The Alternative Investment Fund Managers’ Directive

“Blessed are the Cheese makers”

“Protectionism parading as protection”

In the wonderful movie, “The Life of Brian”, by Monty Python, there is a seminal scene where Jesus is preaching the beatitudes from the mountain and gets to the line, “[b]lessed are the peacemakers, for they will be called sons of God”. A woman at the back of the crowd who can’t hear what he is saying, (it was after all in the days before AV systems and PowerPoint), starts saying, “Aha. What’s so special about cheese makers?” Her husband replies, “Well obviously it’s not meant to be taken literally; it refers to any manufacturers of dairy produce.”

I was reminded of this scene last September when the self declared scourge of the global hedge fund industry and anti-private equity jihadist, Poul Nyrup Rasmussen, descended on the City of London to take on the heathens in their Mayfair lair. Mr. Rasmussen, the head of the Socialist Group in the European Parliament and former trade union official and prime minister of Denmark, was in town to debate the European Union’s (EU) Alternative Investment Fund Managers’ Directive, (AIFMD), with amongst others Lord Myners, the United Kingdom (UK) Government’s City Minister. Mr. Rasmussen was in typical combative form declaring that, “[t]he Directive is mild”, that capital requirements were too modest and that the scope of the rules needed to be broadened. (Financial Times, 13.09.09)

In response Douglas Shaw, the head of alternative investments at Black Rock, stated that if hedge funds were cheese, “then the EU cheese directive would tell all cheese-eaters they could only eat cheese from EU cheese makers using EU milk from EU cows fed in EU fields on EU grass.” Lord Myners went further, cautioning against provoking other countries. “We should not be beguiled by protectionism parading as protection”, he stated, as he warned against over-regulating an industry that had not caused the crisis. “Private equity and hedge funds as asset strippers, cost-cutters and job-flippers is an invention.” He added that he had heard that lawyers and accountants had been involved in the crash and perhaps they also should be investigated as an object of future regulation. “In fact, I hear that 100 per cent of market failures so far have had men involved, so perhaps they need looking at”. (Financial Times, ibid)

Poul Nyrup Rasmussen

Getting the debate and proposed regulation on hedge funds onto the EU agenda has been a significant and very personal coup for Mr. Rasmussen. The EU Commission, which normally proposes EU laws had, under its pro-business Commissioner for the Internal Market and Services, Charlie McCreevy, resisted these moves for over two years.

In a 2007 speech to the European Parliament, Mr McCreevy had stated, “[a]s much as some people want to demonise hedge funds, they are not the cause of the difficulties in the market. Let us not forget where the present crisis has its roots. Poor quality lending, compounded by securitisation of those loans in off balance sheet vehicles that few understood the risks associated with.” (EU Commissioner McCreevy, EU Parliament 5 September 2007)

Mr McCreevy also consistently made the point that alternative investment funds were already subject to rules against abusive trading and were properly monitored by national member state regulators.

Mr. Rasmussen, however, was not deterred by this inaction by the Commission and, together with his Socialist Group in the Parliament, invoked a rarely used procedure to force the Commission to bring in a directive, winning the required vote in the Parliament with an impressive majority of 562-86 in September 2008.

EU Consultation Paper

The vote of the Parliament resulted in the Commission issuing a consultation paper in December 2008, with an incredibly short period for comment to 31 January 2009. The EU consultation paper was itself highly illuminating in terms of the quality of debate and understanding at this level. In the section on systemic risk, the EU paper made the following statement, “[g]lobal hedge funds assets under management peaked at around USD2 trillion in 2007. The size of the hedge fund positions is amplified by the extensive use of leverage. According to the International Monetary Fund, average hedge fund leverage is between 1.4 and 1.7 times capital.”

It is worth considering this staggering statement in some detail. What the EU was saying is that hedge funds pose a significant systemic risk to the global economy, because they are leveraged 1.4 to 1.7 times. This is at a time when investment and commercial banks from Goldman Sachs to RBS were 30 to 70 times more leveraged than that. Most ordinary trading companies are considerably more than 1.5 times borrowed, not to mention household mortgage takers, whose debt to equity ratio can be up to 20 times and beyond.

At the end of the consultation period on 29 February 2009, a conference on private equity and hedge funds was held in Brussels, where selected industry representatives were invited to meet with EU Commission representatives and parliamentarians. Those who attended from the industry side reported that the ‘consultation’ was little more than a star chamber, where the industry was harangued from a platform by officials and told that it was not a matter of if, but when strict regulation was coming.

