EN

(...PICT...)|COMMISSION OF THE EUROPEAN COMMUNITIES|

Brussels, 30.4.2009

SEC(2009) 576

COMMISSION STAFF WORKING DOCUMENT

Accompanying the Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL on Alternative Investment Fund Managers and amending Directives 2004/39/EC and 2009/…/EC IMPACT ASSESSMENT {COM(2009) 207} {SEC(2009) 577}

TABLE OF CONTENTS

1. Introduction 4

1.1. The investment fund universe 4

1.2. Structure and location of AIF and AIFM 5

1.3. Investor base of AIF 6

1.4. Risks associated with AIFM activity 7

1.5. AIFM and the financial crisis 8

1.6. Focus of impact assessment 10

2. Procedural issues and consultation of interested parties 10

2.1. Consultation and expertise 10

2.2. How has the opinion of the Impact Assessment Board been taken into account? 12

3. Problem description 13

3.1. Description of the regulatory patchwork 15

3.1.1. Community rules 15

3.1.2. National rules 15

3.2. To what extent are existing rules effective in responding to the risks? 18

3.2.1. Macro-prudential (systemic) risks 18

3.2.2. Micro-prudential risks 19

3.2.3. Investor protection 19

3.2.4. Market efficiency and integrity 21

3.2.5. Impact on market for corporate control 21

3.2.6. Acquisition of control of companies by AIFM 22

3.2.7. Conclusions 23

3.3. Internal Market aspects 24

3.4. Conclusions 25

4. Objectives 27

5. Options – Analysis of impacts 31

5.1. Target of measure 32

5.2. Coverage of measure 34

5.3. How much of the AIFM value chain should be required to be in the EU? 37

5.4. Appropriate level for potential action 38

5.5. Subsidiarity 42

5.6. Provisions of a potential proposal and expected impacts 43

6. Comparing the options: Conclusions 54

7. Monitoring and evaluation 55

ANNEX I: Acronyms 56

ANNEX II: Categories of non-harmonised funds (non-UCITS) 57

ANNEX III: European Private Equity activity in 2007 60

ANNEX IV: Key UCITS investor protection safeguards 61

ANNEX V: Qualified Investor vs Professional Client vs Eligible counterparty 62

ANNEX VI: Risks related to activities of alternative investment fund managers (AIFM) 64

ANNEX VII: Executive Summary of the Impact Assessment on Private Placement 78

ANNEX VIII: Summary of responses to Commission consultation on hedge funds 79

ANNEX IX: Outline of relevant measures proposed in the Commission communication on Driving European Recovery of 4 March 2009 94

ANNEX X: Effectiveness of existing industry codes and best practice guidelines for private equity and hedge funds 95

Annex X.B. Effectiveness of industry codes and best practice guidelines for Hedge Funds 118

ANNEX XI: The Lamfalussy process 120

ANNEX XII: References 122

1. Introduction

Sections 1.1 - 1.3 of this introductory chapter describe the size and composition of the alternative investment industry in the European Union, the structure and geographical location of alternative investment funds (AIF) and their managers (AIFM), and the nature of the investors in these funds. Sections 1.4 and 1.5 then discuss the risks associated with the activities of AIFM and how they have manifested themselves during the financial crisis. Section 1.6 introduces the core concern of this impact assessment: the extent to which the nationally-fragmented regulatory environment for AIFM provides an effective and efficient framework for the regulation and oversight of this industry, in particular for the monitoring and management of risks that are of cross-border concern.

1.1. The investment fund universe

In the EU, investment funds can be broadly categorised as UCITS (undertakings for collective investment in transferable securities) and non-UCITS (or non-harmonised) funds. A glossary of technical terms and acronyms can be found in Annex I, references are provided in Annex XII. UCITS funds are those that comply with harmonised rules as laid down in the UCITS Directive (85/611/EEC) and are authorised for sale to the retail market.[1]

A glossary of technical terms and acronyms can be found in Annex I, references are provided in Annex XII.

Non-harmonised funds (hereafter referred to collectively as alternative investment funds, or AIF) do not form a homogenous class of investment fund. Categories of non-harmonised funds (non-UCITS) can be found in Annex II AIF invest in a wide variety of asset types and employ very different investment strategies. Inter alia, hedge funds, private equity funds (which can be broken down further into large buy-out funds, mid-cap investment funds and venture capital funds), infrastructure funds, commodity funds and real estate funds can all be classed as AIF. 'Special funds' or 'institutional funds', which exist in many Member States and take various legal forms but are not limited to a specific asset class or investment strategy and can therefore not be attributed to a particular fund type, can also be included in this category.[2]

Categories of non-harmonised funds (non-UCITS) can be found in Annex II

It is these AIF and more specifically the AIFM that form the focus of this impact assessment. As shown in Table 1, over €2 trillion are currently invested in EU-domiciled AIF.

Table 1: Breakdown of Non-UCITS funds by category (1)

|30/09/2008|31/12/2007||

|€ bn|Share|€ bn|% chg (2)|

Special/Institutional funds|914|41%|945|-3.3%|

British investment trusts|55|2%|79|-30.8%|

French employees saving funds|76|3%|85|-10.6%|

Luxembourg other funds (part 2)|84|4%|102|-17.7%|

Real-estate funds|213|10%|208|2.6%|

Other|166|7%|170|-2.6%|

Sub-Total|1,508|68%|1,589|-5.1%|

Sub-Total incl. Ireland|1,663|75%|1,696|-4.9%|

Hedge funds|566|25%|||

Total|2,229|100%|||

(1) Excluding Ireland for which no data breakdown is available. (2) End September 2008 compared to end 2007.

Source: EFAMA for non-UCITS; Morningstar for Hedge funds (various reporting dates, mainly in Q4 2008).

The table below shows that the UCITS sector is about three times larger than the EU- domiciled AIF sector, although the figures do not include funds managed by EU-domiciled hedge fund managers (around €560bn) or private equity funds (around €76bn funds raised in 2007 Source: EVCA Yearbook 2008. The size of private equity funds can not easily be compared to other investment funds as their usual measure, 'assets under management’, does not correspond to the measure of private equity funds, 'capital raised': The former is a value of stock, while the latter is a value of flow. The 'assets under management' of private equity funds can not be calculated as their investments - the portfolio companies - are usually not listed and not valuated at regular intervals. ). Together, investment funds hold more than €6.1 trillion assets under management in the EU, equivalent to half the gross domestic product of the EU.[3]

Source: EVCA Yearbook 2008. The size of private equity funds can not easily be compared to other investment funds as their usual measure, 'assets under management’, does not correspond to the measure of private equity funds, 'capital raised': The former is a value of stock, while the latter is a value of flow. The 'assets under management' of private equity funds can not be calculated as their investments - the portfolio companies - are usually not listed and not valuated at regular intervals.

Table 2: Total net assets of the investment fund industry in the EU end December 2008 (2007)

All funds|UCITS funds|Non-UCITS funds|

Number of funds*|Net assets, €|Number of funds*|Net assets, €|Number of funds*|Net assets, €|

51.232 (46.942)|6.141.704 (7.872.614) -22,3%|35.722 (32.682)|4.593.081 (6.160.328) -25,4%|15.510 (14.260)|1.548.623 (1.749.002) -11,5%|

Share in all funds:|70% (70%)|75% (78%)|30% (30%)|25% (22%)|

* End September 2008 data; http://www.efama.org/images/stories/international_statistical_release_2008_q3__3_.pdf

EFAMA, Quarterly Statistical Release, February 2008; http://www.efama.org/index.php?option=com_docman&task=doc_download&gid=872&Itemid=-99

1.2. Structure and location of AIF and AIFM

As a part of the asset management value chain, AIFM are responsible for the management of investment portfolios. Their tasks include the provision of internal governance structures, risk management, the delegation of functions to third parties and relations with investors. AIFM are typically located on-shore in the EU. They are generally (but not always) subject to registration and supervision in the countries where they are established. Other elements of the value chain include:

· the fund, AIF, itself which is primarily a legal shell;

· administrators, appointed to issue and redeem interests and shares and to value the fund portfolio;

· prime brokers, which provide inter alia leverage and trading services;

· depositaries, credit institutions entrusted with safeguarding the interests of AIF investors, in particular through the safe-keeping of assets.

Some of these functions can be performed either by the AIFM or third parties. The precise nature and distribution of functions varies according to the particular business model. Depending on national rules, administrators and depositaries can be domiciled either within the EU or off-shore.

Within the EU, the management of hedge funds is highly concentrated in the UK, with around 80% of European hedge fund assets managed from London. AIFM for other types of AIF, for example commodity, real-estate and special funds, are more evenly distributed throughout the EU.

The AIF is a structure through which aa legal entity distinct from the AIFM. The AIF may be located onshore or may, especially in the cases of hedge funds and private equity, be located in an off-shore jurisdiction for reasons of tax efficiency. AIF span a wide range of legal structures, including closed and open end funds and partnerships. However, the AIF is merely a legal structure to pool assets and hold investments. It has no economic life of its own: the key decisions in relation to the management and marketing of AIF are taken by the AIFM.

EU-domiciled AIFM may manage funds that are domiciled on-shore, or in off-shore jurisdictions. At the end of 2007, for example, 52% of global hedge funds were registered offshore; while, according to Morningstar database, almost all commodity funds that are registered for sale in the EU are also domiciled in the EU.

