FSA Official Says Proposed Hedge Fund Directive Would Place 40 Percent of Hedge Funds Off Limits to EU Investors

A study commissioned by the UK Financial Services Authority found that up to 40% of hedge funds and 35% of private equity funds would no longer be available to EU investors because of the equivalence requirements imposed on third countries by the proposed EU Alternative Investment Fund Management Directive. This Directive was proposed by the European Commission last April to strengthen the regulation of the non-UCITS fund-management industry across Europe.

The proposed Directive, 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. It would impose 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 entire European hedge fund, private equity, and venture capital industries.

In recent remarks, Dan Waters, Director of Asset Management, said that the FSA supports the creation of a marketing passport for fund managers to sell across Europe under a single authorization that would replace the current patchwork of national private placement regimes. The FSA similarly backs the proposal to empower regulators to collect systemically important information from fund managers.

However, he noted that the benefits of the Directive come at a significant cost to those funds and fund managers based outside of the EU because of the so-called third country aspects, which could adversely affect business models and increase costs and reduce choice for investors. These third country proposals include equivalence tests for the tax and legislative standards of non-EU countries to determine whether EU investors should be permitted to invest wherever a fund or fund managers, depositaries, custodians, or other service providers were based outside the EU.

In his view, the practical implications of the proposed Directive would be significant. For example, if major fund managers domiciled in the United States were deemed not to meet the equivalence tests, then EU pension funds and other institutional investors would be prevented from investing in those funds, even if they decided to do so entirely on their own.

In a low interest rate environment characterized by increasing longevity, a maturing population and a growing savings gap, he continued, it is more important than ever for investors to have access to a range of investment opportunities that best match their liabilities. Imposing the restrictions in the proposed Directive would make these issues even more difficult to manage.

While investors may be able to access substitute products if a significant number of existing funds were no longer available, he conceded, they may not have the access to the best in class funds from across the globe that they currently enjoy. In turn, this could force them to hold sub-optimal portfolios with resulting implications for investment returns and risk management. The FSA study estimated substantial damage to portfolio returns resulting from some of the particularly draconian provisions of the initial draft of the Directive.

Of course, the FSA understands the case for setting minimum standards of investor protection as part of creating a single market. But neither the outcome of the Council negotiations nor the Parliamentary negotiations over the proposed Directive envisage that such a single market will exist for non-European domiciled funds, regardless of where they are managed.

The FSA believes that imposing requirements relating to investor protection or equivalence on non-European domiciled funds is unjustified. For one thing, it would drive legitimate business models offshore. But more importantly from a regulatory perspective, while these fund managers would still be operating in Europe through subsidiaries or delegation arrangements, the powers of European regulators to collect systemic information from these managers and deal with emerging financial stability risks would be severely narrowed.

Regarding the Directive’s outcomes, said the senior official, investor protection should not be delivered at the expense of the protection of financial stability. He urged the EU’s key policymakers to ensure that the final framework of the Directive proportionately reflects the fundamental differences between the single EU market and non-EU national domestic regimes.

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