Smaller property fund managers are struggling to be heard by the regulators, and it is they who stand to be worst affected by the directive, warns Robert Short

Most people in the funds industry have heard of the Alternative Investment Fund Managers Directive (AIFMD), yet there is a general view that fund managers and investors will simply bear the costs, comply with rules and get on with business. We are approaching 12 months from D-Day (July 2013) and, despite a lack of detailed guidance to act on, there is the realisation that the smaller real estate fund managers will be significantly affected.

There has been a lengthy consultation process and, while many of the trade organisations from other asset classes, such as BVCA and AIMA, were actively lobbying at a local and European level, the real estate industry was initially slow to act. The main reason is that, whereas the BVCA represents the entire UK private equity industry, the real estate equivalent is a collection of individual organisations such as the BPF, IPF, RICS and AREF. The principal responsibility of these organisations is to their membership, and at first there was no coordinated response, although more recently the Property Industry Alliance (PIA) has done a great job of soliciting views from the market.

However, the members of the PIA represent the larger fund managers who will ultimately be able to comply with the Directive once it settles into an agreeable final form. The smaller AIFMs are usually not members of any of the PIA organisations, and therefore their specific concerns have not been highlighted to the FSA or the Commission. Worse still, they have no formal way of knowing about the Directive or its effects.

Fund managers will need to comply with the full provisions of the Directive if their total net assets under management exceed €500m. In private equity, debt within portfolio companies is excluded from ‘fund level gearing', so in all likelihood, with management fees at 2% of commitments, there will be an income of €10m a year before needing to comply with the Directive. However, real estate fund managers often use debt which - even if it is within special purpose vehicles - is likely to count towards fund-level gearing. This means fund managers will be caught by the €100m threshold. Management fees tend to be lower, so models submitted by us to the FSA show that management fees could be one-tenth of their private equity equivalents when the provisions of the Directive kick in. They will then need minimum regulatory capital of €125,000 and we calculate over €100,000 of extra internal and external compliance costs per annum to take care of the extra risk management, reporting and insurance.

Many of the most successful fund managers today started just like any small business with a small yet expensive minimum infrastructure and with no guarantee that future cash flow would make the business viable. Economic conditions have made funding a start-up fund management business much tougher for a number of reasons, including:

• The length of time it takes to raise a fund means that a proportion of the set-up costs are likely to have to be borne by the manager;
• Limited partners (LPs) want a greater financial commitment from the manager in the fund;
• LPs are more likely to obtain favourable terms, which have an effect on manager cash flow - for example, discounted management fees;
• In current market conditions the manager may need to use a placement agent and is likely to bear these costs.

All but the very largest LPs find it more difficult to achieve the appropriate diversification through direct investing. Therefore, they are committed to indirect investing through a common strategy of portfolios containing a number of very large fund managers and a number of smaller, specialist fund managers.

LPs realise that the consolidation-effect the Directive will have could dry up the pipeline of smaller fund managers who are creating a range of choice - for example, funds that are specific by geography or by sector, including waste management, caravans, car showrooms, marinas, ground rents, and anything that will provide pension funds with a sensible asset-backed return on investment.

We have a number of small fund managers who are focused on central London residential investment who, in addition to the above, are also grappling with the recent announcement of a 15% stamp duty tax on investment through offshore ‘non-natural persons'.

There are a number of requirements of the Directive that will affect the total expense ratio of funds. Some of the costs associated with ‘protecting investors', such as enhanced reporting, will be passed on to investors. The FSA has assumed that the lack of engagement by investors during the process signals that they welcome the changes.

Another key provision will be the requirement for a fund to have a depository. In the UK it is reasonable to assume that, given the physical nature of property and the fact that title is registered at the Land Registry, the risks to institutional investors are low. Our experience is that, far from needing protection in this respect, investors are very well informed and have even been known to employ their own agents to research and value their indirect assets.

Traditionally it has been the banks that have provided this service and to date it has been unclear whether investors feel that the extra protection warrants the associated cost. The costs per fund are likely to be in the region of 10bps on net asset value subject to a minimum in the region of €40,000. Again it will be the smaller funds and fund managers that will suffer most from this provision, and to that end smaller independent fund administrators are looking at providing this service. However, much will depend on how the FSA determines appropriate regulatory permissions and regulatory capital requirements.

There is a further FSA questionnaire due by 25 May and it is clear that there is still much to be gained from submitting responses. The unintended consequences of this Directive are significant, and small fund managers, LPs and other parties are urged to contribute.

Robert Short is managing director at Langham Hall