07 July 2009
AIMA Breakfast address on the Alternative Investment Fund Management Directive
Check against delivery
1. Thank you to AIMA for arranging this event.
Context and process
2. The alternative investment industry is important to Europe and particularly to the UK. Hedge funds manage around US$1.3 trillion for pension funds, institutions and individuals around the world. One fifth of these assets are managed from Europe and, of these, 80% are managed from the UK. By contrast, only 3% are managed from France. As my colleague Lord Mandelson said last week - the UK has more skin in the game than other European countries.
3. There can be no question that we need better regulation, internationally, at European level and nationally, in the light of recent events in financial markets. The UK is not in the business of blocking more stringent regulation, contrary to what some in Europe may say. We are publishing tomorrow a paper on the future of international regulation and supervision- and this will include some proposals concerning the hedge fund sector. But let me be absolutely clear - imposing ill-considered rules in haste would be counterproductive, whether at European or national level. Hedge funds and private equity have not been central to the financial crisis - as acknowledged by Jacques de Larosiere, Lord Turner and Charlie McCreevy, amongst others.
4. And, unlike in the US, most hedge fund managers in Europe are registered and already subject to information requirements. The UK has regulated hedge fund managers for many years, imposing direct information requirements on the 30 largest hedge funds, and monitoring the industry indirectly through prime broker surveys. Our regulatory regime has almost certainly contributed to the growth of the UK industry. Institutional clients demanded that their fund managers be well regulated and they took a view that the UK system delivered that outcome. I have not heard a single institutional investor welcome the more stringent aspects of the Commission’s proposal, and I think that’s an important point to which I will return later.
5. It is perhaps easy for other European countries to make political capital out of demanding intrusive regulation of an industry of which they have little or no direct experience. But it is woefully short-sighted, bordering on a weak form of protectionism. Europe has a lot to gain from a thriving alternative investment industry and it is important to make that case with conviction.
6. We have made clear to the Commission our views on their failure to consult on the AIFM proposals. However, we are where we are, and we can at least welcome the prospect of a true single market in fund management services. This presents a great opportunity for the UK, particularly as many Member States increase the pre-funding of retirement and move to appreciate the benefits of world-class risk controlled portfolios.
7. Our aim is a framework which allows efficient, well run and well regulated fund managers to compete for business 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 before this can be delivered.
Scope of the directive
8. Innovation is increasingly blurring the dividing lines between different fund management business models. Any classification drafted today would be out of date 5 years from now. So while I broadly endorse the proposed cross-cutting approach the Directive takes, regulation must also acknowledge where there are differences. This applies particularly to the open/closed ended divide. We impose capital requirements on open-ended fund managers to ensure they have enough working capital to continue to process subscriptions and redemptions for a short time if they hit solvency problems. These requirements cannot simply be transposed to closed ended managers because the same justification does not apply.
9. Furthermore, where effective EU regulation is already in place – particularly the Prospectus and Transparency Directives for listed closed ended funds – the directive should not impose new burdens unless it can be demonstrated that the existing directives are deficient.
10. I am also aware that there is concern about the apparent exclusion of banks. I understand that the intention was in fact to exclude banks only in respect of their proprietary trading activities and not where they carry on activities which will be regulated under the proposed directive. We will work with EU colleagues to address this shortcoming.
Third country aspects
11. I also hear your concerns about the treatment of funds domiciled or managed outside the EU, and of the use by EU managers of non-EU administrators, custodians and other service providers. Our open approach to trade in financial services has enabled the City of London to develop as a global centre, and we are not about to change that. We have successfully allowed non-EU funds to be marketed here for a number of years without the need for stringent equivalence tests.
12. Our private placement regime allows foreign fund managers free access to those expert UK investors who have the experience to do their own due diligence. This has given UK institutional investors access to a large range of investment opportunities and styles, and exposed the UK fund management industry to the discipline of global competition.
