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}
Date: 2009-04-30
Institutions: European Commission
Subjects: credit institution, financial instrument, financial market, impact study, investment company, provision of services, securities

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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} 

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TABLE OF CONTENTS 

Introduction .................................................................................................................. 4 
1. 
The investment fund universe ...................................................................................... 4 
1.1. 
Structure and location of AIF and AIFM..................................................................... 5 
1.2. 
Investor base of AIF..................................................................................................... 6 
1.3. 
Risks associated with AIFM activity ........................................................................... 7 
1.4. 
AIFM and the financial crisis....................................................................................... 8 
1.5. 
Focus of impact assessment ....................................................................................... 10 
1.6. 
Procedural issues and consultation of interested parties ............................................ 10 
2. 
Consultation and expertise ......................................................................................... 10 
2.1. 
How has the opinion of the Impact Assessment Board been taken into account?..... 12 
2.2. 
Problem description ................................................................................................... 13 
3. 
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 
Impact on market for corporate control ..................................................................... 21 
3.2.5. 
3.2.6.  Acquisition of control of companies by AIFM .......................................................... 22 
3.2.7.  Conclusions ................................................................................................................ 23 
Internal Market aspects .............................................................................................. 24 
3.3. 
Conclusions ................................................................................................................ 25 
3.4. 
Objectives................................................................................................................... 26 
4. 
Options – Analysis of impacts ................................................................................... 26 
5. 
Target of measure....................................................................................................... 26 
5.1. 
Coverage of measure.................................................................................................. 26 
5.2. 
How much of the AIFM value chain should be required to be in the EU?................ 26 
5.3. 
Appropriate level for potential action ........................................................................ 26 
5.4. 
Subsidiarity ................................................................................................................ 26 
5.5. 
Provisions of a potential proposal and expected impacts........................................... 26 
5.6. 
Comparing the options: Conclusions ......................................................................... 26 
6. 
7. 
Monitoring and evaluation ......................................................................................... 26 
ANNEX I: Acronyms............................................................................................................... 26 
ANNEX II: Categories of non-harmonised funds (non-UCITS) ............................................. 26 
ANNEX III: European Private Equity activity in 2007 ........................................................... 26 
ANNEX IV: Key UCITS investor protection safeguards ........................................................ 26 
ANNEX V: Qualified Investor vs Professional Client vs Eligible counterparty ..................... 26 
ANNEX VI: Risks related to activities of alternative investment fund managers (AIFM) ..... 26 
ANNEX VII: Executive Summary of the Impact Assessment on Private Placement ............. 26 
ANNEX VIII: Summary of responses to Commission consultation on hedge funds .............. 26 
ANNEX IX: Outline of relevant measures proposed in the Commission communication on 
Driving European Recovery of 4 March 2009 ......................................................................... 26 
ANNEX X: Effectiveness of existing industry codes and best practice guidelines for private 
equity and hedge funds............................................................................................................. 26 
Annex X.B. Effectiveness of industry codes and best practice guidelines for Hedge Funds .. 26 

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ANNEX XI: The Lamfalussy process...................................................................................... 26 
ANNEX XII: References ......................................................................................................... 26 

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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.1  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. 

Non-harmonised  funds  (hereafter  referred  to  collectively  as  alternative  investment  funds,  or 
AIF)  do  not  form  a  homogenous  class  of  investment  fund.2  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. 

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 cu rrently invested in EU-domiciled AIF. 
Table 1: Breakdown of Non-UCITS funds by category (1) 

30/09/2008 

31/12/2007 

€ bn 

Share 

€ bn 

Special/Institutional funds 
British investment trusts 
French employees saving funds 
Luxembourg other funds (part 2) 
Real-estate funds 
Other 
Sub-Total 
Sub-Total incl. Ireland 
Hedge funds 
Total 
(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). 

41% 
2% 
3% 
4% 
10% 
7% 
68% 
75% 
25% 
100% 

914 
55 
76 
84 
213 
166 
1,508 
1,663 
566 
2,229 

945 
79 
85 
102 
208 
170 
1,589 
1,696 

% chg (2) 
-3.3% 
-30.8% 
-10.6% 
-17.7% 
2.6% 
-2.6% 
-5.1% 
-4.9% 

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2 

A glossary of technical terms and acronyms can be found in Annex I, references are provided in Annex 
XII. 
Categories of non-harmonised funds (non-UCITS) can be found in Annex II 

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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 
20073). 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. 

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

All funds 
Number of funds*  Net assets, € 
51.232 
(46.942) 

6.141.704 
(7.872.614) 
-22,3% 
Share in all funds: 

UCITS funds 

Number of funds* 
35.722
(32.682) 

70%  
(70%) 

Net assets, € 

4.593.081 
(6.160.328)
-25,4% 

75%  
(78%) 

Non-UCITS funds 
Number of funds*  Net assets, € 
1.548.623
15.510 
(1.749.002)
(14.260) 
-11,5% 

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 

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. 

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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%).4 

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.5 

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  investors6,  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, Luxe mbourg) 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). 

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.7 

4 
5 
6 
7 

Source: EVCA Yearbook 2008. See also Annex III. 
See Annex IV: Key investor protection safeguards. 
See Annex V: Definitions of Qualified Investor, Professional Client and Eligible Counterparty. 
http://ec.europa.eu/internal_market/investment/docs/other_docs/study_non-harmonized_funds.pdf 

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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 areas8 
Macro-prudential 
(systemic) risks, relating 
in particular to the use of 
leverage 

•  Pro-cyclical impact of herding behaviour, risk concentrations in particular 
market segments and ('forced') deleveraging on asset prices and market 
liquidity  

•  Direct exposure of systemically important banks (as the providers of leverage) 

to the AIFM sector  

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 diligence 

•  Conflicts 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 financing 

•  Lack 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 Map9 

Potential sources of risk: 

Macro-prudential risks 
- Use of leverage (by AIFM) 
- Herding  
Micro-prudential risks 
- Market risks 
- Funding liquidity risk  
- Counterparty risk 
- Operational risks  
Investor protection 
- Potential for weakness in investor disclosures  
- Conflicts of interest, failures in fund 
governance 

Relevant to: 
Hedge 
Funds 

Private 
Equity 

Commodity 
funds 

Real 
Estate 

Infra-
structure  

X 
X 

X 
X 
X 
X 

X 

X 

X 

X 

X 

X 

X 
X 

X 

X 
X 

X 

X 

X 
X 
X 
X 

X 

X 

X 

X 
X 

X 

X 

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9 

These risks are described in greater detail in Annex VI. 
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. 

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Market efficiency and integrity 
Use of short-selling / other techniques 
Impact on market for corporate control 
Use of 'activist' strategies 
Accountability of AIFM acquiring and 
managing companies 

X 
X 

X 

X 

X 

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.10 The impact of 
risks  crystallising  in  the  AIFM  sector  in  one  Member  State  will  therefore  be  felt  beyond 
national borders. 

