Reforming Financial Markets I: Hedge Funds

Standard Note: SN/BT/5588

Last updated: 21 January 2015

Author: Timothy Edmonds

Section Business & Transport Section

This is one of a series of notes which looks at actual or proposed reforms of either certain

parts of the financial services sector or reforms of certain activities.

The entire sector has received worldwide attention from regulators, governments, consumer

and intra-industry and professional groups following the financial crisis which began in 2007.

Whilst the financial ‘rescue and recovery’ phase of the crisis is (mainly) past, the legislative

response in many areas is now coming to a head. Regulatory and supervisory proposals

have been discussed at various national and international fora and new legislation is

proposed in many areas.

These notes attempt to describe the progress made on individual issues through these

phases. This note focuses upon the regulation of hedge funds by the Alternative Investment

Fund Managers directive.

This information is provided to Members of Parliament in support of their parliamentary duties

and is not intended to address the specific circumstances of any particular individual. It should

not be relied upon as being up to date; the law or policies may have changed since it was last

updated; and it should not be relied upon as legal or professional advice or as a substitute for

it. A suitably qualified professional should be consulted if specific advice or information is

required.

This information is provided subject to our general terms and conditions which are available

online or may be provided on request in hard copy. Authors are available to discuss the

content of this briefing with Members and their staff, but not with the general public.

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Contents

1 What is a hedge fund? 3

2 The Directive 7

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1 What is a hedge fund?

There are many definitions of what a hedge fund is. This one is taken from Investopedia

(part of a financial website). According to this a hedge fund is:

An aggressively managed portfolio of investments that uses advanced investment

strategies such as leveraged, long, short and derivative positions in both domestic and

international markets with the goal of generating high returns (either in an absolute

sense or over a specified market benchmark). Legally, hedge funds are most often set

up as private investment partnerships that are open to a limited number of investors

and require a very large initial minimum investment. Investments in hedge funds

are illiquid as they often require investors keep their money in the fund for at least one

year.

For the most part, hedge funds (unlike mutual funds) are unregulated because they

cater to sophisticated investors. In the U.S., laws require that the majority of investors

in the fund be accredited. That is, they must earn a minimum amount of

money annually and have a net worth of more than $1 million, along with a significant

amount of investment knowledge. You can think of hedge funds as mutual funds for

the super rich. They are similar to mutual funds in that investments are pooled and

professionally managed, but differ in that the fund has far more flexibility in its

investment strategies.

It is important to note that hedging is actually the practice of attempting to reduce risk,

but the goal of most hedge funds is to maximize return on investment. The name is

mostly historical, as the first hedge funds tried to hedge against the downside risk of a

bear market by shorting the market (mutual funds generally can't enter into short

positions as one of their primary goals). Nowadays, hedge funds use dozens of

different strategies, so it isn't accurate to say that hedge funds just "hedge risk". In fact,

because hedge fund managers make speculative investments, these funds can carry

more risk than the overall market1

From the same source comes a definition of private equity – the other main sector covered

by the directive:

Private equity consists of investors and funds that make investments directly into

private companies or conduct buyouts of public companies that result in a delisting of

public equity. Capital for private equity is raised from retail and institutional investors,

and can be used to fund new technologies, expand working capital within an owned

company, make acquisitions, or to strengthen a balance sheet.

The majority of private equity consists of institutional investors and accredited investors

who can commit large sums of money for long periods of time. Private equity

investments often demand long holding periods to allow for a turnaround of a

distressed company or a liquidity event such as an IPO or sale to a public company.

The size of the private equity market has grown steadily since the 1970s. Private

equity firms will sometimes pool funds together to take very large public companies

private. Many private equity firms conduct what are known as leveraged buyouts

(LBOs), where large amounts of debt are issued to fund a large purchase. Private

equity firms will then try to improve the financial results and prospects of the company

1 Investopedia website at Investopedia.com Headlines

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in the hope of reselling the company to another firm or cashing out via an IPO [stock

exchange flotation].2

A review of the Hedge Fund industry is produced annually by the pro-financial services

research group TheCityUK. Their summary of the state of the hedge fund industry as at the

end of 2012 can be seen in the latest edition of their review published in May 2013.

