ROUNDTABLE: A grand showcase

This year, new regulations governing the operation of fund managers in Europe really will begin to bite. The Alternative Investment Fund Managers Directive (AIFMD), which officially came into force last summer, is familiar to many private equity real estate firms. However, in July, the grace period for existing fund managers to become compliant with the new directive will come to an end, which is prompting uncertainty among some firms and a mad scramble among others.
Therefore, just before Christmas, PERE brought together senior figures from two global investment firms with major platforms in Europe – Kenneth MacRae, head of Hines’ Luxembourg office, and Alexander Taft, Invesco Real Estate’s managing director of structured finance in Europe – as well as Anita Lyse, head of real estate at specialist fund administrator Alter Domus, to discuss the industry’s response to the new rules and the way in which firms are reacting.
Over the course of the conversation, the two fund managers insist that, for them, the new regulation represents not so much a burden as an opportunity to showcase themselves as large, sophisticated organizations that already cope with high levels of regulation and self-imposed checks and balances. Becoming compliant could give them an edge over competitors or even lead to further consolidation as they prove their pan-European capability to investors, they point out.
First impressions 
AIFMD was first proposed in 2009, and both Hines and Invesco Real Estate have used the time to work up considered responses and their ultimate applications. Much paper has been necessary, though they suggest that not that many changes were required in order to comply.
Houston-based Hines, with around $44 billion of assets under management, is a global real estate investment manager with strategies ranging from core to opportunistic and development. “We have been running regulated funds through Luxembourg since 2005,” MacRae says. “From a real estate perspective, I was quite surprised by how little additional work was involved in complying with the directive.”
Invesco Real Estate is the property arm of Invesco, one of the world’s largest investment management firms with $745.5 billion in assets under management. It serves only institutional investors managing assets located across the US, Europe and Asia and has been investing on behalf of its clients in Europe through a regulated framework for 15 years.
“The first draft of AIFMD was no surprise and reminded me heavily of German law,” says Taft, a German lawyer by training. “As a result, we were used to depositories and management companies and already had established third-party management relationships. So, while all these things were totally new for some of the market, it was business as usual for us, more or less. I wouldn’t say that AIFMD didn’t break any news, but it was no shock.”
Becoming compliant 
Hines decided to commit an in-house team to ensuring compliance with AIFMD at an early stage, setting up a steering committee and project team in 2011. “There was a team of four people heavily working on it, ensuring that we were putting the policies into place where they were needed,” MacRae recalls. Hines’ application for licensing under the directive has been submitted to the regulator in Luxembourg, and MacRae anticipates that it will be granted this quarter.
Invesco Real Estate submitted its license application shortly before Christmas. Taft says the year’s grace granted to existing fund managers was useful because it allowed the firm to sit back and watch how the procedure worked in practice. However, he warns: “Now the time is coming where you need to submit so that you are not late, because the regulator will have a backlog. They will struggle to get through all the licenses, so you should be a little bit ahead of the pack. Probably, [our approval] will come in mid-March.”
MacRae was more enthusiastic about being an early mover, as he wanted to be able to counteract any influence that hedge fund operators might have on the regulator over the way in which the directive is applied. “I met with the regulator in July and explained the optimal way we like to operate,” he says. “Unfortunately, the directive and Luxembourg law now stops us operating in the most efficient way, so we needed to explain the issues and see if there could be any room to maneuver.”
Indeed, the way in which the financial regulator in each of the member states applies the rules is likely to vary. There also are potentially many different compliant models that can be adopted. 
“European regulation is principle-based,” Taft explains. “I like that because it allows businesses to come up with policies or procedures that meet the needs of the business, as well as the needs of investors. Meeting the needs of the regulator actually comes last. In principle, though, all those needs shouldn’t be contradictory. The idea of the regulation is to provide ‘bandwidth’ principles and, if you can make a good case that you are applying the principles and have sound procedures, you should be fine.”
Meanwhile, Alter Domus’ clients are asking the administrator for advice in becoming compliant. Indeed, not every fund has the in-house resources of Hines or Invesco Real Estate to deal with various issues. In addition, Alter Domus is looking to seize the opportunities offered by the directive. For example, it is bidding to become a depository, as fund managers will be required to have one under the new regime. 