Mr. Rassmussen, was of course at the head of the Salem-style lynch party, again displaying his unique grasp of the global hedge fund industry. At the EU Conference Mr. Rasmussen stated that, “[t]here are those who say hedge funds and private equity did not cause the crisis. But the crisis most definitely is the result of excessive debt. In a sense all credit creating vehicles including hedge funds and private equity – all of them were in the same boat (sic).” (PR Rasmussen press release 26.02.09) This is a most interesting observation. By the same logic, if a man has two legs and a woman has two legs a man is a woman and vice versa.

EU Draft Directive on Alternative Investment Fund Managers

Following the unprecedentedly rapid consultation period of seven weeks, and just eight weeks after the three hour ‘consultation conference’, the Commission felt sufficiently informed to proceed with a draft directive of some 56 articles on 30 April 2009. It was envisaged that, with a fair wind, the directive could be agreed by the end of 2009 and come into force in 2011. The highly controversial provisions relating to non-EU third countries were to have a transition period until 2014. The timing of these initiatives comes sharply into focus when compared with other EU projects such as 'Undertakings for Collective Investments in Transferable Securities (UCITS) and Markets in Financial Instruments Directive (MiFID), where consultation was extensive and conducted over many years. Indeed the elephant-like gestation of UCITS changes is such that the draft UCITS II had to be abandoned as it was already obsolete by the time it was to be implemented, so that UCITS I was in fact followed after many years by UCITS III.

The draft Directive set as its objectives:

• ensuring that all Alternative Investment Fund Managers, (AIFM), are subject to appropriate authorisation and registration requirements;
• providing for a framework for the enhanced monitoring of macro-prudential risks, eg through information sharing between regulators;
• improvement of risk management and organisational safeguards to mitigate micro-prudential risks;
• enhancing investor protection;
• improving public accountability for Alternative Investment Funds (AIF) holding controlling stakes in companies; and
• developing the single market for AIFM.

The FAQ information issued with the draft directive also drew attention to the fact that the scope of the directive would include all funds that are not UCITS, ie if it’s not a UCITS, it’s an AIF. The FAQ also made the amazing statement that the quantum of AIFs in the EU was “relatively large” at “around” EUR2 trillion as at end 2008. The continued assertion by the EU regulators and Parliament that the hedge fund industry is large and systemically important needs to be confronted with the facts.

The Johns Hopkins University in Maryland, USA attempted in 2008 to put figures on the global investment universe. These are as follows:

Total Asset Volumes by Type

                                                                        USD Trillion

Hedge funds                                                              1.4

Sovereign wealth funds                                              3.2

Reserves ex gold                                                       4.2

Insurance company holdings                                      16.0

Pension funds                                                           17.9

Mutual funds                                                             21.0

Stock market capitalisation                                         42.0

Total debt capitalisation                                              44.4

World GDP                                                                 45.0

(Johns Hopkins University, School of Advanced International Studies, March 2008)

Reaction to the Draft AIFM Directive

Industry reaction to the draft Directive was one of complete shock and amazement. What was immediately apparent was that the stated objectives of the Directive, which in themselves were probably relatively unobjectionable, bore no relationship whatsoever to the text. The breathtaking scope of the Directive, ie any collective investment undertaking which was not a UCITS meant that not only were all hedge funds and private equity funds included, but also credit unions and village savings clubs. What was also fascinating was what wasn’t included, such as European credit institutions’ and insurance companies’ own product initially.

If industry figures in London, Dublin and Luxembourg had not smelt a rat before, they certainly did now. Cross-frontier funds product was now going to be regulated out of existence and in the case of non-EU, eg Cayman product, banned altogether, (subject to a three year ‘investigation’), while German, French and Italian banks and insurance companies would be free to continue to sell their own expensive domestic product untouched by the AIFMD.

In the space of this paper it is not possible to address each of the issues with the initial draft, however, it is fair to say that all 56 Articles contained problems.

