European Legislation

UK lawmakers listen to evidence on the best way forward

Originally published in the November/December 2009 issue

On 27th October 2009, the House Of Lords Select Committee on the European Union Directive on Alternative Investment Fund Managers listened to evidence from industry experts on the legislation planned to regulate alternative investment funds in the region. One of their experts was Andrew Baker, Chief Executive of Alternative Investment Management Association (AIMA). The following is an excerpt of the transcript of that discussion.

Andrew Baker: Would it be helpful if I give you a quick update on what has happened since I last saw you all back in July?

Chairman: That would be very helpful.

Andrew Baker: Back in July we had no European parliamentary involvement, because obviously the parliament had not formed, and we were at an extremely early stage of the Swedish presidency, so very little had happened at European Council level. There have been a number of significant developments since then. We have travelled far and wide across the EU, not only to reach out to investors who are going to be affected by the Directive but managers from other sectors of the investment management industry, because, as we all know, this Directive will affect others than hedge fund managers. We have also spent a lot of time with both the regulators and finance ministers across the Member States. The purpose of doing that is to establish where national interests lie in certain key issues that are of interest to our industry.

In summary, as a result of all of this activity and the Committee meetings which have taken place subsequently within the European Parliament, there does appear to be very widespread consensus now about the areas of difficulty with the Directive – which we have seen plastered all over the newspapers almost ad nauseum – but also the potential for areas where improvements could be made, and there does seem to be very, very strong consensus about where the principle areas of difficulty are. I will list them if you like, but they are quite numerous, and they start with “one size fits all” as a single overriding problem. The good news is that there does seem to be a very strong consensus – so it is not just special pleading amongst our managers’ community; these views are shared by investors and managers alike. The difficulty is what happens next, because the nature of some of the difficulties is very severe and coming up with resolutions which are going to satisfy all constituencies is going to present a number of challenges. One idea I would like to leave with the Committee is that either we have a number of years of extremely detailed and technical discussion ahead of us which will involve better definitions, the consideration of how many sectors of the industry and which ones of them are deserving of a carve out, or else we have to retreat to a much higher level and try to do this on a principles basis, to get the Directive through much more quickly so that we can all get on with our lives. Our industry has fully recognised that there is going to be a measure on this score. The more it looked like the Obama proposal, the more we would welcome it. We would like to see it on the statute books in that form so that we can move on. Part of our problem at the moment is that we are stuck in this sea of mud to do with all the technical difficulties.

Chairman: Does the sea of mud include the Swedish Presidency’s issues note? When I read it, it seemed to me that the areas of mud did look quite extensive.

Andrew Baker: Their issues note is extremely good. It is not comprehensive. There are some topics which have not yet been tackled – certainly not in the notes they have published. We are aware that there have been other notes as a result of other meetings, but they have not been put into the public domain, so we are not aware of their official status. Their issues note was extremely comprehensive and extremely thorough – so full marks to them for effort – however, they have identified a series of options to solve some of the problems, they have not come out in favour of one avenue or another. It strikes us that some of these things are not technical in nature; in other words, you cannot just choose left or right in order to suit a technical issue. Some of them will probably need some kind of political intervention in order to get the process moving forwards.

I hate to say it, but I think the toughest nut of all has not yet been cracked, and that is in relation to the definition that should apply to exactly who is the investment manager to whom all of these requirements will apply. Because of the very, very complex and varied nature of non-UCITS investment managers, there is a very large variety of different structures, whether open-ended or closed-ended, whether partnership-related or limited-company related, and some structures are self managed, so there are extreme definitional difficulties which in turn will affect the scope and which in turn will affect the other measures.

There are some significant challenges which still lie ahead, although the Swedes have done an outstandingly good job today.

Chairman: The major challenge, it seemed to me, still to be looking at us was the size issue. You were suggesting that nobody should be regulated at less than €1 billion, whereas the Commission’s proposal is €100 million. Has there been any movement there?

Andrew Baker: No. A point of clarification, My Lord Chairman, is that that 1 billion relates to the provision of information, not to the provision of regulation. Our proposal is in fact that the threshold for regulation is zero. Everyone gets regulated, but it is how much information is provided – which is the thorny question about volume of information to supervisors.

In terms of the overall threshold, there has been much debate about, for example, smaller funds in the smaller Member States, which are sold only domestically, many of which are way below the threshold, but if they get close to the threshold at what point do they have to apply. There appears to be general recognition, in terms of authorisation, that the current limit could stand.

Chairman: Thank you very much. I have strayed slightly into the question that Lord Trimble wanted to ask.

Lord Trimble: To pick up on that, you are saying that there is a consensus that one of the problems is the “one size fits all” approach. I presume when you say there is a consensus, that it is a consensus of the people who are in this industry.