Assets under management of the global hedge funds industry totalled over $2,050bn

at the end of 2012 (Chart 1). The 6% increase during the year was driven by

performance gains and follows a slight 1% reduction in the previous year. Industry

assets are close to the 2007 peak and have risen more than three-fold over the past

decade. Funds under management increased by a further $75bn in the first quarter of

2013 due both to positive returns and a net inflow of funds. Additional growth in 2013

will largely be dependent on the recovery in global financial markets.

The small net asset outflow seen during 2012 was more than offset by a 6.1%

performance return. This was only slightly below the average annual hedge fund return

of 6.2% seen over the past decade. Assets of fund of funds totalled $500bn, or around

quarter of global hedge fund assets under management. This was down 4% on the

previous year and more than 40% below the peak from 2007.

The number of hedge funds totalled 10,100, with new hedge funds launches outpacing

fund liquidations for the third successive year. Strong growth of UCITS-compliant

hedge funds has supplemented the fund population in Europe. The UK is the dominant

centre in this area and is the management location for nearly three quarters of UCITS-

compliant hedge funds’ assets.

Location of management The US is the largest centre for hedge funds, managing

close to 70% of global assets at the end of 2012, down from 83% a decade earlier.

Europe followed with 21% and Asia with most of the remainder. TheCityUK estimates

that around 42% of global hedge fund assets were managed from New York, down

from over a half a decade earlier. London’s 18% share in 2012 was slightly down on

the previous year, but nearly double its share ten years earlier. The breakdown of fund

of hedge funds by manager location shows that a quarter of global fund of funds’

assets were managed from the UK.

London remains by far the largest centre for hedge funds in Europe. Around 600 funds

located in the UK managed some 85% of European based hedge funds’ assets. The

largest seven hedge funds in Europe were all headquartered in London in 2012.

London retains its structural advantages which make it an attractive location including

its local expertise, the proximity of clients and markets and a strong asset management

industry. London is also a leading centre for hedge fund services providers such as

administration, prime brokerage, custody and auditing. Accounting for around a half of

European investment banking activity, it is a natural location for prime brokerage

services. The UK hedge fund industry employs around 40,000 people. Around 10,000

of these are directly employed by hedge funds and the remainder among the industry’s

advisers and service providers.

Asia also has an important role in the global hedge fund industry, both as a location for

management of funds and as a source of global hedge funds’ assets. Important

centres for management of hedge funds in Asia include Hong Kong, Australia,

Singapore and Japan.3

2 Investopedia website 3 The CityUK, Hedge Funds, March 2013

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This sector was identified as posing a risk to the overall stability of the financial system in the

EU commissioned de Larosiere Report4 and in the Turner Review for the Financial Services

Authority (FSA) in the UK.5 It had previously come under fire for its activities in ‘short selling’

and (along with private equity companies) investment in, and restructuring of, companies, the

remuneration of its executives and the lack of transparency in its actions. As the financial

crisis worsened, the funds experienced dramatic withdrawals by investors (£22 billion was

withdrawn in November 2007 from US funds) such that many refused to allow further

investor redemptions. The argument that hedge funds provided liquidity to a market

appeared short of the truth at times.

Responding to criticism, in January 2008, under the Chairmanship of Sir Andrew Large, the

industry produced a set of standards covering themes such as:

Disclosure

Valuation

Risk Management

Fund Governance

Shareholder Conduct

The Hedge Fund Standards Board (hfSB) oversees the code.6 Members (just over 120 funds

are signed up to the code) are required to follow the guidelines on a ‘comply or explain’

basis. The Standards can be found here.

Looking specifically at hedge funds, the Turner Review pointed out that although it regulates

UK-registered asset managers, hedge funds themselves are usually domiciled abroad and

thus are not subject to either capital or liquidity requirements. It cautioned that

…hedge fund activity in aggregate can have an important procyclical systemic impact.