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 
1.5.11  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.  

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 

10 

11 

"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).  
See Annex VI. 

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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).12 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.13 
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 

12 
13 

See Standard & Poor’s, “Leveraged Commentary & Data”, November 2008 
ECB, Financial Stability Review, December 2008 

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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.14 
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.15  

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 

14 

15 

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

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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.16  

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.17 

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 2009.18 

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.19 

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.20  

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 2008.21  

16 

17 

18 
19 
20 
21 

as 

the 

individual 

found  on 

contributions 

For details on the expert groups, their reports, a summary of the feedback in the public consultation as 
well 
the  Commission  website: 
can  be 
http://ec.europa.eu/internal_market/investment/ alternative_investments_en.htm#alternative.  
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  
http://ec.europa.eu/internal_market/investment/studies_en.htm  
http://ec.europa.eu/internal_market/investment/real_estate_funds_en.htm  
http://ec.europa.eu/internal_market/investment/consultations/index_en.htm#hearing0804  
The executive summary of this impact assessment is attached as Annex VII. 

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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.22 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.  

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 
Expert groups on alternative investments  
Public consultation on expert group reports 
White Paper on investment funds 
Comparative study on investment powers 
Study on the retail distribution of non-harmonised funds 
Expert group on open ended real estate funds 
Open consultation on the report of the expert group 
Call for evidence on private placement 
Workshops on private placement  
Open hearing on non-harmonised retail funds 
Impact assessment on private placement 
Consultation on hedge funds 
Conference on hedge funds and private equity 
Transmission of draft IA report to the IAB 
Examination of the IA by the IAB 
* Publication together with this impact assessment 
Note: for references please see Annex XII. 

Timing 
January - July 2006 
July - October 2006 
November 2006 
December 2006 - January 2008 
December 2007 – September 2008 
July 2007 – February 2008 
March – June 2008 
April – June 2007 
January – February 2008 
8 April 2008 
July 2008 
December 2008 – January 2009 
26-27 February 2009 
6 March 2009  
18 March 2009 

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: 

22 

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

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"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 31st March which in turn submitted 
its  second  opinion  on  8th  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 

EN 

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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.  

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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 Directives23 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.  

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. 

23 

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

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15 

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

EN 

16 

EN 

 
  
 
EN 

17 

EN 

 
  
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. 

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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.24  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) 

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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.25  

Box 4: Evidence on quality and content of information provided to AIF investors: 
Survey  of  institutional  investors26:  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. 

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  study27  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. 
IOSCO  Report  on  Hedge  Fund  Oversight28  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. 

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 

25 

26 

27 
28 

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 
PricewaterhouseCoopers – March 2008, Transparency versus returns: The institutional investor view of 
alternative assets 
EDHEC Hedge Fund Reporting Survey 2008 
Hedge Funds Oversight, Consultation Report, IOSCO, March 2009 

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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).29 

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 

29 

See Regulation of Short Selling, Consultation Report, March 2009 

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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.30 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. 

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 merger31) and 
is therefore in a position to influence and give direction to major strategic changes affecting 
the company.  

30 

31 

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.  
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 

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Box 5: Recent evidence32 suggests the following impact of private equity buyouts on employee relations: 

•  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.33 

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 

32 
33 

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

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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.34  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. 
The evidence in the impact assessment on private placement35 clearly depicts the patchwork 
that exists at EU level in terms of national provisions governing the possibility of distributing 
AIF in different Member States.  

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; 

34 

35 

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

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•  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 

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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 

Macro-prudential 
(systemic) risks, the 
use of leverage 

Micro-prudential 
risks 

Investor Protection 

Market efficiency 
and integrity 

Impact on market 
for corporate 
control 

Acquisition of 
control of 
companies by 
AIFM 

Summary of analysis 
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. 
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. 
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. 
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. 
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. 
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 

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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 
investors 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 

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Commission  Communication  on  Driving  European  Recovery36  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: 

•  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 

36 

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

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28 

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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. 

EN 

29 

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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 

Proper monitoring of 
macro-prudential risks  

Proper monitoring and 
limitation of micro-
prudential risks 

Common approach to 
protect professional 
investors in AIFM-
managed funds 

Greater public 
accountability of AIFM 
holding controlling stakes 
in companies 

Develop the single market 
in AIF 

Ensure that actions are 
proportionate to the risks 
posed and appropriately 
differentiated to take 
account of differences in 
AIFM business models. 

Ensure that all AIFM satisfy a specific set 
of requirements (minimum capital, fit and 
proper, transparency) before operating 
across the EU 
Enhance transparency of AIFM activity, 
including the systematic use of leverage, 
to enable the effective monitoring of 
systemic risks 
Ensure that relevant macro-prudential 
data is shared at European level 
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) 
Reduce potential for weakness in investor 
disclosures as barrier to effective due 
diligence 
Ensure proper management of conflicts 
of interest. Impose appropriate controls 
and processes in key risk areas, such as 
valuation and custody 
Increase transparency of AIFM when 
acquiring a controlling stake in, and 
managing, companies 

Remove barriers to the efficient cross-
border distribution of AIF to professional 
investors without compromising the 
effectiveness of regulation and 
supervision 
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. 

Registration and 
authorisation of AIFM 

Macro-prudential 
(systemic) risks, the 
use of leverage 

Micro-prudential risks 

Investor protection 

Acquisition of control 
of companies by 
AIFM; 
Impact on market for 
corporate control 

Market efficiency and 
integrity 

Relevant to all 

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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 

Whom to target?

AIF 

AIFM

Indirectly 

Coverage

By asset class

All funds

Need for action? At what level?

National measures 

International level 

EU level 

Self-regulation 

EN 

31 

   EN 

 
 
 
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  AIF 
management,  to  monitor  these  risks  on  an  ongoing  basis  and  to  take  mitigating  action  as 
necessary.  The  AIFM  is  thus  also  in  a  position  to  report  on  these  activities  to  regulatory 
authorities, investors or counterparties as appropriate; and to implement the requirements of 
regulatory authorities as necessary.  

The focus on the AIFM does not imply that the AIF itself is not effectively monitored. Rules 
on  the  AIFM  would  determine  how  the  AIF  and  the  associated  risks  are  managed. 
Information  on  the  characteristics  of  the  AIF  could  therefore  be  collected  via  the  AIFM, 
regardless of the location of the AIF. 