With regard to private equity, the UK has a large share of the headquarters (or main offices) of private equity firms within the EU. In 2007, UK-based private equity firms raised more than 50% of the funds raised in Europe by country of management, followed by France (9%) and Germany (7%). Nearly 50% of the (equity) investments made during 2007 were by private equity funds managed from the UK, followed by France (17%) and Germany (10%). Source: EVCA Yearbook 2008. See also Annex III.[4]

Source: EVCA Yearbook 2008. See also Annex III.

1.3. Investor base of AIF

Unlike UCITS, which are designed to be suitable for distribution to retail investors, many AIF are regarded as entailing too much risk, or having other features which render them unsuitable for retail investors. See Annex IV: Key investor protection safeguards.[5]

See Annex IV: Key investor protection safeguards.

Specifically, the returns on these investments are often much more volatile than for retail products, with the result that the risk of incurring large investment losses, or even total loss of assets through the default of the AIF, is considerably higher. AIF also typically lock investors in for a longer period than retail funds, affording them the opportunity to earn a premium from investment in less liquid assets. More generally, AIF investment strategies tend to be more complex and therefore harder for prospective investors to assess.

For all of these reasons, access to many AIF has traditionally been restricted to professional or institutional investors See Annex V: Definitions of Qualified Investor, Professional Client and Eligible Counterparty. , who are both better able to understand the risks their investments entail and as a result of their large and diversified investment portfolios are generally able to absorb the potential losses associated with these investments. These restrictions take the form both of practical barriers to investment, e.g. the imposition of investment thresholds (which vary, for example, from €125,000 (Ireland, Luxembourg) to €500,000 (Italy), although some Member States apply lower thresholds where the fund is domiciled and authorised locally) and legal restrictions imposed on AIFM and financial intermediaries by national regulators. The presumption that most AIF are only suitable for professional or institutional investors has been reinforced by the experience of the financial crisis (see Section 1.5 below).[6]

See Annex V: Definitions of Qualified Investor, Professional Client and Eligible Counterparty.

However, some types of AIF such as open-ended real estate funds and funds of hedge funds are directly accessible to retail investors in some Member States. While there has been some increase in direct or indirect retail exposure to different forms of AIF in recent years, research indicates that on aggregate this exposure is marginal. http://ec.europa.eu/internal_market/investment/docs/other_docs/study_non-harmonized_funds.pdf[7]

http://ec.europa.eu/internal_market/investment/docs/other_docs/study_non-harmonized_funds.pdf

1.4. Risks associated with AIFM activity

The activities of AIFM give rise to risks for AIF investors, counterparties, the financial markets and the wider economy over and above the investment risk that is intrinsic to any financial investment. Table 3 summarises the main sources of risk in the AIFM sector.

Table 3: Overview of key risk areas These risks are described in greater detail in Annex VI.[8]

These risks are described in greater detail in Annex VI.

Macro-prudential (systemic) risks, relating in particular to the use of leverage|Direct exposure of systemically important banks (as the providers of leverage) to the AIFM sector Pro-cyclical impact of herding behaviour, risk concentrations in particular market segments and ('forced') deleveraging on asset prices and market liquidity |

Micro-prudential risks|Possible weaknesses in internal risk management systems with respect to liquidity risks, market risk, counterparty risks (credit and settlement risks, especially in the case of short selling) and operational risks|

Investor protection|Gaps in investor disclosure on investment policy, risk management, internal processes etc as barrier to effective due diligenceConflicts of interest and failures in fund governance, in particular with respect to remuneration, valuation and administration|

Market efficiency and integrity |Impact of dynamic trading and short selling techniques on market functioning Potential for market abuse in connection with certain techniques, for example short-selling.|

Impact on market for corporate control|Lack of transparency when building stakes in listed companies (e.g. through use of stock borrowing, contracts for difference), or concerted action in 'activist' strategies|

Acquisition of control of companies by AIFM|Potential for misalignment of incentives in management of portfolio companies, in particular in relation to use of debt financingLack of transparency and public scrutiny of companies subject to buy-outs|

The types of risk associated with the activity of particular categories of AIFM vary as a function of the investment strategy, the investment techniques employed and the markets in which they participate. However, some risk types are common to several or all AIFM business models, as illustrated in Table 4.

Table 4: Risk Map The table does not contain an assessment of the relative intensity of the risks, which may vary significantly between business models. Discussion of whether existing regulatory regimes and industry practices are capable of effectively mitigating these risks follows in Section 3.[9]

The table does not contain an assessment of the relative intensity of the risks, which may vary significantly between business models. Discussion of whether existing regulatory regimes and industry practices are capable of effectively mitigating these risks follows in Section 3.

|Relevant to:|

Potential sources of risk:|Hedge Funds|Private Equity|Commod ity funds|Real Estate|Infra-structure |

Macro-prudential risks||||||

- Use of leverage (by AIFM)|X||X|||

- Herding |X||X|||

Micro-prudential risks||||||

- Market risks|X|X|X|X|X|

- Funding liquidity risk |X|||X||

- Counterparty risk|X||X|X|X|

- Operational risks |X|X|X|X|X|

Investor protection||||||

- Potential for weakness in investor disclosures |X|X|X|X|X|

- Conflicts of interest, failures in fund governance|X|X|X|X|X|

Market efficiency and integrity|X|||||

Use of short-selling / other techniques|X||X|||

Impact on market for corporate control||X||||

Use of 'activist' strategies|X|||||

Accountability of AIFM acquiring and managing companies||X||||

Given the global nature of their activities, many risks posed by AIFM have an important cross-border dimension. Investors, counterparties and service providers may be located in jurisdictions other than that of the AIFM. AIFM trade on international financial markets and invest in portfolio companies in other Member States. As discussed further below, some types of AIFM are major players in financial markets and can therefore have a substantial impact on asset prices and market liquidity in markets throughout Europe and beyond. "For example, in 2005 the consulting firm Greenwich Associates estimated that while hedge funds accounted for 15% of trading volumes in US fixed income markets, this proportion rose to 45% of trading in emerging market bonds, 47% in distressed debt, and 58% in credit derivatives." Financial Stability Forum: Update of the FSF Report on Highly Leveraged Institutions (May 2007). The impact of risks crystallising in the AIFM sector in one Member State will therefore be felt beyond national borders.[10]

"For example, in 2005 the consulting firm Greenwich Associates estimated that while hedge funds accounted for 15% of trading volumes in US fixed income markets, this proportion rose to 45% of trading in emerging market bonds, 47% in distressed debt, and 58% in credit derivatives." Financial Stability Forum: Update of the FSF Report on Highly Leveraged Institutions (May 2007).

1.5. AIFM and the financial crisis

The importance of AIFM to European financial markets and the significance of the risks their activities present - both for their investors and the stability of the financial markets - have been underlined by the events of the financial crisis. As active participants in European financial markets, AIFM activities make a significant contribution to market liquidity and efficiency. However, adverse market conditions have severely affected the sector and have provided evidence of the role of AIFM in exacerbating market dynamics.

Macro-prudential risks

Certain types of AIFM have exhibited considerable appetite for credit derivatives and asset-backed securities (including mortgage backed securities) and thus have contributed to the rapid growth of these markets. AIFM – in particular those managing large, leveraged AIF - may also have contributed to asset price inflation in many markets, where they were active momentum traders in the period to mid-2007.

These same actors may have contributed to the speed and scale of the market correction witnessed over recent months. On average, AIF lost significant value during 2008 and assets managed by EU-domiciled AIFM contracted by 11.5%. In addition to adverse market conditions, many AIFM were faced with increased redemption demands from investors and with tighter lending conditions from banks. Leveraged funds were forced to unwind positions and to scale back leverage - hedge fund leverage in particular has declined from around 3 to 1.5. See Annex VI. Faced with such pressures, funds (particularly hedge funds) were often forced to sell assets into declining markets – thereby realising losses and adding further momentum to declining asset prices. This pro-cyclical behaviour may have undermined financial stability and contributed to a deepening of the crisis. [11]

See Annex VI.

Micro-prudential risks

The financial crisis has also highlighted failings in risk management and due diligence across the financial system. Excessive reliance on counterparties and trend-following at the expense of sound risk management and due diligence were observed by many market participants, including AIFM. AIFM also faced severe risk management and valuation challenges, as asset prices plummeted, key counterparties failed (including prime brokers), credit and market liquidity dried up and redemption requests increased.

The combination of increasing redemption requests and illiquid asset markets resulted in major funding liquidity risks for several business models. Many sectors experienced net outflows of funds. Others unable to exit illiquid investments had to activate gate provisions in order to limit withdrawals. Others offered lower fees in exchange for longer lock-up periods. Smaller funds were particularly vulnerable to these risks, since market participants reportedly observed an increased preference by investors to reallocate their funds to larger hedge funds that could afford and prove adequate risk controls and reliable operational infrastructures.

The counterparty risks faced by hedge fund managers were demonstrated by the near-failure of Bear Stearns and the bankruptcy of Lehman Brothers that highlighted the importance of monitoring the security of the cash and security balances held with prime brokers.

Box 1: The impact of the financial crisis on particular AIFM strategies

Hedge funds shrank by a quarter in value when measured by assets under management during the course of 2008. While this compares favourably to retail equity funds, it has triggered a crisis of legitimacy for hedge funds – which were able to charge high fees on the grounds that they could deliver absolute returns even in declining markets. The rapid unwinding of the leveraged positions associated with these and other types of AIF has had severe consequences for asset prices and financial stability. "If hedge funds increasingly fail to retain their investors, the possibility of further sizeable position unwinds by the sector may pose a challenge to financial markets." (ECB, Financial Stability Review, December 2008)

Funds of hedge funds faced a serious mismatch between liquidity and redemption intervals. While many apply relatively short redemption periods, their investments in hedge funds could not be liquidated as quickly due to the much longer redemption periods and some hedge fund closures. Therefore, they had to resort to emergency measures (fund closure, gates, etc.) in order to manage redemption requests. Some funds were also hit by exposures to the Madoff scheme in the US.

