EUROPE NEWS: Big fear for smaller funds

Advisors to smaller property funds last month were urging limited partners and others in private equity real estate to help lobby against the impact of the forthcoming Alternative Investment Fund Managers (AIFM) directive.

The fear is that the costs associated with complying with AIFM will lead to a “drying up” of the pipeline of smaller fund managers, which by implication limits the overall choice of managers and strategies for investors.

AIFM, which is being ushered in by the European Commission based in Brussels, already has been the subject of a lengthy consultation process. However, with rules set to come into force in July 2013, advisors were pushing those in the industry to submit responses to the latest questionnaire to the UK Financial Services Authority by 25 May.

Rob Short, founder of London-based fund administration firm Langham Hall, said:  “There’s a general view that fund managers and investors will simply bear the costs to comply with the rules and get on with business. However, despite the fact that there is still little detailed guidance that anyone can act on, there is the realisation that the smaller real estate fund managers will be significantly affected.”

Indeed, fund managers will need to comply with the full provisions of AIFM if their total net assets under management exceed €500 million. In mainstream private equity, debt within portfolio companies is excluded from the ‘fund-level gearing’ definition of the directive. Therefore, with management fees at 2 percent of commitments, there will be income of €10 million per year before private equity firms need to comply with the directive.
However, experts pointed out that, for private equity real estate managers, it is not the same. They argued that real estate fund managers often use debt that likely would count towards fund-level gearing, even if it is within a special purpose vehicle. This means that real estate managers will be caught by the lower €100 million threshold set out in the rules.

Models submitted by Langham Hall to the Financial Services Authority show that fees for real estate fund managers could be one-tenth of those of their private equity counterparts when the provisions of the AIFM directive kick in. “We calculate that they will then need minimum regulatory capital of €125,000 and have more than €100,000 of extra internal and external compliance costs per annum to take care of the extra risk management, reporting and insurance,” said Short. 

Many of the most successful fund managers today started out just like any small business, with minimal infrastructure and no guarantee that future cash flow would make the business viable. Economic conditions, however, have made funding a start-up fund management business much tougher for a number of reasons, including the length of time it takes to raise a fund.

“That means that a proportion of the set-up costs are likely to have to be borne by the manager,” Short said. “In addition, limited partners want a greater financial commitment from the manager in the fund and are more likely to obtain favourable terms such as discounted management fees, both of which have an effect on manager cash flow. Furthermore, given current market conditions, the manager may need to use a placement agent and is likely to bear those costs as well.”

Experts such as Short point out that all but the very largest LPs find it more difficult to achieve diversification through direct investing. Therefore, they are committed to indirect investing, and a common strategy appears to be a portfolio containing a number of large fund managers and a number of smaller specialist fund managers. 

“LPs realise that the consolidation that the directive will accelerate will dry up the pipeline of these smaller fund managers, which are creating a range of choice, including funds that are specific by geography or by sector,” Short said.

Another key provision of AIFM will be the requirement for a fund to have a depository, Short noted. The costs per fund are likely to be in the region of 10 basis points on net asset value, subject to a minimum in the region of €40,000. “Again, it will be the smaller funds and fund managers that will suffer most from this provision,” he added.
Short believes there is still much to be gained from submitting responses to the Financial Services Authority. “The unintended consequences of this directive are significant, and small fund managers, limited partners and other affected parties should contribute,” he said.