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New rules for alternative funds are emerging: more transparency, options and investor protection

Do you know what archive wines, cryptocurrencies and valuable works of art have in common? Perhaps that you don’t have any, but maybe you’d like to? In such case, this article about investing in these “alternative” commodities is exactly what you need.

What is it all about?

The economic crisis in 2008 brought many changes in the sphere of business and investment, including a new European Union directive on investment in alternative investment funds. So-called alternative investments include all investments that do not fall into the “traditional category” of investing in commodities with high liquidity, such as bonds, shares and currencies, and do not qualify under UCITS conditions. Real estate, rare commodities, precious metals and even cryptocurrencies therefore fall under the category of alternative investments.

The described directive, however, does not regulate alternative investments as such, but addresses the funds that offer and manage these investments, in particular, their managers. The main objective of this 2011 legislation was to bring a certain harmonised regime to a hitherto completely unregulated investment environment which, while potentially offering a higher rate of return than conventional funds, also entails a higher level of risk for investors. In addition, alternative investment funds often charged high management fees and were largely non-transparent.

What is the purpose of the current legislation and what are its weaknesses?

The objective of the current legislation was therefore primarily to protect investors and reduce the systemic risks of these funds. AIFs are aimed at both professional and retail investors, but only with additional safeguards. At the same time, a coherent approach to the supervision of the management of these funds has been established and rules have been laid down for the licensing of their managers and their supervision within the EU.

While these new rules, regulating all hedge funds, private equity funds and real estate investment funds registered in the EU, have been very successful in fulfilling their intention, the need to further harmonise liquidity management tools and the lack of detail in the market data submitted to the supervisory authorities have prompted an update of this existing directive. In particular, hedge funds are very risky investments, as they are virtually unregulated at present and many funds choose very risky investment strategies in the hope of making large profits. They are also often domiciled in so-called tax havens. Last but not least, legislation needs to be adjusted in response to the UK’s departure from the European Union, as many EU-based funds have their portfolios managed in London.

What is going to change?

In its proposal, the European Commission is introducing changes at two levels, firstly within the AIFMD (Alternative Investment Fund Managers Directive) itself and secondly, it proposes to harmonize this directive with the existing UCITS (Undertakings for Collective Investment in Transferable Securities) directive.

So, if you are looking to invest in these funds or are already investing in them, here are the main reasons why you should be interested in the change to the directive.

  • End to fake management companies from third countries

In the event that a fund manager delegates portfolio management or governance to countries outside the European Union, the competent national authority (NCA) will have to disclose this delegation, together with full details of the delegated person, his/her function, form of cooperation, etc. to the European Securities and Markets Authority (ESMA). At the same time, the AIF will have to employ at least two EU residents for the purpose of managing the fund. Simultaneously, according to the proposal, the appointed manager must report regularly to ESMA on their activities. The proposal also introduces the same rules for UCITS.

In other words, the sole purpose of this part of the proposal is to expose fake management companies from third countries that are in reality just a “shell company with an anonymous owner” and thus protect investors’ funds.

  • More efficient liquidity management

Liquidity management tools allow the managers of open-ended funds to respond flexibly to current market conditions and thus better protect investors’ interests. The availability of these tools to the funds notably varies under current legislation. However, ESMA will now be mandated to develop a proposal for regulatory technical standards to provide definitions and specify the characteristics of liquidity management tools so that AIFMs have access to the uniform tools they need in exceptional circumstances.

  • Fair money lending from an alternative investment fund

Among other things, AIFs can provide loans to European and small and medium-sized enterprises, opening up access to a wider range of competitively priced financing options. However, there are currently different national regulatory standards for lending, which both reduces the level of funding and makes it more difficult for supervisory authorities to monitor financial stability risk. The aim is therefore to make this alternative financing available to European businesses and to harmonise national legislations within the EU.

  • The end to fraudulent managers

The proposal further specifies information on the persons actually carrying out the activities of the IAF manager. When a manager applies for a licence in its EU Member State, they have to provide the relevant supervisory authorities with a range of information about their activities, job title, responsibilities, etc.

  • Cross-border depositary services

Last but not least, AIFs offer depositary services. However, these are currently in short supply, which is why the new directive proposes to make cross-border depositary services available.

The Pirates: it’s a good start, but we need improvements

The new directive on Alternative Investment Fund Managers is definitely a step in the right direction. In particular, greater supervision of fund managers by supervisory authorities is a welcome development, which will help to prevent so-called “shell management companies”. The harmonisation of liquidity management tools for better financial stability, improved data collection and increased disclosure of information on the activities delegated to financial institutions are also seen as significant improvements to the current legislation.

Nevertheless, there is still considerable space for improvement, especially in the area of delegation to third parties. While AIFs will be obliged to disclose the delegation of management functions to the relevant supervisory authorities outside the EU, they will have no power to object to any such delegation. There is also still a question as to whether and, if so, how the new legislation would apply to existing AIFMs and investors. At the same time, it has been argued that some of the new legislative requirements could disadvantage sustainable funds. Any detriment to managers who invest exclusively in companies that promote environmental protection is certainly not acceptable to us (!).

But what is most important? That the directive comes into existence in the first place and that it brings together a single, functioning European market. If it were to break up into 27 local markets, we would lose a huge opportunity for efficient and innovative investment.

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