Apply firm pressure here

Criticism of the European Commission’s draft Directive on Alternative Investment Fund Managers has steadily increased since it was published, without any real consultation, in April. And – even though that criticism has come from investors, from politicians on the left and the right, from regulators, and from the media, among many others – it is clear both that there will be a Directive, and that it will extend to private equity funds. It remains entirely unclear, however, which of the hundreds of suggested amendments will find their way into the final regulation.

Adrian Brown

In their current form, the draft rules would regulate alternative investment fund managers (not the funds themselves) who manage portfolios in excess of €100 million. If the fund does not employ leverage, and locks investors in for at least five years, that threshold rises to €500 million. However, one of the key concerns raised by critics is the sweeping scope of the Directive, which covers all “funds” not covered by the UCITs Directive (the European rules dealing with retail funds); for instance, it would seem to extend to internal incentive and co-investment arrangements and to listed funds, as well as all types of private fund.

As the criticism has mounted, so has the hope that many of the flaws in the Directive will be addressed in the final proposal.

The consequences of being caught by the Directive would be onerous and disproportionate, and could put many European funds at a competitive disadvantage, while serving to make it harder for European investors to access international investment opportunities. Extensive disclosure requirements for portfolio companies – applying only to companies owned by a fund – also create a very uneven playing field and undermine established principles of company law.

Other measures include increased regulatory capital, requiring most managers to hold reserves of at least a quarter of the firm’s annual expenses. That could make it harder for managers to align incentives with their investors and is especially tough on new entrants, potentially impeding competition. Managers will also be required to appoint a European bank to act as custodian, as well as an independent “valuator” to value their portfolios. The logic for these proposals is not clearly explained, and their impact has not been thoroughly analysed by policy makers in Brussels.

Taking into account additional restrictions on non-EU (so called “third country”) funds and fund managers, the impact of the proposed measures is likely to be huge. Open Europe, a think tank, interviewed 41 private equity firms, concluding that initial costs of compliance with the Directive could be as high as €1.9 billion, with recurring, annual costs of between €689 million and €985 million across the private equity and hedge fund industry. Investors have criticised many of the proposals, arguing that they have not asked for them, and pointing out that the Commission itself has concluded that private equity funds do not pose systemic risk.

As the criticism has mounted, so has the hope that many of the flaws in the Directive will be addressed in the final proposal. The Swedish presidency is actively considering the issues identified by the Directive’s many critics, as is the Parliament’s influential Committee on Economic and Monetary Affairs. However, the political process is far from over, and is moving very fast. Any final rules will be a political compromise the result of which remains entirely uncertain. Continued pressure from all quarters must remain a key priority.

Adrian Brown is a partner in SJ Berwin's financial markets group.