marketing passport.
Most UK-based managers run their money offshore, so the vast majority of European hedge funds would be much harder for investors to access if the passport provisions are passed.
But to get a marketing passport, non-EU funds will have to meet exceptionally strict regulatory requirements. Among them: a stipulation that the jurisdiction in which the fund is managed must have an equivalent regulatory regime. The Council version differs sharply from Parliament’s version, because the Council wants to continue to allow European investors to invest in non-EU managers under the existing private placement rules already on the books in each EU country.
But the Council wants to add some additional qualifications for non-EU funds, such as cooperation arrangements with the national authorities of non-EU countries for increased information sharing about the fund’s activities. The Council represents the interests of the EU’s member states, which do not want to surrender their existing powers over hedge funds. Managers of hedge funds say they are happy to comply with existing private placement rules.
“A passport has proven to be difficult to implement in other fields of financial services, so seeking to introduce it rigorously to alternatives is a curious move,” says Andrew Baker, chief executive officer of the Alternative Investment Management Association, a hedge fund trade group.
“Our main concern is that it will limit the potential for European investors to take a diversified approach to hedge fund investing,” says Stephen Oxley, managing director of $10 billion fund-of-funds firm PAAMCO. “Most European institutional investors, such as funds of funds and their pension fund clients, are invested in global portfolios that might constitute more than 80% of their assets in what now appears to be offshore or third-party managers.”
Richard Baker, CEO of the Managed Funds Association in the United States, warns that the EU intends to restrain investors from selecting the fund managers of their choice, while fund managers may find it very difficult to engage in traditional business activities. The MFA has been a major supporter of lobbying against the harshest aspects of the directive, and the association has bankrolled most of the lobbying done on the industry’s behalf to date. AIMA has played the most high-profile role in lobbying on behalf of the hedge fund industry in Europe.
“It’s not clear whether or not the private placement scheme will even be permitted, and there are practical impediments to the passporting approach,” says the MFA’s Baker. “We are hopeful, however, that an agreement will emerge out of the trialogue process that addresses systemic risk and customer protection issues while permitting reasonable access for European investors to funds managed outside the EU.”
Another major area of concern: leverage. The original draft of the directive proposed allowing the EC to set hard caps on levels of leverage. The Council then decided to dispense with hard caps in its version in favor of allowing national regulators to intervene in terms of levels of leverage. Parliament’s version wants to let managers set their own limits on leverage but also give authority to the European Securities Markets Authority, a newly created regulator, to allow for emergency intervention on leverage levels.
Although hedge fund managers widely accept the notion of supplying regulators with information on their levels of leverage, they oppose proposals allowing ESMA to impose caps on a fund’s use of leverage. As James Grieg, a partner at London firm PwC Legal, a division of PricewaterhouseCoopers, argues, “hedge funds are generally not materially leveraged—especially when compared to banks. But no such limits have yet been imposed on banks, while funds could get it in the neck.”
The directive may even put the screws to hedge funds on what service providers they can use. Both the Parliament and Council drafts contain rules regarding how hedge funds can use depositaries—for hedge funds, this means prime brokers and custodians—but the Parliament and the Council drafts differ in many important areas. Both versions have confused managers.
Parliament has proposed that both EU and non-EU funds operating in an EU state can use only independent depositaries that are European-accredited institutions. “U.S.-based prime brokers, such as Goldman Sachs or Morgan Stanley, would not be acceptable,” says Antonio Borges, chairman of the Hedge Fund Standards Board. “This constitutes pure protectionism.”
He adds that some functions could not be delegated to third parties. For example, “If you wanted to invest in emerging markets, [you would be] required to have your depositary in Europe although your assets are in Brazil or China. Hedge fund managers would find this to be extremely onerous,” he says.
The depositaries would also incur steep liabilities for any losses—even if these losses result from circumstances beyond their control. Depositaries would likely have to increase their fees for taking on more liability, and these extra costs will be passed on to hedge funds, lowering returns for their investors. Also, insisting on using only EU-based depositaries will concentrate these activities among fewer accredited players—which could produce the unintended consequence of greater systemic risk.
Compensation is yet another thorny issue. When Sweden held the EU presidency, it produced its own compromise version of the original draft of the directive. Many industry professionals found this version to be more reasonable than the original version, with one major difference: Sweden inserted new language about manager pay, including proposals about deferred compensation. Critics say the rules pertaining to manager pay were copied and pasted from guidelines on remunerations in a separate directive on the banking sector. But these guidelines were not applicable to the investment management industry because they were based on the concept of controlling bonuses.
Both Parliament and the Council have language about pay rules in their current drafts. But Parliament’s version requires fund managers to fully comply with Annex II, a list of specific proposals on manager pay—which includes a clause calling for a deferral of at least 40% of any pay that comprised a “variable remuneration component.” In the case of hedge funds, this means performance gains. The Council’s version merely says managers should take the principles of Annex II into account.
The various measures designed to gain more control over hedge funds and their service providers will likely alter the shape of the industry. Many industry players predict that the European regulations will afford a clear competitive advantage to the larger, more diversified hedge fund groups, because it will be more expensive to run a hedge fund that complies with the new regulations. Inevitably, this trend will result in a greater concentration of hedge fund players and assets.
The backdrop of the debate is a wider cultural clash between an Anglo-Saxon philosophy, which calls for tempering government interference in markets, and the belief traditionally held in continental Europe that the state should play a powerful interventionist role in all economic and financial activities. Until recently, European parliamentarians and bureaucrats felt justified in blaming the financial crisis on the collapse of the Anglo-Saxon model.
More recently, Europe’s currency and debt problems have reduced the credibility of the EU’s stance. In an ideal world, managers say, hedge funds would be operating within a system approximating what is now operating in Anglo-Saxon economies like those of the United States and the U.K.
Since the EU will likely fail to wrap up negotiations by the original deadline of July 6, and Parliament will go into recess for the rest of the summer after that, a compromise set of regulations is not likely to be approved before September at the earliest. Once that hurdle has been passed, it’s expected that it will take about two years for the directive to be passed into national law throughout the EU. During this period, the industry will have to adapt to the new environment as best it can.
In the midst of so much speculation and uncertainty, hedge fund managers and investors find it difficult to position themselves to cope with potential changes. In the worst-case scenario, a highly protectionist EU directive could open up a new version of trade wars in global finance.
“The bigger groups will have the ability and resources to adapt, even though it will be a pain and take business away from Europe,” says Christopher Fawcett, senior partner at Fauchier Partners, a London-based fund of hedge funds. “For example, if a U.S. hedge fund could no longer approach our London office because it would be breaching European rules, they could nevertheless approach our U.S. office. So, at the end of the day, for a group like us, the center of gravity would tend to shift from London to New York.” AR
