US Hedge Fund Industry Concerned about EU Proposed Hedge Fund Directive

The Managed Funds Association, a US and global hedge-fund industry association, has added its voice to the growing chorus of industry groups and policy makers critical of the European Commission’s proposed Directive on the regulation of hedge fund managers. In a comment letter to the Commission, the MFA expressed concern about the degree to which the Directive would interfere with existing efficient market practices and the unintended consequences it would have on hedge fund managers and European investors.

The proposed Directive on Alternative Investment Fund Managers, centered on enhanced disclosure and effective risk management, is designed to create a comprehensive and effective regulatory framework for hedge and private equity fund managers at the European level. The proposed Directive would provide 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. The draft proposes regulations that will affect, among others, the European hedge fund, private equity, and venture capital industries.

MFA responded to a call for evidence regarding the Directive with a twelve-page comment letter cautioning, among other things, that the Directive “would interfere with efficient market practices without justification” and would both obstruct hedge-fund managers and limit the choices of EU hedge-fund investors.

The comment letter stressed the significant role hedge funds play in the global financial system, particularly by providing liquidity and price discovery to capital markets, capital to businesses, and diversification to investors to reduce overall investment risk. While acknowledging that the hedge-fund industry as a whole is systemically relevant, the MFA emphasized that hedge funds did not cause the global financial crisis and did not cause systemic risk.

The MFA noted that hedge funds’ borrowings from banks and brokers are collateralized, that hedge funds do not provide banking or similar services to the public, and that, notably, contrary to popular perception that apparently carried over into the text of the Directive, hedge funds are not highly leveraged. The comment letter cites studies finding that hedge funds have had a leverage ratio of, on average, two or three to one and that more than 25 percent of hedge fund managers reported using no leverage.

As such, the comment letter objects to the Directive’s figure of one times capital (a two-to-one leverage ratio) as the threshold for what constitutes a high level of leverage on a systemic basis. More broadly, the MFA objected to any strict limitation on the amount of leverage a hedge fund may employ. Noting that one of the stated purposes of the Directive was to focus on issues inherent to the hedge-fund industry, the MFA protested that there should not be restrictions on the use of leverage outside of more general systemic-risk regulation that would affect all market participants, including banks, in light of the fact that the risks associated with leverage are not specific to hedge funds.

For similar reasons, the MFA opposed the Directive’s requirement that a fund manager make certain disclosures when one of its funds acquires 30 percent or more of the voting rights in a company—a requirement that does not apply to other types of market participants.

The comment letter also objected to the initial capital requirement contained in the Directive, protesting that it may be a barrier to new entrants, is a static approach that does not consider whether the fund manager’s obligations increase along with assets under management, and would not be geared to the fund manager’s risks or expense obligations. Furthermore, the capital requirement fails to allow for the fact that, in practice, many of the management risks in the industry are contractually borne by the fund itself and not by the fund manager.

The comment letter also expressed concerns regarding some of the Directive’s requirements for third parties and its restrictions on non-EU funds and managers. The MFA argued that the Directive’s requirement that a fund manager hire a third-party valuator would bypass managers’ own expertise and may give investors a false sense of security about the resulting valuations. Because European hedge funds typically hire independent third-party administrators, the valuator requirement would increase costs without a corresponding improvement in independence (assuming that there are parties willing and able to act as valuators at all).

Similarly, the restrictions on depositaries under the Directive, particularly the requirement that depositaries be EU-authorized credit institutions and the increased standard of liability that they would be subject to, would limit the number of available custodians and lead to a corresponding cost increase for funds’ investors. The requirement to use an EU-authorized depositary also ignores the “integral” existing practice of maintaining custody of fund assets with the manager’s prime broker.

The MFA also found the disclosure requirements of the Directive problematic. Any sensitive information required to be disclosed to regulators should be kept confidential, it explained. Furthermore, disclosure of side letters should be required only where the side letters would have a material effect on other investors, and the identity of investors subject to the side letters should be kept confidential.

Finally, the MFA echoed recent comments by the Mayor of London expressing concern about the effect of the Directive on competitiveness among hedge funds in the global marketplace. Because the Directive prohibits unauthorized fund managers from managing funds domiciled in the EU and does not permit a non-EU manager to seek authorization, it effectively prohibits a non-EU manager from managing an EU fund. Additionally, the Directive permits only a very limited power of delegation from an EU manager to a non-EU manager.

These limitations, the letter argues, would cause difficulties for many managers with global operations. Furthermore, the Directive restricts non-EU managers from marketing non-EU funds to European investors. The comment letter also expressed some ambivalence about the passporting provisions of the Directive. While passporting would standardize currently disparate offering and compliance processes, it would restrict marketing in some countries that currently have broader laws.

My compliments to my colleague Anne Sherry for this post.

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