13. I recognise of course that other EU Member States have different traditions and take different approaches on this issue. However, to deny our 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.
14. 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 risks. If we achieve this then the EU will be able to compete globally in fund management without recourse to any form of protectionism.
15. Allowing the use of custodians, valuers, administrators and delegated portfolio managers from outside the EU is also key to ensuring that the EU remains a viable centre for globally integrated fund management businesses. Again there is no need for centralised equivalence tests as the MiFID and UCITS directives already enable us to control delegation. As long as managers maintain direct responsibility for all of their regulatory obligations and supervisors maintain a right of veto over delegation arrangements, experience shows that relatively unrestricted delegation can be allowed without compromising investor protection.
16. This leads us into the broader question of custody. Fallout from the Madoff affair has focused attention on the importance of robust custody rules. Independent custody and asset verification is a model which is widely used in the funds industry and which works well. I believe that codifying this approach would represent a step forward. However, there are problems with the Commission’s approach. There is no reason why the custodian should be a bank. If a firm is authorised under MiFID to safeguard client assets, it should also be permitted to safeguard the assets of a fund. Delegation of custody is essential to investment – a single lead custodian cannot realistically have a local presence in all the markets a fund might choose to invest. Imposing strict liability for delegated custodians would impose large capital costs, make investing in some emerging markets impractical and increase costs to investors. We need a solution which delivers appropriate levels of investor protection but which does not make the delegation of custody non-viable.
17. We also need to think about how custody requirements fit with the prime brokerage model. In May this year we published the Treasury's initial thinking on effective resolution arrangements for investment banks which, while they have a much broader scope, are relevant in this context. This report was developed in close cooperation with industry representatives, including AIMA, to whom I am grateful for their input. The paper is open for consultation until July 10th, and I would encourage those of you who have not yet replied to do so.
18. The Commission’s proposals require better tailoring to the prime brokerage model. It is not practical to require prime brokers to act always in the interests of AIF investors, as the directive proposes, for instance when they are holding the fund’s assets as collateral. The directive should also permit the use of multiple lead custodians to allow managers to continue to diversify their counterparty risk by appointing multiple prime brokers.
19. Turning to the issue of leverage, I agree with the Commission that excessive leverage in the funds industry may potentially contribute to systemic risk. I also agree that supervisors should monitor closely the extent of leverage across systemically important market sectors and that they should have the power to intervene where they identify immediate systemic risks. However, where I differ from the Commission is on the imposition of leverage caps and I know that this is an issue of serious concern to many of you in the industry.
20. The Commission proposes strategy-by-strategy limits on leverage at the fund level to be set in level 2 implementing measures, but it isn’t clear why they have reached their conclusion.
21. 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. Equally, leverage caps would not help protect the solvency of prime brokers This needs effective banking solvency rules. And even if the intention were to try to limit the risks fund managers can take with their investors’ money, leverage caps would be the wrong approach since leverage is at best only a partial measure of a fund’s risk exposure.
22. Leverage caps could even be counterproductive. Leverage generally increases as investment positions move against the manager. If this caused a fund to break through its cap, it may be forced to sell assets. If this happened across the market, it could cause a dangerous downward spiral in valuation.
23. So I find the case for imposing leverage caps unproven. To guard against excessive leverage the FSA is piloting a survey of UK hedge fund managers, covering data on investment strategy, holdings across market sectors and margin terms. This will allow the FSA to identify the warning signs of excessive leverage and we will ensure it has the powers to intervene directly with managers to prevent the build-up of excessive leverage wherever this is justified.
Portfolio company disclosure
24. Finally, I want to touch on portfolio company disclosure. This is a critical point for most of the private equity industry. Private equity ownership is not fundamentally different from any other private ownership model, and UK regulation recognises this. In the current economic climate, many over-stretched businesses are in real need of equity recapitalisation at a time when many private equity houses have funds which have not been drawn down. We should actively encourage private equity to provide more funding, not burden it with unnecessary rules or regard it prejudicially as an unwelcome form of capital or skill.
