22 July 2013

Investment Europe: AIFMD may work if AIFMs and investors act responsibly, says BDO's Carroll

Michelle Carroll, partner in the financial service team at BDO, says investors and providers alike cannot shirk responsibilities just because AIFMD puts alternative investment funds within an EU regulatory framework.

AIFMD is now formally transcribed into Member State regulation. Although this date has proven to be a bit of a soft launch, it's probably a good time to sit back, whilst on holiday, and consider the macro implications of becoming a regulated AIFM.

Brussels' objective from the very start was to regulate AIFs in a manner similar to UCITS. There was significant push back from industry regarding this and rightly so - hedge funds are not retail funds and shouldn't be forced to become retail funds for many reasons. Then took place years of lobbying; vocally, discretely, sometimes successfully and other times it was wasted effort.

It is now time to dispose of our opinions over the fairness or otherwise of AIFMD and to consider, practically, how an AIFM is going to be different under the Directive.

Improved investor protection was the key driver of the Directive. I think there are two ways of translating this:

The wrong way is to assume that it takes away any responsibility from the investor with regards to making a sound investment decision. In no way should investors consider that an AIFMD compliant fund manager means that they have a reduced responsibility to perform thorough due diligence. AIFs are still aimed at professional investors. AIFs can still have limited liquidity and can take on a high risk strategy or positions. It is important that AIFs are still encouraged to provide opportunities for investors to take on higher risk and rewards.

Investors were probably not very good at performing thorough due diligence prior to the AIFMD and there is a risk that they may feel the introduction of the Directive means that they can continue to avoid some of the responsibility for their own investment decisions. This is entirely not the case. In as much as the Directive is pushing the standards up for AIFMs, so too should investors consider racheting up their own due diligence standards. Relying on SSAE16 reports or AIFMD badges is not sufficient due diligence and in fact, as shown by the detrimental effect felt by some UCITS funds after the Madoff scandal, they are not guarantees of immunity.

The right way to consider improved investor protection under the AIFMD regime is to expect AIFMs to adopt a higher degree of evidenced governance internally. It is up to the investor, as part of their investor due diligence, to identify the strength of that documented governance. I suspect that investors don't actually want their AIF investments to have the same risk profile as UCITS funds but I do think they would expect the governance of the AIFM to be as robust and as well documented as a UCITS fund manager. My expectation is that, if required to investigate, a Member State regulator will want to see documentation that previously did not exist. This is a consideration I suspect some hedge fund managers, already regulated in Europe, have not quite appreciated. For most regulated hedge fund managers, the adoption of the Directive will not introduce entirely new requirements but instead, existing behaviour will need to change such as documentation of AIFM board meetings, evidence of trader training, clearly documented conflict of interest policies AND procedures, written explanations of soft limit breaches.

Ultimately (and ignoring political ambushing), I think that the introduction of the Directive may be a good thing for the alternative industry in Europe if all involved parties, AIFMs, investors and regulators, agree on a reasonable and appropriate interpretation, allowing high risk/reward investment opportunities to exist in a well governed but not restricted environment and making sure investors understand their role in assessing the AIFs suitability for their investment needs.

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