Same rules, different concerns

Cheerleaders for new regulations governing the private equity industry often argue stricter rules and reporting requirements will throw light on an asset class perceived by too many as esoteric and risky. Seldom mentioned by this group, however, is the uncertainty caused by legislators’ snail’s pace approach to crafting how exactly these rules should read and be interpreted.

The EU’s Alternative Investment Fund Manager directive, which was passed in November last year, is a prime example of such regulation that is poised to affect funds of funds managers. Among other things, the long-anticipated directive will impose new reporting requirements on funds, set restrictions on “asset stripping” and introduce stricter depositary guidelines. It will also impact the way in which Europe-domiciled as well as third-country funds market their vehicles across the 27-member bloc.

EU legislators volleyed back and forth 17 different compromise proposals before finally agreeing the directive’s language late last year. But fund managers will be unsure of what to fully expect until the directive’s core principles are fleshed out under so-called “Level 2” measures which are due to be completed by early 2013.

During this compromise process, several market sources expressed dismay over how little the government seemed to understand about the alternative assets it was determined to supervise. More than a handful of fund of fund managers PEI spoke with pointed to depositary rules as a primary example of where the directive gets private equity wrong. Article 21 of the directive mandates GPs to appoint a depositary whose task is to safeguard a fund’s financial instruments – a measure designed to ensure tradable securities don’t fall into the wrong hands. But the instruments in the private equity toolbox have less need for this protection, argues David Currie, chief executive officer of fund of funds SL Capital Partners. “Banks are going to charge silly money just to keep a copy of your partnership agreement in a safe box,”  he notes.


Lawmakers’ lack of understanding when it comes to private equity has led to some sore spots for funds of funds managers in particular.

For example, in a bid to prevent private equity firms from “asset stripping” a portfolio company, AIFM rules governing the buyout of large non-listed companies will limit GPs as to how much capital they may extract from the company in the first two years of ownership. This could also affect funds of funds’ receiving distributions in some instances, as taking a stake in a private equity investment vehicle structured as an EU-based non-listed company would be captured under the provision.“Buyout funds are typically setup as limited partnerships but some debt, energy or infrastructure-focused funds and holding vehicles use non-listed company structures,” notes Michael Newell, a private equity specialist at international law firm Norton Rose.

It would be a heavy cost if we were subject to independent monitoring and verification of reporting we get from our investee funds, compared to taking the information at face value – subject to meeting certain standards and an audit

Dan Kjerulf 

Legislators have already carved out an exemption for special purpose vehicles holding real estate investments, although it’s not yet clear exactly what this covers or whether further exceptions will be made for the non-listed corporate funds and joint ventures holding into which a fund of fund might invest.

Another worry are the provisions in the AIFM designed to increase fund transparency by having GPs submit detailed reports to investors and regulators on an annual basis. For direct investment funds, the requirement means that portfolio companies must follow a more rigid reporting process. For funds of funds the task may not be so simple, warns Gregg Beechey of international law firm SJ Berwin, who notes a fund of funds lacks the same level of control over an investee fund. “Emerging market funds in particular may be subject to light-touch reporting regimes and unfamiliar with such extensive reporting requirements,” he adds.

Above all else is the lingering question of whether a fund of funds would be responsible for an underlying fund’s financial records. “It would be a heavy cost if we were subject to independent monitoring and verification of reporting we get from our investee funds, compared to taking the information at face value – subject to meeting certain standards and an audit”, says Dan Kjerulf, chief legal counsel at bank-owned fund of funds operation Danske Private Equity.


On the bright side third country restrictions under the AIFM may provide a market niche for funds of funds. While a fund of funds is treated as a fund manager with respect to raising capital, its role shifts to that of an investor when choosing which funds it commits capital to. In essence wearing two hats gives a fund of funds the unique advantage of being able to act as a middleman between EU institutional investors and non-EU private equity funds unwilling to meet the directive’s demands.

Smaller funds unwilling to absorb the compliance costs of the directive, or funds domiciled in jurisdictions deemed unfit for the privileges of a marketing passport are barred from knocking on the doors of EU investors, or what’s known as “active marketing”. However passive marketing, in which EU investors are the ones initiating contact, would still be allowable. 

While it’s feasible a large EU pension or dedicated wealthy individual could jet set around the globe in search for an attractive non-compliant fund, “it’s funds of funds with a network of relationships and knowledge of the most promising funds in market best suited to handle the task”, says Andrew Lebus, a partner at Pantheon, one of the world’s largest primary and secondary funds of funds managers.

But the advantage doesn’t come without its own regulatory issues, cautions Christopher Gardner of international law firm Dechert. A fund of funds placing 85 percent or more of its capital in one fund, or funds with identical investment strategies, falls into the definition of a “feeder fund”, notes Gardner.

EU lawmakers were careful to include feeder fund setups in the directive’s scope to prevent crafty managers from using an offshore master fund, fed into by a compliant fund, from circumventing the law’s intent. An EU fund of funds captured under the feeder definition would consequently lose its ability to freely market its fund across the EU under the passport regime if the “master fund” it invests into is non-compliant, explains Tamasin Little a partner at SJ Berwin.


If the AIFM gives funds of funds managers a headache, even more ibuprofen may be needed over a new US law aiming to clamp down on tax dodgers. The Foreign Account Tax Compliance Act (FATCA), which takes effect in 2013, will among other things impose a 30 percent levy on certain types of distributions made by a US-based fund to a foreign fund of funds. That is unless the taxman is satisfied he knows enough about all the US limited partners involved in the relationship.   

Non-US firms will have to provide US tax authorities a look into the financial details of all its US-based limited partners. But for funds of funds the law means not only ensuring its own investors are FACTA compliant, but confirming that any non-US funds within the portfolio are also compliant. Likewise GPs taking on a fund of funds as an investor risk swallowing a 30 percent tax penalty when exiting certain US assets should a fund of funds skirt the new tax-avoidance rules.

The only true safe way for the fund of funds and direct fund to ensure FACTA compliance is for both to demand the other party guarantees maintaining its tax sharing information agreement with US authorities

Adam Levin

Thus for funds of funds, compliance costs hit from both ends, both as an investor and fund manager, explains Adam Levin, a private equity lawyer at Dechert. “Worst still the only true safe way for the fund of funds and direct fund to ensure FACTA compliance is for both to demand the other party guarantees maintaining its tax sharing information agreement with US authorities,” exhorts Levin, adding, “I would expect many GPs to balk at this commitment, especially if it means exposing itself to liabilities for the actions of its LPs”.

While much will depend on the Treasury department’s issuance of specific regulations for the applications of FACTA, a report from PricewaterhouseCooopers warned that some fund managers may find compliance costs prohibitive and choose to stop making US investments or taking commitments from US-based investors.

Just how the global funds of funds industry confronts all of these challenges will be interesting to observe in coming months and years. The various regulations on the horizon will mean a great deal of time, energy and money on the part of managers, and perhaps even some changes to certain funds’ investment strategies. Watch this space.