Private equity funds have experienced a different set of challenges, relating to the availability of credit and the financial health of their portfolio companies. The inability to obtain leverage has significantly reduced buy-out activity and those companies that have been subject to leveraged buy-outs are in some cases struggling to roll over the debt on their balance sheets. "It is estimated that, at the global level, more than USD 500 billion of leveraged loans and high-yield bonds will have to be refinanced between 2008 and 2010." (ECB, Financial Stability Review, December 2008). Although these figures do not relate to private equity alone, it is likely that tightened credit conditions will lead to stresses in corporate credit and CDS markets. The resulting difficulties for portfolio companies of private equity funds might backfire on the returns of the funds and might lead to detriment effects in the real economy, at least at local or regional level.

The volume of newly extended leveraged buyout (LBO) loans declined sharply in 2008, to just above €47 billion (in the months from January to October). See Standard & Poor’s, “Leveraged Commentary & Data”, November 2008 This corresponds to around one third of the LBO loan volume in the same period a year earlier. In addition, about one-third of the 2008 issuance volume was accounted for by transactions mandated in 2007, which the banks were committed to underwrite. Difficulties in syndication processes are likely to have put pressure on banks’ funding costs and capital requirements, as high risk-weighted assets have had to be warehoused longer than expected on banks’ balance sheets. Indeed, forced selling by leveraged investors is likely to have contributed to further drops in the already depressed prices in the US and European secondary loan markets. ECB, Financial Stability Review, December 2008[12][13]

See Standard & Poor’s, “Leveraged Commentary & Data”, November 2008

ECB, Financial Stability Review, December 2008

Real estate funds : In Q4 2008, German open-ended real estate funds (OEREFs) faced significant redemption pressure following withdrawals primarily from institutional investors, but also private retail investors that depleted their cash reserves. As a result, such funds, representing about €32bn, temporarily suspended the redemption of shares in October 2008 for an initial three month period. This marked the second time in their history that such funds had temporarily suspended redemptions, following the turmoil in the German open real estate market at end 2005. In February of 2009 a majority of real estate companies decided to extend the suspension period for up to twelve months. The companies said they did this because of an inability to raise cash levels within the three month period to adequate levels, but also to resist pressure for property fire sales that would negatively impact the funds' performance. The BVI, Germany's asset manager association, has proposed new measures for managing the liquidity in OEREFs by imposing compulsory 12-month notice periods for institutional investors in retail mutual funds. http://www.easybourse.com/bourse-actualite/marches/press-releasefitch-sees-liquidity-challenge-for-german-oeref-618339[14]

http://www.easybourse.com/bourse-actualite/marches/press-releasefitch-sees-liquidity-challenge-for-german-oeref-618339

Market efficiency and integrity

AIFM, in particular hedge fund managers, have also been central to the ongoing debate about the impact of certain trading practices on the integrity of financial markets. In particular, curbs on short-selling in several jurisdictions reflected unease over the impact of such activities. But AIFM were also a cause of concern in 2008 when prices in some commodity markets, in particular food prices, increased dramatically. Allegedly, speculation in futures markets had a distorting impact on spot markets with adverse impacts on the real economy, particularly on the poor who have to rely heavily on these products. For a discussion about the causes of the price movements see Commission Staff Working Document SEC(2008)2971: "Is there a speculative bubble in commodity markets?" [15]

For a discussion about the causes of the price movements see Commission Staff Working Document SEC(2008)2971: "Is there a speculative bubble in commodity markets?"

1.6. Focus of impact assessment

Recent events and the risks that they have exposed necessitate a comprehensive review of regulatory and supervisory frameworks for all significant market actors, including AIFM. As described in the Commission's recent Communication for the Spring European Council and in accordance with the conclusions of the G20, the Commission is committed to ensuring that ' all relevant actors … are subject to appropriate regulation and oversight ', which requires filling gaps in areas where European and national provisions are incomplete.

The core concern of this impact assessment is therefore the extent to which the current combination of national and European regulatory provisions and self-regulatory codes constitutes an effective framework for monitoring and managing the risks associated with the activities of AIFM. In particular, it seeks to establish whether the current arrangements represent a sound basis for organising the regulatory and supervisory oversight for AIFM, given the organisation of the industry in Europe and the transmission of risks across the EU.

2. Procedural issues and consultation of interested parties

This impact assessment draws on the results of a series of workstreams which addressed issues relating to the cross-border distribution of non-harmonised funds in the EU. Although the focus of these work streams was different to that of the present impact assessment, the input gathered through broad consultation of stakeholders, the gathering of expert views and research contributed significantly to the Commission's understanding of these issues. For this reason they are briefly outlined in this section.

Due to the short period of time in which this impact assessment was produced, no formal steering group was established.

2.1. Consultation and expertise

The Commission considered the question of whether there is a need for 'single market solutions for non-harmonised investment funds' in the White Paper on Asset Management (COM (2006) 686) of November 2006. The conclusion was that the question should be approached from two angles. Should some types of non-harmonised funds be granted an EU passport similar to UCITS to market their funds to retail investors across Member State borders? And should a European private placement regime for the cross-border distribution of non-harmonised funds to institutional or sophisticated investors be established?

This conclusion was, among other things, based on the reports of two industry expert groups on private equity and hedge funds, respectively, and the feed-back provided by interested parties in an open internet consultation on these reports. For details on the expert groups, their reports, a summary of the feedback in the public consultation as well as the individual contributions can be found on the Commission website: http://ec.europa.eu/internal_market/investment/ al t ernative_investments_en.htm#alternative . [16]

For details on the expert groups, their reports, a summary of the feedback in the public consultation as well as the individual contributions can be found on the Commission website: http://ec.europa.eu/internal_market/investment/ al t ernative_investments_en.htm#alternative .

To improve understanding of the non-harmonised fund market and in particular the boundary between harmonised and non-harmonised funds, the Commission services launched two external studies . The first focused on the differences in the investment strategies, techniques and the main risk-return features of harmonised funds and retail-oriented non-harmonised funds. The study was based on a broad industry survey. The final report has been published on the Commission's website. Study on "investment funds in the European Union: comparative analysis of use of investment powers, investment outcomes and related risk features in both UCITS and non-harmonised markets", http://ec.europa.eu/internal_market/investment/other_docs/index_en.htm#studies [17]

Study on "investment funds in the European Union: comparative analysis of use of investment powers, investment outcomes and related risk features in both UCITS and non-harmonised markets", http://ec.europa.eu/internal_market/investment/other_docs/index_en.htm#studies

The second aims to analyse the actual distribution of non-harmonised funds to retail investors: Which types of non-harmonised funds are being sold to retail investors at national level? What is the size of the relevant markets? What is the regulatory framework in place at national level? Which are the most relevant distribution channels? The final report was published in January 2009. http://ec.europa.eu/internal_market/investment/studies_en.htm [18]

http://ec.europa.eu/internal_market/investment/studies_en.htm

The Commission also set up an expert group on open ended real estate funds in June 2007. This group of industry experts from a wide range of Member States and professional backgrounds presented its report in March 2008. The report was subsequently subject to a public consultation. http://ec.europa.eu/internal_market/investment/real_estate_funds_en.htm [19]

http://ec.europa.eu/internal_market/investment/real_estate_funds_en.htm

Both the final report of the first study and the expert group report formed the basis for a public debate of the issue of retail-oriented non-harmonised funds at an open hearing in Brussels on 8 April 2008. This hearing was attended by some 270 participants from industry, investors and public authorities. http://ec.europa.eu/internal_market/investment/consultations/index_en.htm#hearing0804 [20]

http://ec.europa.eu/internal_market/investment/consultations/index_en.htm#hearing0804

As regards non-harmonised funds that target institutional investors, the Commission launched a detailed investigation into whether a European regime should be created for the private placement of these funds across borders. While there was no opposition in principle to such a framework, it was decided to first obtain a better understanding of how private placements are regulated nationally and how they work in practice before entering in the design of a regime that potentially would provide cross-border access for fund products that are not authorised or supervised in the EU in any way. The main questions focused on the definition of the eligible investor and the extent to which and under which conditions products from third countries should be allowed to be privately placed in the EU.

A call for evidence in spring 2007 and two workshops in January and February 2008 provided valuable input for an impact assessment on private placement published in July 2008. The executive summary of this impact assessment is attached as Annex VII. [21]

The executive summary of this impact assessment is attached as Annex VII.

In December 2008 a consultation on hedge funds was launched in order to gather views from all stakeholders on a series of issues relating to the activities of hedge funds, impact on financial markets and their interactions with investors and other market participants. Over 100 responses were received. Annex VIII: Summary of responses to Commission consultation on hedge funds A feedback statement and the individual replies were published in March 2009. A public conference on hedge funds and private equity in February 2009 with about 350 participants from all interested sectors focused in particular on financial stability, transparency and investor protection. [22]

Annex VIII: Summary of responses to Commission consultation on hedge funds

Although not originally tailored as input for this impact assessment, all these work streams, - the impact assessment on private placement and the expert groups, consultation and conference on private equity and hedge funds - provide important background and information for the reflections on a potential regime for AIF and their managers. In addition to these inputs, the analysis is also based on extensive desk research taking into account the ongoing international debate on these issues in forae such as the IMF, IOSCO, FSF and G20, as well as work conducted by the industry, such as the hedge fund standards developed by the President's Working Group in the US and the Hedge Fund Working Group in the UK, and the Walker guidelines and EVCA codes of conduct for private equity.