Risk-based reasoning therefore militates in favour of focusing action on the AIFM. This focus 
is  consistent  with  the  conclusions  of  the  IOSCO  Task  Force  on  Unregulated  Financial 
Entities,  which  found  that  'progress  towards  a  consistent  and  equivalent  approach  of 
regulators to hedge fund managers should be a high priority'.37 

Role of third party service providers 

As  noted,  a  number  of  key  functions  in  relation  to  the  management  of  AIF  are  typically 
performed  by  entities  other  than  the  AIFM.  These  activities  can  play  an  important  role  in 
protecting the interests of investors. Fair and appropriately independent valuation is necessary 
to  mitigate  potential  conflicts  of  interest  between  AIFM  and  their  investors.  Likewise,  the 

37 

IOSCO Task Force on Unregulated Financial Entities, March 2009, p.32 

EN 

32 

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depositary  performs  an  essential  role  in  protecting  the  interests  of  investors,  in  particular 
through the safe-keeping of fund assets.  

It  is  essential  that  the  entities  to  whom  these  responsibilities  are  delegated  are  capable  of 
performing the functions assigned to them and are subject to appropriate rules and oversight. 
Consequently,  while  actions  targeted  at  particular  service  providers  will  by  definition  only 
serve to mitigate a subset of AIFM-related risks, such actions are an indispensable part of a 
comprehensive response to risks in this sector. 

Targeting the AIF 

Existing  EU  fund  regulation  -  the  UCITS  Directive  –  contains  in  addition  to  rules  on  the 
management company rules on the fund itself and portfolio composition. It prescribes the type 
of  assets  that  can  be  bought  for  a  UCITS,  the  minimum  degree  of  diversification  of  the 
portfolio, the maximum level of leverage, etc. 

The case for 'product rules' in the UCITS context relates primarily to the protection of retail 
investors. The investment strategies of AIF are more diverse and involve investment not only 
in liquid financial securities but also in a wide variety of illiquid assets such as, for example, 
real estate or private equity. The greater flexibility of investment strategies and invested assets 
is  consistent  with  the  predominantly  professional  investor  base  and  offers  considerable 
advantages to these investors. UCITS-style regulation of the product itself would undermine 
these investment strategies and would not be a proportionate response to the risks posed. 

A focus on the AIF would also fail to address in a comprehensive way the identified risks. As 
explained earlier, the AIF and the AIFM are separate legal entities. In many cases, the former 
is purely a legal shell for the pooling of assets and even then, the assets of the fund are usually 
not held by the AIF but by a custodian or depositary, depending on the business model. The 
AIF has no economic life of its own – the AIFM is the key decision-maker. 

Rules  on  the  fund  itself  would  not  therefore  respond  to  any  real  regulatory  need,  given  the 
professional nature of the investor base. As noted, all major decisions in relation to structure, 
systems  and  AIF  management  are  taken  by  the  AIFM.  Other  important  risks,  notably  those 
relating to valuation and asset safe-keeping, could be addressed by provisions focusing on the 
providers of those services. 

'Indirect approach' 

Risks  posed  by  AIFM  could  also  be  monitored  indirectly  by  third  parties,  in  particular 
banks/prime brokers. This 'indirect approach' is currently central to the supervision of hedge 
fund-related risks, where there are only a few global banks providing prime broker services to 
the vast majority of hedge funds. Prime brokers are not only the primary financiers of hedge 
funds,  they  usually  also  provide  a  number  of  additional  services.  This  puts  them  in  a 
favourable position to monitor and assess the risks associated with the AIFM. This monitoring 
is essential for counterparty risk management and compliance with prudential regulations.38 It 
can also provide the basis for regulatory reporting on hedge fund exposures, as is the case in 
the UK.  

Indirect  supervision  of  this  sort  is  important  and  necessary  but  does  not  constitute  a  full 
response.39 Large hedge funds typically use the services of several prime brokers and hence 

38 

39 

The prudential  regulation of the prime  broker  is  currently  the  main  regulatory  tool for preventing  the 
potential transmission of risk from the hedge fund sector to the banking sector. 
Views expressed in the public consultation on hedge funds were relatively equally split on the question 
whether  indirect  supervision  would  suffice.  However,  even  some  of  those  who  thought  that  indirect 

EN 

33 

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them  necessarily  has  a  complete  overview  of 

none  of 
the  AIFM  activities  and 
creditworthiness.  More  generally,  while  the  use  of  prime  brokerage  services  is  common  for 
hedge  funds  this  is  less  so  for  other  types  of  AIFM,  although  they  might  have  privileged 
relations  with  a  bank.  Finally,  monitoring  by  prime  brokers  can  only  capture  those  risks 
relevant  to  the  bilateral  relationship  between  the  prime  broker  and  AIFM.  It  cannot  capture 
the  full  range  of  risks:  for  example,  risks  to  investor  protection  and  the  impact  of  AIFM 
activities on wider markets. 

The indirect supervision of certain types of AIFM is therefore an important part of the picture 
but is not a substitute for actions targeted directly at the AIFM and key service providers. 

Conclusions on the locus of regulation 

Targeting the AIFM is the most direct and effective approach to addressing the risks posed by 
the AIFM sector in a comprehensive way. All of the objectives can in principle be addressed 
through an AIFM-focused approach, since the AIFM is the key decision-maker, has access to 
all  relevant  information  and  is  directly  responsible  for  risk  management  and  relations  with 
investors. The AIFM also has access to all relevant information regarding the characteristics 
of the AIF. The AIFM option is also preferable in relation to its flexibility, since the approach 
is applicable to all business models. 

It should be noted, however, that the options are not mutually exclusive. Third party service 
providers  play  a  key  role  in  mitigating  potential  conflicts  of  interest  and  other  risks  to 
investors.  The  achievement  of  the  objectives  therefore  requires  that  these  providers  are 
appropriately qualified and regulated. The effective management of potentially systemic risks 
propagated  through  the  credit  channel  also  necessitates  prudent  risk  management  on  an 
ongoing  basis  by  prime  brokers.  Further  work  is  being  conducted  in  this  area.  However,  as 
discussed, indirect monitoring cannot address all of the problems identified. 

5.2. 

Coverage of measure 

The  AIF  sector  is  diverse,  incorporating  a  wide  variety  of  business  models  and  strategies, 
investing in an array of different asset classes and employing different techniques. The precise 
characteristics of a particular business model determine the type and intensity of the risks that 
the activity of that AIFM presents. In view of this diversity, this section considers a second 
important  question:  should  action  to  address  the  identified  risks  seek  to  apply  a  common 
approach  to  the  full  spectrum  of  AIFM,  or  take  an  'asset  by  asset'  approach,  focused  on 
specific business models? 