The simultaneous attempt by many hedge funds to deleverage and meet investor

redemptions may well have played an important role over the last six months in

depressing securities prices in a self-fulfilling cycle. And it is possible that hedge funds

could evolve in future years, in their scale, their leverage, and their customer promises,

in a way which made them more bank-like and more systemically important.7

Accordingly, the Review argued that the appropriate approach to hedge funds would entail:

• Regulators and central banks in the performance of the macro-prudential analysis

role (Section 2.6 below) need to gather much more extensive information on hedge

fund activities (or on the activities of any other newly evolving form of investment

intermediation) and need to consider the implications of this information for overall

macro-prudential risks.

• And regulators need the power to apply appropriate prudential regulation (e.g. capital

and liquidity rules) to hedge funds or any other category of investment intermediary, (or

4 High Level Group on Financial Supervision in the EU (the Larosiere Report), February 2009, p25 5 FSA, Turner Review: A regulatory response to the global banking crisis, 18 March 2009 6 An overview of the hfSB Code can be found here. 7 FSA Turner Review, p72

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to otherwise restrict their impact on the regulated community), if at any time they judge

that the activities have become bank-like in nature or systemic in importance.8

While the Commission did not ‘blame’ the sector for the financial crisis they remained

concerned about aspects of their activities:

While AIFM were not the cause of the crisis, recent events have placed severe stress

on the sector. The risks associated with their activities have manifested themselves

throughout the AIFM industry over recent months and may in some cases have

contributed to market turbulence. For example, hedge funds have contributed to asset

price inflation and the rapid growth of structured credit markets. The abrupt unwinding

of large, leveraged positions in response to tightening credit conditions and investor

redemption requests has had a procyclical impact on declining markets and may have

impaired market liquidity.

Funds of hedge funds have faced serious liquidity problems: they could not liquidate

assets quickly enough to meet investor demands to withdraw cash, leading some

funds of hedge funds to suspend or otherwise limit redemptions. Commodity funds

were implicated in the commodity price bubbles that developed in late 2007.

On the other hand, private equity funds, due to their investment strategies and a

different use of leverage than hedge funds, did not contribute to increase macro-

prudential risks. They have experienced challenges relating to the availability of credit

and the financial health of their portfolio companies. The inability to obtain leverage

has significantly reduced buy-out activity and a number of portfolio companies

previously subject to leveraged buy-outs are reported to be faced with difficulties in

finding replacement finance.9

8 Ibid., p73 9 Alternative Investment Managers directive EC Com 2009 (207)’ p3

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The Commission identified the following specific risks:10

Risk Source of risk

Direct exposure of systemically important banks to the AIFM sector

Pro-cyclical impact of herding and risk concentrations in particular market

segments and deleveraging on the liquidity and stability of financial

markets

Weakness in internal risk management systems with respect to market

risk, counterparty risks, funding liquidity risks and operational risks

Inadequate investor disclosures on investment policy, risk management,

internal processes

Conflicts of interest and failures in fund governance, in particular with

respect to remuneration, valuation and administration

Impact of dynamic trading and short selling techniques on market

functioning

Potential for market abuse in connection with certain techniques, for

example short-selling

Lack of transparency when building stakes in listed companies (e.g.

through use of stock borrowing, contracts for difference), or concerted

action in 'activist' strategies

Potential for misalignment of incentives in management of portfolio

companies, in particular in relation to the use of debt financing

Lack of transparency and public scrutiny of companies subject to buy-outs

Source: EU Commission

Macro-prudential

sytemic risks

Micro-prudential

risks

Investor protection

Market efficiency

and integrity

Impact on market

for corporate

control

Impact on

companies

controlled by AIFM

2 The Directive

2.1 Introduction

The EU Commission produced a draft directive on the regulation of hedge funds, - the

Alternative Investment Fund Managers (AIFM) Directive in April 2009.11 The directive would

apply to hedge funds and private equity funds, as well as real estate funds, commodity funds,

infrastructure funds and other types of institutional fund. The directive has been subject to

intense scrutiny and lobbying particularly by the industry with the support of both the previous

and current UK governments. Some of the debate has had nationalistic tones; since 80% of

the industry affected is based in London, the proposals would affect the City more

extensively than the rest of the EU. The broad elements of the directive were summarised in

an EU press release of April 2009.12

The initial text of the directive was heavily criticised, and the Internal Affairs Commissioner

later acknowledged that ‘the original text was far from perfect’.13 However, there has been

strong support for the directive from some countries, for example France and Spain, who 10 Alternative Investment Managers directive EC Com 2009 (207)’ p3 11 Alternative Investment Managers directive EC Com 2009 (207) 12 Europa press release 29 April 2009 13 See Alternative Visions, Financial Times 14 May 2010

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both had citizens with substantial investments in Madoff owned investment funds, and in

Germany, where established manufacturing companies were bought and the ‘restructured’

by hedge fund and venture capital funds.