Table 5: Preparatory steps

Major steps / inputs|Timing|

Expert groups on alternative investments |January - July 2006|

Public consultation on expert group reports|July - October 2006|

White Paper on investment funds|November 2006|

Comparative study on investment powers|December 2006 - January 2008|

Study on the retail distribution of non-harmonised funds|December 2007 – September 2008|

Expert group on open ended real estate funds|July 2007 – February 2008|

Open consultation on the report of the expert group|March – June 2008|

Call for evidence on private placement|April – June 2007|

Workshops on private placement |January – February 2008|

Open hearing on non-harmonised retail funds|8 April 2008|

Impact assessment on private placement|July 2008|

Consultation on hedge funds|December 2008 – January 2009|

Conference on hedge funds and private equity|26-27 February 2009|

Transmission of draft IA report to the IAB|6 March 2009 |

Examination of the IA by the IAB|18 March 2009|

* Publication together with this impact assessment

Note: for references please see Annex XII.

2.2. How has the opinion of the Impact Assessment Board been taken into account?

The Impact Assessment Board (IAB) concluded that the report did not meet the expected standards as it provided only a partial analysis. It requested significant further work on a number of issues. This included a better identification and substantiation of the risks posed by AIFM and their systemic and cross-border nature; a much more detailed analysis of the options, setting out the concrete measures envisaged. The report should illustrate the principle-based nature of the preferred option and its implications for the different types of AIFM, supervisors, stakeholders and administrative costs. It should better specify the nature of the single market problems and the solution proposed. Finally, international aspects, the potential for an international regulation and the risk for the competitiveness of the EU industry should be analysed and strengthened.

Box 2: Impact Assessment Board Opinion of March 23, 2009:

" General recommendation: The Board acknowledges that the preparation of the report has been affected by the tight schedule for adoption of the related proposal as part of the Commission's response to the financial crisis, and that this has had a significant impact on the quality of the report. The current draft provides only a partial analysis and does not meet the standards expected of an impact assessment. Significant further work is needed on a number of issues: the report should better identify and substantiate the risks posed by AIFM' activities, their systemic nature and their cross-border dimension. Against this background, it should more clearly identify the problematic issues that can be addressed by EU regulatory intervention, provide a much more detailed analysis of the options for such action and set out the concrete measures proposed in sufficient detail in the preferred option. In so doing, the report should ensure that illustrate the principle-based nature of the envisaged regime and its implications for different types of AIFM, national supervisors, relevant stakeholders and administrative costs. The report should also better specify the nature of the single market problems identified and the solution proposed to deal with them. Finally, the analysis of international aspects such as the role of non-EU funds, the potential for international regulation and the risk for the competitiveness of the EU industry should be strengthened ."

On the basis of the IAB's comments the IA report has been thoroughly revised. The most significant amendment is the new Section 5.6 on the substance of the proposal and its impacts on stakeholders and a discussion on proportionality. Other modifications include:

– a revision of the problem definition in Section 3 to strengthen the description of risk transmission channels

– the addition of relevant evidence to Sections 1, 3 and the Annexes

– an assessment of international-level responses

– an expanded discussion of the off-shore dimension

– an improved consistency between the chapters

– better explanation of terminology/jargon.

The revised IA report has been resubmitted to the IAB on 31 st March which in turn submitted its second opinion on 8 th April. These comments have been taken into account through amendments to section 5.6 in particular.

Box 2a: Impact Assessment Board Opinion of April 8, 2009:

" General recommendation: The report has been significantly improved. There remain, however, some areas where further clarification would be welcome. These regard: the implications of the on-shore / off-shore structure of the AIF industry, notably with regard to the off-shore provision of valuation and depository services; the justification for the suggested de minimis thresholds; the distribution of supervisory responsibilities within the EU; and the impact on AIFMs domiciled in third countries. "

3. Problem description

This section explores whether the current combination of national and European regulatory provisions and self-regulatory codes constitutes an effective framework for monitoring and managing the risks arising from the activity of AIFM. In particular, it considers whether the cross-border impacts of risks are adequately addressed and effective mechanisms are in place to monitor risks on a cross-border basis. It also considers the impact of the fragmented regulatory framework on the development of the single market for AIFM.

The introductory section has described the AIF market and the risks that the activities of AIFM pose for investors, counterparties, the financial markets and the wider economy. It has also described how some of these risks have crystallised during the financial crisis.

In response to the risks described, a variety of regulatory responses have been developed at European and national level. The activities of AIFM are not therefore currently unregulated. Many Member States have introduced legislation for AIFM; however, the scope and content of national measures vary significantly, for example with regard to the requirements for the registration and authorisation of AIFM, their prudential regulation, regulatory reporting requirements and standards for investor disclosure and risk management.

It is important to recall in this context that whereas these regulatory and supervisory frameworks are predominantly national, the risks posed by AIFM domiciled in one Member State are not only of concern to the financial markets and market participants in that Member State. They also have an important cross-border dimension. There are several aspects to this:

· The investor base of many AIFM business models is highly international, as investors seek to optimise and diversify their portfolios by seeking investment opportunities in other countries;

· AIFM may obtain credit from banks / prime brokers in other Member States and will interact with counterparties located throughout the EU, both through on-exchange trading and through bespoke contracts with derivative counterparties;

· AIFM are frequently major players in financial markets outside their domicile and can have a substantial influence on price formation and liquidity in these markets; and

· AIFM investing in companies frequently acquire portfolio companies located in other Member States.

Risks associated with AIFM activity can therefore be transmitted rapidly across borders both through one-on-one relationships with investors and counterparties and through the impact on the stability and efficiency of financial markets.

This implies that investors and counterparties across the EU have a legitimate interest in the effective regulation and supervision of foreign AIFM. Public authorities in 'host' Member States will also have an interest in the interactions between market participants located and supervised in their jurisdictions with AIFM located elsewhere. Similarly, market operators and the authorities responsible for supervising those markets are directly concerned by the risks posed by AIFM from other Member States. This is particularly the case with risks that are potentially systemic in nature; for instance, macro-prudential authorities throughout the EU will be concerned with the activities of large, leveraged AIFM active in their markets.

Two important and related problems flow from this juxtaposition of increasingly interlinked financial markets and nationally-fragmented regulatory approaches to the AIFM sector:

· First, regulatory fragmentation may inhibit the effective regulation, supervision and macro-prudential oversight of AIFM by failing to take account of the cross-border dimension of their activities . This may result in incomplete or inconsistent monitoring and control of the macro-prudential, micro-prudential and market efficiency risks described in Section 1; weaknesses in frameworks for ensuring investor protection; and insufficient public accountability of AIFM investing in and managing companies.

· Second, it may also impede market integration and the development of the single market by creating barriers to the efficient cross-border distribution of AIFM products.

The discussion of these problems is structured as follows. Section 3.1 provides a brief overview of the current regulatory provisions applicable to AIFM at EU and national level. Section 3.2 explores the effectiveness of existing regulatory frameworks with respect to each of the risk types identified, in particular with regard to their cross-border impact. Section 3.3 considers the implications of the current arrangements for the efficiency of cross-border AIF distribution in the EU and the development of the internal market. Section 3.4 concludes.

3.1. Description of the regulatory patchwork

3.1.1. Community rules

There is at present no direct Community regulation of AIF or AIFM. However, AIFM are subject to Community rules that apply to all market participants, for example, the Market Abuse and the Anti-Money Laundering Directives. When investing in listed companies, AIFM have to comply with disclosure requirements under the Transparency Directive.

In addition, the distribution of AIF is subject to the Markets in Financial Instruments Directive (MiFID). Some AIFM are also directly subject to disclosure requirements under the Prospectus Directive if they publicly offer shares for subscription or launch an initial public offering. Depending on the legal status of the AIFM in a given Member State, relevant provisions of the European Company Law Directives The 2 nd Company Law Directive, Take-over Bid Directive, the Shareholders' Rights Directive may apply, ranging from initial capital requirements to rules on capital maintenance and capital formation or production of audited accounts and disclosure or risks management and valuation practices. [23]

The 2 nd Company Law Directive, Take-over Bid Directive, the Shareholders' Rights Directive

Some of the major counterparties of AIFM are also subject to regulation at Community level. Banks providing leverage through their prime brokerage activities are subject to the Capital Requirements Directive. Some categories of investor are subject to Community rules on due diligence, in particular through the Solvency regime for insurance companies and the Institutions for Occupational Retirement Provision (IORP) Directive, which influence how the industry's investor base allocates resources and makes investments in AIF.

3.1.2. National rules

The current regulatory environment for the supervision of AIFM varies across Member States and asset classes. Several Member States have introduced national regulatory regimes to provide an environment for the onshore management, constitution and distribution of AIF. Table 6 below provides an overview of the divergence in regulatory approaches to hedge funds, private equity funds and real estate funds in selected EU Member States.