'Asset class by asset class' approach 

An approach whereby separate measures would be implemented for managers of each of the 
relevant  asset  classes  (e.g.  managers  of  hedge  funds  or  private  equity)  would  have  the 
advantage  that  it  could  address  issues  that  are  specific  to  a  certain  AIF  type  more  directly. 
This  could  be  achieved  without  creating  unnecessary  burdens  for  other  AIF  types,  or 
ambiguities about the applicable rules. Such measures could be sensitive to the specific risks 
posed: problems related to hedge funds, for example, are quite different from those associated 
with real estate funds or private equity. 

However, such an approach suffers from a number of serious shortcomings. There would be a 
need  to  define  clearly  in  each  case  the  respective  asset  class,  which  would  be  a  significant 

supervision would be sufficient to insulate the banking system did not think that this would suffice to 
address all other relevant risks. 

EN 

34 

   EN 

 
                                                                                                                                                         
challenge. For example, the public consultation on hedge funds confirmed that there is serious 
doubt  regarding  the  feasibility  of  developing  a  sound  and  enduring  definition  of  a  hedge 
fund.40 At present, no common approach is found in national regulatory regimes, which adopt 
very different approaches to the regulation and supervision of AIFM (see Annex 5 in IOSCO 
report41). In many cases, there are no specific definitions in national law of particular AIFM 
types. There is therefore a significant risk that even the best attempt to define AIFM business 
models would leave room for interpretation and therefore legal uncertainty.  

Furthermore,  it  would  allow  the  funds  concerned  that  do  not  wish  to  comply  with  the  new 
rules to amend their strategy so as to fall outside the definition and thereby to circumvent the 
rules.  This  is  particularly  problematic  since  this  impact  assessment  has  shown  that  many  of 
the risks identified are not confined to particular investment strategies but may materialise to 
a  greater  or  lesser  extent  in  a  number  of  AIFM  strategies.  Action  in  respect  of  a  subset  of 
these AIFM may simply result in migration towards those that are not covered. An approach 
that  focuses  on  certain  AIFM  but  does  not  address  the  same  risks  in  other  AIFM  will  not 
therefore constitute a comprehensive and effective response to these risks. 

The  advantages  of  an  'asset  class  by  asset  class'  approach,  in  particular  the  opportunity  to 
tailor  actions  specifically  to  a  particular  business  model,  would  be  outweighed  both  by 
definitional obstacles and by the difficulty of establishing a comprehensive framework for the 
management  of  risks  in  the  AIFM  sector  in  a  piecemeal  way.  It  would  also  not  be  'future-
proof': a new process would need to be initiated each time a new relevant asset class emerged. 

'All encompassing' approach 

The alternative would be a measure covering all AIFM, that is, all non-UCITS fund managers. 
Such  an  approach  would  offer  considerable  advantages  over  an  'asset  class  by  asset  class' 
approach, both in terms of the coverage of risks in the sector and in avoiding the pitfalls of 
rigid legal definitions of fluid business models. 

An 'all encompassing' approach would ensure that risks were addressed irrespective of where 
they  arose  in  the  AIFM  sector.  It  would  permit  a  focus  on  specific  behaviours  or  activities, 
and  the  risks  associated  with  them,  rather  than  the  labels  attached  to  particular  business 
models. As discussed above, an attempt to single out particular business models may fail to 
deliver sufficient traction over the risks, since those AIFM not captured by the definition, but 
generating  similar  risks,  would  not  be  subject  to  the  measure.  It  would  also  avoid  the 
difficulties  associated  with  developing  robust  legal  definitions  of  specific  business  models 
and would thus eliminate opportunities for regulatory gaming within the AIFM sector.  

A related advantage concerns the innovative nature of the AIFM industry and the potential for 
the  emergence  of  new  AIFM  business  models.  A  horizontal  measure  would  automatically 
apply to all new AIFM, irrespective of their strategy or techniques employed. If the approach 
were  not  all-encompassing,  new  bespoke  actions  would  be  required  whenever  new  models 
emerged. 

40 

41 

EN 

About  80%  of  the  respondents  expressed  the  view  that  the  asset  class  was  too  heterogeneous  to 
distinguish  them  properly  from  other  asset  classes.  In  addition,  the  sector  would  develop  fast.  Any 
definition  would  therefore  become  obsolete  very  quickly.  For  a  summary  of  the  replies  see: 
http://ec.europa.eu/internal_market/investment/alternative_investments_en.htm#hedgefunds 
IOSCO: 
March 
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD288.pdf. 

Consultation 

Oversight, 

Report, 

Hedge 

Funds 

2009, 

35 

   EN 

 
                                                 
The 'all-encompassing' approach is consistent with the recommendation of the IOSCO Task 
Force that regulatory oversight should be risk-based42 and with the conclusion of the G20 that 
all financial market actors should be subject to appropriate regulation and oversight. 

A  drawback  of  a  horizontal  approach  is  a  possible  failure  to  take  due  account  of  objective 
differences  between  business  models.  This  could  in  principle  mean  that  measures  that  are 
appropriate for one business model are applied to models for which they are not. This would 
clearly be disproportionate.  

However,  an  'all-encompassing'  approach  is  not  synonymous  with  a  'one  size  fits  all' 
approach.  An  appropriately  designed  measure  could  be  made  sensitive  to  the  differences  in 
business models and calibrated to the risks posed. This could be achieved by supplementing a 
set  of  provisions  common  to  all  business  models  (for  example  in  relation  to  internal  risk 
management,  investor  relations  and  other  basic  prudential  requirements)  with  tailored 
requirements for AIFM engaging in particular activities, for example the use of leverage. The 
need for such differentiation can be seen in the following table. 

Table 9: Relevance of objectives for different types of AIFM 

Relevant to 

Objective: 
All AIFM are subject to 
appropriate authorisation and 
registration requirements 
Proper monitoring of macro-
prudential risks  

Systematic use of high leverage 

Proper monitoring and limitation 
of micro-prudential risks 
Common approach to protect 
professional investors in AIFM-
managed funds 
Greater public accountability of 
AIFM holding controlling stakes 
in companies 
Develop a single market in AIF 

Hedge 
funds 

Private 
Equity 

Commodity 
Funds 

Real-estate 
funds 

Other 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

X 

The design of a proportionate measure will be discussed in greater detail in Section 5.6. 

Conclusions on the scope of action 

The option of an 'asset class by asset class' approach suffers from three fundamental flaws: the 
need  to  precisely  define  the  asset  classes  while  trying  to  prevent  arbitrage;  an  incomplete 
coverage  of  the  risks  associated  with  the  sector,  potentially  exacerbated  by  regulatory 
arbitrage; and the need to adopt a new measure when new asset classes emerge in the future. 

These serious shortcomings lead to the exclusion of this option and the preference for an 'all 
encompassing  approach'.  An  appropriately  differentiated  horizontal  approach  to  the  AIFM 
sector  could  offer  a  comprehensive,  consistent  and  proportionate  approach  to  the  risks 
identified,  wherever  those  risks  crystallise,  while  avoiding  the  definitional  challenges  and 
arbitrage risks associated with a sectoral approach. 

