A funny thing happened on the way to the Directive…

Hedge Fund Regulation 10 Apr 2011

Directives are funny things. By definition, they are laws, edicts or any official or authoritative instruction. From an adjective standpoint, they involve the management or guidance of operations.

In short form, they tell you what to do, when to do it and how to do it.

It’s easy to put the European Alternative Investment Fund Management Directive (“AIFMD”) in the context of what it’s actually supposed to mean. Simply, it was born from financial crisis and propagated by politicians bent on reining in hedge funds, whose activity purportedly contributed to the financial market melee.

What it degenerated into was a nearly two year-long political battle that almost led to a shut-out of hedge fund capital from Europe, which would have likely sent hedge fund managers domiciled there fleeing to Switzerland or other locales where the Directive’s tentacles didn’t reach.

Instead, the multi-pronged set of rules, which are set to come into effect in 2014, will for the first time introduce a harmonized regulatory regime for managers of alternative investment funds, who if they reside in the European Union will need to apply for authorization to manage assets.

Ernst & Young, in a recent report focusing on the Directive (click here to download), highlights some of the things that not only fund managers but also service providers need to start thinking about if they’re going to be ready for it. (E&Y provided the handy provisions chart below.)

Non-EU managers will also need to apply if they’re conducting business in Europe and / or raising assets, but will be able to use a passport system that will allow them to avoid applying everywhere they operate.

Whether or not the Directive is onerous or heavy handed is beyond debate at this stage. What is now the focus is how managers both inside and outside the EU are preparing for it.

At the top of the list: Transparency in reporting, which according to Ernst & Young will involve not only re-evaluating but likely re-defining the way managers report their activities to both investors and regulators.

For instance, every manager will now need to provide an annual report detailing how much money they made – something typically not disclosed beyond the percentage management and performance fees a fund would disclose to its investors up front. Each will also need to split the information into fixed and variable remuneration, as well as the aggregate amount paid to senior managers and staff “whose actions have an impact on the material risk profile of the AIF.”

Good luck defining that one.

Beyond that, managers will need to regularly report data, including: percentage of illiquid assets subject to special arrangements, the risk profile of the AIF, the management tools used to manage market, liquidity, counterparty and other risks and the result of now-mandated stress tested.

Furthermore, some managers will need to appoint a separate independent depositary that will be responsible for custody and any loss of assets – something that isn’t going to come cheap. Meanwhile, prime brokers will need to separate their depositary function from their counterparty function, meaning a revamp of operations. We bet that a bunch of new “Chinese walls” and other changes that aren’t going to be easy or even frankly cost-effective.

The bottom line – and the report’s key message – is that it’s fairly easy to think of the Directive as a forgone conclusion given now that it’s said and done. In reality, it’s going to be a lot more complex to implement and managers are going to face a lot of problems getting themselves ready to comply with the new rules as they get rolled out over the next few years.

It will be interesting to see how many managers, investors and service providers opt to go to other jurisdictions, ones where the new regulation may also be more stringent than in the past but not as formidable a beast as what the AIFMD is likely to be.

Perhaps a not-so-funny thing on the way to a new edict for hedge funds that could cost Europe business.

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