These regimes typically involve registration and oversight of fund managers, as well as structural separation of the manager and the custodian. These regimes may also regulate certain product features or aspects of the investment policy (such as diversification limits, use of leverage, valuation and other portfolio constraints). At present, national legal frameworks governing establishment of the different categories of AIFM and the requirements for registration and authorisation of AIFM differ across Member States, and within Member States for different fund types.

Table 6: Regulatory mapping – Hedge Funds, Private Equity Funds and Real Estate Funds

(...PICT...)

(...PICT...)

3.2. To what extent are existing rules effective in responding to the risks?

The experience of the financial crisis indicates that a number of the risks posed by AIFM have been underestimated and are not sufficiently addressed by the current combination of national financial and company law regulation, general EU provisions and self-regulation.

One of the major weaknesses is the lack of coherence in national approaches to the regulation of the sector and of co-ordination between macro-prudential authorities. An important lesson of the financial crisis has been that risks crystallising in one jurisdiction may have important implications for market participants and financial markets elsewhere. The interconnectedness of financial markets and the mobility of market participants imply that risks originating in one national market will be rapidly propagated to other markets and as such a broader perspective is necessary.

A pre-requisite for the effective control of these risks is that AIFM in the EU are subject to appropriate registration and authorisation requirements. These requirements must ensure that AIFM are suitably qualified to provide management services; that they comply with certain minimum standards in relation to their governance, capital and processes; and that supervisors have an adequate legal basis and access to relevant information to oversee their functioning. The adequacy of existing arrangements with respect to each of the major sources of risk are analysed in the following sections.

3.2.1. Macro-prudential (systemic) risks

The financial crisis has exposed important weaknesses in existing systems of macro-prudential oversight, in particular in relation to those AIFM that make systematic use of leverage and take large (and sometimes crowded) positions in key financial markets (primarily hedge funds and some commodity funds). To the extent that systems exist for the collection and aggregation of relevant data on risk concentrations and leverage, the risk management perspective is currently largely national, whereas many of the risks associated with AIFM activity are cross-border or international in nature.

From recent experience, significant doubts persist as to whether AIFM provide for sufficient transparency towards regulators with regard to key variables such as leverage, risk concentrations, liquidity and the size and volatility of positions. Regulators are not always able to reach a clear and timely view of the existence and scale of systemic vulnerabilities.

An important barrier to effective oversight is the variation in regulatory reporting requirements across Member States. Some national regulators do possess relevant information, for instance on the exposure of major prime brokers to the hedge fund sector. However, such data collection is often voluntary, infrequent and, crucially, segmented along national lines. There are currently no effective mechanisms for the sharing, pooling and analysis of this information at European or international level.

Given the cross-border nature of these risks, the inability to piece together a comprehensive picture of AIFM leverage and activities in all major European markets is a major flaw in existing systems of macro-prudential oversight. These conclusions are supported by the responses received from public authorities to the recent Commission consultation on hedge funds and were echoed by several participants at the recent conference on hedge funds and private equity.

Box 3: Response to question in Commission hedge fund consultation: Do supervisors have access to relevant information to undertake macro-prudential monitoring?

A large majority of respondents, including most public authorities, financial organisations and investors, felt that supervisors do not have enough information to monitor the trading activities of hedge funds and that to that extent, transparency and disclosure standards for hedge funds with regard to the supervisory authorities could be improved and harmonized. A (global) registration of hedge funds and its manager could for instance contribute to improve the transparency towards authorities. Hedge funds could also be required to deliver periodic regulatory reports […] Many respondents argued that the indirect prudential approach needs to be strengthened and be supplemented by direct surveillance measures.

3.2.2. Micro-prudential risks

Just as the potential for AIFM activities to create risks of macro-prudential significance is of cross-border concern, so too is the effective management of micro-prudential risks at the level of the AIFM. Investors and counterparties located in other Member States have a direct stake in the robustness of risk management systems and governance structures of all AIFM with which they interact, irrespective of their domicile. Moreover, the robustness of internal processes is not merely of concern to the immediate investors and counterparties. Failures in risk management can produce ripple effects across the financial markets and hence inconsistencies and inadequacies in risk management practices may be a significant problem for the wider market.

As discussed in Section 1, the financial crisis has exposed important weaknesses in risk management systems throughout the financial system. The management of liquidity risks has posed a particular problem for the AIFM sector (particularly hedge funds and funds of hedge funds), where the combination of illiquid investments and pressure for deleveraging and investor redemption has exposed a severe liquidity mismatch. Counterparty risk management systems have also been tested by the failure of significant counterparties. The illiquidity of key asset markets has also exposed weaknesses in valuation processes and methodologies.

Effective management of the cross-border dimension of these risks necessitates a common understanding of the obligations of AIFM, and clear arrangements to support supervisors in ensuring that risk management systems are sufficiently robust. In this context, a fragmented, nationally-based, approach to the regulation and oversight of AIFM activities appears inefficient and may provoke regulatory arbitrage.

3.2.3. Investor protection

AIF are marketed predominantly to sophisticated, professional investors. It is commonly assumed that these investors have the capacity to understand and to bear the risks that their investments entail. This is reflected in the 'light-touch' approach of regulators to the protection of professional investors in most Member States. When funds are distributed directly to professional investors, disclosure practice is driven largely by contractual arrangements between the funds and their investors. Investors request information to serve as the basis for their due diligence and to ensure compliance with their own investment constraints. In some jurisdictions, certain information obligations have been codified through self-regulatory standards, such as those overseen by the Hedge Fund Standards Board in the United Kingdom. Private equity industry also developed European Guidelines governing the standards of AIFM reporting to investors. (EVCA Reporting Guidelines) Most Member States have in place national private placement regimes, but these vary as to who is eligible to invest and the products that can be promoted.[24]

In some jurisdictions, certain information obligations have been codified through self-regulatory standards, such as those overseen by the Hedge Fund Standards Board in the United Kingdom. Private equity industry also developed European Guidelines governing the standards of AIFM reporting to investors. (EVCA Reporting Guidelines)

The financial crisis has provided cause for reflection with regard to the adequacy of regulatory protections in this area. Inadequacies have been exposed in the due diligence applied by professional investors of all types. While this can in part be attributed to failures on the buy-side, in particular a tendency to follow trends and thus to invest without due scrutiny, another contributing factor was a lack of clear and comparable information on the risks associated with particular investments. The importance of ensuring an appropriate level of investor protection has grown as the investor base of AIFM has expanded to include pension funds, insurance companies and some public authorities, which invest on behalf of a very broad investor base.

Evidence suggests (see below) that the quality and content of the information provided to investors varies considerably, depending in particular on the nature of the AIFM. New investors seek to have the same or comparable level of information and therefore assurance about associated risks and processes and other related indicators from AIFM as they get from traditional asset managers. A recent study by EDHEC finds that there are 'great differences between hedge fund managers' perceptions of relevant information disclosure and their investors' needs suggest that the industry should rethink its overall disclosure practices.' Hedge Fund Reporting Survey, November 2008 [25]

A recent study by EDHEC finds that there are 'great differences between hedge fund managers' perceptions of relevant information disclosure and their investors' needs suggest that the industry should rethink its overall disclosure practices.' Hedge Fund Reporting Survey, November 2008

Box 4: Evidence on quality and content of information provided to AIF investors :

Survey of institutional investors PricewaterhouseCoopers – March 2008, Transparency versus returns: The institutional investor view of alternative assets : A recent survey of institutional investors points to a number of areas of dissatisfaction among investors across a range of issues associated in particular with reporting, risk management and disclosure. Investors complain that a lack of transparency makes it difficult to compare or benchmark performance between various AIF, understand the investment risks and strategies; others voice their concerns as regards standardised valuation reporting and reliability and consistency of valuations for ongoing investments.[26]

PricewaterhouseCoopers – March 2008, Transparency versus returns: The institutional investor view of alternative assets

Commission consultation on hedge funds: The majority of respondents highlight that the level and the quality of information available to investors often depends on the investors targeted and is quite unbalanced. Some report deficiencies in the disclosures provided, which are either incomplete or not available on an ongoing basis. Most information transparency concerns relate to the transparency of the fund liquidity management, redemption policy and on the equality of treatment of shareholders and side letter practice.

A recent academic study EDHEC Hedge Fund Reporting Survey 2008 highlighted some of the specific shortfalls in hedge fund reporting practice. In particular: (i) Hedge fund disclosure does not meet investor expectations, (ii) Industry practices fall short of academic standards for hedge fund reporting and (iii) Industry guidelines fall short of providing sufficient guidance. See Annex X.B for more detail.[27]

EDHEC Hedge Fund Reporting Survey 2008

IOSCO Report on Hedge Fund Oversight Hedge Funds Oversight, Consultation Report, IOSCO, March 2009 refers to current market practices in the hedge fund sector and suggests that some aspects of investor information are not as transparent as necessary. In particular, disclosure of valuation procedures, the existence of 'side letters' and 'gating structures', may not occur consistently. It concludes that the provision of information to the market in general could be described as inconsistent or even opaque and that the provision of information to regulators varies. It is unlikely that any one jurisdiction has a blueprint for others to follow. Specific attention should be focused on: what additional information should be provided by hedge funds/hedge fund managers and associated counterparties and with what frequency, in order to enable regulatory bodies and other market participants to more accurately measure the risks being run by these parties.[28]

Hedge Funds Oversight, Consultation Report, IOSCO, March 2009

Transparency relates not only to the features of the investment (e.g. the investment policy and the risks that entails) but also to the internal processes of the AIFM. Many aspects of AIFM activity and the way in which the AIFM is organised impact directly on the interests of their investors. For example, the processes for valuing the AIF's assets, ensuring that these assets are secure, and for ensuring that conflicts of interest do not drive a wedge between the interests of the AIFM and their investors (or between categories of investor) are also of direct interest to the investor. Effective and well-governed internal processes are thus necessary if an appropriate level of investor protection is to be achieved.