Following the lobbying campaign, supported by the UK government, substantial changes

were made to the directive.

The main areas of contention remaining were:

Restricting the scope of the directive to active AIFM firms

Clarification of application of the directive where the fund has no responsibility for

aspects of the work

Optional exemption from the directive where the funds in any one fund is below €100

million and all funds collectively are less than €500 million

Allow Member States to apply stricter rules to overseas funds operating in their

country than domestic ones

Reductions in capital requirements for non-leveraged funds

Obligations surrounding the safe keeping of client monies

Remuneration policies required to reduce risk taking consistent with similar proposals

to banks

Information on fund leverage gathered by domestic regulators should be shared with

other Member States

The Association of Investment Fund Managers (AIFM) have produced an internal document

outlining their remaining concerns.14 These include:

Overly restrictive and ‘onerous’ rules regarding depositaries

“Unprecedented level of interference in the ability of managers to outsource activities”

Leverage controls are disproportionate to the risk posed by hedge funds and, as

worded, “make very little sense technically”

Third party controls are impossible to enforce in the European Parliament text of the

directive. Third party countries have access to the EU without meeting the whole of

the directive’s conditions.

Remuneration rules have been copied over from banking guidance and are not

applicable to fund management

Short selling – “it seems like the hedge fund industry could be the only one affected by

various restrictions and bans on short selling”

The directive, was also examined by the House of Lords, European Union Committee.15 It

published its Report in February 2010. Its summary and conclusions are shown below:

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204. We concur with the conclusions of the Turner Review and the de Larosière group

that AIFs did not cause the recent financial crisis. However, we note the aggregate

activity of hedge funds could increase market instability (para 64).

Key aspects of the AIFM Directive

205. We welcome EU regulation of Alternative Investment Fund Managers. We support

the principle of harmonising regulation of AIFMs across the EU on the basis that a

robust legal framework at EU level can strengthen the single market and benefit

investors. AIFMs we spoke to recognised that some regulation would increase their

integrity and public perception of the worth of their activities. We welcome also the

elements of the Directive that provide for coherent oversight of AIFMs across the EU

by requiring the registration of, and the collection of appropriate data from, managers,

in line with the conclusions of the G20 (para 71).

206. We urge the Government to negotiate a solution that will avoid penalising smaller

entities without encouraging managers to attempt to avoid the Directive through

threshold manipulation. Thresholds that reflect the differences of the private equity and

venture capital industries should also be identified (para 80).

207. A one size fits all approach will not work. We recommend that the Government

seek to tailor the Directive in a way that respects the differences between the types of

funds it covers. A possible solution could be to establish broad principles in the

Directive (para 91).

208. We agree that it is appropriate for the Directive to regulate the manager rather

than the fund, as the latter is merely a vehicle in which assets are held. Targeting

AIFMs will ensure that the risks of AIFs are effectively monitored, irrespective of the

domicile of the fund, whilst leaving AIFMs with the flexibility they need to operate. In

reality some provisions of the Directive will also have the effect of regulating the funds.

We urge the Government to ensure during negotiations that the focus of the Directive

is kept on the regulation of the manager rather than the fund (para 98).

209. We agree that AIFMs should be the subject of appropriate regulation. However,

the retail level of protection offered by the Directive as drafted is not required by the

informed and experienced institutional investors and high net worth individuals who

invest in Alternative Investment Funds, who are able to carry out their own extensive

due diligence. We recognise that the success of these Funds has an impact on those

not directly involved in the investments industry, including through pension funds (para

102).

