From the perspective of limited partners, there is plenty to applaud in November’s decision by the European Parliament to pass the controversial Alternative Investment Fund Managers (AIFM) directive. Yet, there is also reason for limited partners to fear a downside.
Among the key elements of the directive that LPs will like is the requirement that fund managers will be subject to higher capital reserves, making investors feel better protected from liquidity and other worries associated with money management. In theory, LPs also should feel good about greater governance and transparency, given compliance with the directive obliges the publication of an annual report, among a host of other things.
However, according to some experts, there is an element of the new directive that LPs might not be so enthusiastic about.
Andrew Wylie, funds and indirect real estate partner at London law firm Nabarro, said the requirement that fund managers use a “depository” looks like another good protective measure in principle, but it could turn out to present an additional cost to the investor.
Depositories are third-party financial institutions that can act as custodians on behalf of managers and offer some protection against malpractice. Both European Union and non-European Union managers must ensure that funds they manage appoint a depository. The depository of a non-EU fund must be in the country in which the non-EU fund is established, and that country must meet certain regulatory tests.
Until now, real estate fund managers in Europe have been under no compulsion to hold any assets with a depository, but the AIFM will change that. A new industry is now expected to mushroom among those able to offer depository services to real estate funds, and those that do so will charge a fee to the fund manager. After all, these depositories will carry the risk of being strictly liable for losses.
This, said Wylie and other experts, is a cost that will be borne by the fund manager but ultimately could be passed on to investors as part of the management fee. In a recent poll by PricewaterhouseCoopers, 41 percent of the respondents, which ranged from hedge funds to private equity and real estate funds, said they expected the directive to result in increased management fees, and more than half of the asset managers surveyed expect their profitability to be hit by the costs.
Given the likely cost to GPs and potentially to LPs, experts wonder whether using a depository is necessary. Unlike hedge funds, the assets being held by real estate funds are immovable objects – the properties themselves. This is not an asset that can be spirited away, unlike cash and electronic securities. The most that one might need to deposit is perhaps a share certificate related to ownership of a property.
Therefore, the question becomes whether using a depository is a necessary protection and, by extension, whether it is something that LPs would ultimately be willing to pay for.
Next steps
The AIFM directive will undergo a secondary rulemaking process, known as Level II, led by the EU Commission and Europe’s super-regulator, The European Securities and Markets Authority (ESMA), which will be created on 1 January 2011. During this process, the EU is expected to further consult with the alternatives investment industry in clarifying and detailing the directive’s provisions. Following that, EU member states should have one further year to pass the directive into national law, meaning early 2013.
Fuzzy passport picture
The most controversial part of the AIFM directive – marketing funds to Europe’s
investors – has been passed, but the result is blurry
General partners have plenty to digest from the AIFM directive, but the most important issue is to what extent they will be able to market their services and funds to professional European investors.
There has been much debate during negotiations between EU member states – the UK and France in particular. In the end, however, the text settled upon has been called a “fudge” or a “messy compromise” by some experts because it doesn’t set out one clear rule.
As expected, European Union fund managers that adhere to regulations about structure, transparency, reporting and others issues will have a region-wide “passport” from 2013 to market a fund to Europe’s professional investors. But for so-called “third-country” funds – non-European fund managers and European funds that are managed by a non-European manager – it is different.
Non-EU funds managed by EU fund managers and non-EU fund managers marketing EU funds can continue to market their product by adhering to national placement rules until at least 2018. However, the European Commission may introduce a passport for third-country funds starting in 2015. From that point, a dual marketing system will be in place until 2018, in which a passport scheme will co-exist alongside national private placement regimes, which allow marketing rights on a country-by-country basis. After this three-year period of co-existence, national regimes are set to be terminated after the entry into force of a delegated act by the European Commission.
Then again, said Nabarro partner Andrew Wylie, it is possible that third-country funds may never benefit from the passport if the Commission sides with Germany and France, both of which have argued that a country’s individual placement rules should continue. Indeed, he points out that some countries might tighten up their regimes if they wanted to, making life tougher for non-EU fund managers to market their product.
For some jurisdictions, the net result has been a reprieve. Jersey in the Channel Islands has been popular for London-based fund managers to base their funds, and experts had wondered whether Jersey would remain so after the directive.
“Prior to the directive, Luxembourg was expecting a huge influx of business from the Channel Islands,” said Rob Short, co-founder of fund administration firm Langham Hall. “That is unlikely to occur now with funds being able to passport into the EU under the old regime until 2018.”
The final chapter
Here are some of the key terms of the directive, which some GPs will find a painful read:
• Bonuses should be balanced appropriately with salary
• Cash bonuses are capped at 30 percent (or 20 percent for particularly large bonuses)
• At least 40 percent of bonuses for senior managers and other staff at funds must be deferred for at least three to five years. It will be 60 percent for “particularly high” remuneration and potentially can be recovered if relevant investments perform badly
• At least 50 percent of bonuses must be paid in “contingent capital”, which are funds to be called upon first in difficult times, and shares or equivalent ownership interests
• Managers must maintain a minimum level of funds of €125,000, plus 0.02 percent of gross assets exceeding €250 million
• The following groups are exempt from the directive: managers with aggregate assets under management of no greater than €100 million, unleveraged funds with less than €500 million in assets, pension funds, sovereign wealth funds and holding companies whose shares already are trading on a regulated market
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