On a crisp afternoon in early January, three real estate industry professionals gathered at the Luxembourg offices of Brown Brothers Harriman (BBH) to talk about the forthcoming, all-consuming Alternative Investment Fund Managers (AIFM) directive. The three professionals assembled for this special roundtable include Geoffrey Cook, partner and co-head of investor services for Europe, the Middle East and Africa at BBH; Michael Hornsby, real estate funds leader for Europe, the Middle East, India and Africa at Ernst & Young in Luxembourg; and Hubertus Bäumer, co-head of institutional property solutions at German asset manager Union Investment.
The roundtable is a neat mix: a large real estate fund manager, a ‘Big Four’ accounting firm and a bank that specializes in fund services – and they seem to hit it off. Indeed, the trio is so eager to exchange their views that they launch into a discussion about the directive even before the roundtable officially commences. Their enthusiasm is hardly surprising, given that the directive is already upon us.
In December, just a short time before this roundtable, the European Commission issued its latest salvo, the AIFM ‘Level 2’ rules, clarifying a number of important elements of the directive so far. Moreover, by July this year, every alternative investment fund manager in the European Union that manages an EU alternative investment fund (AIF) must comply with all the requirements of the directive. In return for compliance, the directive will provide the manager with a ‘marketing passport’ for the EU, allowing the firm to market products to institutional investors across the region.
As you can imagine, one-and-a-half hours of conversation is hardly sufficient to cover every aspect of this important piece of European legislation, which was created primarily in response to the 2008 global financial crisis and the Bernard Madoff fraud scandal. It initially was aimed at regulating the hedge fund industry, but it has engulfed private equity and real estate managers just the same.
“This is the first piece of major regulation since the 2008 global financial crisis,” says BBH’s Cook. “Its creation and tone reflects a very different reality of the world compared to the previous one, which focused on Undertakings for Collective Investment in Transferable Securities (UCITS) for retail investors and encouraged expansion across the European Union. The AIFM directive, however, is about institutional investors and is all about risk mitigation, investor protection and a number of other priorities borne out of 2008 and Madoff.”
Though there are certain exemptions for smaller operations, most managers would fall within the scope of the directive. An AIFM is simply a legal entity that manages one or more AIFs, and the directive captures EU managers managing EU or non-EU AIFs and non-EU managers managing an EU fund. To come within the scope, a manager need only to have raised capital from at least two investors with a view to investing it through a defined investment policy on behalf of those investors.
The main point to note upfront is the two clear aspects to the directive. First, there is the need for EU AIFs to be compliant by July 2013. Second, this piece of regulation is not just about compliance but also about planning how a future business in Europe should be structured. Hornsby says this is the point that E&Y is really trying to drum home.
“Senior management who see this as a mere compliance exercise will miss the boat,” Hornsby says. “In the long run, this is very strategic.”
Hornsby continues: “A fundamental question is: how are you going to structure your AIFM platform in Europe? Are you going to have multiple hubs or concentrate on one centre? The use of branches may also be possible. Are some of your products so independent they are best designated as self-managed? Management also should focus on operational efficiency opportunities. Why have six entities when you can have one? Another important consideration is where to build from a tax point of view. In essence, the big strategic question is: what sort of products and investors am I likely to be managing in the future and how does this drive my AIFM platform design?”
Cook agrees that it is a mistake to view the directive as simply something a business needs to be compliant with by the summer. “There are very big strategic decisions,” he adds. “In July 2013, it is more about compliance, but everything beyond that is about how one builds the right product set for the right investor set.”
The way the participants explain it is like this: Imagine you are a global investment manager headquartered in the US and managing hundreds of entities and funds out of a number of different hubs in Europe. How many AIFM’s do you need and in which countries are they located? This provides a very complicated case with many permutations.
Hornsby explains: “You probably have a complex product range – some offshore funds, some on-shore funds and some funds that will be below the directive’s scope or grandfathered. You also have segregated accounts and other exempt vehicles. Portfolio and risk management activities could be spread across several locations supported by a number of service providers. This complexity is compounded by the fact that the product range could encompass a variety of different asset classes other than real estate, which can be difficult to consolidate in one platform.”
Putting such a jigsaw puzzle together will require some key decisions, Hornsby says. “For instance, do I completely separate my non AIF business from my AIF business? What do I do with all my offshore funds? Do I bring them all on-shore and, if so, when? Do I consolidate operational centres because I don’t need people spread out between Munich, London and Paris anymore? I could have an all-in-one centre and fully use the management passport.”
Summing up, Hornsby adds: “At the end of the day, it is a question of making the analysis and optimizing outcomes. Everyone has their own legacy going into this process and a slightly different view as to what they want as an outcome.”
The practical impact
As Union Investment’s Bäumer recounts, the path to the current AIFM directive has not been an easy one. Introduced in 2009, it has been a ‘bumpy road’, as he puts it. “It wasn’t clear what kind of funds would be affected,” he recalls. “It was assumed only the hedge funds would be.”