Supervision of AIFMS

210. We agree that disclosure requirements could enable supervisors to identify where

AIFMs pose excessive risk to financial stability, which should enable steps to be taken

to reduce this risk (para 110). We welcome the work of the FSA to date on their survey

of hedge fund managers and prime brokers to build up an overall view of the UK

alternative investment industry. We also agree with the Government’s support for the

Swedish Presidency’s compromise to help ensure that only systemically relevant data

is collected (para 111).

14 The report is not generally publicly available, however, Members wishing to request a copy should apply to

dtonner@aima.org in the first instance to request access. 15 Directive on Alternative Investment Fund Managers, House of Lords EU Committee, HL 48 2009-10

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212. The Government should ensure that national supervisors take on the role of data

analysis and intervention. National supervisors, including the FSA in the UK, are likely

to be most effective at analysing systemically relevant data and taking action to reduce

risk. The Government should also work to put in place systems to require national

supervisors to provide relevant data to the ESRB and bodies at a global level (in

particular the Financial Stability Board) to help ensure that these bodies can identify

systemic risks at an EU and global level respectively (para 112).

213. Transparency requirements could in principle help provide protection to investors

in AIFs and increase public understanding of the industry. However, the Government

must ensure that such requirements set out in the Directive reflect the variations of

different types of alternative investment funds to prevent them placing companies

owned by private equity funds at a competitive disadvantage (para 116).

214. We agree with the Financial Services Authority and the Government that

supervisors should have the power to impose leverage caps where appropriate, based

on the aggregated information they receive from fund managers. We welcome the

Swedish compromise on this issue and the Government’s support for this proposal

(para 125).

215. We agree that if capital requirements are set in the Directive, they must

differentiate sufficiently between different types of funds covered by the Directive. The

Government should also consider whether it will be more appropriate to enforce capital

requirements through the Capital Requirements Directive (para 128).

Towards an EU Passport regime for AIFMS?

216. We support the principle of an EU passport extended to non-EU funds, managed

by both EU and non-EU managers. However, we believe that as originally drafted the

proposal for a passport for these funds would impose significant obstacles in the way

of managers wishing to market non-EU funds in the EU. EU managers should be able

to continue to invest in non-EU funds and fund managers located outside the EU

should be able to invest in Europe (para 160).

217. We agree with the Minister that if equivalence is an assessment of whether a third

country operates an identical regulatory regime to the EU as in the draft Directive, then

it will be hard, if not impossible, to achieve. We therefore support the continuation of

national private placement regimes to maintain options for investors, whilst efforts are

made to achieve the principles-based equivalency with third-country regimes that is

required for the EU passport to operate effectively (para 161).

218. The Government should continue to negotiate a solution that does not penalise

the marketing of non-EU funds which will eventually have negative repercussions on

the UK and European financial markets (para 162). The Government should ensure

that EU regulation is in line with, and complements, global arrangements. We believe

that the Government should not agree the Directive unless it is compatible with

equivalent legislation with regulatory regimes in third countries and in particular in the

United States, in order to avoid a situation in which EU AIFMs lose competitiveness at

a global level (para 174).

Depositary and valuation

220. We urge the Government to press for an amendment to the Directive which would

enable AIFMs to use non-EU depositaries, and to sub-delegate custody functions so

long as they are suitably regulated and supervised (para 185).

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221. We do not support the Directive’s provision that depositaries should be liable for

risks and losses of sub-custodians that they cannot control. We recognise the

improvements included in the Swedish compromise and we urge the Government to

support this aspect of the compromise during the negotiation under the Spanish

Presidency (para 186).

222. In this respect we agree with the suggestion made in the Gauzès Report whereby

private equity funds would be exempt from the requirement for an independent

valuation agent. We urge the Government to negotiate a valuation mechanism which is

consistent with the operational reality of AIFs, such as that proposed by the Swedish

Presidency (para 193).

Better regulation

223. Had the Commission followed its own Better Regulation principles, the

shortcomings of the Directive could have been dealt with at a much earlier point or

might not have been there in the first place. The Government must put pressure on the

Commission to ensure that future proposals are subject to the better regulation agenda

(para 202).