“We see a number of small and mid-sized fund managers that are far from being as well advanced in this discussion,” Lyse says. “We received feedback from one of our clients that they are going to take a final look this quarter, which is when they will make the in-depth review and set the strategy. It is what we are seeing for other mid-size and smaller clients as well.”
It ain’t easy being small 
Administrators like Alter Domus are likely to play a significant role in helping smaller funds to adjust. “For us, it has taken a lot of time and resource to get into the directive and understand what it means for our clients and what it means for us to be able to serve those new needs,” says Lyse. “Most of our clients are now coming to a set-up with which they feel comfortable. Now it is time to get the application in, whether that is in Luxembourg or outside of Luxembourg; to get the depository appointed if the fund is in the UK, for example; and get on with it.”
Alter Domus is unlikely to put together full applications for AIFM status on behalf of its clients, but Lyse predicts there will be some increased work helping funds to comply. That may be counterbalanced in part by some funds looking to increase their substance within Luxembourg in order to take continued advantage of the country’s favorable tax regime and consequently outsourcing fewer services to administrators. 
Submitting an application, by the way, can be expensive. Taft says he had a conversation with a fund manager in Germany whose firm spent a “seven-figure sum” on advisory fees, although he puts his own firm’s spending on the process at a relatively low six-digit figure. 
Some fund managers may even attempt to avoid the expense and hassle of compliance altogether. “We do get questions from clients about how they can get around this,” Lyse says. “We have clients that want to go offshore or stay on the Channel Islands, for example, to avoid this, but the majority recognize this is today’s reality and they need to accept that and move forward. Personally, I cannot see how you can get around things in the long term.”
Non-EU managers with EU funds can have a passport from 2015 to market them across Europe, provided they are AIFMD compliant. However, they can still continue to market funds using the private placement method past 2015, where provided for in the respective member states. The EU has signalled that it is likely to close that loophole from 2018.
Lyse says a few US clients have indicated that they will avoid the need to become AIFMD compliant by relying solely on their American and Asian investor bases and ceasing to market their funds to EU investors. They can, of course, continue to buy European property, but they effectively will be unable to raise European capital. 
That prospect causes Taft and MacRae some amusement. “More for us,” they quip.
Indeed, there is an expectation in the European real estate market that some smaller funds will go under because they are unable to adapt to the new regulation. “There are many people who think that smaller fund managers must either find themselves a sort of niche or they will just die,” says Lyse.
MacRae welcomes that outcome. “There should be some evolutionary selection going on here,” he says. “This is clear Darwinism, and you need to be fit for purpose.” 
Still, not all fund managers will need to be AIFMD compliant. Managers of separate account clients do not necessarily need AIFMD status if they are providing investment advice or individual portfolio management only. Only managers of funds with multiple investors are covered by the directive, and some very small funds will be exempt on the grounds of their size. 
Taft suggests that some smaller players could benefit if they outsource more of their administrative functions in an effort to become compliant. “If they do that, they actually will increase their own profitability by focusing on core activities and expertise,” he argues.
Challenges and opportunities 
The new rules may not have come as a shock, but they have caused some inconvenience even to the Hines and Invescos of this world. For instance, in order to comply with the directive, Hines has been forced to alter its corporate structures a little. 
Hines has individual management companies for each of its funds and needed to create a separate fund management entity, an AIFM, from which the management companies contract services. This is in addition to its existing licensed business as a Professionnel du Secteur Financier, which is precluded by the directive and law from performing both its existing and the new AIFM roles.
“The inefficiency is in the fact that you are duplicating legal entities, which means a higher cost for a start,” says MacRae. In addition, personnel must be transferred between companies so the new AIFM vehicle has sufficient substance to demonstrate to the regulator that it is not a ‘letter-box entity’. It also needs its own office – of sorts. 
“One very minor thing, which I hadn’t anticipated, is that the regulator insisted we have a separate office within our office,” MacRae adds. “We have to partition off an area now as the new entity’s office, where the books and registers of that entity are kept.”
