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U.K. Official Says Draft Directive on Alternative Investment Fund Managers Is Flawed

Paul Myners, the U.K. Financial Services Secretary to the Treasury, said at a recent Alternative Investment Management Association event that the proposed directive on the regulation of hedge fund and private equity fund managers is flawed and he recommended major changes to the proposal. He noted that the U.K., which has regulated hedge fund managers for many years, favors a framework that allows efficient, well run and well regulated fund managers to compete without restriction across the EU and to make the EU a base from which to compete in global markets. The draft directive "needs major surgery" to deliver such a framework, he said.

The Directive on Alternative Investment Fund Managers is designed to provide harmonized regulatory standards for all alternative investment funds within its scope and to enhance the transparency of the activities of the funds towards investors and public authorities. This would 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.

Myners said that the U.K. is not in the business of blocking more stringent regulation, but that imposing ill-considered rules in haste would be counterproductive. Hedge funds and private equity were not central to the global financial crisis, he noted.

He expressed concern about the scope of the directive, noting that any attempts to classify different fund management business models today will be out of date in five years due to ongoing innovation in the industry. In addition, where effective EU regulation is already in place --particularly the Prospectus and Transparency Directives for listed closed-end funds --he believes the directive should not impose new burdens unless it can be demonstrated that the existing directives are deficient.

One controversial aspect of the proposed directive is that in order to operate in the EU, all hedge funds and private equity funds would have to be authorized by their home state regulator. Non-EU funds would have to meet certain equivalency requirements. Myners noted that the U.K. has successfully allowed non-EU funds to be marketed there for a number of years without the need for stringent equivalence tests.

Myners acknowledged that other Member States have different traditions and take different approaches on the issue, but believes that denying institutional investors a global choice of fund manager would come at a direct cost to pension savers and others who rely on the returns from institutional investment funds. It would lead to the EU industry becoming less efficient by removing the discipline of global competition, in his opinion.

He noted that some people have argued that it is only by closing the EU market to all who do not meet equivalence tests that the EC can incentivize managers to locate in the EU. He rejected this argument, stating that the directive should only impose those requirements which are necessary to mitigate genuine risks. Under this scenario, the EU will be able to compete globally in fund management without recourse to any form of protectionism, he added.

On the issue of leverage, Myners agreed with the EC's conclusion that excessive leverage in the funds industry may contribute to systemic risk. He also agreed that supervisors should monitor closely the extent of leverage across systemically important market sectors and should intervene where they identify immediate systemic risks.

However, Myners disagreed with the proposed imposition of leverage caps. The systemic risks posed by the leverage of any one fund can only be assessed in the context of wider market conditions, so capping leverage on a fund-by-fund basis cannot be an effective protection, he said.

He believes leverage caps could be counterproductive because leverage generally increases as investment positions move against the manager. If this causes a fund to break through its cap, it may be forced to sell assets, he noted. If this happened across the market, it could cause a dangerous downward spiral in valuation, in his view.

The U.K. Financial Services Authority is conducting a survey of U.K. hedge fund managers, covering data on investment strategy, holdings across market sectors and margin terms. The data collected will enable the FSA to identify the warning signs of excessive leverage, according to Myners, and ensure that it has the powers to intervene directly with managers to prevent the build-up of excessive leverage when justified.

A key piece of the proposed directive is the call for improved disclosure by investment funds. 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, their fees and expenses and 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.

Myners opposes the imposition of additional disclosure requirements on the portfolio companies of EU private equity funds. In the current economic climate, many over-stretched businesses are in need of equity recapitalization at a time when many private equity houses have funds which have not been drawn down. Regulators should encourage private equity to provide more funding, not burden it with unnecessary rules, he said.

With the low thresholds in the directive, the disclosure requirements would apply to relatively small companies, Myners noted. He believes this would impose administrative costs and put these companies at a competitive disadvantage by effectively forcing them to disclose details of their business plan to competitors.

In addition, the disclosure requirements would not apply to companies owned by family offices, sovereign wealth funds or non-EU private equity funds, but would apply to investment in non-EU companies by EU funds. It cannot have been the EC's intention to create such an uneven playing field, he said. He called for a "radical rewriting" of this piece of the proposal if it is retained at all.

Although the draft directive is flawed, Myners said that in the long run an open single market in fund management is a major opportunity for Europe. Regulators and industry participants must ensure that the final directive delivers the best possible result for EU investors and for the future of the EU funds industry, he concluded.