Still, Bäumer’s company provides a good example of what it will mean to operate under the new directive. Union Investment is a large asset manager based in Frankfurt and whose real estate business is in Hamburg. It has some €21.2 billion in real estate assets under management in Europe, Asia and the Americas, and its client base is made up primarily of German private and institutional investors. Some €18.1 billion worth of assets are managed through three open-ended retail property funds operated by Union Investment Real Estate, and the remaining €3.1 billion in assets are managed through an institutional fund operated by Union Investment Institutional Property.
Not only does Union Investment manage direct real estate funds on behalf of third parties, but it also provides a “platform” for investors that want to use their own investment management or require exposure to a certain asset class such as residential property, where Union Investment will find an adequate partner and outsource the management to a third party.
Because Union Investment’s products are open-ended real estate funds and special funds, it already is regulated, and the themes and requirements of the AIFM directive are therefore familiar, says Bäumer. Still, the firm is devoting many hours to assessing everything about the directive to ensure compliance. “We have accounting systems and a risk management system in-house, but a lot of work has been done on how much we need to change it, as well as how many man hours will need to go into reporting under the directive and the cost of that.”
While the Level 2 guidelines that came out in December were meant to clarify everything, Bäumer says there still are some blind spots. “The problem is that words in the regulation say ‘adequate’ or ‘periodic’, but those are unclear,” he argues. “On practical implementation, it is about making sure we are compliant, but the devil lies in the details. We have spreadsheets on every single paragraph, including whether we have it already and how much work is needed.”
In general, German special funds are not expected to be at risk at all. Therefore, firms like Union Investment should be well prepared to meet the regulations. Still, from the way Bäumer talks about it, one can easily imagine that managers have been spending significant time and money wading through the draft legislation to make sure they will be compliant.
We know this for sure from BBH, a global investment bank that acts as a depository and provides fund administration and related services for more than $100 billion in alternative assets, including more than $40 billion in real estate assets. As a service provider, Cook says BBH’s biggest change relates to the additional duties that are included in the custody and depository requirements of the directive – services that the bank provides to both offshore and cross-border managers of alternative assets. “Our AIFM taskforce is reviewing and enhancing our current operational workflows and systemic infrastructure,” he emphasizes. “We also are working individually with clients to make sure they understand all the aspects of the directive before July 22.”
Meanwhile, Ernst & Young has been performing a significant amount of advisory work for depository banks and asset managers around Europe – as well as those from overseas – since last summer. At the same time, the accountancy firm is working hard to promote a “sensible and practical” interpretation of the Level 2 clarifications with relevant trade associations as well as clients.
In terms of depositories – just one of the many items that managers need to be compliant with – the depository must be located in the home member state in the case of an EU fund. The depository has to monitor the reception of all investors’ subscriptions and hold in custody financial instruments, for which it has a strict or ‘no fault’ liability for losses.
All European Union countries are required to introduce legislation to bring in the directive, and national laws will be a “copy and paste” of the directive. Despite this, BBH’s Cook says depository provisions do provide national regulators some leeway in determining the eligibility criteria for depositories. For example, Luxembourg, the Netherlands and Germany are allowing non-banks to be depositories for AIFs for the first time, and other countries might follow.
Given that large asset managers often find themselves with a number of depository banks, it is suggested that the directive could be a catalyst to consolidate the number of service providers. “What people are predicting is that the ‘one-stop shop’ or the fully integrated service provider is going to be the strongest model,” says Hornsby. Union Investment’s Bäumer, however, points out that this might not be healthy if it endangers competition.
Still, it seems as though the market is very fragmented when it comes to depositories. The theory is that fund managers might decide to ‘clean up’ or reduce the number of banks they use from say eight to just two. “The thing about being a depository bank for real estate is that, if you are doing the administration, you are getting 90 percent of the information you need to be a depository as well,” observes E&Y’s Hornsby. “If you have two or more service providers, it could be less efficient.”
The cost of compliance
The directive might well mean consolidation among service providers, but for real estate fund managers it means additional expense. Performing an audit and making necessary changes to become fully compliant is a costly business. For this reason, the participants discuss the potential effect upon smaller managers and start-ups.
Indeed, Cook points out that there is a question mark over whether the directive creates a higher barrier to entry. “Is this actually something that will assist the large players to the detriment of the smaller players that need to cover the fixed costs of becoming compliant?” he posits. “It favors those that already have infrastructure.”
Ernst & Young’s Hornsby argues: “People will decide what their core competencies are: investment advice – people who actually source deals and make recommendations to buy, sell and add value to assets – or the skill of fund management and governance. What the directive does is clearly define the organization and functions a fund manager needs to manage institutional money in Europe. It does not directly regulate entities providing investment advice,” he stresses.