42 

Op cit. 

EN 

36 

   EN 

 
 
 
 
 
 
 
 
 
 
 
 
                                                 
5.3. 

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

The previous sections have argued that action in this area should be targeted at the managers 
of all types of AIF.  

The  implication  of  this  is  that  the  AIFM  must  be  domiciled  in  the  EU  in  order  to  manage, 
administer  and  market  funds  in  the  EU.  This  would  enable  EU  competent  authorities  to 
supervise  and  enforce  compliance  of  the  AIFM  with  the  relevant  requirements  and  thereby 
address the primary sources of risk associated with AIFM activity. 

However,  the  question  arises  as  to  whether  effective  oversight  requires  other  parts  of  the 
AIFM value chain to be undertaken on-shore, subject to the direct control and enforcement of 
EU authorities in order to address real risks to the market or to investors. 

AIF: For certain business models, it is commonplace for the AIF itself to be located in a third-
country,  often  in  so-called  off-shore  jurisdictions  which  are  beyond  the  direct  reach  of  EU 
legislative  provisions.  It  is  important  to  recall,  however,  that  the  AIF  is  merely  a  legal 
structure for the pooling of assets: the risks in relation to the management and marketing of 
AIF  are  created  and  managed  by  the  AIFM.  Moreover,  information  on  the  AIF  can  be 
collected  via  the  AIFM.  Given  that  the  AIF  is  not  in  itself  a  source  of  risk,  the  off-shore 
location  need  not  undermine  effective  risk  management.  AIFM  may  be  required  to  notify 
domestic  regulators  of  the  AIF  they  intend  to  manage  and/or  market  and  to  provide 
information about them, but there is no risk-based case for imposing direct requirements on 
the AIF or for distinguishing between AIF domiciled on- or off-shore. 

Third-party  service  providers:  As  discussed,  AIFM  appoint  third-parties  to  perform  key 
services,  including  administration,  valuation,  the  safe-keeping  of  assets,  auditing  and  prime 
brokerage.  While  the  AIFM  is  ultimately  responsible  for  putting  in  place  appropriate 
arrangements, it is also vital that the third-parties appointed are fit to perform their functions. 
If they are not, this is a potentially significant source of risk for the AIF and its investors. 

If  the  service  provider  is  located  in  the  EU,  then  appropriate  regulatory  provisions  can  be 
applied  (as  is  the  case,  for  example,  through  the  regulation  of  banks  providing  depositary 
services). However, if the service provider is located in a third-country jurisdiction, domestic 
supervisors will not be in a position to assess these arrangements directly. 

In response to these risks, it could in some cases be required that such services be provided 
on-shore.  This  may  be  the  case  with  respect  to  administration/valuation  functions.  In  other 
cases, off-shore service provision may be permitted provided that certain conditions are met. 
For  instance,  if  assets  are  to  be  held  with  a  depositary  (credit  institution)  in  an  off-shore 
jurisdiction, domestic authorities will need sufficient assurance that the depositary is subject 
to appropriate regulation and supervision in its jurisdiction. Appropriate agreements would be 
required between on- and off-shore regulators for this purpose. 

The  analysis  of  this  section  implies  that  European  action  targeted  at  the  AIFM  would  be 
capable of providing domestic regulators with an appropriate degree of oversight and control 
over  the  risks  their  activities  generate,  irrespective  of  whether  the  AIF  they  manage  are 
domiciled  on-  or  off-shore.  However,  if  AIFM  are  to  be  permitted  to  use  the  services  of 
certain  third-parties  domiciled  off-shore,  effective  oversight  of  the  sector  will  require  off-
shore regulators to provide sufficient reassurance that the risks associated with these activities 
are effectively managed. In the case of valuation, for example, accounting standards and rules 
used  by  valuators  established  on  its  territory  are  equivalent  to  those  applicable  in  the 
Community. As regards depositary tasks, the third country must provide standards to prevent 
money laundering and terrorist financing that are equivalent to those laid down in Community 

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law and sub-depositaries domiciled in that country have to be subject to effective prudential 
regulation and supervision which is equivalent to the provisions laid down in Community law. 

5.4. 

Appropriate level for potential action 

The  preceding  analysis  has  concluded  that  the  most  promising  approach  to  achieving  the 
specified objectives would be to: 

•  focus on the AIFM as the only actor in a position to monitor and control the full spectrum 
of risks associated with AIF management, as well as key third party service providers; and  

•  adopt  an  'all  encompassing  approach'  to  the  sector,  focused  on  activities  and  risks  rather 
than  rigid  definitions  that  would  risk  being  arbitraged,  with  measures  applied  in  a 
proportionate way according to the location and intensity of risks. 

In this section, the options available for implementing this approach are analysed. The section 
begins with consideration of the status quo and then proceeds to assess four potential 'levels' 
for  action:  action  by  the  industry  (self-regulation);  and  regulatory  action  at  the  national, 
European and international levels. 

'Do Nothing' 

Without  targeted  action  in  relation  to  AIFM,  there  is  no  reason  to  believe  that  the  risks 
highlighted  by  the  crisis  will  dissipate.  Some  behavioural  change  is  to  be  expected  in  the 
coming months as a result of continued adverse market conditions, the vulnerability of many 
financial institutions and a generalised loss of investor confidence. However, the underlying 
risks associated with the AIFM industry will remain, as will the cross-border channels for the 
transmission  of  those  risks.  The  incomplete  and  nationally  fragmented  regulatory  and 
supervisory system for AIFM would not therefore be a solid foundation on which to rebuild 
the European financial system. In addition, the EU would forego the benefits of single market 
integration in that area. 

This  is  not  to  say  that  the  European  regulatory  environment  would  remain  static  without 
action  in  this  area.  As  described  in  Section  4,  the  reforms  announced  in  the  recent 
Commission  Communication  cover  a  wide  array  of  themes  and  industry  sectors.  While  in 
some cases relevant to AIFM, these measures are not targeted specifically at the risks posed 
by  AIFM  and  do  not  respond  directly  to  the  particular  problems  of  the  AIFM  sector.  For 
instance,  an  overhaul  of  the  European  architecture  for  the  monitoring  of  macro-prudential 
risks  would  not  in  itself  address  concerns  relating  to  the  lack  of  transparency  of  the  AIFM 
sector.  Such  a  system  could  only  work  effectively  if  AIFM  were  subject  to  appropriate 
regulatory controls and disclosure requirements. Planned market-wide measures are therefore 
a complement to, not a substitute for, targeted action in this area. 

