EUROZONE: OTC rule is over the top

A new regulation drafted by Eurocrats could be the worst thing ever for opportunity funds…or mean nothing at all.

Agreed, there is some gap between those two statements, but it is the most accurate one having just spent an hour reading and re-reading a law firm’s advice to an opportunity fund manager based in Luxembourg.

The more solid conclusion, however, is that the industry should lobby to make sure opportunity funds are not caught by the new rule.

The regulation in question is the European Union proposal on over-the-counter (OTC) derivatives, which are contracts not traded on an exchange but instead privately concluded by two counterparties. Its genesis is that the near-collapse of Bear Stearns in March 2008, the bankruptcy of Lehman Brothers and the bailout of AIG highlighted shortcomings in the functioning of the OTC market, where 80 percent of all derivatives transactions take place. In response, the EU is trying to bring greater transparency to the market and reduce counterparty risk.

The text of the European Market Infrastructure Regulation (EMIR) was published last year, but the possible effects of it are only just beginning to dawn on people.

Last month, the British Property Federation warned of the “potentially dramatic effects” of the rules. Bill Bartram, director of property risk at JC Rathbone Associates, said: “The people that are going to be affected the most by these reforms are, without doubt, property funds who do not appear to have registered this as a threat.”

Before returning to the law firm’s advice, it should be noted that some private equity real estate firms are certainly aware of EMIR. Marc Mogull, founder of Benson Elliot Capital Management, attended a workshop seminar by Ernst & Young in October on the Alternative Investment Fund Managers (AIFM) directive. He put up his hand at the back and, to paraphrase, said: “Nevermind about AIFM, I want to talk about EMIR.” The rest of the workshop was dominated by it.

If you want detailed advice, please seek a qualified adviser, but essentially the threat is this: opportunity funds that hedge against interest-rate movements on loans used to make investments could come within the scope of the regulation and thereby be required to post highly liquid collateral, depending on the daily exposures of the relevant OTC derivative in place.

The problem is that real estate assets cannot be used to post collateral, so an opportunity fund would need to find cash – perhaps hundreds of millions of euros – to abide by the regulation. Cash is not something most opportunity funds are rich in, and so this would present a huge problem.

Indeed, Marcus Shepherd, finance director of Aviva Investors Real Estate, said in the British Property Federation salvo: “This could fundamentally change the way that property funds are structured.”

Now back to that law firm’s advice to the opportunity fund manager. The basic position seems to be this: a fund manager may well be a “financial counterparty” within the scope of the regulation, but it is unlikely to be party to any OTC derivative contract – that is more likely at the asset-owning level, the special-purpose vehicle. The draft regulation currently does not provide for an SPV, so the manager should not have to post collateral.

But wait. Even if the SPV were not caught, it might still come within the new rules if the size of the derivative contract is over a certain threshold – but that threshold has not been made clear. Then again, as the law firm points out: “Given that the OTC derivative transactions of the SPVs are not of a speculative nature (we understand that the existing derivatives are only interest hedges covering existing risks under existing facilities), they will likely not be taken into account in the calculation of the threshold.”

The law firm, however, also readily acknowledges it ultimately might be wrong in saying a fund manager would not be caught by the rules, noting that it would sort of make sense for the fund manager to be caught if an SPV was engaging in OTC derivatives. So, to return to the original point, this would be bad.

Mogull told PERE just before Christmas: “Two years ago, the unrealised swap loss on a medium-term loan could easily have reached 10 to 15 percent of the loan amount. Assuming 60 to 70 percent leverage, that would mean unrealised swap losses equivalent to 15 to 35 percent of invested equity. An obligation to post that kind of collateral could devastate returns on leveraged property funds and certainly would not be in the interest of fund investors.”

The new rules definitely were not designed to catch opportunity funds that enter into interest-rate hedges in the name of good risk management. Perhaps Mogull put it best when he said: “We can fret about AIFM but, if rational minds don’t prevail, we may actually have to do something about EMIR.”