At present, national regulatory regimes do not provide a consistent and effective regulatory baseline for the protection of AIFM investors. In some Member States, requirements that exist have been supplemented with industry-developed disclosure standards. However, such standards have not been applied consistently throughout the EU. Variation in disclosure standards is thus an additional source of uncertainty for investors operating cross-border.

3.2.4. Market efficiency and integrity

As active participants in financial markets, AIFM can impact significantly on the efficiency of the markets in which they operate, both positively and negatively, and may pose risks to the integrity of those markets. Since AIFM frequently trade on markets outside their home jurisdiction, the surveillance of such risks has an important cross-border dimension. However, at present, the provision of information relevant to market surveillance is not consistent and is largely fragmented along national lines.

A recent example of the fragmented approach to the monitoring of risks to market efficiency and integrity has been the response to concerns raised in relation to short-selling. The events of the financial crisis provoked a series of largely uncoordinated national responses to short-selling by AIFM, in particular by hedge funds. While short-selling techniques are available to all market participants and are generally considered to contribute positively both to AIFM risk management and to market efficiency and price discovery, the extensive use of such techniques (in particular ‘naked’ short-selling) by some AIFM may have compromised the efficiency of securities settlement and may have served to undermine the stability of systemically important financial institutions.

A key driver of the uncertainty surrounding these activities was a lack of transparency in stock lending and short positions. This uncertain environment provoked a range of uncoordinated responses from national regulators. Greater co-ordination in data collection and responses to these challenges may have resulted in a more coherent response to these policy concerns, a view also shared by the majority of respondents to the Commission consultation on hedge funds. The significant differences in regulatory approaches to short selling across jurisdictions and the overall inefficiency in this area have also been recognised by the International Organisation of Securities Commissions (IOSCO). See Regulation of Short Selling, Consultation Report, March 2009[29]

See Regulation of Short Selling, Consultation Report, March 2009

It is important to draw a distinction between these activities and the abuse of markets (for example through the spreading of false rumours to profit from short-selling), which is illegal under European and national law. Nevertheless, a more coordinated approach would facilitate the detection of potentially abusive behaviour and the development of a coordinated response.

3.2.5. Impact on market for corporate control

Some AIFM strategies entail the acquisition of stakes in listed companies and an active role in the governance of those companies. Certain cases of hedge fund 'activism' have attracted adverse publicity. Criticism of these activities centres on techniques that may allow investors to build stakes in listed companies in a manner that is not sufficiently transparent to company management and may be detrimental to the interests of other stakeholders. Examples of such techniques include the practice of voting on borrowed stocks and the use of certain derivatives instruments, such as contracts for difference. While such techniques are employed by certain categories of AIFM (notably, hedge funds), they are widely available to all market participants.

At European level, the Transparency Directive requires notification of all positions that confer the entitlement to vote, independently of the ownership of the shares and the existence of an economic interest. Certain derivatives and borrowed stock are therefore covered by the disclosure duties set out in the directive. However, the directive's basic threshold of 5% is relatively high and the notification duty, for practical reasons, only becomes effective a few days after the acquisition.

A review of Member States' implementation of the threshold reveals that in some Member States (Germany, Spain, Ireland or the United Kingdom) a stricter threshold of 3% is already applied. In Italy and Portugal, it is even lower, at 2%. In addition, some Member States have acted to impose additional disclosure requirements, for example the UK FSA's recent decision to require disclosure of positions obtained through contracts for difference. However, there is at present no consensus among Member States on the appropriate response to these issues.

It is important to note that the legitimate concerns that exist in the area, while relevant to some types of AIFM, are not limited to the activities of AIFM. The techniques and instruments that may require greater scrutiny in future are widely available and thus, to the extent that there is a regulatory failure in this area, an appropriate response would focus on the technique rather than any particular category of actor.

The Commission plans to review the Transparency Directive in 2009. This review will cover issues including shareholder identification, registration and requirements of shareholders to notify issuers of the proportion of their voting rights. In addition, the Shareholders' Rights Directive is due to be transposed by August 2009.

3.2.6. Acquisition of control of companies by AIFM

In the context of the financial crisis and tightening credit conditions, concerns have arisen in relation to the sustainability of debt assumed by private equity portfolio companies. In autumn 2008 there were about 75% of portfolio companies behind schedule in their earnings plans to decrease the debt burden, which clearly reflects the difficulty of accessing credit to re-finance the debt, as was common practice prior to the financial crisis. This has been a particular concern for companies subject to leveraged buy-outs by private equity firms, many of which are currently experiencing difficulty in servicing debt. Some may fail as a result. Similar problems are experienced elsewhere in the financial system where extensive recourse was made to debt finance during a period of low interest rates and a ready supply of credit.[30]

In autumn 2008 there were about 75% of portfolio companies behind schedule in their earnings plans to decrease the debt burden, which clearly reflects the difficulty of accessing credit to re-finance the debt, as was common practice prior to the financial crisis.

An additional concern relates to the treatment of employees when a company is acquired by private equity, namely that employees do not enjoy the same protection and rights as is the case when a transfer of undertaking occurs. Underlying this concern is the desire to ensure that labour is treated equally in situations in which an AIFM acquires a controlling stake in a company (this acquisition does not result in a legal transfer of the company or a merger As defined by the Directive 2001/23/EC relating to the safeguarding of employees' rights in the event of transfers of undertakings, businesses or parts of undertakings or businesses ) and is therefore in a position to influence and give direction to major strategic changes affecting the company. [31]

As defined by the Directive 2001/23/EC relating to the safeguarding of employees' rights in the event of transfers of undertakings, businesses or parts of undertakings or businesses

Box 5: Recent evidence Bacon et al. 2008 study of 190 Pan-European Private Equity buyouts suggests the following impact of private equity buyouts on employee relations :[32]

Bacon et al. 2008 study of 190 Pan-European Private Equity buyouts

· Little change in union recognition, union member density or management attitudes to unions

· Little change in issues over which managers negotiate with and consult unions

· More consultative committees, more influential, increased focus on production, employment and financial issues and future plans

· General increase in high commitment management practices (e.g. team working and training)

· Occupational pension schemes: increase but shift to defined contribution schemes based on investment performance and contribution schemes based on investment performance and contributions open to new members

· Buyout process: 47% did not inform union representatives before

Existing national and European regulatory provisions providing general safeguards accommodate these concerns only partially. The most relevant is the Second Company Law Directive (77/91/EEC), as recently amended by Directive (2006/68/EC) that provides a framework for capital formation, maintenance and alteration of a company. The Directive on Transfer of Undertakings (2001/23/EC) and the framework Directive for consulting and informing employees (2002/14/EC) provides a framework for employee protection. As regards the Directive 2001/23/EC, it applies only in cases where legal transfer of the company or a merger takes place. The Take-over Bid Directive has also limited applicability from the perspective of portfolio companies that are not listed.

The existing regulatory framework and industry codes governing disclosure and information provisions of AIFM do not sufficiently address the cross-border character of private equity transactions , both in terms of the geographical location of investors and of the investee companies. About 30% of private equity funds are invested in portfolio companies in Member States other than that of the AIFM and about 24% of funds are raised from investors located in Member States other than that of the AIFM. EVCA Yearbook 2008: in 2006 and 2007, 23% and 24% of funds raised by European AIFM originated from investors in other Member States, 38% and 42% were raised in 2006 and 2007 from domestic investors and the remainder 40% and 34% from investors outside EU.[33]

EVCA Yearbook 2008: in 2006 and 2007, 23% and 24% of funds raised by European AIFM originated from investors in other Member States, 38% and 42% were raised in 2006 and 2007 from domestic investors and the remainder 40% and 34% from investors outside EU.

However, there is no consistent standard for the level of transparency required in relation to such deals. Consequently, key stakeholders (existing shareholders of target companies and their employees as well as investors in AIF) of these transactions may not receive comparable and consistent information about the intentions of the acquiring AIFM and the strategic implications of such acquisition either at the time of the transaction or on a continuous basis.

In the absence of relevant legislative provisions, national trade associations in some Member States have acted to introduce additional disclosure requirements on their home AIFM with regard to companies subject to buy-outs in their jurisdictions. However, despite recent efforts to deliver a more harmonised approach, these standards are not applied on a consistent basis across Member States and hence the level of transparency towards key stakeholders and public accountability associated with private equity deals varies.

3.2.7. Conclusions

This section has identified important gaps and weaknesses in European and national approaches to the regulation and supervision of the AIFM sector. The core problems relate to a failure to appreciate the cross-border nature of the risks their activities pose.

In particular, the absence of a coordinated approach to the monitoring and supervision of the AIFM sector is a significant barrier to the effective macro-prudential oversight of the sector at the European level. The absence of consistent data collection from AIFM and of effective mechanisms to share and process this information prevents regulators from compiling a comprehensive picture of the potentially systemic risks arising from AIFM activity. Enhanced and coordinated information gathering on AIFM activities would strengthen macro-prudential oversight and market discipline.