These problems included, but were not limited to:

• extreme problems with the limitless scope of the directive;
• an inability to superimpose the definitions of players, such as ‘valuators’, or ‘depositories’ on the actual functions and roles of existing players in the industry;
• the assumption that mind and management of funds rests exclusively with the AIFM, which, inter alia, has the potential to cause tax havoc as residence of funds would, under most double tax treaties, move to that of the manager with serious real tax consequences;
• the lack of mention of self-managed funds and the complete ignoring of funds’ boards of directors and their significant role;
• the totally confusing introduction of unworkable thresholds;
• the scope for massive confusion with existing UCITS and MiFID rules and the significant costs of multiple and non-linked up compliance;
• the ability of the EU Commission to bring in ‘implementation measures’ on leverage, marketing and delegation;
• restrictions on the previous position regarding unrestricted ‘self-solicitation’ by professional and institutional investors, ie self-solicitation now to be regarded as ‘marketing’ and restricted;
• potential inability of EU administrators to administer Cayman funds, an EUR800 billion business in Ireland;
• potential inability of United States (U)S and other non-EU investment managers to provide investment management services to EU funds;
• potential inability of EU pension schemes and insurance companies to invest in non-EU funds, including PE funds and non-EU funds of funds;
• the re-writing of the rules for European professional and qualifying investor funds, currently governed at a national level;
• the protectionist restriction of custodians, named ‘depositories’ to EU credit institutions only; and
• the strict liability requirement, including for delegation of custody, by such depositories, with serious consequences for prime brokers.

In responding to the draft, the very limited number of member states with material hedge fund industries, including Ireland and the UK, faced a tactical quandary. The initial reaction was that one should simply refuse to engage on the grounds that the Directive was so unworkable that it would be better to bin it, agree on sensible objectives and start again.

However, faced by a small, determined group led by France and Germany, with a big political agenda, the imminent danger was that the ‘Club Med’ and other uninvolved member states would baulk at reading the impenetrable 56 articles of the Directive and go along with the French and Germans, in being seen to clean up the bad guys of the hedge fund and private equity industries. Also under the Lisbon Treaty, the Directive will be approved by qualified majority voting, so every member state’s vote – including the uninvolved – counts.

The Position as at End of 2009

For these reasons, both the UK industry, via its industry representatives lead by the Alternative Investment Managers Association (AIMA), and the Irish industry through the joint public/private sector working group of the Department of Finance, have been very actively engaged with the Swedish EU Presidency in the period from 1 July to the end of the Swedish Presidency on 31 December 2009.

This engagement and strong representations from investors, not least the powerful intervention of both German and Dutch institutional investor groups, has resulted in a series of amendments to the Directive. The last iteration of the amended Directive issued from the Swedish Presidency on 15 December 2009. The EU Council running on the Directive will now switch to the Spanish Presidency, which assumed office on 1 January 2010.

The final Swedish draft has significantly improved the AIFMD, although there are still important problems. Articles concerning remuneration and bonuses have also been added at the last minute to the Directive. Perhaps the most important relaxation has been the almost complete restoration of the status quo ante for non-EU alternative funds sold into professional and institutional investors in the EU. In this regard, the suggested position now reverts to the self-solicitation and national regulation position, which pre-existed the first draft in April 2009. The most significant continuing problems, however, still remain around scope and definitions, where the Directive still attempts to define and regulate players and roles, which in practice do not exist.

The EU Parliament

As the Directive is a post-Lisbon Treaty Directive of both the EU Council and the Parliament under the so-called ‘co-decision procedure’, the role of the Parliament in the forming of the Directive is critical. Unfortunately, owing to the recent EU Parliament elections, which resulted over the summer in a change of membership and a delay in addressing the draft Directive, this is only now coming before the Parliament for discussion, notwithstanding that at a Council level, via the Swedish Presidency, it is well advanced.

In consideration of the draft Directive, the role of the Parliament’s Economic and Monetary Affairs Committee is central. In this context the appointment of Sharon Bowles as Chairwoman of the Committee, taking over from Pervenche Beres, a French socialist, is generally seen as positive. The Economic and Monetary Affairs Committee has appointed Jean-Paul Gauzès from France, as the Rapporteur for the passage of the AIFMD through the Parliament.

Sharon Bowles, who is a Liberal Democrat MEP for the South East Region of England, has wasted no time in wading into the AIFMD debate. In a Financial Times (FT) interview on 29 July 2009, Ms. Bowles stated that the Directive will have to be substantially amended, not least because of the several “unintended consequences” of the current draft. She highlighted the fact that European pension funds and institutional investors face “excommunication” from global capital markets, owing to the draft Directive’s onerous restrictions on non-EU funds and fund managers.

