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One-size-fits-all regulation may not work for all EU alternative managers, says KPMG

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Professional services firm KPMG has warned that the European Commission’s proposals for ‘one-size-fits-all’ regulation of alternative investment managers based within the European Union ma

Professional services firm KPMG has warned that the European Commission’s proposals for ‘one-size-fits-all’ regulation of alternative investment managers based within the European Union may not be appropriate for all asset classes covered by the draft Directive on Alternative Investment Fund Managers.

‘We believe that the regulation must separate out different asset classes in what is a wide and varied industry,’ says UK-based private equity partner Vincent Neate. ‘The current proposal does not present a clear and well-articulated regulatory objective and, in fact, presents changes to accounting, transparency, valuation, and custodianship which cannot be aligned to the private equity model in its current form.

‘The private equity industry does not cause systemic risk and is instead a viable source of capital and good governance to support economic recovery. If the current proposal is voted through, we believe it will hinder the free flow of capital into a market that remains blocked.

‘We recommend that private equity funds engage with professional bodies and politicians, tell the good stories and be open about the bad, to ensure their role in the market is not obfuscated.’

His colleague Tom Brown (pictured), an investment management partner, says that politicians must be wary of measures that could destroy the European hedge fund industry. ‘For several years, the alternative industry has been working hard to demonstrate its adoption of good practice in areas such as corporate governance and controls, risk management and liquidity management,’ he says.

‘The creation of the Hedge Fund Standards Board was one such measure to encourage the hedge fund industry to vocalise their support for transparency and strong codes of conduct. We have also seen other evidence that hedge funds are keen to be recognised as part of the mainstream financial community – such as the launch of Ucits funds by several hedge managers. Clearly, the politicians were not convinced.

‘While we can welcome the directive from the perspective of supporting the industry’s own agenda of building good practice, and while the better-run hedge funds will likely find little change from many of the measures being introduced, the real challenge is one of implementation. Politicians need to ensure that the political agenda doesn’t end up destroying the European hedge fund industry by imposing sweeping changes that are unworkable or unnecessary.’

Real estate funds are likely to be most affected by the regulatory capital aspects of the draft directive, according to KPMG real estate partner Richard Ross. ‘Real estate funds that are part of larger investment management organisations will probably see the requirements as one more thing to factor into their capital management plans and will probably just get on with it in the wider context of the businesses they operate,’ he says.

‘Independent funds, however, particularly those that probably don’t have the resources (whether management or financial) to throw at this may feel the burden more. Often these funds run ‘lean and mean’ with limited capital and infrastructure.

‘They manage large portfolios of assets with small teams, so changing capital requirements to be based on assets under management rather operating expenses will hit these funds disproportionately hard. It would be unfortunate if the proposed changes acted as a disincentive to new entrants to the marketplace and thereby jeopardised innovation and investor choice.’

A measure in the draft directive requires alternative managers to employ the services of an EU-based valuator that is legally and functionally independent of the fund manager and for the valuator to be disclosed.

Says corporate finance partner Jonathan White: ‘Valuation is a subjective process, and removing the inherent conflict of interest that exists when fund managers value their own investments is a positive step towards dealing with concerns from investors and the broader market about lack of transparency and adequate disclosure.

‘Alternative investment funds started using independent valuation teams on an annual or quarterly basis about three to four years’ ago. Initially some funds used this to demonstrate strong governance. The marketing materials set out in detail the valuation policies and procedures and made it clear valuations would be subject to explicit external review.

‘Now with nervous investors demanding increased transparency and non-executive directors and regulators taking an increased interest in the area of valuation, we are seeing more and more funds adopt an external review of their valuations. I believe that increased disclosure and the use of independent valuations will improve the industry’s reputation and help address the concerns of investors and regulators.’

John Alshefski, managing director of SEI’s investment manager services, argues that managers may be better prepared than they realise for the impact of today’s legislative changes.

‘A number of managers already employ industry best practices, such as risk management, compliance, independent valuations and recordkeeping matters, to attract and retain institutional assets, and these practices will make it easier to accommodate additional regulation announced in today’s draft EU law,’ he says.

‘The regulations will bring more detailed reporting as investors demand faster access to data to ensure that their daily operational practices are satisfactory. Having an operational infrastructure and data management capabilities to support a manager’s risk analytics, internal management reporting, and increasing transparency needs is paramount in the new environment.

‘A major factor is that investors have not merely been waiting for increased regulation. Many managers have increasingly been subject to significant investor due diligence focusing on valuation procedures, financial reporting practices and procedures designed to identify and address conflicts of interest, in addition to understanding a manager’s investment process and evaluating the firm’s principals.

‘They are also mandating that single manager funds employ independent, well-respected administrators and auditors. Not only is this good for our business, but we think this is a move in the right direction to regain some of the trust lost by investors from recent events.’

Ronald Paterson, a partner at law firm Eversheds, says the directive should be accompanied by the long-debated common EU regime governing private placements. He says: ‘If there is to be pan-EU regulation of [alternative] funds. that must include a pan-EU private placement regime governing which institutional and sophisticated investors these funds can be sold to, so the stakes are high for all concerned.

‘In devising the right regulatory system for these types of fund, it is important to bear in mind that, as the Turner review demonstrated, hedge funds were not the cause of the global banking crisis and hedge fund leverage is well below that of banks. The UK system of regulating hedge funds has worked well and provides a sound model for evolving a system of pan-EU regulation.’

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