The effective regulation of the AIFM sector – both from a macro-prudential perspective and in relation to the protection of investors in AIF – requires greater consistency in the regulatory protections provided. Variations in national approaches to the registration and authorisation of AIFM, to risk management and the governance of internal processes and to the provision of key information to investors and regulators all contribute to a fragmented regulatory framework that does not currently provide sufficient assurance that consistently high standards are applied throughout the EU.

3.3. Internal Market aspects

The discussion hitherto has focused on the effectiveness of existing regulatory arrangements in responding to the risks described in Section 1, in particular with regard to the effective monitoring and management of macro-prudential risks. This section considers a second, related, problem: the fragmented approach to the regulation of AIFM may also have significant implications for the efficiency of European financial markets and the development of the single market.

Across Member States, a significant number of different legal entities or structures are used to create and operate AIF. Study conducted in 9 Member States found more than 60 different legal vehicles used for non-harmonised funds http://ec.europa.eu/internal_market/investment/docs/other_docs/study_non-harmonized_funds.pdf ) These structures include companies limited by shares, companies limited by guarantee, transparent entities structures with no legal personality and limited partnerships. All these structures have specific characteristics and features often exclusive to one local jurisdiction. Although these fund structures display many similar features in a number of jurisdictions there is no overall harmonisation. These differing approaches may act to inhibit the distribution of AIF on a cross-border basis.[34]

Study conducted in 9 Member States found more than 60 different legal vehicles used for non-harmonised funds http://ec.europa.eu/internal_market/investment/docs/other_docs/study_non-harmonized_funds.pdf )

The evidence in the impact assessment on private placement Private placement is understood as an officially recognised distribution method through which designated market participants can buy and sell financial instruments with each other without having to comply with rules that would usually apply when the same instruments are offered to the public/retail investors (http://ec.europa.eu/internal_market/investment/docs/legal_texts/ia_private-placement_en.pdf) clearly depicts the patchwork that exists at EU level in terms of national provisions governing the possibility of distributing AIF in different Member States. [35]

Private placement is understood as an officially recognised distribution method through which designated market participants can buy and sell financial instruments with each other without having to comply with rules that would usually apply when the same instruments are offered to the public/retail investors (http://ec.europa.eu/internal_market/investment/docs/legal_texts/ia_private-placement_en.pdf)

The discrepancies described above and divergent and distinct national standards and approaches to conditions under which AIFM can distribute AIF on a cross-border basis, result in legal and regulatory obstacles to the cross-border distribution of AIF and manifest themselves in the following areas:

· Requirements to produce local disclosure documents to accompany the offer;

· Restrictions on marketing, promotion, etc;

· Restrictions on placing entities approaching prospective investors;

· Different approaches to defining the population of eligible investors;

· Requirements regarding prior approval or registration of instruments;

· Limits on the eligible offerors or intermediaries who are permitted to approach prospective investors.

The aforementioned inconsistencies in national approaches to distribution of AIF support the argument that the existing regulatory framework impedes the efficient functioning of the single market in this area. This situation has the following consequences for the main actors concerned:

· Public Authorities : The lack of a common approach to supervision of AIFM obliges national supervisors to make complex and comprehensive assessment of foreign AIFM which intend to sell and distribute AIF to professional investors in their jurisdiction. The absence of a common regulatory baseline applicable throughout the EU complicates this task, with the result that additional costs are incurred both by the AIFM and the national supervisor.

· AIFM : AIFM are usually the pro-active party in initiating approaches to prospective investors and are the ones most immediately confronted with problems associated with the cross-border distribution of AIF. They incur much of the cost and legal risk associated with these transactions.

· Investors : Investors' choice of investment propositions and their potential for portfolio diversification are significantly restricted in smaller markets due to the barriers and obstacles described. The increased competition among AIFM could also benefit professional investors through lowered costs and/or improved performance.

· Businesses, enterprises : Fragmentation along national lines deprives companies across Europe from access to funding. Since neither companies nor AIFM can exploit fully the benefits of single market, it leads to a sub-optimal capital allocation in European economies. Existing restrictions of fund-raising prospects for venture capital funds in particular, can have an adverse impact on the financing of small and medium-sized companies and of innovation.

Nationally fragmented regimes may therefore act as a barrier to market integration by raising regulatory compliance costs for foreign competitors. Burdens associated with compliance with multiple regimes constrain cross-border business, with an attendant impact on the efficiency of AIF markets. AIFM are therefore unable to take full advantage of the available economies of scale (e.g. through increased fund size and cost reduction). Investors do not have access to the complete universe of AIF in the EU and therefore might not be able to diversify their portfolio optimally and to choose the funds with the best risk-return features for their investor profile. These problems are compounded by differences in national provisions on investor protection and disclosures.

3.4. Conclusions

There are no specific provisions of Community law that relate specifically to the activities of AIFM. However, EU provisions influence the general regulatory and company law environment in which AIFM operate. Most AIFM are subject to registration and supervisory oversight in the Member States in which they are established. However, the nature of that oversight varies across Member States and asset classes.

This divergence has important consequences for AIFM, their investors, counterparties and for supervisors. From the perspective of professional investors, many of which are highly mobile and active in more than one European market, the divergence in standards creates uncertainty about the extent of the regulatory protections in place. From a supervisory perspective, the current patchwork of national regulatory arrangements does not represent a comprehensive or effective basis for monitoring and responding to the risks posed by AIFM to their counterparties and the financial system. When judged from an EU perspective, these deficiencies become even more pronounced. Gaps and inconsistencies in approaches to the registration and authorisation of AIFM in the EU may impede the effective oversight of the sector and varying standards may provoke regulatory arbitrage between jurisdictions. The European dimension of the 'public good' to be protected by regulation/supervision is not sufficiently taken into account, that is the impact of crystallising risks on investors, counterparties and financial markets in other jurisdictions. The focus of any national regulation or supervision is currently largely national.

The geographically fragmented approach to the supervision and macro-prudential oversight of these entities is compounded by the fact that information gathered from AIFM and different requirements imposed in different Member States. This significantly complicates the task of piecing together an overarching view of the impact of AIFM on market conditions or of their behaviour vis-à-vis other market participants.

Table 7: Evaluation of key risks posed by activities of AIFM

Source of risk|Summary of analysis|

Macro-prudential (systemic) risks, the use of leverage|The absence of a consistent approach to the collection of macro-prudential data (on leverage, risk concentrations etc) and of effective mechanisms for the sharing of this information between prudential authorities at the European or global level is a significant barrier to robust macro-prudential oversight. Existing arrangements do not take sufficient account of the cross-border nature of risks arising in the AIFM sector.|

Micro-prudential risks|AIFM in the EU are not currently subject to consistent requirements as regards their risk management procedures and processes. Weaknesses in risk management practice present risks for investors, counterparties and the market at large. Greater consistency in regulatory standards in this area would provide greater assurance for domestic and cross-border investors and counterparties and would reduce opportunities for regulatory arbitrage.|

Investor Protection|Although the majority of investors in AIF are professional and qualified, the financial crisis has demonstrated that even this category of investors requires reliable and comprehensive information from AIFM on an initial and ongoing basis. National regulatory approaches to disclosure practice and governance vary and do not appear to provide a consistent regulatory underpinning for AIFM practice in this area.|

Market efficiency and integrity|AIFM activity may impact not only on financial stability but also on the efficiency and integrity of the markets in which they operate, irrespective of the location of those markets. One area of particular recent concern has been the impact of short-selling on financial markets and institutions. Some AIFM engage heavily in such activity for both risk management and speculative purposes. However, the activity of short-selling is a legitimate trading technique and is not the exclusive preserve of the AIFM sector.|

Impact on market for corporate control|Concerns raised in relation to AIFM activities as minority 'activist' shareholders in companies throughout the EU are not unique to AIFM. Certain techniques for the acquisition of voting rights (e.g. through derivative positions and stock borrowing) raise important questions in relation to the transparency of stake building to companies and other stakeholders. However, insofar as these techniques are available to all market actors, this does not constitute an AIFM-specific issue.|

Acquisition of control of companies by AIFM|Concerns in relation to the impact of private equity activity on their portfolio companies relate to: (1) the sustainability of the debt taken on by the portfolio company in a leveraged buy-out transaction and (2) the rights of employees throughout the buy-out transaction in particular. Empirical evidence on these points is not conclusive. There are national and European regulatory provisions providing general safeguards to accommodate these concerns. However, greater transparency and public accountability of private equity activities would help to ensure that the interests of all relevant stakeholders are taken into account in the governance of the portfolio companies.|

The fragmentation of the regulatory environment also impacts on the efficient functioning of the respective markets, with the result that AIFM are unable to take full advantage of the available economies of scale (e.g. through increased fund size and cost reduction) and i nvestors are not able to diversify their portfolios optimally and to choose the funds with the best risk-return features for their investor profile

The following sections consider how this situation could be rectified.

4. Objectives

This section transforms the problems identified above into a set of objectives in relation to the activities of AIFM and explains how these objectives relate to other ongoing regulatory reform initiatives. Certain of the risks described in previous sections are considered to relate not just to AIFM activity but also to the actions of other market actors. In these cases, it is argued that the risks are better addressed by market-wide initiatives. However, there remains an important set of risks that relate directly to AIFM activity and are the object of the remainder of this impact assessment.

The previous section has described the fundamental weaknesses in the current regulatory and supervisory arrangements for AIFM in the EU. While the risks posed by the activities of AIFM - both for their investors and counterparties and the stability of the financial system at large – are cross-border in nature, existing regulatory and supervisory arrangements are highly fragmented along national lines. In particular, the lack of transparency in the AIFM sector is compounded by a failure to share and analyse the available data at European or international level: a significant lacuna in existing systems of macro-prudential oversight.

