Friday Letter Four letter word

There are real concerns that the incoming Alternative Investment Fund Managers (AIFM) Directive will lead to the loss of a generation of smaller fund managers.

Friday May 25 – today – is the deadline for something that probably few UK private equity real estate fund managers have in the diary.

It is the last day to submit to the Financial Services Authority (FSA) a questionnaire providing a breakdown and analysis of the costs associated with each requirement of the incoming Alternative Investment Fund Managers (AIFM) Directive.

For UK managers that didn’t know about this deadline, don’t worry, it is no surprise. The truth is that there is and has been no single association ready to help out managers with the directive from the outset.
But if you don’t believe this is a problem, then listen to this anecdote: even a household-name real estate opportunistic firm has apparently recently gone to the British Venture Capital Association (BVCA) for help given the number of loose ends it perceives to be in the directive. That is the equivalent of, say, Permira asking the Investment Property Forum (IPF) for assistance.

However, putting that issue and the lack of detail about the directive aside, the issue giving rise to most concern is that costs associated with the directive – which must be complied with by July 2013 – could lead to a drying up of the pipeline of smaller fund managers which, by implication, limits the choice of fund managers and strategies for investors. Experts say this is a very real concern and not just hyperbole.

Fund managers will need to comply with the full provisions of the directive if their total net assets under management exceed €500 million. In mainstream private equity, based on the a fund manager with €500 million of assets, debt within portfolio companies is excluded from the ‘fund level gearing’ definition of the directive, so in all likelihood, with management fees at 2 percent of commitments, there would be an income of €10 million a year before they need to comply.

However, experts point out that for private equity real estate managers, it is not the same. They argue that real estate fund managers often use debt which – even if it is within special purpose vehicles as it often is – would be likely to count towards fund level gearing. In the case of real estate fund managers, they would be caught by a lower €100 million threshold set out in the rules.

As real estate fund management fees tend to be lower these days, they could be one tenth of their private equity equivalents when the provisions of the directive kick in. They would then need minimum regulatory capital of €125,000 and perhaps over €100,000 of extra internal and external compliance costs per annum to take care of the extra risk management, reporting and insurance and so on.

Another key provision will be the requirement for a fund to have a depository with costs per fund likely to be in the region of ten basis points on net asset value subject to a minimum – expected to be in the region of €40,000.

Of course, many of the most successful fund managers today started just like any small business with a small yet expensive minimum infrastructure and with no guarantee that future cash flow would make the business viable. Yet economic conditions have made funding a start-up fund management business much tougher.
Also, limited partners want a greater financial commitment from the manager in the fund. LPs are more likely to obtain favourable terms these days, which have an effect on manager cash flow, such as the aforementioned discounted management fees. Further, in current market conditions the manager may need to use a placement agent and would likely bear these costs on top.

No wonder experts warn the directive and its costs would accelerate the drying of the pipeline of smaller fund managers, including funds that are specific by geography or by sector. Potentially out the window goes a range of choice that would have provided pension funds with a sensible asset-backed return on investment.

When PERE first reported on the AIFM Directive some years ago, we called it a four-letter word. But we never imagined the problems it could create for a section of the market. The unintended consequences of the directive are significant and small fund managers need help, which is why today’s deadline suddenly takes on significance.