EUROZONE: Cache 22

Here is a tale all the way from New York that exemplifies the amazing reach that Europe’s Alternative Investment Fund Managers Directive (AIFMD) has.

The story actually begins in Denmark and Germany, however, because regulators of these two countries have decided that even though non-EU managers of alternative investment funds do not need to comply with one of the chief AIFMD requirements – namely appointing a depository – nevertheless, Denmark and Germany insist upon it.

A depository, as readers will know, performs certain functions designed to protect investors such as monitoring cash flows of a fund, verifying if a fund actually owns an asset that it says it does, and monitoring the fund manager, and so on. It is a good thing in other words.

But what has this got to do with New York real estate fund managers or indeed managers from other US towns and cities? Well, imagine this scenario: You are a US firm that wants to launch a domestic fund and you are targeting European investors. Feeling the pressure to start the fund now, you want to work flat out to circulate a prospectus and would like to reach a first close in a few short months. You also have an eye on investors from Denmark and Germany that you just know are going to lap up your compelling pitch for whatever it is that you do.

But the problem is, the lead-in for Denmark and Germany’s regulators to rubber stamp your depository arrangements once your application is logged can be lengthy. Indeed, experts say an application takes 8 to 12 weeks to determine, so you have a little issue. You want Danish and German LPs, but it would be unfair to be able to offer your US investors preferential terms and not allow certain European investors into a first close with equally pref terms with a weak explanation that, “Sorry, you can come in the second close, but we cannot allow you in the first close because our application to be approved to market in your jurisdiction takes too long.” That would be plainly be unfair to them. So, in order to be able to allow everybody to have an equal shot at incentives for coming into the fund early, you get a hurry on to pick a depository and hope to demonstrate to the German and Danish regulators you have one appointed.

Though this does not sound like too much of a pain, in practical terms there is a dilemma. Perhaps in the first place, the notional fund manager thinks quickly about appointing a bank that can tick the box as a depository. Of course, a bank can be appointed. However, the firm might discover that the bank they talk with has quite a rigid way of dealing with funds that seek its services. They can have a model that is quite intrusive, perhaps insisting on pre-approval of investment transactions, or being unable to accept information after the event.

One can instantly understand that this is unappealing to US firms that quite often might have to move at lightning speed to seal a deal in a week. And here is the news: This is why some of them are quite frenetic in talking to as many fund administrators and other outfits as possible to see if they possess a more user-friendly way of working. This has been happening in New York and no doubt elsewhere. It certainly looks like a catch 22 or cache 22 if you will forgive a quasi-depository joke. Funds need a depository to market to Danish and German LPs, but if they choose a depository that prevents them getting deals done, it is hardly worth it in the first place. It could make it almost impossible to operate within a rapid deal process.

Now if you think this scenario only applies to the smaller shops you have never heard of because you assume all the big guns are already organized with depositories, you would be wrong. Some of the biggest franchises or stellar names in the business are needing to rapidly find a solution to the thorny question outlined above.

None of this is to be criticized, however. That is because one has to bear in mind the root cause of the AIFMD in the first place. After the huge shock to the financial system in 2008 and indeed major scandals such as Madoff, Europe got together and decided to try to protect investors from some of the worst evils under-regulated alternative investment fund managers could perpetrate. If ever there was to be a scandal or crisis again in the alternatives world because of under-regulation, next time it could be somehow worse for fund managers. Perhaps actuaries will turn their backs on alternatives, and investors would follow suit. So the pain and catch 22 of trying to pitch investors in Denmark and Germany is really part of a greater good.