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Newsroom & speeches
17 September 2009
Check against delivery
1. I would like to thank Dan Waters and the Financial Services Authority (FSA) for arranging this event and inviting me to speak.
2. I am delighted that this conference is dedicated exclusively to the European Commission’s proposed directive on Alternative Investment Fund Managers.
3. This directive is very important for the future of the EU financial services industry. As many will know, I have taken a close personal interest in its development, an interest borne out of my concern at the risk it could pose to Europe’s economic recovery, and the efficient allocation of capital and the growth of responsible and safe financial service provision in the EU.
4. I have spoken previously about the UK’s overall support for the objectives of this directive. And we continue to support this initiative.
5. Forming an effective EU single market in institutional investment funds would represent a major step forward for the EU and a major opportunity for the UK and EU funds industry.
6. Effective supervisory co-operation to enhance safeguards against any possible systemic risk from this industry would also be a good achievement. A good directive would offer sufficient and appropriate support to investor protection and financial stability, proportionate to proven need.
7. However, many of the issues with this directive are due to it not having gone through the usual rigours for new European legislation – a thorough impact assessment and proper consultation with stakeholders.
8. Nevertheless, we are where we are. I therefore hope that today’s event can provide a forum for measured and non-partisan debate on the key issues and help us in forming solutions to the various challenges with the Commission’s current draft proposal.
9. But before getting in to detailed discussion of some of these concerns, let me say a few more words about why this matters- not just to the UK but to the whole of the EU.
10. The alternative investment industry is important to the broader European economy. Over the last 3 years, the UK private equity industry invested over £30 billion into companies in Continental Europe, and about the same again in the UK.
11. EU firms need that sort of investment now more than ever as they look for capital to rebuild and de-risk their balance sheets. The private equity industry has capital to invest, and the skills to do it well
12. The industry worldwide had $1 trillion in uninvested capital by the end of 2008. We must not deprive EU firms of this investment by closing Europe’s doors to this business.
13. Hedge funds manage around US$1.3 trillion for pension funds, institutions and individuals around the world, offering investment solutions which largely focus on carefully balancing return and volatility to produce tailored outcomes.
14. One fifth of these assets are managed from Europe and, of these, 80% from the UK. The demand for these and similar approaches to portfolio construction and optimisation, including liability drive styles, is increasing globally. This is a growth opportunity for Europe.
15. Turning to the substance of the proposal, the UK agrees that we need better regulation, internationally, at European level and nationally, in the light of recent events in financial markets. Indeed we are leading the cause for more effective regulation and supervision.
16. The UK is not in the business of blocking more regulation. But imposing ill-considered rules in haste would be counterproductive.
17. Hedge funds and private equity have not been central to the financial crisis - as acknowledged by Jacques de Larosiere, Paul Volker, Charlie McCreevy and Adair Turner, amongst others.
18. If one does want to look to the fund management industry as a contributor to the crisis, one might look, for instance, to long-only equity funds, closet indexers or benchmark huggers who might have investments in which they are underweight and accordingly have no obvious performance incentive to address deficiencies in strategy or leadership of relevant companies.
19. But I will say quite categorically that there is no evidence of involvement of hedge funds or private equity
20. While we share the Commission’s desire for appropriate common regulation in this area, the lack of time for consultation has meant that a number of technical but important provisions in the draft are either without purpose or, if they do have a legitimate purpose, are not fit for that purpose.
21. I would therefore like to set out in more detail some of the ways we can improve this directive; still delivering the objectives set out by the Commission but without imposing disproportionate costs or precipitating economic damage.
22. One of the trickiest technical questions in the directive is that of custody. I am glad that the Commission has chosen to consult on this issue in the UCITS context and I hope that the Council and Parliament can and will take the consultation responses into account in the AIFM debate.
23. The biggest issue here is the standard of liability for depositaries. As the Commission has pointed out, the failure of custody in EU feeder funds of the Madoff ponzi scheme has demonstrated uncertainty over the application of EU law in this area.