Self-regulation by AIFM industry 

Industry  associations  have  developed  a  range  of  self-regulatory  instruments  at  national,  EU 
and  international  level.  These  instruments  concern  in  particular,  but  not  exclusively,  hedge 
funds, private equity and real estate funds. They range from illustrative lists of best practices 
to voluntary codes of conduct, to 'mandatory' guidelines. Most of these instruments have been 
adopted only in recent years. 

How  are  the  concerns  identified  earlier  addressed  by  existing  self-regulatory  frameworks? 
Existing  standards  address  many  of  the  risks  described  above,  including  corporate 
governance, risk management, valuation and disclosure practice. Some of these codes are not 
specific to the European market but are designed to be applied internationally. 

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38 

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The role of industry codes and best practice guidelines is in some areas to enhance existing 
regulatory  regimes;  in  others  they  have  emerged  as  a  substitute  for  direct  regulation.  They 
thus  have  the  potential  to  compensate  for  the  some  of  the  weaknesses  in  the  regulatory 
framework outlined in previous sections. 

However,  the  effectiveness  of  standards  and  best  practice  guidelines  in  influencing  the 
behaviour of AIFM depends critically on the coverage of those codes and the effectiveness of 
mechanisms  instituted  for  monitoring  and  enforcing  compliance  with  their  provisions. 
Without  the  latter,  such  initiatives  will  lack  credibility  and  hence  will  not  provide  the 
necessary reassurance that best practices are being widely applied.  

An analysis of the coverage and effectiveness of the self-regulatory framework applicable to 
the private equity and hedge fund sectors provides a good indication of how, if codes do not 
fulfil the effectiveness criteria, their ability to exert influence and to affect the behaviour of 
those  to  whom  they  apply  or  should  apply  will  be  limited.43  The  analysis  shows  that  the 
professional codes and standards at national and EU level do not ensure full coverage of all 
relevant issues and market players. 

Moreover,  there  is  also  significant  doubt  regarding  the  level  of  compliance  with  such 
measures.  Self-regulatory  instruments  are  not  legally  binding  and  enforcement  mechanisms 
are generally weak. Sanctions are not foreseen for the majority of these instruments. They can 
not therefore on their own ensure that all relevant risks are addressed in a credible way.  

Another  concern  in  relation  to  self-regulatory  approaches  relates  to  their  patchy  coverage. 
There  is  evidence  of  certain  industry  sectors  working  towards  more  harmonised  or  unified 
codes.  However,  a  comprehensive  response  would  require  agreement  on  a  harmonised 
approach  bringing  together  the  current  set  of  very  diverse  initiatives  across  Member  States 
and sectors to ensure that all concerns are addressed for all relevant players and activities.  

However,  there  has  been  no  attempt  to  develop  'cross-sectoral  codes'  for  different  types  of 
AIFM. Newly emerging asset classes, which often carry new risk features, would potentially 
fall outside the scope of existing codes until the asset class had grown to a certain maturity 
and had developed its own codes. As long as codes are not integrated into a single instrument 
it might be that amendments would have to be integrated into various codes at national and 
EU level in parallel. 

Moreover,  unless  these  standards  were  recognised  beyond  national  barriers,  they  would  not 
adequately address the cross-border nature of the risks posed nor provide a foundation for the 
further development of the single market. 

The  major  advantage  of  industry-developed  standards  is  their  flexibility.  As  they  can  be 
updated or amended relatively easily, future developments could be smoothly integrated.  

This  is  not  to  say  that  self-regulatory  initiatives  could  not  play  a  role  in  the  future.  The 
experience  and  expertise  reflected  in  existing  codes  could  provide  a  valuable  source  of 
inspiration for legally-binding measures adopted at national, European or international level. 
Moreover, the industries concerned could continue to play a role in elaborating the principles 
contained in legislative measures.  

However, such initiatives could not on their own respond to the risks because: 

•  They are partial in their coverage, both in terms of addressees and content.  

•  There is a lack of co-ordination between competing and overlapping codes.  

43 

See Annex XI 

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39 

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•  Most  importantly,  they  lack  credibility  and  effective  monitoring  and  enforcement 

mechanisms.  

In Europe, the capacity of such initiatives to mitigate market failures is thus debateable and 
thus  does  not  provide  a  sufficient  response  to  the  substantive  and  coordination  problems 
flowing from the fragmented regulatory framework for AIFM. 

Member State action 

Contrary to some claims, AIFM are not currently unregulated. Their activities are subject to 
Community  regulation  as  well  as  to  national  provisions.  Many  AIFM  are  subject  to 
authorisation  requirements  and  to  ongoing  scrutiny  from  national  regulators.  However,  as 
described in Section 3, these frameworks have been developed within Member States and are 
therefore  very  specific  to  the  national  context.  This  has  led  to  gaps  and  inconsistencies  in 
macro- and micro-prudential supervision and oversight, and a failure to take full account of 
the cross-border impacts of the risks posed by AIFM, in particular those relating to financial 
stability. 

Achieving greater coherence in national regimes and enhancing cooperation and information 
sharing between regulators would in principle be achievable through simultaneous adjustment 
of  national  regimes  by  Member  States.  In  order  to  achieve  effective  risk  control,  Member 
States would have to review national regimes and then to ensure some degree of commonality 
to avoid inconsistencies or loopholes. As the coverage of national regimes in terms of asset 
class differ widely it would also be necessary to ensure consistency and full coverage in this 
area.44  Market  participants  could  only  benefit  effectively  from  internal  market  rights  if 
Member States could ensure a high degree of harmonisation of rules. 

From past experience it would require an immense effort by the 27 Member States to develop 
and  implement  a  co-ordinated  approach.  Well-known  limits  exist  to  such  coordination 
exercises  in  multi-jurisdictional  environments.  Information  sharing  between  authorities  has 
been  a  source  of  contention  in  several  sectors.  Moreover,  the  failure  to  achieve  a  minimum 
degree of harmonisation would imply that barriers to efficient cross-border service provision 
would  remain.  Finally,  any  future  amendments  to  such  a  regime  would  be  as  difficult  and 
time-consuming  to  achieve  as  the  harmonisation  itself.  Given  these  limitations,  this  option 
would not be a promising or efficient way to achieve the specified objectives.  

EU-level action 

EU-level action would require the adoption of new legislation to harmonise to some extent the 
fragmented regulatory framework for AIFM that currently prevails. This could be designed in 
such a way as to provide harmonisation of the key elements of the regulatory framework for 
the  registration  and  authorisation  of  AIFM,  whilst  providing  the  flexibility  in  specific 
provisions to take account of the risks associated with different business models. 

The  establishment  of  common  regulatory  standards  through  Community  legislation  would 
provide  greater  comfort  to  investors  and  counterparties  investing  through  AIFM  located  in 
other  Member  States.  It could  also  be  designed  to  take  due  account  of  the  impact  of  AIFM 
activity on financial markets in other Member States, for instance by creating obligations for 
supervisors to cooperate and to share information of common macro-prudential interest. 

