The European Commission proposes to regulate hedge funds active in Europe as from 2011. Experts agree that hedge funds, even if they’re not the cause of the current financial crisis, certainly helped to aggravate it.

Such funds, which practice an “alternative” form of management to that employed by funds open to the general public such as SICAVs, have notably been accused of contributing to the spectacular boom in the structured credit markets, hard hit by the crisis. Hedge funds are also accused of having aggravated the drop in share prices, as they were forced to liquidate positions hurriedly when faced with investors pulling out on a massive scale and the inability to obtain refinancing on a stalled credit market. To top it off, the vast majority of hedge funds are based offshore, in tax havens much criticized by the G20, and are the primary culprits of naked short selling (i.e., the practice of selling a financial instrument short without first borrowing the security or ensuring that it can be borrowed). And of course, one mustn’t forget the scandal surrounding the hedge fund managed by Bernard Madoff, which resulted in an estimated $50 billion vanishing into thin air.

Aside from these partially founded allegations, the question arises as to possibility of a major hedge fund collapse and the risk of this collapse spreading to and infecting the fund’s counterparties (notably banks). With this in mind, the G20, at its meeting in April, emphasized the need for the supervision of hedge funds on an international scale. The European Commission, which had been studying the issue for quite some time, was quick to react and published on 30 April a proposal for a directive intended to regulate hedge funds. Needless to say, this proposal has given rise to heated debate.

What types of funds are covered by the Commission’s proposal?

The proposed directive goes much farther than the supervision of hedge funds alone. It is intended to cover all managers of alternative investment funds, including private equity, commodity funds and real estate funds. The underlying idea is that it is sometimes difficult to differentiate between these types of funds – an argument which is not always relevant – and that the identified risks can manifest themselves in various types of funds. The proposal does not however group all these funds under the same umbrella - the requirements differ depending on the type of management (such as, for example, the use of leverage to finance investments).

The proposed directive is intended to regulate the managers of funds rather than the funds themselves. In the Commission’s view, the greatest risks are created by the actors that revolve around the funds (the managers who control the funds as well as the depositaries of the managed funds). The inclusion of the funds themselves would result in a glut of regulators and, according to the Community executive, give the mistaken impression that these same regulators ensure the effective supervision of funds.

Small funds which are unlikely to cause systemic risks do not fall within the scope of the proposed directive; only fund managers with at least €100 million in assets under alternative management will be covered (or €500 million if the fund is not leveraged and does not grant investors redemption rights for a period of at least five years from its date of formation). Given the significance of offshore funds and the risk of managers establishing themselves outside the EU simply in order to escape regulation, the proposal is not limited to managers established in the EU. Indeed, after a transition period of three years, the directive will be extended to cover funds and managers outside the EU, if the fund in question is marketed to professional investors within the EU.

The Commission proposes making alternative investment fund managers ("AIFM") subject to multiple requirements. Aside from heightened transparency with respect to risk exposure and investments, AIFM will have to be authorised by the competent supervisory authority of their home Member State, have the value of their fund assessed by an independent expert, deposit their assets for safe-keeping with a bank in the EU, respect minimum capital requirements and separate the functions of portfolio management and risk management. In order to avoid, to a certain extent, the need to liquidate positions in an emergency, thus causing share prices to drop, managers will need to ensure that their investments are sufficiently liquid when investors have the option of requesting redemption at regular intervals. The Commission moreover will be able to set leverage limits for hedge funds. Finally, investment in a hedge fund will be reserved to professional investors, which is already the case in the majority of EU Member States.

Criticism from all sides

The Commission’s hastily drafted proposal has been heavily criticized. The Alternative Investment Management Association (AIMA), the trade association of hedge fund managers, has stressed that hedge funds are not responsible for the financial crisis and has conjured up the risk of a mass exodus of fund managers from the EU, with a concomitant loss of thousands of jobs in places such as London and Luxembourg. In political circles, on the other hand, the proposal is widely considered to be insufficient. Pressure from Paris and Berlin even resulted in last-minute changes to the draft, an earlier version of which did not impose real constraints on offshore funds and exempted a greater number of managers (that is, those with less than €250 million in assets under alternative management, as opposed to €100 million under the current proposal).

Certain parties criticize the proposal for not providing a stricter regulatory framework for short selling. This criticism is unfounded, however, since short selling is a practice which is not exclusively reserved to hedge funds. While it is advisable to reflect on the abuses associated with short selling, the rules in this regard should apply to all actors in the same way.

The Commission’s proposal is not stillborn, but the Member States will most likely need considerable time to work out a consensus on the scope of the future regulation of hedge funds.

What is the impact for Belgium?

There is no Belgian market for hedge funds, and Belgian professional investors are wary about investing in such funds. The proposal for a directive will thus have little impact for Belgium in that respect.

However, since the Commission’s proposal covers not only hedge funds - it concerns all managers of funds not open to the general public investing in securities and governed by the UCITS directives - the Belgian government should be mindful of the fact that the proposed directive does not extend to existing structures, which are already largely regulated in Belgium. This is notably the case with SICAFIs, which are considered to be real estate funds and are governed by the Belgian legislation on collective investment vehicles.