Andrew Baker: And investors. And increasingly you will hear it from the members of the committees in the European Parliament and from the people on the Council Working Group who are negotiating on behalf of the governments of Member States.

Lord Trimble: If there is this broad consensus that “one size fits all” is not the right approach, how do you think that is going to be resolved?
Andrew Baker: My view is that we are either going to be faced with many years of discussion about definitions and potential exemptions, or we can retreat to a much higher level and principles-led approach and come back and revisit this at a later date.

Lord Trimble: Could you tell me what you mean when you say “principles-led approach”?

Andrew Baker: Some of the provisions of the Directive stray into level 2 territory. The landfill issue process allows for this sort of complexity by saying that level 1 issues should be tackled at the principles level and then the level 2 stuff is left to the Member States individually under guidance and advice from their national regulators. We think that is a very sound way of working. It does not appear to be in use on this occasion. The tools already exist.

Lord Trimble: Turning for a moment to managers, you have a similar situation. You are saying that having the regulation on the managers is a problem because the manager can take so many different forms and the structures can take so many different forms. Would there be a case for switching the tension of regulation to the funds as well as the managers?

Andrew Baker: I do not think that solves any of the issues. As the EC says in its own paper and as IOSCO has said in its paper on hedge funds, the right way of doing this is to look at the managers because they are the decision makers. The funds are really only empty shells. Given that management activity can take place outside of a fund structure as well as within a fund structure, you would worsen the level playing field problem by doing that.

Lord Renton of Mount Harry: I would like to ask you a question about leverage. I know that in your evidence you say that you think it is wrong for there to be such strict figures to be imposed by the Directive, but I am not clear in my own mind as to how important this issue is. I get the impression that there is a huge variety between the leverage unit and the hedge fund industry, which tends to be one time assets whereas in the banking industry it is 50 times assets. It is an extraordinary change. Do you think the Swedish note and the ideas they have put forward on this makes sense? What would you like to see happen?

Andrew Baker: The Swedish note offers a resolution to this. Let us go back to a prior point which needs to be covered; that is to say that if there are build-ups of leverage which become dangerous, of course we need to be able to monitor them and of course we need the tools to be able to intervene in a controlled way to prevent the situation getting worse. From that point of view, we fully accept the principle that leverage should be monitored. Leverage is not the same as risk, by the way, but leverage, nevertheless, is a potential accelerant during a market crisis and therefore it is entirely appropriate that there is a mechanism for monitoring leverage. To translate that into, “Therefore there should be caps on leverage”, regardless of the type of organisation and the type of assets which are being supported within an investment fund, is far too blunt an instrument.

Quite clearly you all understand that the liquidity and volatility of the asset which is being supported by the leverage will determine whether it is safe or not to take any leverage to purchase the asset. For very illiquid and very volatile assets, it is extremely dangerous to take any leverage.

Lord Renton of Mount Harry: What you are concerned about is that suddenly, if leverage is fixed in advance, too many people might get into the wrong position at the same time.

Andrew Baker: That is called the pro-cyclicality argument. That says that at the very time when markets are most stressed, you have to unwind positions and make the situation worse. Reading the evidence from everyone who submitted to this case, they virtually all make that case. The FSA makes it particularly strongly and pungently.

Lord Renton of Mount Harry: Do you get the impression that your point of view is going to win?

Andrew Baker: We think that having a cap in place at the manager level or at the fund level is the wrong way of looking at it. There needs to be a monitoring mechanism. There needs to be very careful consideration about definitions of leverage. It is nice to think that there is a simple and single definition that equates to borrowing from the bank, but, sadly, that is not the case. Leverage is used in all kinds of ways to assist with hedging. Unless it is tracked and monitored and the definitions are understood and related to individual types of specialist asset class, then you can end up in a frightful muddle. Anything which pushes us away from common definitions or simplistic caps is the right way to go.

Chairman: Could I just ask you what, from an alternative investment point of view, is an illiquid and volatile asset? Can you give me an example?

Andrew Baker: Yes, very easily. Securities which trade on a market and where you can establish the price and where they are traded pretty much any day of the week would be regarded as highly liquid. Shares which are small capitalisation shares which oscillate all over the place and can move by ten/20/30 per cent at a time would be regarded as very volatile. Asset classes which are extremely illiquid would include real estate investment, would include private equity investment, would include some kind of categorisation of securitised vehicles.

Some types of over-the-counter derivatives may be illiquid. The closer they are to being traded on the market, the more likely they are to be highly liquid, but it is the two characteristics you have to monitor: the liquidity of the asset and the volatility of the asset. If you cannot establish a price for it, then you have to treat it in a different way and it comes to borrowing in order to buy more of that asset.

