European Regulators Closing in on Hedge Funds by Stuart Calder

European politicians have long been hostile to hedge funds.  In 2007, the German Vice Chancellor Franz Müntefering famously branded them ‘financial locusts’.  Prior to his election, French President Nicolas Sarkozy described them as “predators” that “create zero wealth,” and proposed punitive taxes on ‘speculative’ transactions.

Their objections are probably rooted in the fact that hedge fund activities are perceived as largely unregulated, and therefore outside the control of politicians and bureaucrats.  The fact that 80% of European hedge funds are based in London, not Paris or Frankfurt, has only added to their antipathy.

The financial crisis that took hold in 2008 gave these politicians the perfect opportunity for a regulatory crackdown, with hedge funds a convenient scapegoat – even though several studies have concluded that banks, not hedge funds, were most guilty of excessive leverage and risk.

The result was AIFM – the proposed directive on Alternative Investment Fund Managers.  The wheels of European regulation grind slowly, but finally we are approaching the stage where legislation may be enacted – although even now there are complications: two separate drafts of the directive have been proposed by the European Parliament and the European Council, and they are now trying to come up with a single version.

Under the AIFM proposals, hedge funds managers based in EU countries would be subject to quite onerous new capital and reporting requirements.  The rules are based on the domicile of the managers, so basing the funds themselves in Cayman or other offshore havens provides no exemption.

What is more, the ripples will be felt much more widely, because managers from ‘3rd Countries’ outside the EU, which includes USA, are supposed to comply with certain provisions before they can market themselves to EU investors.  US Treasury Secretary Geithner has been forceful in expressing his concerns, and some watering down seems likely.

Some hedge fund managers have looked to avoid the AIFM provisions by offering their hedge funds under a regulated UCITS structure – the so-called ‘NewCITS’ approach that was supposed to provide hedge fund returns, but with higher levels investor protection.

However, the consensus is that NewCITS funds have yet to be stress-tested, and many doubt their ability to deliver on the investor liquidity requirements when the going gets tough.  The amount of new money they have attracted has so far fallen short of their early promise, so they are no proven silver bullet.

Either way, it seems the financial crisis has played into the hands of regulation-hungry Eurocrats.  Whether this proves to be in the long-term interests of investors is another matter, as the regulations come with a significant cost burden.  Singapore and other locations will be rubbing their hands.

Stuart Calder is based in the UK and is global head of product management at Paladyne.  Prior to this he spent over 4 years as a Product Director at Linedata Services, where he had global responsibility for the Beauchamp suite of products that focused on the alternative investment space.  Stuart has been a frequent speaker at industry events, and a regulator contributor to trade publications in the asset management space.