Analysis: EU derivatives regulation could lead to ‘financial Armageddon’

Experts warn that a new European regulation could force opportunity and other leveraged real estate funds to post cash collateral against their interest rate hedges and potentially even lead to large cash calls upon their limited partners

A new threat to the health of opportunity and other leveraged real estate funds is just beginning to emerge in Europe, with at least one pan European real estate fund manager calling it the equivalent to “financial Armageddon”.
The European Commission – which is already responsible for bringing forward the controversial Directive on Alternative Investment Fund Managers (AIFM) – has proposed a regulation on over-the-counter derivatives which has the potential to lead general partners to make significant capital calls upon their limited partners.

The proposed European Market Infrastructure Regulation (EMIR) on OTC Derivatives, central counterparties and trade repositories was released on 15 September and is aimed at improving the transparency and safety of the over-the-counter derivatives – privately negotiated derivatives. It is set to become operational by the end of 2012.

Real estate funds typically take out floating rate debt as part of their normal investment operations. However, in order to safeguard against disadvantageous movements in interest rates, they will ‘hedge’ by taking out interest rate swaps. The regulation will require ‘financial entities’ and their swap activities to be cleared through exchanges rather than be privately negotiated, and mark-to-market those positions regularly, as well as post collateral in connection with negative valuation movements. The collateral has to be cash.

Fears are now rising that the scope of the new regulation will catch opportunity funds and other leveraged real estate funds that hedge against movements in interest rates even though they do so only as part of their ordinary risk management approach when they take on debt.

Experts PERE has spoken with said so far funds had not focused on the derivatives regulation much given the plethora of other new regulations to grapple with such as the US Dodd-Frank Wall Street Reform and Consumer Protection Act and the AIFM.
However, they warn the new regulation could cost serious amounts of money, with the cash collateral being posted simply having to sit on the sidelines un-invested. They said general partners might well have to meet the cash collateral requirement by calling down capital from their investors.

According to those that have studied the regulation, there do not appear to be ‘grandfathering rights’ meaning the regulation could force firms to post collateral for interest rate hedges they have already made.

One large pan European fund manager recently said that the regulation was going to be the equivalent to “financial Armageddon” and just last week the European Public Real Estate Association (EPRA) said the EU regulation could take €65 billion of working capital out of Europe’s real economy.

Gareth Lewis, EPRA director of finance, said in a statement: “The consequences of being subject to rules designed for financial entities would be an immediate withdrawal of much needed capital from a sector critical to Europe’s physical economy and a reduced ability to manage future financing risk.”

What remains to be seen is how much private equity real estate will lobby and mobilise against this latest threat. Notably, there was little in the way of a concerted effort against elements of the AIFM directive.

With EMIR now threatening the sector, some veteran private equity real estate managers are saying the industry might well have to galvanise itself this time. Click here.