What has been most encouraging about Ms. Bowles is her indication that she intends to get stuck into the detail. She says that when member states look at the detail of the Directive they may realise that they have more in common than first appears. “There is a big danger in doing big picture stuff”, she says. She has also indicated that she intends to liaise closely on the Directive with the US and has already met delegations of US congressmen.

The Rapporteur, M. Gauzès has recently published a detailed 83 page Draft Report on the AIFMD, (COM(2009)0207) on 23 November 2009. In its review of the Report, AIMA noted that, “We agree with the Rapporteur that the right balance needs to be struck between the vitality and the creativity of this industry and proportionate regulation and supervision.” (AIMA statement 26.11.09)

While most have welcomed the suggestion of M. Gauzès that alignment should be sought between the AIFMD and existing EU financial laws and regulations, there are a significant number of red herrings, (such as restrictions on short selling) and other problems with this report. For non-EU centres and EU institutional and pension investors, one in particular to note is the suggestion that funds of hedge funds cannot invest more than 30 per cent of their assets in non-EU funds. As AIMA has commented, the substantial revisions suggested by both the Swedish Presidency and M. Gauzès are proof, if such was needed, that the original draft Directive is fundamentally flawed.

The Economic and Monetary Affairs Committee MEPs have until 21 January to table amendments to the draft Directive, which will be debated in committee on 22 February and put to a Committee vote on 12 April. So-called ‘trilogues’ between the Council, Commission and Parliament are scheduled for May. A vote in Parliament at plenary session is scheduled for July.

What’s It All About?

Following eight months of study of the AIFMD, most industry observers are now no wiser as to what the Directive is about and what it is attempting to achieve. At this stage, however, it would seem abundantly clear that the Directive is above all political, rather than any type of attempt at regulatory, fiscal, systemic risk or prudential reform.

Both the drafters of the Directive and its political supporters have very limited knowledge of the industry they are attempting to change in such a fundamental manner. In making this last statement, I speak from personal experience of having engaged with the actual draftsmen of the original directive, who demonstrate both extremely limited knowledge of the hedge fund industry and of the consequences of their actions. Informed Commission sources have not denied that the Directive is 100 per cent a political initiative.

If this is the case, what is the political objective? In a perceptive July 2009 editorial, the FT described the Directive as like a bar room brawl, where when the fight breaks out, you punch the guy you always wanted to punch, irrespective of what the fight was about or who started it.

There is a very small number of strong supporters of this Directive, of which the most important and powerful are the French and German political and economic elite, for whom the socialist Mr. Rasmussen, almost certainly unwittingly, has proven very helpful indeed. The Germans, it is clear, wish to smash once and for all any attempt by international venture capitalists and private equity houses to disturb the cosy and very exclusive capitalist club, which has enabled Deutschland Inc. to be run by the same leading families and industrial complexes for over 100 years.

In the case of the French, I leave the explanation to Mme. Lagarde. The (previously only slightly hidden) French political agenda, is the long-term project for Paris to take its rightful place as the centre of European finance. The ever exuberant French finance minister, Christine Lagarde, surprisingly broke cover and admitted as much on 22 July 2009.

In an FT interview, which she humbly described as a, “cri de couer against the old ways”, Ms. Lagarde stated that while she didn’t want to “talk down London………the City has lost some its advantages during the crisis…... Paris, as a financial centre stood to benefit from the enhanced reputation of its universal bank business model and from London’s tarnished image”.

Picking up on this theme, billionaire investor George Soros more recently told it like it is at a conference before Christmas at the London School of Economics. “Continental Europe would like to see London sink. The Franco-German alliance is the driving force.” (Bloomberg, 10.12.09).

“Blessed are the cheese makers,” indeed!

Peter O'Dwyer
Peter J. O’Dwyer is a business and financial consultant with a number of interests. He primarily specialises in providing bespoke advice to cross-frontier businesses, in particular to those involved in international investment funds, holding company structures and structured finance and to Governments and regulatory authorities. He is Managing Director and proprietor of Hainault Capital Limited, based in Ireland. He is a non-executive director of several private and public companies, including investment companies, mutual funds, energy, property and hedge funds domiciled in Ireland and the Cayman Islands for amongst others; HBOS, Barclays Capital, Citigroup and BNP Paribas. He is a former director of a Shari’a hedge fund and has lectured widely on the subject of Shari’a investment funds.