Whatever the practical difficulties, both MacRae and Taft are determined to derive some advantage for their businesses from the directive. “When I looked at the first draft of AIFMD in 2009, I wrote a paper to understand what that could mean,” Taft recalls. “At the forefront of that was the possibility to market and to manage fund products across Europe. The idea was to look at the positives rather than the negatives.”
Compliant fund managers will gain a passport to market funds across the EU, a benefit that Taft says should not be underestimated. “Through AIFMD, you can market in 28 countries quite cheaply and seamlessly, without real regulatory risk,” he argues.
MacRae believes complying with the new rules also could help fund managers market themselves to potential investors. “There are great opportunities for showing to your investors an even higher level of transparency,” he says. “This is just another way in which we are able to differentiate ourselves from some of our competitors.”
Taft concurs. “We have both taken a conscious decision to go into a regulated framework that provides transparency and comfort to investors, and we can leverage on that now,” he says. “Our profitability in a low returning environment comes from creating more productivity per unit of work and scaling it. That puts smaller market participants under pressure, so they need to be even smarter and find ways to provide investment strategies in a way that makes sense for their clients.” 
Struggling with risk 
Some areas of the regulation are highlighted by the roundtable participants as likely to have the greatest effect on real estate funds. Chief among these is risk management, as the regulation requires AIFMs to establish policies and procedures for operational risk management within the fund, which are to be reviewed on an annual basis at least.
“What many managers are struggling with is the risk management function,” Lyse says. “All of them do risk management already, but how should that be structured internally and how should that be formalized? There are a lot of options in that area, but we are saying to clients: ‘You already do risk management, so it is a question of putting that down on a piece of paper because you need to have a formal policy’.”
Taft and MacRae both argue that risk management is something that their firms – and the real estate industry as a whole – do very well as a matter of course. The quantitative side of risk management as known in other sectors of the financial industry, including model-based back and stress testing, is where the industry has a way to go, but it also is limited in its ability due to a lack of data, coherent benchmarks and the slower life cycle of real estate. Most financial instruments are traded daily; real estate values in comparison are available only quarterly, if at all, on a valuation or transaction basis.  
In a way, that always has presented an argument against real estate fund managers being swept up in AIFMD in the first place. The directive, which came in response to the financial crisis of 2008 and the Bernard Madoff fraud scandal, aims to help protect the financial system from further shocks and provide additional protection for investors. At its heart is a list of rules for the authorization, ongoing operation and transparency of fund managers that market and manage alternative investment funds within the European Union. 
“It is something we need to live with,” says Taft. “It is a matter of fact that financial institutions have failed to deliver to their clients in the past, and therefore the reaction of the governments after the fall of Lehman Brothers and the financial crisis is to be expected and probably the right thing.” 
Still, Taft adds: “Real estate is 70 percent to 80 percent operational risk management, from buying and conducting due diligence to proper asset management and having a manager at the building to see that it is abiding to health and safety rules.” 
Invesco Real Estate introduced formal risk reports in 2012 and now produces them on a quarterly basis. In the future, those will be submitted to the board of the AIFM for review and approval.
Hines has taken a similar approach. “Everyone is looking at risk on a regular basis, but it was never formalized and was never segregated out,” says MacRae. While his firm is producing more frequent risk reports and will have a dedicated risk manager reporting to the AIFM, he predicts that some funds will hive off the formal risk reporting function to administrators while keeping asset-focused risk management in-house.
Taft adds that it is important to understand, while the directive calls for more formal risk management procedures, that does not mean that funds must eschew risk altogether. “You can do proper risk management in an opportunistic fund,” he says. “It doesn’t mean you don’t buy anything; it means buying exactly what fits into the risk appetite agreed upon with the client and stipulated in the fund documentation.” 


The depository conundrum 
AIFMD mandates the appointment of a depository to monitor cash flow, to ensure safekeeping and recordkeeping of assets (primarily ensuring that title in the assets actually is bought) and to oversee certain operational functions. Lyse suggests that this is the issue of most concern among UK funds, which have hitherto not been required to use depositories. It also is a novelty in the Netherlands and the Nordic countries, although not in Luxembourg, France or Germany, where funds already use depositories.
