Will the AIFMD fall victim to the law of unintended consequences?

Date: June 16, 2014

The AIFMD is designed to increase investor protection by introducing an EU-wide framework for the regulation of alternative investment funds. 

If it succeeds it could result in more widespread interest in these products and greater competition, but there is a risk that the high cost of compliance could encourage the providers to move elsewhere.

It is the North American alternatives industry that is the key. This could turn out to be a major issue, especially for European pension funds, as many have historically relied on US-based hedge funds to diversify their portfolios.

Around 10% of American hedge funds have an office in Europe, but the anecdotal evidence suggests that a number of these firms have decided to pull out as a result of the new legislation. Many already have access to the Asian and the Middle Eastern markets, and if they can attract sufficient capital from these less onerous jurisdictions they can avoid the cost of having to comply with the new Directive.

A survey of the global hedge fund industry by KPMG found that 50% of the largest managers with AUM of $5bn or more had thought about exiting markets or other lines of business because of increased regulatory pressure. Just over half of the respondents from Europe had considered moving their fund domicile, management company and/or centre of main economic activity for the same reason.

It is possible that many of them will settle on a more pragmatic approach such as the adoption of a dual product strategy. This would entail having one AIFMD compliant version of the fund for distribution in the EU and another based in a friendlier jurisdiction like the Cayman Islands for sale in the rest of the world. If this is the case it could result in European investors having to buy smaller, less cost-efficient fund classes.

Dave Goodboy, the Founder of the Palm Beach Hedge Fund Association, says that at its very core, capital has a freedom seeking soul. “It flees regimes with onerous regulatory requirements and gathers in less regulatory environments. The burdensome AIFMD can only impair the EU as a domicile for alternative investments.”

It is not just the EU that has been toughening up its rules. In the US, the new legislation introduced as a result of the Dodd-Frank reforms, represents the biggest overhaul of financial regulation since the 1930s with hedge funds now having to register with the Securities and Exchange Commission.

Running these sorts of products is an expensive business wherever they are based with the KPMG survey estimating the average cost of compliance for a small outfit to be $700,000, rising to $6m for a medium-sized operation and $14m for the largest.

It is much easier for the bigger firms to absorb these costs than the smaller organizations, especially as they are the ones that are more likely to attract the most lucrative institutional mandates.

Often it’s the smaller boutiques that drive innovation, but at least in the US the Jumpstart Our Business Startups (JOBS) Act means that hedge funds can now advertise and take money from retail investors for the first time. Hitherto this had been a largely untapped source of capital for these products, yet it remains off limits for their European counterparts.

“The EU appears to be taking the opposite tactic of the United States in the alternative investment universe. The United States recently allowed hedge funds to market via the JOBS act, while the EU is seeking to stifle the very same type of fund from marketing with the AIFMD,” says Goodboy.

It is possible that US-based alternative investment fund managers may decide not to market their products in Europe, particularly if they only have a small proportion of their AUM in the continent, although this may change once the AIFMD passporting system is extended to non-EU managers in 2015.

Until then EU-based funds have a big advantage as they can market to all member states under a single registration, whereas offshore managers will have to use the private placement regime in each country in which they wish to operate.

“Hedge funds and alternative investments are designed for sophisticated, high net-worth investors. These individuals do not require the nanny state to build a wall of protection,” warns Goodboy.

There is however a strong counter argument. Many European investors have steered clear of alternatives because of their relatively uncontrolled and sometimes opaque practices. It is perfectly feasible that the tighter regulation will encourage pension funds and others to increase their allocation to this area.

It is still too early to tell how it will work out. If managers operating outside of the EU believe that the larger potential market justifies the additional cost of compliance they will continue to operate here and may even expand. The more pessimistic might avoid the region altogether, although that is more likely to be the case for smaller firms or those with minimal AUM in Europe.

Visit our AIFMD resource page for more articles and information.

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