25. I therefore oppose the Commission’s proposal to impose stringent and costly disclosure requirements on the portfolio companies of EU private equity funds. With the low thresholds in the directive, these requirements would apply to relatively small companies. 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, rendering private equity to disadvantaged status in the provision of capital. These requirements would not apply to companies owned by family offices, sovereign wealth funds or even non-EU private equity funds but would apply to investment in non-EU companies by EU funds. It cannot have been the Commission’s intention to create such an uneven playing field and I believe this aspect of the directive requires radical rewriting if it is to be retained at all.
26. The question now is how to deliver these improvements, and the many others which I know are important to you but which I have not been able to cover today. I am encouraged by discussions with my EU colleagues, including the Swedish Presidency. There is an appetite to make significant changes and a will to engage in making them.
27. The directive is now being discussed in Council Working Groups, under Sweden’s chairmanship, and the technical input we have had from industry will be immensely valuable in securing a good outcome there.
28. As well as explaining our case in the technical working groups, and engaging in the detail with the Commission, the UK is also reaching out bilaterally to leverage natural alliances and win over others. Officials will lobby in more than a dozen key capitals over the summer. I myself will be engaging directly with my opposite numbers in key member states.
29. The directive is subject to a qualified majority vote so it will be vital to win over a majority of Member States. Sweden is keen to complete the directive under its presidency, so time is tight, especially as the proposals will need to go through the co-decision process with the European Parliament.
30. We expect the European Parliament to have appointed the ECON and JURI committees by the middle of this month, and to exchange views with the Commission at the end of August. There will be a public hearing around the end of September, and ECON will report on the proposal in November. ECOFIN should reach agreement on an amended report at its 2 December meeting, with the Parliament voting in mid December.
31. To achieve a good outcome, we will need your help, not just to tell us where the proposals cause problems but also to help us develop practical solutions. To that end, I am grateful that so many firms have joined the expert groups we have set up to progress these solutions. The 7 working groups cover Custody and third-party oversight, Delegation and structures, Leverage, Closed-ended application, portfolio company disclosure, Third country fund issues, and marketing.
32. Together, we have already developed proposals for a new structure for custody. We have also brought forward proposals to remove pre-vetting by regulators of fund documents at launch.
33. Because of the complexity of the co-decision process, with its multiplicity of key players and qualified majority voting in Council, means there is a real need for the industry to make its voice heard more widely in Brussels and in other EU capitals. Angry tirades against the iniquities of EU process will not be well received. Quotes in the press from managers threatening to quit the UK will make my job harder- and there should be no need to deploy such threats because of the strength of the argument. Those who lobby constructively, offering solutions as well as pointing out problems, seeking to understand as well as to be understood, will I believe get a fair hearing anywhere in the EU. The focus of lobbying efforts must be on other member states, those less in line with our thinking than for example Sweden. Because as Andrew said in his introductory remarks- there will be a Directive, not least because of the political momentum behind this issue, and we must work to improve it.
34. So I encourage all of you to go out and sell the benefits of your industry to the key people who will shape this Directive over the coming months and to explain why the proportionate regulatory framework you want does not pose the excessive risks they may fear. Use your networks of contacts to lobby Finance ministries and key MEPs, including particularly the rapporteurs for the dossier once appointed, and the ECON committee members.
35. I also think it is vital to call on the clients of this industry – the institutional investors and their advisers – to make your voices heard. As I said earlier, there has been no call from end users for these regulatory measures. 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. And submissions coming from European clients would add a powerful voice.
36. And you must highlight the symbiotic relationship between prime brokers and the hedge fund and private equity industries- and use the leverage of the likes of Soc Gen and BNP Paribas to lobby their own Government and Finance Ministries.
37. In conclusion, it is clear to us all that the draft directive is flawed. This was perhaps inevitable given the inadequate process by which it was developed, driven by political concerns. 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.
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