Closing the borders

Proposed EU regulations may block some funds from doing business in Europe while giving others a leg up on their locally based competitors.

New proposed regulations could impose barriers for foreign fund managers, particularly those domiciled in the US, trying to market and manage funds in the EU. Those who are able to overcome these hurdles, however, may find themselves with a competitive advantage over their EU-based counterparts.

The European Commission’s “Directive on Alternative Investment Fund Managers”, which is coming up for debate in the European Parliament, would create a comprehensive regulatory framework for hedge and private equity fund managers in the European Union, applying to leveraged fund managers with more than €100 million in assets and unleveraged funds with more than €500 million in assets.

But while industry groups including the British Venture Capital Association (BVCA) have called attention to the negative effects the regulations could have on firms based in the EU, the directive could also have serious consequences for US-based alternative fund managers who raise and manage assets in the EU. Specifically, foreigners trying to market their funds in Europe will have to demonstrate to the relevant authorities that they are subject to equivalent regulation in their home jurisdiction. It is unclear that – absent new proposals from the US government – US managers would be able to do so.

“At that point you can’t raise any more money in the EU, unless you become registered here or your regulatory regime becomes approved as equivalent by the EU,” says Adam Levin, partner at law firm Dechert. “And the EU has a track record of not approving American regulatory regimes, as they just don’t like them for one reason or another. So unless they approve the US regulatory regime those fund managers will not be able to raise funds from Europe.”

The new rule would hurt the European LPs just as much as the American GPs of course – not only would foreign fund managers have to set up shop in the EU to market to EU investors, but European investors would also face a serious loss of access to top-performing alternative investment managers in the US.

“We have seen a pattern I like to call regulatory contagion, which is to say that when you have a regulator making a set of changes in a given country or region, it seems that often that ends up flowing into other places where people think they need to do something,” says Josh Lerner, a professor of investment banking at the Harvard Business School. “As the private equity market has become more global, a regulation done in even a single country will have a much broader impact.”

Unintended consequences
Lerner says the new EU proposals could have a similar effect on private equity as the US’s Sarbanes-Oxley Act had on public companies – imposing very substantial costs on lower- and middle-market firms. “Even though you can see where people were coming from when they enacted it, there’s a sense that regulations had unintended consequences,” he says.

One of those unintended consequences for the EU, Levin says, is that those foreign funds that are allowed to market in the EU will be in a much better position that their EU-domiciled competitors who will be having to deal with more intrusive regulations, including disclosure obligations requiring the publishing of a development plan for a company they have purchased and the external and internal communication policy. They must also publish their policies for preventing conflicts between the fund and a company that has been acquired.

“These things are usually jealously guarded by the investment community; firms don’t really want people looking at their plans and then trying to measure them by comparison,” Levin says. “And suddenly we have this whole range of disclosures that are going to come in which produce a really uneven playing field between non-EU and EU funds. Non-EU funds won’t have to abide by these rules, and contrary to whatever else the EU says it’s doing, this will give a competitive advantage to non-EU funds for investing in Europe and a disadvantage to EU funds investing everywhere else.”

On the latter point, when an EU fund does a deal in the US, for example, they will have comply with EU regulations in addition to US regulations. “If you want to use European money to make acquisitions in the States, you’re going to have to produce all of this information as well,” Levin said.

While such measures in the EU directive are intended to keep money-raising opportunities in Europe for Europeans, they may in fact lead to an exodus of managers from EU members. Some of the biggest London-based hedge funds have already reportedly told government officials they are looking at relocating offshore to countries like Switzerland, which is not a member of the EU.

“Fund managers are already looking very seriously at Switzerland to set up there to avoid these rules,” Levin says. “In the end you may see the world divided into two camps, the EU and everyone else.”

In order to keep that from happening, Lerner says the relevant industry groups need to get the facts out at a time when regulations are being rushed through to solve financial troubles, when it is still unclear that the private equity industry was a part of the cause. “To the extent possible, they should try to shape the regulations to get away from the micromanagement of individual investment decisions by policymakers,” he says. “When we’ve gotten policymakers involved in individual investment decisions, it has generally not been a tremendous recipe for success.”

Toward that end, the European Private Equity and Venture Capital Association (EVCA) recently hit back by claiming the proposed regulations could restrict the free movement of capital. The group has requested that regulation be limited to only funds managing more than €1 billion, accommodate differences between hedge funds and private equity and grant passport rights to non-EU funds to market themselves to professional investors.

EVCA chairman Jonathan Russell, echoing Lerner, says the European Commission’s proposals would open the door to similarly protectionist legislation from other countries, and make investing capital in Europe less attractive. He adds, however, that he is confident that the governments who are part of the European Parliament will be persuaded to make the necessary changes to the directive.

London calling
The city of London in particular has come out against the added regulatory burdens, as it is home to 80 percent of Europe’s estimated $400 billion in hedge fund assets, as well as more than 65 hedge funds. It also recently received a boost when the financial minister of Sweden, which has assumed presidency of the European Union until next January, said that private equity does not pose a systemic risk to the economy.

Such statements are significant as the country is reportedly keen to get the directive ratified on its watched before Spain – which has sided with France and Germany in favor of heavier regulations – takes the EU presidency position at the beginning of 2010. If that happens, the new EU regulations are likely to be more to the industry’s liking.

In the meantime, however, firms may want to consider themselves in a holding pattern regarding European investment. “Regretably, at this point the best advice for non-EU managers may be that they should think twice about making long-term decisions about establishing in Europe, as the regulatory environment is too unclear,” Levin said. “If they want to establish something major in the EU they do it at their own peril.”
“Certainly setting up in the EU in a small way is probably fine, but if these regulations come into force they may be better off looking at Switzerland or Jersey as a European base unless they need to raise EU money, in which case they will have to bite the bullet.”