The EU's proposed AIFM Directive lacks clarity and potentially creates more problems than it solves. Bas Kundu reports

On 30 April the European Union published a draft directive on Alternative Investment Fund Managers (AIFMs).

As it stands, the directive will catch managers of hedge funds, private equity funds, commodity funds and other types of institutional funds, but also: real estate funds, REITs, listed investment trusts and other forms of collective investment vehicle that have previously been outside the scope of financial services regulation.

The directive could radically reshape the alternative asset management industry in some EU countries, potentially requiring changes to managers' business models and significantly increasing the regulatory burdens on the funds themselves. The directive also poses serious questions on the accessibility of the EU's markets to non-EU alternative fund managers and how EU-based managers with funds or connections outside the EU are going to be able to continue to operate.

In its current form, the directive will impose a comprehensive regulatory regime on the managers of all collective investment vehicles which are not qualifying UCITs, whether open-ended or closed-ended and whether listed or not, subject to a few exclusions. This could significantly increase costs for real estate fund managers.

It appears that AIFMs which are divisions of EU banks or insurers, authorised pension fund managers or various categories of sovereign wealth funds may be excluded from the scope of the directive, potentially putting them at a competitive advantage.

The directive will apply to all AIFMs with AUM over €100m. In the current drafting it is unclear if this is net or gross assets but it does include assets "acquired through the use of leverage". This limit is cumulative - that is, it applies to the total of all funds managed by the AIFM and is not on a per fund basis.

All AIFMs caught by the directive will need to be regulated by their ‘home state' financial regulator. The authorisation process will require submission of detailed information to the regulator about managers and controllers, about the funds to be managed (strategies and constitution), the countries where the funds are to be sold and details of the custodians, valuers and other third parties to whom material functions are delegated.

All AIFMs that become regulated will need to meet the following requirements (among others):

Documented internal systems of management and control complying with EU standards (as yet unspecified) relating to liquidity, management of conflicts of interest, risk management (including appropriate "documented and regularly updated due diligence when investing") and short selling; An independent ‘valuator', who must value assets in the fund on at least a yearly basis, in accordance with local GAAP or in accordance with rules set out in the fund's constitution; An independent depositary (which must be an EU authorised credit institution), whose function will be to receive investor subscriptions, safe keep financial assets and to verify the fund has ownership of assets it has invested in.

All AIFMs will be required to disclose to their regulators details (yet to be specified) of the principal markets and investments in which they trade (including details of their principal exposures and concentrations) and details of their leverage through quarterly reporting. The directive contains unusual provisions specifying that the Commission (rather than a home state regulator) can impose caps on the amount of leverage an AIFM can employ in a fund. The home member state of an AIFM can impose additional limits on leverage, in exceptional circumstances if required to maintain financial system stability.

All AIFMs will be required to produce detailed information for prospective investors and, to the extent they use leverage on a systematic basis, detailed information on that usage on a quarterly basis.

Participations in alternatives funds managed by AIFMs which are authorised may be sold only to professional investors (as defined in the EU's Markets in Financial Instruments Directive). Initially such funds may be marketed to investors in the AIFM's home member state but may, subject to complying with passporting requirements, be sold to investors in other member states.

Although the directive establishes clear procedures for marketing funds domiciled in the EU, the ability of an AIFM to market funds that are domiciled outside the EU (for example, in Jersey or Cayman) will be subject to detailed restrictions, including a requirement that the relevant authorities in the fund's jurisdiction have signed an agreement to share tax information that complies fully with the OECD standards with the jurisdiction into which the fund is to be marketed. This passport will not be available for three years, and prior to this, non-EU domiciled funds may only be marketed into those EU states where they can currently be sold under domestic law. In addition there are stringent conditions applying to AIFMs established outside the EU.

There are several ways in which the Directive could affect the real estate industry:

Currently the real estate fund regulatory regime around Europe is broadly divided between relatively lightly regulated partnership regimes (for example, the UK) and more heavily regulated regimes, such as Germany, Luxembourg and France. The new regime will result in all AIFMs being heavily regulated with significant increased costs; The directive could accelerate a consolidation in the European fund management industry, with the burden of regulation making the cost/benefits of managing smaller funds uneconomic; There does not appear to be a level playing field, with managers owned by sovereign wealth funds, EU registered banks, pension funds and insurance companies potentially enjoying a carve-out from the directive that could give them an advantage over other real estate fund managers.

The EU Commission said that it expects the Directive to be the subject of intense discussion and negotiation. It is to be hoped this discussion includes suggestions for considerable simplification and clarification.

If political approval on the Commission's proposals is reached by the end of 2009, the AIFM Directive could come into force in 2011. Given its proposed reach, businesses that are likely to be affected need to assess the potential impact of the Directive immediately, so that they can seek to influence the shape of the final Directive and its regulations and start planning for the changes it will require.

Bas Kundu, partner in PwC's real estate team