Revisions to the Directive and significant discussion between the Commission and the

European Council took place throughout the summer of 2010. One of the main debating

points was the treatment of AIFMs originating outside of the EU. Under the original

proposals AIFM could only be sold in the EU if the originating country had equivalent

legislation to the EU’s. This provoked protests from an alliance of American based hedge

funds (the world centre for funds) and EU government development agencies that use

overseas funds in their development work.16 An agreed Council position was reached in

October 2010, European Parliament approval was given to the revised document in

November 2010 followed by final Council approval in May 2011. The final version of the

Directive was published in July 2011.

The proposed changes to the regulations provoked some intense activity in the hedge fund

sector. The Financial Times reported in July 2010 that “bank traders rush to launch spin-offs

before rules change”. It continued, “in the first quarter [of 2010] there were 254 fund

launches, the largest quarterly number since the financial crisis”.17 The industry also began a

period of analysis of the rules and how they would affect them. In the media this was

crystallised in the number of hedge funds leaving the City for extra-EU jurisdictions. In a

report in October 2010, a consultancy calculated that “one in four hedge fund employees has

left London for Switzerland”.18 The tax revenue impact of which was put at £500 million. In

March 2011 a report suggested that Malta was becoming an alternative venue for “dozens

rather than hundreds” of hedge funds all “at the expense of London”.19 It should be noted

that this movement was not ascribed purely due to the directive. Also cited as reasons were

the 50% tax rate, “political attacks and regulatory uncertainty”.20

16 AIFMD Rules to be diluted, Financial Times 12 July 2010 17 Financial Times , 14 July 2010 18 Financial Times, 2 October 2010 19 Financial Times, 4 March 2011 20 Financial Times, 2 October 2010

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2.2 Details & implementation

The Directive document itself is 73 pages long, the directive itself about 60 pages long.

Broadly the Directive divides into four main parts:

general provisions, authorisation and operating conditions

measures regarding the depositary of funds

Transparency Requirements and Leverage

measures regarding supervision

A more accessible guide to the provisions can be had from the Commission’s Europa

website which has a ‘Frequently Asked Questions’ page about the Directive. Parts of this are

shown below:

What are the objectives of the AIFMD?

The overarching objective of the AIFMD is to create, for the first time, a comprehensive

and secure framework for the supervision and prudential oversight of AIFM in the EU.

Once the AIFMD enters into force, all AIFM will be required to obtain authorisation and

will be subject to ongoing regulation and supervision. In this way, the AIFMD will:

Increase the transparency of AIFM towards investors, supervisors and the employees

of the companies in which they invest;

Equip national supervisors, the European Securities Markets Agency (‘ESMA’) and the

European Systemic Risk Board (‘ESRB’) with the information and tools necessary to

monitor and respond to risks to the stability of the financial system that could be

caused or amplified by AIFM activity;

Introduce a common and robust approach to the protection of investors in these funds;

Strengthen and deepen the single market, thereby creating the conditions for

increased investor choice and competition in the EU, subject always to high and

consistent regulatory standards; and

Increase the accountability of AIFM holding controlling stakes in companies (private

equity) towards employees and the public at large.

Have the United States introduced new rules for this sector?

Effective regulation of the financial markets requires consistent and effective action to

be taken in all major jurisdictions. In this and other areas, the commitments made by

the G20 leaders provide the framework for this action.

In accordance with these G20 commitments, as in Europe, the United States have

acted to strengthen regulation in this area. New rules on hedge funds and private

equity were adopted in July as part of the Dodd-Frank Act. These rules will require the

registration of managers of private equity and hedge funds with the Securities and

Exchange Commission. Managers will be subject to substantive regulatory

requirements and will be required to report regularly to supervisors for the purposes of

systemic risk by the newly-created Financial Stability Oversight Council.

The objectives and approach of these reforms are consistent with those of the AIFMD.

How do the rules adopted differ from the Commission's proposal?

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The rules adopted by the Council of Ministers and European Parliament fully respect

the objectives and structure of the Commission's proposal.

The 'all-encompassing approach' of the proposal is retained, covering all the major

types of AIFM and alternative investment fund. This will ensure a level playing field and

will help to minimise the risks of regulatory arbitrage. Strict rules have been included

on, inter alia, transparency, the valuation and safekeeping of assets, risk and liquidity

management, the use of leverage and the acquisition of companies.