Lord Jordan: At the moment Europe and America are looking for some sort of controls that will prevent another financial industry generated crisis that caused an awful lot of pain to the people on both those continents. To what extent is the US proposal on hedge funds similar to that which the Commission is proposing? What do you think are the significant differences between the two? What did you mean when you said, “The more it looks like Obama’s proposal, the more we like it?” Is this being less demanding than Europe is?

Andrew Baker: No, because it concentrates on the issues which have been identified at the G-20 level as those which should be tracked and monitored. There are two pieces of evidence which I will bring to your attention that were submitted to this hearing: one provided by the law firm Deckert; and one provided by Citadel (who are in attendance as observers today) which lists the similarities between the two approaches and the differences. I would summarise the two approaches by saying that they are really quite materially different. Where they align and where we support that alignment is in relation to managers being authorised and registered – so if you want to drive on the road, you have to have a driving licence – and in the provision of information via disclosure to the supervisory authorities so they can build up a picture of potential build-up of systemic risk. We support that completely. There I would say the similarities end, because the Directive then goes into what I would call level 2 issues, some of which relate to the fund and not the manager This is supposed to be a Directive about managers, but some of these provisions relate to the fund itself. They are detailed implementing measures, not principles. We would just echo the findings that came out of the G-20 meetings, which have been repeated in numerous reports from very distinguished writers, which emphasise these two points: Who is operating the markets? – “Let’s authorise them.” What are they doing? – “Let’s track the information around their portfolio activity and let’s aggregate it and share it at a consolidated and aggregated level in private amongst supervisory authorities.” We wholly support those ideas.

Some of these other measures will provide protection to investors, but that is very, very different from providing protection to markets against systemic risk issues.

Lord Jordan: What would you regard as thesingle most effective tool that the two continents could have in preventing another disaster of the sort we have seen? I know that you have concentrated on the provision of information, but if the industry is being renowned for anything, it harks back to the brilliant engineers who have come in and enabled you to provide so much information in such a diverse way that people often. Question whether even they understand it. I know they do: it is just that they know no-one else will. What is the good of providing that information that is deliberately designed to confuse? The complexity has become unbelievable in this last 20 years. What single tool, in spite of these devices that are being used, do you think would be the most important for the governments of the two continents to prevent a reoccurrence of what has happened?

Andrew Baker: I would say that this is not just an issue about regulation – because to prevent a future financial crisis, there are obviously political issues and monetary policy issues, tax policy issues and consumer behaviour issues which are far too broad for me to go into at this hearing. Turning just to issues around financial market behaviour and financial regulation, I would say that the single most powerful tool would be avoiding unilateral action and making sure there is a degree of co-ordination to prevent regulatory arbitrage, to prevent people going to a different environment and shopping around for an easier place to do business. If we are told we live in global markets and protectionism is to be assumed, then surely it would be better to come up with global solutions. If you meet in London on 2 April in the G-20 and agree to a certain set of measures, why would you then endorse a Directive three weeks later which goes in the opposite direction. Coming up with co-ordinated measures is incredibly powerful.

Lord Renton of Mount Harry: You said in your Executive Summary that you concluded that: “without significant revision, the Directive would lead to less choice and greater costs for investors within the EU – without achieving the stated objectives of the Directive.” That is a very harsh comment. Would you like to enlarge on it for a moment?

Andrew Baker: I think it is very simple arithmetic. In the case of hedge funds, the industry I represent, approximately 90 per cent of those that are run around the world are either managed by a non-EU manager or the assets sit in a fund which is not based in the EU, is outside the EU, so the incidence of EU funds being managed by EU managers is only about ten per cent of the overall population. Under the strict interpretation of the third country provisions within the Directive, as currently drafted, those funds and managers are locked out (as soon as this is enacted) for a three-year period. On the basis under which they could be readmitted in the future, it is our judgments that the conditions cannot be satisfied and therefore the lock-out would not be a three-year temporary lock-out; it would turn into a permanent lock-out if these measures are not altered. They are the Articles in the mid-30s (pages) all relating to third country privileges.

Lord Renton of Mount Harry: This is a very fundamental objection as far as you are concerned.

Andrew Baker:
It is extremely fundamental and it is not unique to us. Whenever investors have written in – and there have been numerous investor letters written into the Commission, to the Swedish Presidency, to the authorities here in Westminster – they have emphasised this point over and over and over and over again, that it is bad for choice, bad for efficient portfolio management and the funds that do remain will also be charged more for investor protection they do not feel they want.

Chairman: Thank you very much indeed for coming,

Andrew Baker: It has been most useful.