EUROPE - European Parliament report slams AIFM Directive

The European private equity community was given further heart today in its battle against the proposed Alternative Investment Fund Managers Directive, when a report, commissioned by the European Parliament, described the regulation as "poorly constructed, ill-focused and premature".

The review, produced by regulation consultancy European Economics, further criticised the policy problem as defined in the Directive, calling it "vague, sweeping, and inadequate as a basis for justifying regulation".

There was, however, a sting in the tail in the form of warnings over leverage levels employed by alternative investment funds. The report claims that managers have "powerful incentives" to over-lever following government bail-outs of bondholders, a situation it describes as "dangerous".

In terms of the critique of the Directive, there was a striking similarity to other analyses that have been conducted since the proposals were first launched in April this year. There was, for example, the familiar refrain regarding the marketing and distribution provisions, which are accused of being likely to increase costs of compliance "to a much greater degree" than is acknowledged.

The report further states that the requirements would have a disproportionate effect on nationally-focused funds, which would be put at a competitive disadvantage, and it therefore argues the virtue of an exemption for such vehicles.

Another common grievance was aired in relation to third-party fund provisions, arguably the most contentious area of the proposals, which are revealed as clumsy and potentially damaging to EU competitiveness.

In particular, the equivalence tests for non-EU domiciles are of concern in that they threaten to create a "protectionist spiral", with reciprocal action likely to be taken by other jurisdictions. This is particularly worrying for the UK, the report says, where 59% of capital raised for private equity and venture capital comes from outside the EU.

There are familiar defences of the private equity to those offered by the industry itself, with the report echoing calls for the asset class to be regulated separately from hedge funds. The systemic risk posed by both investment classes is emphasised as relatively minimal, given that they are populated by professional rather than retail investors, who understand the associated risks.

The report did see risk, though, in the application of leverage in the alternative investment funds industries. While there is an admission that AIFs have tended to utilise lower leverage levels than banks, the bail-outs of bondholders since the financial crisis could provide incentives to over-lever, as firms may believe that governments will step in to save them, and will typically "wipe out equity holders and save bondholders".

There is therefore a call for there to be some limit on leverage within AIFMs, though there is considerable disagreement that this Directive is an adequate method through which to impose this. In fact, the review argues the rationale in this sense is "hasty" and "weak", given that the proposals contain "no consideration of how the Market might respond to recent events and to new regulation of the banking sector".

As an alternative to such regulatory moves, the report suggests that AIFs that are "systemically significant" (read: large) be put under the jurisdiction of central banks, which could impose individually tailored leverage limits in each case.

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