The absence of a common regulatory and supervisory baseline may also impede the smooth functioning of the single market, since supervisors, investors, counterparties and market operators based in one EU jurisdiction do not always have sufficient assurance with regard to the regulatory and supervisory arrangements applying to AIFM in other jurisdictions; and differences in regulatory arrangements create additional costs and legal uncertainty for AIFM themselves.

In view of these shortfalls in existing arrangements, the overarching objective of this work is to provide a clear and consistent framework for the regulation and supervision of AIFM in the EU . This objective is fully consistent with the G20 appeal for appropriate regulatory and supervisory arrangements to apply to all systemically relevant market actors, and with the conclusions of the European Council's Spring Summit.

Objectives of market-wide action

However, in formulating specific objectives , it must be recognised that not all of the risks described in previous sections are exclusive to the AIFM sector. On the contrary, the financial crisis has exposed generalised failings throughout the financial system in the breadth and quality of macro-prudential oversight; in risk management by financial institutions of all types; and in relation to the transparency of an array of financial entities, markets and products.

To rebuild market confidence and to prevent a repeat of recent events, all of these failings will require remedial action. The problems of the AIFM industry should not therefore be viewed in isolation: action taken elsewhere in the financial system will also impinge on the activities of the AIFM sector. In particular, the comprehensive package of reforms announced in the recent Commission Communication on Driving European Recovery For an outline of measures proposed in Commission Communication COM(2009) 114 of 4 March 2009 see annex IX. will have significant repercussions for all market actors, including AIFM, and will respond in part to the risks discussed in this impact assessment. For instance:[36]

For an outline of measures proposed in Commission Communication COM(2009) 114 of 4 March 2009 see annex IX.

· Proposals on the establishment of a new European body to oversee the stability of the European financial system, and on the reform of the European financial supervision system, will impact, at least indirectly, on all market actors, including AIFM.

· Ongoing reform of European banking regulation will affect the regulation of prime brokers and their relationships with the AIFM sector.

· Ongoing work on centralising the clearing of OTC derivatives and increasing the transparency of derivatives and complex financial products will affect the markets and products in which some AIFM are major investors.

· The forthcoming recommendation on remuneration in the financial services sector will apply to AIFM.

In other areas, planned work will respond in full or in part to some of the specific risks identified in this impact assessment. This is the case in areas where concerns relate to specific techniques or instruments that are available to all market participants and where the discriminatory treatment of particular market actors would create distortions and would not respond in a comprehensive manner to the risks posed. These areas include:

· Market efficiency and integrity : Short-selling and its associated impacts on market efficiency and integrity are not the exclusive preserve of the AIFM sector. To the extent that stricter regulatory controls and/or greater transparency is required in this area, actions would be better targeted at all market practitioners. The Commission is considering these issues as part of the ongoing reviews of the existing acquis.

· Market for corporate control / transparency of minority shareholders : many of the concerns expressed in relation to the activities of activist AIFM relate primarily to the transparency of particular instruments and techniques, e.g. stock borrowing and certain derivative instruments. Such techniques are available to all market players and as such are better examined on a market-wide basis, in particular in the context of the Commission's review of the Transparency Directive.

Objectives of AIFM-specific action

However, these broader reforms do not respond to the specific problems arising from the particular services and activities of AIFM. Certain regulatory and supervisory failings relate directly to AIFM activity. Risks and vulnerabilities relating to the macro-prudential oversight of the AIFM activity, the micro-prudential supervision of AIFM and the protection of investors in AIFM all require action targeted at this particular sector. The remainder of this impact assessment will focus on these AIFM-specific risks.

A comprehensive response to these risks requires a clear and consistent regulatory and supervisory framework for AIFM. Specifically, such a framework would aim to achieve:

· Appropriate authorisation and registration requirements for all AIFM operating in the EU: specifically this would require all AIFM to respect and satisfy a common set of requirements (minimum capital, fit and proper, transparency, etc.) before operating across the EU.

· Improved monitoring of macro-prudential risks through the provision of relevant information to prudential authorities. To take due account of the cross-border dimension of these risks, relevant information would need to be pooled at European or global level. At operational level, this objective would require the collection of relevant data on inter alia leverage, trading activity, risk concentrations and performance, and appropriate information-sharing mechanisms to be established.

· Enhanced management of micro-prudential risks through the imposition of strict risk management controls on market, liquidity, counterparty (credit and settlement, especially in case of short selling) and operational risks.

· A common approach to protecting investors in AIFM-managed funds is required, including improvements in investor disclosures to ensure that due diligence can be performed effectively. Ensuring the proper management of conflicts of interest and imposing independent controls and processes in key risk areas, in particular valuation and custody functions, would also help to achieve this specific objective.

· Greater public accountability of AIFM investing in and managing companies should be achieved so as to ensure that such activities are subject to an appropriate level of public scrutiny. The operational objective related to this is to impose additional transparency requirements on AIFM when they acquire controlling stakes in companies with the aim to actively engage in and influence these companies' future management.

· The removal of barriers to the efficient cross-border distribution of AIF should allow an internal market in AIF in the EU to develop which is grounded in a robust and consistent regulatory supervisory framework.

It is against these objectives, summarised in Table 8, that possible actions in relation to AIFM will be assessed.

Table 8: Objectives

General objectives|Specific objectives|Operational objectives|Problem addressed|

A complete and consistent framework for the supervision and prudential oversight of AIFM|All AIFM are subject to appropriate authorisation and registration requirements|Ensure that all AIFM satisfy a specific set of requirements (minimum capital, fit and proper, transparency) before operating across the EU|Registration and authorisation of AIFM|

|Proper monitoring of macro-prudential risks |Enhance transparency of AIFM activity, including the systematic use of leverage, to enable the effective monitoring of systemic risksEnsure that relevant macro-prudential data is shared at European level|Macro-prudential (systemic) risks, the use of leverage|

|Proper monitoring and limitation of micro-prudential risks|Impose risk management controls on major risks to which AIFM are exposed (market, liquidity, counterparty – credit and settlement risks (especially in case of short selling) and operational risks)|Micro-prudential risks|

|Common approach to protect professional investors in AIFM-managed funds|Reduce potential for weakness in investor disclosures as barrier to effective due diligenceEnsure proper management of conflicts of interest. Impose appropriate controls and processes in key risk areas, such as valuation and custody|Investor protection|

|Greater public accountability of AIFM holding controlling stakes in companies|Increase transparency of AIFM when acquiring a controlling stake in, and managing, companies|Acquisition of control of companies by AIFM;Impact on market for corporate control|

|Develop the single market in AIF|Remove barriers to the efficient cross-border distribution of AIF to professional investors without compromising the effectiveness of regulation and supervision|Market efficiency and integrity|

|Ensure that actions are proportionate to the risks posed and appropriately differentiated to take account of differences in AIFM business models.|Focus action on AIFM of systemic relevance and, in addition to actions of relevance to all fund types, impose requirements that are calibrated to specific activities and behaviours.|Relevant to all|

5. Options – Analysis of impacts

This section discusses the options available to deliver on the objectives outlined in Section 4. It considers four key questions. Which parts of the value chain should be targeted by action in this area? Can a horizontal approach provide the appropriate degree of differentiation between asset classes, or would a more targeted approach be preferable? At which level should any such action be taken? And how much of the AIF value chain should be required to be located in the EU for action to be effective? The final subsection considers to what extent the preferred set of options complies with the principles of subsidiarity and proportionality.

This section will consider the options available to respond in an effective and comprehensive way to the stated objectives. The discussion will focus primarily on four key questions:

· Which parts of the value chain should be targeted by action in this area: the AIFM, AIF or other service providers (valuators, depositaries etc)?

· What is the appropriate scope for action: should specific AIFM business models be targeted, or is a more horizontal approach preferable?

· How much of the AIF value chain should be required to be located in the EU for action to be effective?

· What is the appropriate level for action (industry, national, European, international)?

Building on the conclusions to the discussion of these questions, Section 5.6 will then consider in greater detail how a measure could be designed to deliver on the specified objectives, while ensuring that requirements placed on AIFM are proportionate to the risks posed and sufficiently calibrated to the diversity of business models in the AIFM sector.

Chart 1: Structure of discussion of options

(...PICT...)

5.1. Target of measure

As a first step, it has to be decided which parts of the value chain should be targeted by action in this area. Broadly, the options are:

· Targeting the AIFM, as the entity responsible for the management of the AIF, including third party service providers, such as valuators and depositaries;

· Targeting the fund vehicle (AIF) directly; or

· Imposing requirements indirectly on AIFM/AIF via other actors with whom fund managers interact closely for instance, prime brokers.

These approaches are not necessarily mutually exclusive. We consider the merits and drawbacks of each of these approaches in turn.

Targeting the AIFM

The primary reason for focusing on the AIFM is that the risks associated with the management of AIF lie almost exclusively at the level of the AIFM . The AIFM is responsible for almost all decision-making in relation to the management of AIF, such as:

· investment decisions, including trading and the use of leverage;

· the development and maintenance of the governance structure and internal systems for risk management and the avoidance of conflicts of interest;

· the management of relationships with investors, counterparties and regulators, including the provision of information; and

· the organisation of administrative functions (including valuation), safekeeping of assets and audit, even if these functions are delegated to third parties.

The AIFM is therefore uniquely placed to identify the full spectrum of risks posed by A