24. Some would like to resolve this by imposing strict liability on depositaries, so that whenever assets were lost, the depositary would have to compensate the fund in full.
25. This approach fails to recognise the circumstances where a depositary could not reasonably avoid a loss of assets. It would impose large capital costs, make investing in some emerging markets impractical and increase costs to investors for very little advantage.
26. We think the right solution is to set out clearly and precisely the duties of a depositary, including the due diligence required over sub-custodians.
27. Where assets are lost because a depositary fails to perform these duties, it is only right that they should accept liability, but where the loss happens in spite of the depositary having done all the appropriate checks it should surely not be held liable.
28. Currently, the directive only allows a credit institution – a bank – to carry out the function of custody.
29. This simply does not make sense. It would concentrate custody risk in the hands of a small group of institutions and reduce competition. If a firm is authorised under MiFID to safeguard client assets, it should also be permitted to safeguard the assets of an alternative type fund.
30. And a ban on delegation of custody outside the EU would make it impossible for funds to invest in many non-EU markets. Depositaries must be allowed to delegate custody outside the EU.
31. We need to consider how to tailor custody rules to the different types of assets. While there are established and effective solutions for listed securities, assets like real estate and private equity require different approaches.
32. I am not persuaded by those who say that the concept of independent custody is not applicable to the private equity model.
33. I believe this is one of the areas where a properly tailored set of rules could possibly be a useful reinforcement to investor protection. However, it is also not practical or necessary to require custodians to hold actual title to these assets. In the private equity context the focus of custody rules should be on asset verification.
34. The current drafting on the subject of valuation evidences poor understanding of valuation in a private equity context. This is not surprising given the lack of consultation the directive went through.
35. Third country aspects and marketing is another key topic in this directive. In the UK, we have an open approach to trade in financial services that has enabled us to develop as a global centre, to the benefit of the UK and Europe.
36. We have successfully allowed non-EU funds to be marketed in the UK for a number of years, providing broad access to those expert UK investors who have the experience to do their own due diligence.
37. This has given UK institutional investors access to a large range of investment opportunities and exposed the UK fund management industry to the discipline of global competition.
38. I recognise of course that other EU Member States have different traditions and take different approaches to this issue.
39. However, to deny European institutional investors a global choice of fund manager would come at a direct cost to pension savers, charities and others who rely on the returns from professionally managed institutional investment funds. It would lead to industry across the EU becoming less efficient by reducing competitive intensity.
40. Some people have argued that it is only by closing the EU market to all who do not meet equivalence tests that we can incentivise managers to locate in the EU. I reject this argument.
The directive should only impose those requirements which are necessary to mitigate genuine threats to stability or investor damage.
41. The directive also covers private equity portfolio company disclosure. This is an important issue not only for private equity managers but to all stakeholders of private equity portfolio companies - their employees and trade unions, their suppliers and their customers.
42. These groups have a shared interest in ensuring that the firms whose long-term success they rely on are not put at a competitive disadvantage through ill-considered regulation.
43. There are two key disclosure obligations set out in this directive. The first is to provide information to employees, shareholders and the target company regarding the private equity manager's intentions for a possible takeover and future running of the target company once the fund has taken a significant stake.
44. These obligations are similar to those placed on any bidder under the Takeover Directive, but there are important differences.
45. The Commission's draft would leave the target company and its shareholders holding different information about a possible takeover from an EU private equity firm compared to one from any other bidder. Particularly in a competitive bid situation, this could lead to serious bias, contrary to the best interests of those investing through private equity funds.
46. Let me be clear: unless this obligation is removed, it will lead to less investment by private equity in European companies. At a time when so many EU companies are in real need of new equity investment, this would surely be a bad outcome.