The strong single market dimension of the proposal has also been preserved,

introducing a single market passport for European managers and funds, as well as a

'third country passport', which will in due course become a single harmonised regime

for third country access to investors in the EU.

The Commission has worked closely with Council and Parliament throughout to refine

the detailed rules where necessary. In some areas, such as remuneration, new rules

have been introduced by the Council and Parliament. These are consistent with the

regulatory objectives and are welcomed by the Commission.

What is the 'passport'?

The AIFMD introduces for the first time a genuine ‘single market framework’ for this

sector, which will allow AIFM to ‘passport’ their services throughout the EU on the

basis of a single authorisation.

Specifically, once an AIFM is authorised under the AIFMD in one Member State and

complies with the rules of the directive, this manager will be entitled upon notification to

manage or market funds to professional investors throughout the EU.

By creating a single regulatory and supervisory regime for all AIFM active in the EU,

the AIFMD will help market participants to overcome the barriers and inefficiencies

created by the current patchwork of national regulation. This will help to increase

choice and competition, to the benefit of European investors.

When will the passport be made available to non-EU managers and funds?

Alternative investments are a global industry and it is important that European

investors have access to the best that the global market has to offer. At the same time,

it is imperative that all AIFM active in the EU are subject to the same high standards of

transparency and conduct, irrespective of where they, or the funds they manage, are

located.

Following a limited transition period of two years, and subject to the conditions set out

in the AIFMD, the passport will be extended to the marketing of non-EU funds,

managed both by EU AIFM and AIFM based outside the EU. In accordance with the

principle of ‘same rights, same obligations’, this approach will ensure a level playing

field and a consistently high level of transparency and protection of European

investors.

The phased introduction of the third country passports will allow European supervisors

to ensure that the appropriate controls and cooperation arrangements necessary for

the effective supervision of non-EU AIFM are operating effectively.

Before the third country passport is introduced and for a period of three years

thereafter, national regimes will remain available subject to certain harmonised

safeguards. Once this period has elapsed and on the basis of conditions set out in the

AIFMD, a decision will be taken to eliminate the parallel national regimes. At this point,

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all AIFM active in the EU will be subject to the same high standards and will enjoy the

same rights.

Will the Directive limit leverage in the hedge fund sector?

Leverage employed by a wide variety of actors throughout the financial system has

contributed to the fragility of the financial markets and amplified the effects of the

financial crisis. It is therefore necessary to ensure that leverage is used responsibly

and that the associated risks are understood and managed prudently.

The AIFMD introduces a range of transparency requirements and robust safeguards in

relation to the use of leverage by AIFM. Each AIFM will be required to set a limit on the

leverage it uses and will be obliged to comply with these limits on an ongoing basis.

AIFM will also be required to inform competent authorities about their use of leverage,

so that the authorities can assess whether the use of leverage by the AIFM contributes

to the build-up of systemic risk in the financial system. This information will be shared

with the European Systemic Risk Board.

The AIFMD will also create powers for competent authorities to intervene to impose

limits on leverage when deemed necessary in order to ensure the stability and integrity

of the financial system. ESMA will advise competent authorities in this regard and will

coordinate their action, in order to ensure a consistent approach.

How will the AIFMD protect investors?

Investor protection is one of the core objectives of the AIFMD. The financial crisis has

highlighted the range of risks to which investors in investment funds – both retail and

professional – are exposed. The AIFMD introduces safeguards to ensure that investors

in alternative investment funds are well-informed and adequately protected.

In particular, the AIFMD will increase the transparency of AIFM and the funds they

manage and market. This will help investors to perform better due diligence. In

addition, a variety of operational and organisational requirements will help to ensure

that investors are appropriately protected. For example, the AIFMD will require that:

conflicts of interest are avoided or managed and disclosed;

AIFM employ adequate systems to manage risks to which the fund is exposed,

and to ensure that the liquidity profile reflects the obligations towards investors;

a fund's assets are safe-kept by an independent depositary subject to a high

liability standard;

valuation is performed properly and independently; and

strict conditions are met when AIFM delegate functions to third parties.