The directive also could be a factor in a further swing to segregated accounts, as BBH’s Cook suggests. Managers typically won’t offer segregated accounts unless they have a certain amount of assets under management because of the costs. However, because of the cost of becoming compliant as an AIFM, the cut-off point between a segregated account and a fund starts to tip and change. “Watch that space,” he says, meaning we could see a further expansion of segregated accounts. “The directive is putting additional cost and pressure on one solution for institutional investors, which has the potential to make other types look attractive.”
Additionally, Hornsby notes that some American firms are saying they won’t raise money in Europe anymore. A US firm might consider that option because it has only a small percentage of its investors from Europe at the moment and becoming complaint sounds very complicated. “They will stay in Delaware or offshore in the Cayman Islands or the Channel Islands and raise enough capital from other investors to buy assets in Europe,” he says. “They just won’t offer these funds to European investors anymore.”
Marketing and passports
The directive is indeed powerful enough to dictate the way a firm raises capital from investors. An EU manager marketing an EU AIF must become compliant with the directive by July this year and cannot choose the private placement anymore. The upside is that once compliant, it is eligible for a ‘passport’ to market a fund to European institutional investors.
In contrast, an EU manger marketing a fund for outside the EU must comply with the directive, but it cannot get a passport until 2015. In the meantime, it can continue using the private placement method.
Here is another permutation: A non-EU manager marketing an EU fund can only choose the private placement method, but it can have a passport from 2015 so long as it is AIFM compliant. However, it doesn’t have to go for a passport. It could continue using the private placement method past 2015, though it should be aware the EU has the power now and probably will outlaw private placements from 2018. Confused? Well, it is not so confusing once one has had the chance to study it, but the permutations are great.
So, say a company is in Europe raising money from German investors. It is on-shore and must comply with the directive starting this year. If a firm is offshore, it has a choice to get a licence under the directive in 2015 and act as if it is on-shore, with all the benefits of being an AIFM.
It comes back to the starting point that this isn’t just about compliance but about the long-term strategy. BBH’s Cook says: “You might not see existing funds change overnight, but you will see changes when managers talk about launching their next product.”
As E&Y’s Hornsby says, there are some important philosophical considerations about where to base the AIFM. “Do I want to work with BaFin (the German regulator), the Financial Services Authority (UK) or the Commission de Surveillance du Secteur Financier (Luxembourg)? We also see that everyone has a different legacy structure. Sometimes it is obvious where to locate the AIFM, and sometimes it is more challenging. Sometimes the decision can be political. The logical answer might be to have one AIFM in Luxembourg, but because the firm’s headquarters is located in another country the AIFM model needs to be replicated there as well.”
As the discussion begins to wrap up, the conversation touches on the underlying investors. Union Investment’s Bäumer mentions that investors “want more say in what they do. What we have seen is lots of investors that asked for more individual solutions. One could be that they decide to separate the platform from the investment management. The directive allows that; you can change the investment manager whenever you want but keep the platform.”
At the same time, some firms outside of Europe will get used to AIFM. Hornby says: “Some funds will no doubt benefit from it, and I would suggest that large-scale core funds that are all about stable-income returns and raising money from a broad range of investors could benefit enormously in the long run from the passport.”
One may get the impression that the directive might have been forced upon real estate fund managers, given it initially was aimed at regulating hedge funds. However, the key is to find the opportunities as much as deal with the challenges. Indeed, the next few months will be busy for real estate managers as well as depositories and consulting firms, although our three protagonists seem to have things well in hand and are ready to embrace the new norm.
Partner and co-head of investor services, EMEA
Brown Brothers Harriman
Cook is a partner and co-head of investor services for Europe, the Middle East and Africa at Brown Brothers Harriman (BBH). He also operates as the supervising partner of BBH in Luxembourg and Zurich and is responsible for global relationship management and sales.
Cook has 23 years of financial industry experience, including a long stint at BBH, which he joined in 1997. Prior to BBH, he was a senior manager in the London, Luxembourg and New York financial services practices of Pricewaterhouse, which merged with Coopers & Lybrand in 1998 to form Price-
Co-head of institutional property solutions
Bäumer works for Union Investment, where he co-leads the German firm’s institutional property solutions business. The firm has some €19 billion in real estate assets under management in Europe, Asia and the Americas, with a client base that comprises German private and institutional investors.
Before joining Union Investment, Bäumer was a managing director of Generali Immobilien Verwaltungs and a member of the board of directors of Generali Europe Income Holding in Luxembourg. While at Generali, he was responsible for setting up and looking after indirect investments as well as developing the insurance group’s property funds business.
Real estate funds leader, EMEIA
Ernst & Young
Hornsby is the real estate sector leader for Ernst & Young Luxembourg, as well as the real estate funds leader for Europe, the Middle East, India and Africa. He has more than 20 years of experience in audit and advisory for the property industry.
Hornsby is a member of the real estate working committee of the Association of the Luxembourg Fund Industry (ALFI), as well as the reporting committee of the European Association for Investors in non-listed Real Estate Vehicles (INREV). He also is chairman of the AIF (alternative investment funds) Club of Ernst & Young, Luxembourg.