47. The second obligation is to provide information to employees on an annual basis. Through the Walker guidelines, the UK private equity industry voluntarily agreed to provide substantial annual disclosure for larger portfolio companies. This disclosure must be timely and must include effective communication with employees. The UK has helped set a global standard in these areas.
48. These disclosures– in the main – are similar to the AIFM expectations. However, a key difference is that the Walker guidelines limit this requirement to larger portfolio companies on the grounds that they are likely to be competing with listed companies with a similar level of disclosure, and there is therefore less of a concern about putting the portfolio company at a competitive disadvantage.
49. Walker argued the case for focusing disclosure on larger companies whilst not adversely affecting flows of new capital to smaller ventures.
50. However, the directive proposes a very low threshold for these disclosure obligations. This would impose administrative costs on smaller companies and put such funds at a competitive disadvantage.
51. This would benefit neither private equity investors nor the portfolio company employees who may see their company being unable to compete with its peers, with potentially adverse consequences for corporate success and workplace security.
52. Let me be clear again: I see no reason, other than enlightened self-interest, why private equity should be required to go beyond Walker guidelines and no reason why we should penalise private equity by placing upon it burdens that do not apply to, for instance, family controlled businesses, oligarchs, offshore investors or subsidiaries of multi-nationals.
53. The evidence simply does not support discriminating against private equity.
54. Similarly, I can see no sense in provisions that would place disclosure obligations on a European private equity fund invested in a Chinese company, but not on a Chinese investment in a European fund.
Of less significance to private equity, but of major significance to hedge funds and others is the issue of leverage caps. One of the improvements the FSA is making to its already robust system of hedge fund manager regulation is to strengthen its oversight of the impact hedge fund trading has on markets.
55. We and the FSA recognise that excessive leverage can lead to instability.
56. But I know that one of the insights from the FSA’s work to develop this strengthened oversight has been that simple leverage ratios are of very little use in making the kinds of judgements required, particularly around risks associated with crowded trades.
57. Proper oversight requires more detailed and nuanced analysis.
58. So we agree very much with the Commission that regulators need to do more to control the risks of excessive leverage, but having looked seriously at the issue, we are also certain that imposing in advance arbitrary leverage caps is more hindrance than help in achieving that goal. Such caps represent a simplistic approach that would not capture the fact that leverage can take many forms. Consultation would have exposed these points.
59. Instead we need proper oversight and powers for regulators to intervene in a tailored way when they identify particular risks.
60. The Commission’s proposal on capital imposes initial and ongoing capital requirements on the AIFM. Again, we agree with the Commission that the directive needs to address this issue.
61. However, capital requirements need to be tailored to different types of manager.
62. The Commission says that there are two reasons to require firms to hold capital. The first is to allow for an orderly wind down if the manager becomes insolvent. This is particularly important for managers of open ended funds and funds whose strategy relies on regular trading.
63. Capital requirements on this basis are included in the MiFID and UCITS directives and have worked well.
64. The second justification for capital which the Commission offers is to help the manager in meeting any liability claims from investors. This is of course an important contingency for which managers should plan. The vast majority hold professional indemnity insurance for this reason.
65. But the idea that these capital requirements would be enough to meet any possible significant liability claim is not realistic.
66. For this reason, we believe it is necessary to set capital requirements based on the level required to allow orderly wind down.
67. For managers of open ended funds the proposed standards are broadly the right ones, based on established EU standards and developed as a consequence of proper consultation and research.
68. However, for fund managers, particularly private equity and real estate managers, who manage closed ended funds which do not offer frequent or daily dealing, the level of capital required for orderly wind down is much lower.
69. Put simply, if a private equity manager were to fail tomorrow, the portfolio companies it owns would not suddenly become unviable businesses and the investors would have time to decide whether to appoint a new manager or liquidate the fund.
70. On the other hand, for a hedge fund with a strategy relying on regular trading, investors could suffer real losses from a sudden failure of the manager. We must recognise this difference in setting capital requirements.