44 

The  major  point  here  would  be  that  Member  States  have  taken  different  approaches  as  to  how  to 
regulate  AIF.  While  some  have  decided  for  a  broad  approach  with  only  a  few  specific  requirements, 
others have opted for a more product-specific approach with special laws for individual fund types like 
hedge funds or real estate funds. 

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40 

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An EU-level response would deliver advantages not only in terms of the management of risks 
but  also  in  relation  to  the  removal  of  barriers  to  the  efficient  pan-European  distribution  of 
AIF. The harmonisation of key regulatory and supervisory requirements in relation to AIFM 
could  offer  advantages  for  AIFM  while  providing  a  high  level  of  assurance  to  national 
regulars in relation to the activities of AIFM domiciled in other Member States. 

The creation of an EU regime would potentially offer a number of benefits to fund managers. 
As discussed, fund managers that are properly authorised and comply with the requirements 
of the EU legislative measure would be able to distribute their funds to professional investors 
in all Member States. Recognition of a secure and effective regulatory regime in Europe may 
also  provide  EU-domiciled  AIFM  with  a  comparative  advantage  vis-à-vis  non-authorised 
third  country  fund  managers.  This  might  even  turn  into  a  significant  'pull  factor',  attracting 
more fund managers to the EU, if a widely recognised label similar to UCITS evolved. 

There  are  two  primary  disadvantages  of  developing  actions  at  European  level.  First,  the 
process  of  adopting  legislation  can  be  lengthy  and  securing  agreement  on  a  legislative  text 
challenging.  Following  adoption,  a  further  period  would  be  required  for  transposition  into 
national  law.  Any  subsequent  modifications  would  also  be  time-consuming  and  hence  the 
measure  may  lack  flexibility  in  response  to  market  developments.  Second,  a  European 
approach may fail to take sufficient account of the specificities of national markets and of the 
business models that are specific to particular national contexts. 

However, these drawbacks can be mitigated by the choice of instrument and process. The use 
of  the  'Lamfalussy  approach'  would  allow  for  the  broad  regulatory  framework  to  be 
established  at  Level  1,  followed  by  the  development  of  more  detailed  implementing 
legislation at Level 2.45 This would also provide for greater flexibility in amending details at 
Level  2.  The  choice  of  a  Directive  would  also  allow  Member  States  flexibility  in 
incorporating provisions into national law. 

International-level action 

The effects of many of the risks described are felt not only across borders within the EU but 
also  at  international  level.  The  global  financial  system  is  tightly  interlinked:  the  crisis  has 
demonstrated how systemic risks crystallising in the United States, for example, may have a 
serious impact on the stability of the European financial system. As discussed above, parts of 
the  AIF  value  chain  are  located  outside  of  the  EU  and  hence  regulatory  improvements 
elsewhere  may  have  a  direct  impact  on  the  risks  associated  with  AIFM  activity.  There  is 
therefore a strong argument for designing a framework to monitor and control these risks at 
the global level. 

However,  there  are  significant  legal  and  practical  barriers  to  reaching  consensus  at  global 
level in a timely fashion. There is some evidence of convergence of views on the regulation of 
AIFM,  as  evidenced,  for  example,  by  the  conclusions  of  the  G20  Finance  Ministers  and 
Central  Bank  Governors  meeting  in  March.  However,  agreement  on  broad  principles  falls 
short  of  specifying  detailed  global  standards.  This  is  due  to  the  challenges  of  international 
coordination  (in  particular  in  relation  to  an  industry  of  which  a  large  part  is  domiciled  off-
shore)  and  of  the  differences  in  regulatory  approach  that  exist  between  the  main  global 
financial centres. 

In addition, the institutions do not exist to design and implement legally binding provisions at 
global  level  in  this  area.  To  the  extent  that  agreement  can  be  reached  on  principles,  the 

45 

Annex XI provides a description of the Lamfalussy approach. 

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policies would still require implementation in the legal systems of each of the parties to that 
agreement.  Action  at  international  level  is  therefore  unlikely  to  achieve  the  objectives 
specified in a comprehensive and timely fashion.  

Nevertheless,  action  at  national  or  European  level  does  not  preclude  parallel  or  subsequent 
international  level  activity.  For  example,  the  collection  and  analysis  of  relevant  macro-
prudential data at national or European level could feed into the monitoring of systemic risks 
at  global  level  (for  instance,  by  the  Financial  Stability  Forum  or  International  Monetary 
Fund). It may also complement action at national or European level and, in due course, may 
foster greater convergence in regulatory approaches to the AIFM sector. 

Conclusions 

This discussion has highlighted the advantages and disadvantages associated with each level 
of  action.  Each  offers  an  improvement  vis-à-vis  the  status  quo  –  doing  nothing  and 
persevering  with  a  fragmented  and  incomplete  regime  is  therefore  not  a  viable  option. 
However,  the  effective  monitoring  and  mitigation  of  AIFM  risk  requires  binding  and 
enforceable  measures  to  ensure  a  high  standard  of  regulation  and  oversight  throughout  the 
EU. Industry-developed standards may have a role to play in elaborating on legal norms and 
are sensitive to market developments but they do not on their own provide a sufficient degree 
of assurance. Member States could in principle upgrade their own regulatory and supervisory 
arrangements. However, a piecemeal response would risk failing to take account of the cross-
border nature of risks and binding cooperation and information-sharing agreements may prove 
elusive.  

Therefore,  in  comparison  with  industry  and  national  action,  EU-level  action  has  clear 
advantages, both in terms of effective risk monitoring and control and in providing a secure 
framework for pan-European AIF distribution. There is a risk that such an approach would not 
international-level 
take  adequate  account  of 
agreements  would  take  considerable  time  to  conclude  and  would  likely  be  limited  to  broad 
principles.  The  development  of  a  robust  framework  in  Europe  could  nevertheless  provide  a 
good starting point for global discussion and sharing of information, and effective cooperation 
will be essential for the monitoring of those parts of the value chain located off-shore. 

international  dimension.  However, 

the 

The table below illustrates these conclusions in a schematic way. 

Table 10: Achievement of objectives – Level of action 

Effectiveness of risk control 

Internal Market 

Coverage 

o 

o 

+ 

Do nothing 
Self-regulatory 
instruments 
Member State 
action 
++ 
EU-level action 
+ 
International 
o: no effect;+/++: improvements in relation to 'do nothing' 

++ 
o 

+ 

+ 

o 

o 

o 

+ 

+ 
+ 

Flexibility and 
proportionality 
o 

+ 

+ 

+ 
+ 

5.5. 

