They say that the bigger they come the harder they fall, but it is the smaller firms that look at greatest risk of being toppled or at least tied up by the EU Alternative Investment Fund Managers Directive (AIFMD).
The directive has ramped up the weight of the regulatory burden faced by private equity fund managers active in the EU. Although it came into force in July 2013, market observers say that many funds are still trying to work out the best response.
“A large fund manager with a large back office can afford all of this burden, but for a fund with six people, it’s not necessarily viable,” says Adam Turtle, partner at Rede Partners, the fundraising advisory business.
AIFMD requires the functional separation of risk management from portfolio management: the same person cannot do both, so a small fund manager that did not previously have a separate risk manager must hire one. It also makes an independent depositary responsible for the safekeeping of assets. Responsibility for these functions has to be held by EU-based staff.
The regulations also require the provision of annual reports to investors, and quarterly reporting to regulators in the case of larger funds.
The directive applies to any fund that wants to market in the EU without major restrictions on how it does so, regardless of where the fund is based.
Asked what is toughest, in practice, about AIFMD, Turtle says: “The really problematic aspects, particularly for smaller general partners, are to do with compliance and the depositary function.”
The days are over when the cost of such burdens could have been passed on to clients, says Alan Flanagan, global head of private equity and real estate fund services at BNY Mellon in Dublin. “Loading on additional costs is something that investors have a lot less tolerance for,” he says.
One way to avoid the directive is to not accept Alternative Investment Fund Manager (AIFM) status. But then funds have to rely on “private placement” – the sale of stakes in the fund to a relatively small number of select parties – to secure funds from EU investors.
Private placement is, however, highly constraining, says Aymeric Lechartier, London-based managing director at Carne Group, the governance firm for asset managers.
He notes that because of various national and EU-wide restrictions, fund managers relying on private placement rules cannot seek investment from pension funds or family offices in much of mainland Europe. In practice, few insurers will invest with fund managers that do not have AIFM status, because of the high capital charges they incur for regulatory reasons.
Many smaller managers based outside the EU have responded to the choice between tough private placement rules and AIFMD by simply giving up, says Turtle. “If you’re a good US manager that doesn’t need to come to Europe but might do so just to get diversity in your investor base, you’re not going to bother any longer,” he says.
Relying on private placement can work for a small fund whose investors are concentrated in one country. However, “if a fund manager is serious about growing its pan-European business, it will eventually need to comply”, says Flanagan.
For this reason, service providers think many US fund managers are likely to seek AIFM status over the next few years.
But just as there is more than one way to skin a cat, there is one more than one way to comply with AIFMD.
Some managers have responded by setting up or strengthening EU offices.
However, others have outsourced AIFM status to governance specialists such as Carne. Lechartier puts the case for the AIFM status which firms such as his can provide.
“Setting up full AIFM capability takes probably about a year, including nine months for the approval process and three months for preparation,” he says.
The fund manager must also bear the running costs of maintaining the AIFM status – which Lechartier puts at “about a million euros for a UK AIFM”. This encompasses the costs of hiring “at least four or five people”, including two portfolio managers, a risk manager and a compliance manager, in London.
The cost of outsourcing the governance aspects of an AIFM to Carne is, he estimates, between €60,000 and €200,000, depending on the fund size – “a fraction of the cost it would have taken to set up one’s own full-blown infrastructure”. This is because one person can do the risk management, regulatory filing and compliance work for a number of fund managers. Portfolio management is delegated back to the original fund manager which can be outside the EU.
PARALLEL FUND STRUCTURES
Jake Green, London-based partner in the financial regulation group at law firm Ashurst, notes that the outsourcing price is “not cheap – it’s a cost which managers need to think about”. But “funds dead set on a mass European marketing tour will need either this, or their own AIFM capability”.
He says that US fund managers are increasingly accepting the need to have parallel fund structures, in, say, the Cayman Islands and in an EU location such as Luxembourg.
But AIFMD itself cannot entirely be blamed for the increased burden, says Giles Travers, a director of alternative investment funds at SEI Investment Manager Services: “There’s been a whole tsunami of regulatory changes over the last few years.”
He recalls the financial controller of a big European private equity firm telling him that the time he spent on regulatory reporting and compliance had risen from 10-20 percent of his day to about 45-50 percent.
Fund service administrators say that they ease the burden of dealing with regulations by enough to provide a cost saving for fund managers, though are reluctant to give precise figures.
“There are definitely economies of scale for a fund manager in outsourcing, because we do this with a much greater investment in technology and infrastructure,” says Travers. Fund administrators can also act as the depositary for a fee, characterised by one administrator at “low single basis points”.
There is also another reason to outsource it, says Travers: it liberates people. “If you’re running a finance, compliance or operations team at a private equity firm, you don’t want those people focused on low-value work which is not helping drive your investment decisions and fund returns.”