“There are big question marks about how this is going to work and what the purpose of it is,” says Lyse. “It is another layer of cost, and many people don’t see the benefit of it.”
Taft argues that “real estate has been caught up in a requirement aimed at regulating the activities of funds dealing in tradable securities and other financial instruments.” Regulators are seeking to avoid a repetition of the Madoff scandal, which would not have happened with a proper depository system ensuring assets actually are held in custody for the fund.
“We lost that battle, so we need to move on,” MacRae says. Still, “to be honest, I am not sure anyone sees the benefit in this additional layer of work that depositories are supposed to undertake now. It is a fund cost, so it hits investor returns.”
The depository rules may provide some business for Alter Domus, however. It is applying for licenses to become a depository in the UK and in Luxembourg. “Being a depository is a lot about collecting documents, keeping track of your investments and ensuring that you have everything on hand to verify ownership at all the levels of the chain of ownership,” says Lyse. “As an administrator of funds, we already have those documents on record for many of the underlying special purpose vehicles and property companies. Therefore, [if we also are the depository], there is much to gain in terms of efficiency.”
Odds and ends 
Several other issues for real estate funds are identified over the course of the discussion. In truth, there would be too much to log here. Still, there are a few additional items worth mentioning.
One issue is that AIFMD calls for the independent valuation of assets under management or for safeguards to be put in place to prevent any conflicts of interest if the AIFM carries out valuations itself. “The majority of fund managers use external valuers, but there still are some smaller fund managers who would try to do the valuation internally,” Lyse notes.
The AIFMD also requires remuneration policies to comply with detailed remuneration rules. That may have implications for the way in which some funds distribute carried interest to their investors.
As a traditionally core investor, Invesco Real Estate has never paid out carried interest. Taft says his firm has been in dialogue with the regulator over whether it can carry on with its current policy.
“What I took out of the directive is they expect there to be alignment of interest and transparency so that the fund manager doesn’t profit unduly at the expense of the investor,” says MacRae. “If you look at the big players, we have always acted in that way. We are dealing with institutional investors that are very smart themselves and wouldn’t have it any other way. We haven’t had to do anything additional in this matter.”
Lyse suggests that, while AIFMD does not say much about tax, it has potential tax implications where the AIFM and management company are based in different countries. In some jurisdictions, there is doubt as to whether the fund will be taxed according to where it is registered or where the fund manager is based. 
“We have some clients that are still worried about that,” Lyse says. “Their local authorities haven’t come out with a clear-cut position on this topic yet and, for that reason, they still are sitting on the fence and looking at what is going to happen over the next few months.”
With the full implications of the directive only becoming clear over a period of years, it is likely that AIFMD will alter the European fund management landscape significantly but gradually. “We have had an event that really causes firms to evolve,” MacRae sums up. “Those that adapt will not only survive, they will benefit. For those firms that try to resist the change, it will be a very difficult future.” 
Anita Lyse 
Head of real estate
Alter Domus
Lyse is the head of real estate at specialist fund administrator Alter Domus, which provides services for more than 1,500 real estate funds and holding, financing and property companies worldwide. Based in Luxembourg, she is expert in the management, accounting and financial reporting, corporate tax and legal aspects of Luxembourg-domiciled vehicles. Before joining Alter Domus in 2001, Lyse was a market analyst at Alcatel Business Systems’ mobile phone division.  
Kenneth MacRae 
Managing director
Hines (Luxembourg)
MacRae joined Hines in 2002 and has been managing director of the firm’s Luxembourg operations since September 2008. In that role, he heads up a team of 30 professionals servicing 15 different investment vehicles with more than €4 billion of assets under administration. Prior to joining Hines, MacRae was group financial controller of an international boutique hotel group. 
Alexander Taft 
Managing director of structured finance, Europe
Invesco Real Estate
Taft is responsible for the legal and tax aspects of corporate real estate transactions and fund structures for Invesco Real Estate throughout Europe, as well as sitting on the investment firm’s European investment committee and European executive committee. He is a German lawyer by training, admitted to the bar in Munich. Before joining Invesco in 2008, he was a partner with the law firm of CMS Hasche Sigle and advised clients in all legal aspects of corporate real estate and M&A transactions.