EMIR: regulation will ‘restrict’ opportunity funds

Europe’s latest attempt to improve the transparency and safety of financial firms and their activities is going to restrict opportunity funds and could cost them up to hundreds of millions of euros, according to a real estate funds expert.

Matt Maltz, partner and real estate funds leader in London at global accountant Ernst & Young, said the European Market Infrastructure Regulation (EMIR) on over-the-counter derivatives, which was introduced by the European Commission in September, had the potential to cost “serious amounts of money” and has come at a time when opportunity funds are already having to come to terms with the effect of other new regulations.

EMIR will require ‘financial entities’ and their swap activities to be cleared through external exchanges rather than be privately negotiated. They will also have to mark-to-market those positions regularly, as well as post cash collateral in connection with negative valuation movements.

This would catch opportunity funds and other leveraged real estate funds that hedge against movements in interest rates when they take on a floating rate loan to buy a property.
           
If opportunity funds are ultimately decided to sit within the scope of the regulation – as they were for Europe’s Alternative Investment Fund Managers Directive – this would require them to post “up to hundreds of millions” in cash collateral, said Maltz. He added general partners might well have to meet the cash collateral requirement by calling down capital from their investors. 

It would affect all those caught by AIFM directive, including US funds marketing in Europe.

“This could cost serious amounts of money and that the money would simply be sitting on the sidelines that couldn’t be invested,” he said. 

According to him, there did not appear to be ‘grandfathering rights’ meaning the regulation could force firms to post collateral for interest rate hedges they have already made, although this could be introduced in later versions of the regulation.

He also said that the detail of the regulation had not yet been clarified and so there was still a chance that opportunity funds would not be as greatly affected as currently feared.

If the regulation only applied to the “ultimate fund vehicle” created at the “top” of a typical real estate fund structure then the regulation could have a more limited impact, he said. This is because hedges and swaps tend to happen at the level of a Special Purpose Vehicle below the fund manager in the overall structure. As such, they might not be required to post any cash collateral.

If they were caught, however, opportunity funds might have at least two choices. They might opt not to hedge against the risk of interest rates movements, which appears unlikely as it could expose them to negative interest rate fluctuations. More likely, they may choose to take out fixed rate debt or a cap, which they would not have to collateralize, but which would be more expensive than floating rate debt.

“They are going to be restricted in how they would like to operate to make money for themselves and for their investors,” warned Maltz.

“This is something they have not catered for in terms of how they intend to operate the fund, or when   marketing the fund. One large fund recently said to me this is going to be ‘financial Armageddon’.”

His comments came a day after Marc Mogull, founder of London-based firm Benson Elliot Capital Management, became the first private equity real estate heavy-hitter to speak out against the regulation.

Yesterday, he said: “We aren’t engaging in the creation or trading of naked positions and, as such, our swap activities pose no threat whatsoever to financial stability. This is so manifestly obvious, and the proposed regulations, insofar as they relate to our sector, so manifestly ill-conceived, that I assume someone will realise this and carve us out. They’d better, because for leveraged funds the cost could be enormous.”