Long road to ruin? AIFMD and the high cost of unintended consequences

The introduction of the Alternative Investment Fund Managers Directive means the hunt for yield is about to get tougher, writes Emma Cusworth.

Hedge funds had been enjoying a resurgence in interest due to the prolonged period of historically low yields, but the Alternative Investment Fund Managers Directive (AIFMD) threatens to cut off access to many of the best managers for all but the most ardent and well-resourced investors.

22 July marked the deadline for managers wishing to market to European investors to register for authorisation under AIFMD, which is the most significant EU regulation of the alternative investment funds industry in recent times. All alternative fund managers (AIFs) based in the EU are subject to AIFMD whether they offer EU or non-EU domiciled funds. The Directive also governs non-EU based AIFs marketing funds in the EU.

Yet, so far, the willingness of US managers in particular to register under the Directive has been lacklustre.

RESTRICTED CHOICE

According to Lisa Fridman, head of research at PAAMCO: “We are hearing that, due to the complexity of full registration and passporting not being available yet for non-EU based managers, a significant number of US managers are deciding not to actively market to European investors, relying instead on reverse enquiry.”

Anecdotal evidence of a meaningful withdrawal of US managers from the European market is growing, with investors reporting a decline in the number of funds contacting them and frustration at the lack of information they are able to receive now the Directive is in force. Some experts have suggested less than 40% of US managers plan to register in at least one jurisdiction.

Under the reverse solicitation rules, however, investors are finding it increasingly difficult to conduct proper manager research. The exact interpretation of what constitutes reverse solicitation has not been clearly defined in many European jurisdictions and varies between them.

“Managers are quite nervous to protect themselves from the risk of running into problems with the regulators,” according to Diane Miller, senior investment consultant at Mercer. “The big question is whether it is considered marketing if a consultant mentions a manager’s name to a client. We would say that it is not.”

Capital introduction services, however, have traditionally proven to be an invaluable route for investors to discover which hedge funds are worth exploring, but those teams are finding their ability to provide introductions being restricted as it could constitute marketing.

The lack of cap intro is a particular frustration for investors. One senior investment representative of a large UK institution demonstrates this, saying: “AIFMD is the worst piece of legislation ever written. It really inhibits our ability to do manager research.

Consultants are typically weak in this area so we rely on the capital introduction route. That is being severely restricted so we don’t have that avenue anymore.”

Even where some institutions have existing relationships with US managers, they may find their ability to allocate further capital becomes limited. It is not always clear, for example, if private banks would be able to add new clients’ money to managers with whom other clients are already invested.

As Patrick Ghali, managing partner of hedge fund advisory firm, Sussex Partners, explains:

“We have seen managers saying they can’t take additional capital from some clients. They are saying ‘thanks for your business, you can keep your current allocation, but you won’t be able to add more.’ Where a private bank has 100 clients invested in a manager, it is not clear whether the 101st individual could be grandfathered in, for example.”

Even for US managers planning to market under the transitional provisions using private placement, there will likely be a greater concentration on certain key jurisdictions. Going down the private placement route will take longer to register and cost more than many expected and, some jurisdictions, notably France, Denmark and Germany, are making it increasingly difficult if not impossible to do so, requiring managers to appoint one or more firms to perform a “Despository-Lite” function of safe-keeping of assets, cash-flow monitoring and oversight.

“Marketing under the private placement regimes in Europe involves a pretty onerous process and is not inexpensive,” says Graham Rodford, chief operating officer at Omni Partners, an AIFMD-licensed alternatives specialist asset manager.

“Importantly, there is no harmonious definition as to what constitutes marketing across the different countries in the region. Firms will have to consider the rationale for each jurisdiction carefully and make a commercial decision in each case.”

For many US firms, the demands placed on them by their home regulatory regime will already prove a stretch. Furthermore, with the 40 Act coming into effect, US hedge funds are able to access a significant and largely untapped pool of capital from the domestic retail market.

“A large proportion of the US hedge fund industry is deciding it is not worth the effort to market into Europe and as a result comply with AIFMD as they can easily fill their capacity in their home market,” Rodford says.

LOCKED OUT

Investors are already reporting a considerable decrease in the number of cold calls and emails they are receiving from US hedge fund managers. With their traditional avenues to gather information on potentially interesting US managers increasingly closed, there are concerns investors are more vulnerable to the wrong kind of manager.

As one pension fund manager reports: “The funds we would want to hear from are being very respectful of the rules, but we are still getting cold calls from the cowboys. The ones we would really want to hear from are the ones we aren’t hearing from.”

Because of the economies of scale associated with compliance costs, the largest US managers tend to be more willing to comply with AIFMD, especially where they are already offering UCITS funds. These big-brand managers are also more easily able to rely on reverse solicitation. However, in recent years, institutional investors have been investing further down the AUM scale.

The Preqin Investor Outlook: Alternative Assets 2014 published in February this year showed 52% of respondents expected to invest with firms managing between $100m to $500m. The lowest proportion of stated investor interest was for managers with more than $5bn in assets, suggesting investors are beginning to look towards the mid-to-large funds, and away from the behemoths of the industry. Nineteen percent of respondents said they prefer investing with smaller managers due to these firms offering more attractive fund terms.

If a large proportion of small and mid-sized US managers decide not to market themselves in Europe because of the new regulatory regime, not only could the trend towards investing down the AUM scale reverse, European investors could find themselves effectively locked out of the biggest and best performing market for hedge funds.