71. This is just one of the several examples I could mention where the conflation of different investment styles and fund structures in a single directive has only been achieved at some considerable cost to relevance and practicality.
72. These are to me the key issues with the Directive as it is currently drafted. Now let me say a few words about the negotiating process that the directive will go through.
73. Since the middle of this year, Council Working Groups, under the Swedish Presidency, have been discussing this directive. It is in these groups, in which finance ministry officials from all 27 Member States discuss improvements to the draft directive, that much of the important work is being done.
74. The Presidency has been listening to other member states’ concerns and working very constructively to find solutions to the issues raised. I expect that we will hear more from my good friend Mats Odell, Swedish Minister for Local Government and Financial Markets and representative here of the Swedish Presidency on how this work is progressing. We are fortunate to benefit from Mats’ involvement in this process.
75. The directive is also subject to co-decision by the European Parliament, so it is important that we engage with parliamentarians and with the rapporteur, M. Jean Paul Gauzes, whose role it is to co-ordinate the Parliament’s input into the drafting process.
76. I am certain he will do an excellent job.
77. I know that the Parliament's ECON Committee held its first discussion earlier in September and that Jean Paul hopes to produce his draft report later in the year. Given the lack of public consultation, this is the first opportunity that MEPs will have formally to engage in this debate, and they will make a vital contribution to this legislation.
78. Over the coming months, we will all need to work closely with the European Parliament to ensure that this legislation becomes a success story for Europe and something that we can proudly regard as a good international standard in a similar way to the UCITS standard in retail.
79. The UK is already heavily engaged in the European process, and I personally commit a substantial part of my time to achieving a good outcome for the UK on the directive.
80. Having met with industry to hear their concerns, I have travelled to Brussels to discuss this directive with key MEPs and other stakeholders. I have also so meet with the Swedish Presidency both in London and Stockholm to set out our concerns and plan to have similar discussions with my Spanish counterpart in Madrid over the coming weeks.
81. Our engagement continues at working level. My officials represent the UK at the Council working group meetings – of which there are 4 more before the end of October.
82. In recent weeks they have also been travelling across Europe, having bilateral discussions with several finance ministries with the aim of understanding their concerns and finding solutions.
83. But this work is not for Government alone. It is important that all stakeholders get involved in this process if we are to ensure the right result for Europe.
84. So, to finish, let me make a call to action.
85. This is EU legislation and stakeholders should make their voices heard at EU level. We need to see investment managers and institutional investors - the end clients of this industry - getting involved and making their voices heard, lobbying parliamentarians and Government officials and ministers in other member states. Trade associations should work together constructively and avoid politicking or grandstanding.
86. The UK Government already has a thorough understanding of the problems this directive could cause the industry - now it is time to start making these arguments more widely across Europe.
87. The whole of Europe benefits from an efficient, competitive fund management sector and the whole of Europe would suffer from any major damage caused to it.
88. It is encouraging that some larger pension funds have started raising their voice to tell the Commission and the European Parliament what things they like and dislike in this Directive.
89. Today I today want to urge you to continue and indeed accelerate this effort.
90. If institutional investors can make clear which regulatory safeguards they want to see applied to their fund managers and which they find to be costly and unnecessary, this will send a powerful message to policymakers.
91. Those who lobby constructively, offering solutions as well as pointing out problems, seeking to understand as well as to be understood, will get a fair hearing anywhere in the EU.
92. Those who come across as arrogant or self-serving are undermining the good work done by others.
93. In conclusion, it is clear to us all that the draft directive will be amended before it is agreed. This is inevitable given the inadequate way in which it emerged. But let there be no doubt, there will be a directive, the expectation in Brussels is now fixed on the need for legislation in this area.
94. However, in the long term an open single market in fund management must be a major opportunity for Europe, and we must all do our bit to ensure we deliver the best possible result for EU investors and for the future of the EU funds industry.
