European Commission Proposes Directive on Hedge Funds and Private Equity Funds under Strong Disclosure and Risk Management Regime

In a move that is the first of its kind in the world, and anticipates similar legislation in the US, the European Commission has proposed the broad regulation of managers of hedge funds and all private equity funds with 100 million euros of assets under management. The Directive on Alternative Investment Fund Managers is designed to create a comprehensive and effective regulatory framework for hedge and private equity fund managers at the European level. The proposed Directive will provide robust and harmonized regulatory standards for all alternative investment funds within its scope and enhance the transparency of the activities of the funds towards investors and public authorities. This will enable Member States to improve the macro-prudential oversight of the sector and to take coordinated action as necessary to ensure the proper functioning of financial markets. The proposed regulations would require extensive disclosure of risk management procedures and other aspects of fund governance.

There had been some confusion over whether just hedge funds, and not private equity funds, would be included in the proposed Directive. Members of the European Parliament recently expressed concern to the Commission that earlier remarks by Commissioner McCreevy indicated that only hedge funds would be covered by new regulations. In the end, the Commission opted for the broad regulation of all alternative investment funds over a certain minimum asset management level. The Commission said that it was loath to attempt to define hedge funds, fearing that many systemically relevant funds may fall through a regulatory gap.The proposed Directive parallels a proposal presented by the Obama Administration to Congress, which would federally regulate both hedge funds and other private equity funds. Fully acknowledging the need for harmonized fund regulation, the Commission anticipates similar US legislation later this year.

In order to operate in the European Union, all hedge funds and private equity funds will have to be authorized by their home state regulator. They will have to demonstrate that they are suitably qualified to provide fund management services and will be required to provide detailed information on the planned activity of the fund, the identity and characteristics of the assets managed, the governance of the fund, including arrangements for the delegation of management services, arrangements for the valuation and safe-keeping of assets. The alternative investment funds would also be required to hold and retain a minimum level of capital.

To ensure effective risk management of hedge fund activities, the funds will be required to satisfy their regulators of the robustness of their internal risk management procedures, in particular liquidity risks and additional operational and counterparty risks associated with short selling. They will also have to set forth procedures for the management and disclosure of conflicts of interest and the fair valuation of assets.

Disclosure is a centerpiece of the proposed regime. Hedge and private equity funds would have to disclose to investors their investment policy, including descriptions
of the type of assets and their use of leverage. They would also have to disclose their redemption policy in both normal and exceptional circumstances, as well as their fees and expenses. The funds would also have to disclose their risk management and valuation procedures. The funds would be required to disclose to regulators the principal markets and instruments in which they trade, as well as their principal exposures, performance data and concentrations of risk.

The proposed legislation grew out of a consensus that hedge funds should be regulated as part of systemic risk regulation. Although some prudential reporting to regulators is currently required, regulators do not have enough information to monitor hedge fund trading activities. The European Commission recently endorsed a High Level Group report setting forth a broad blueprint for a complete overhaul of financial regulation in the European Union, including the regulation of hedge funds. Similarly, the G-20 recommends systemic risk regulation that includes hedge funds.