Due to their complexity and risk, investment in many types of alternative investment

fund is limited to professional investors. Consequently, the AIFMD creates rights for

marketing to professional investors only. Member States are not prevented from

making certain types of alternative investment fund available to retail investors.

However, in this situation, competent authorities will be able to apply additional

safeguards at national level to ensure that retail investors are adequately protected.

What is the purpose of the rules on pay?

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An important lesson of the financial crisis has been to ensure that remuneration

practices in financial institutions do not create incentives for excessive risk-taking.

While bonus payments in banks have dominated the headlines in recent times, it is

essential that sound remuneration principles be applied consistently throughout the

financial services industry. Failure to do so may result in excessive risk-taking by

individuals in certain sectors and may create opportunities for arbitrage as employees

move between sectors.

Rules on remuneration practices are therefore being introduced in all major financial

services sectors, including in the AIFMD. Specifically, AIFM will be required to

implement remuneration policies that are consistent with and promote sound risk

management and do not encourage risk-taking which is inconsistent with the risk

profile and fund rules of the funds managed.

Will smaller managers be covered by the AIFMD?

A comprehensive approach to regulation is necessary to ensure that standards are

consistently high and to allow regulators to monitor risks wherever they arise in the

financial system.

However, in order to avoid imposing disproportionate requirements on the very

smallest AIFM and to allow supervisors to focus on those AIFM whose activities are of

greatest relevance to financial stability, the AIFMD incorporates a system of ‘de

minimis’ thresholds.

Depending on the type of fund they manage, AIFM whose assets amount to less than

€500 million (for unleveraged funds with long 'lock-in' periods) or €100 million for other

types of alternative investment fund will be subject to a tailored regime. These AIFM

will be required to register with national authorities and to comply with harmonised

transparency requirements, as well as additional requirements applied at national level.

The AIFMD also provides for the possibility for these AIFM to ‘opt-in’ so as to avail of

passporting rights in return for full compliance with the AIFMD.

How will the depositary rules help investors?

The functions of the depositary are critical for investor protection. When the entities

charged with safeguarding the assets of the fund do not perform their duties effectively,

investors stand to lose all or part of their investment. The experiences of Madoff and

Lehman have highlighted the potential weaknesses in this area and the pressing need

to clarify and strengthen investor protections.

Under the AIFMD, all AIFM will be required to ensure that the funds they manage

appoint an independent and qualified depositary, which will be responsible for

overseeing the fund's activities and ensuring that the fund's cash and assets are

appropriately protected. Depositaries will be held to a high standard of liability in the

event of a loss of assets and the burden of proof will reside with the depositary.

The AIFMD will also introduce a robust mechanism for the delegation of depositary

functions and will regulate carefully the circumstances under which liability can be

transferred to a sub-depositary, including when the sub-depositary is located outside

the EU. This will allow investors to benefit from investment in third countries without

compromising the level of investor protection.

The Commission is currently examining the corresponding depositary rules in the

UCITS Directive with a view to producing proposals for their revision in 2011. This will

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ensure that the standard of protection afforded to investors in UCITS does not fall

below that of the AIFMD. The rules adopted in the AIFMD will serve as a clear

benchmark for this work; however the Commission will also assess whether additional

safeguards are required to reinforce further the protection of retail investors.

How does the AIFMD regulate private equity buy-outs?

Private equity and venture capital investment can play a crucial role in restructuring

and financing companies in the EU.

The objective of the AIFMD is to introduce safeguards to increase the transparency of

this type of investment towards the employees of the companies acquired and the

public at large and to address potential risks to portfolio companies acquired by private

equity funds, while minimising any competitive distortions that may result.

In particular, the AIFMD introduces rules relating to the disclosure of significant

holdings by private equity funds. In the event of acquisition of control, the AIFMD will

require the AIFM to ensure that the fund discloses relevant information in relation, for

example, to the intentions with regard to the future business of the company and to the

financing of the acquisition. The AIFMD also includes specific rules to mitigate risks to

the long-term health of companies linked to 'asset stripping'.

Detailed implementation of the Directive is with the European Securities and Markets

Authority (ESMA) which has held consultations upon the detailed rules and national

implementation.

Industry responses to the directive can be found on the hfSB website here.