Subsidiarity 

Any potential EU action must respect the principle of subsidiarity. According to the protocol 
on the application of subsidiarity and proportionality, EU action could be justified if: 

•  Transnational  aspects  could  not  be  satisfactorily  regulated  and  the  proposed  objective 

could therefore not be sufficiently achieved by the Member States; 

EN 

42 

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•  Action by Member States alone would conflict with the requirements of the Treaty; 

•  Action by Member States would significantly damage Member States' interests;  

•  Action at Community level would produce clear benefits by reason of its effects of scale 

compared with action at the level of the Member States.  

The preferred approach of EU level action targeted at the AIFM takes into account the above 
principles. The objective to remove market fragmentation could not be satisfactorily achieved 
by Member States action and the level of harmonisation achieved. The risks in question are 
inherently  transnational  in  nature  and  hence  consistency  is  required  in  the  way  in  the 
requirements placed on AIFM and in the information collected from them.  

The choice of instrument is also crucial in finding an appropriate balance between EU-level 
and  national  action.  In  this  case,  the  choice  of  a  Directive  would  appear  to  provide  for  the 
appropriate  balance  between  harmonising  key  risk  control  measures  and  allowing  Member 
States the flexibility to incorporate these provisions in their national. Any such regime could 
also provide sufficient flexibility for Member States to implement additional requirements to 
AIFM operating in a purely domestic environment; and if appropriate to provide a regime for 
the distribution of certain types of AIF to retail investors. 

The EC Treaty provides a legal basis for EU-level action in this area through Article 47(2). 

Action at EU level must also respect the principle of proportionality. The proportionality of 
a  proposed  measure  would  depend  critically  on  the  design  of  that  measure.  The  following 
section 5.6 explores in detail how an all-encompassing legislative approach  to AIFM at  EU 
level could be designed so as to provide an appropriate degree of security while ensuring that 
the provisions are sensitive to the risks posed by particular business models. 

5.6. 

Provisions of a potential proposal and expected impacts 

The  analysis  of  the  previous  sub-sections  has  indicated  that  the  most  effective  method  of 
delivering  a  secure  and  coherent  framework  for  AIFM  regulation  and  supervision,  the 
coordinated  monitoring  of  macro-prudential  risks  and  an  efficient  internal  market  for  AIF 
would be to develop a measure: 

•  targeted at the AIFM and other key service providers;  

•  applicable to all AIFM but differentiated to take account of differing risk profiles; and 

•  at EU level. 

This  sub-section  discusses  how  such  a  measure  could  be  designed  so  as  to  deliver  the 
specified objectives while respecting the principle of proportionality. It presents the elements 
that such an EU level measure would have to include and discusses how effectiveness can be 
ensured, while minimising unintended consequences. Particular attention is paid to increasing 
administrative burdens, adverse impacts on the competitiveness of AIFM concerned or on the 
economy, in particular small and medium-sized enterprises (SME). It will also assess whether 
the proposed measure would be proportionate. 

Box 6: Principal elements of the proposed Directive: 
Scope and definitions:  
In  order  to  ensure  that  all  AIFM  operating  in  the  EU  are  subject  to  effective  supervision  and  oversight,  the 
proposed  Directive  introduces  a  legally  binding  authorisation  and  supervisory  regime  for  all  AIFM  managing 
AIF in the EU. The regime will apply irrespective of the legal domicile of the AIF managed.  
For reasons of proportionality, the Directive will not apply to AIFM managing portfolios of AIF with less than 
250  million€  of  assets.  A  manager  auth orised  in  accordance  with  the  UCITS  Directive  requires  an  additional 
authorisation to operate under the AIFM regime. 

EN 

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General provisions: 
Operating conditions and initial authorisation:  
To operate in the EU, all AIFM will be required to obtain authorisation from the competent authority (CA) of 
their home Member State. All AIFM operating in the EU will be required to demonstrate that they are suitably 
qualified  to  provide  AIF  management  services  and  will  be  required  to  provide  detailed  information  on  the 
planned activity of the AIFM, the identity and characteristics of the AIF managed, the governance of the AIFM 
(including  arrangements  for  the  delegation  of  management  services),  arrangements  for  the  valuation  and  safe-
keeping of assets, audit arrangements, and the systems of regulatory reporting, where required.  
The  AIFM  will  be  required  to  satisfy  the  CA  of  the  robustness  of  internal  arrangements  with  respect  to  risk 
management, in particular liquidity risks and additional operational and counterparty risks associated with short 
selling; the management and disclosure of conflicts of interest; the fair valuation of assets; and the security of 
depository/custodial arrangements have to be equivalent to those in the Community. CA will be required to pay 
particular attention to the robustness of these depository arrangements.  
The  proposed  Directive  foresees  that  the  precise  requirements,  in  particular  with  regard  to  disclosure 
requirements, will be tailored to the particular investment strategy employed. 
Capital requirements: 
The AIFM will also be required to hold and retain a minimum level of capital. 

Treatment of investors:  
While  the  marketing  of  AIF  will  be  limited  to  professional  investors,  the  proposed  Directive  provides  for  a 
minimum  level  of  service  and  information  provision  to  such  investors,  on  an  initial  and  ongoing  basis,  to 
facilitate their due diligence and ensure a minimum level of investor protection. The proposed Directive requires 
AIFM to provide to their investors a clear description of the investment policy, including descriptions of the type 
of  assets  and  the  use  of  leverage;  redemption  policy  in  normal  and  exceptional  circumstances;  valuation, 
custody,  administration  and  risk  management  procedures;  and  fees,  charges  and  expenses  associated  with  the 
investment. 
AIFM will be required to treat their investors fairly and, if investors are not treated equally, to disclose any such 
preferential treatment clearly to all investors. 

Disclosure to regulators:  
To support the effective macro-prudential oversight of AIFM activities, AIFM will be required to report to the 
CA  on  a  regular  basis  on  the  principal  markets  and  instruments  in  which  it  trades,  its  principal  exposures, 
performance data and concentrations of risk. 
The AIFM will also be required to notify the CA of the home Member State of the identity of the AIF managed, 
the markets and assets in which the AIF will invest and the organisational and risk management arrangements 
established in relation to that AIF. 

Specific provisions  

Specific requirements for AIFM managing leveraged AIF: 
An  AIFM  employing  leverage  on  a  systematic  basis  above  a  defined  threshold  will  be  required  to  disclose 
aggregate  leverage,  the  form  of  leverage  (cash  borrowing,  securities  borrowing,  leverage  embedded  in 
derivatives), and the main sources of leverage (lending institutions such as prime brokers, banks etc) to the home 
authority of the AIFM. The proposal does not impose obligations upon CA as regards the use of this information. 
It however recognises emergency powers for authorities to restrict the use of leverage in respect of individual 
managers  and  funds,  if  the  stability  and  integrity  of  financial  markets  so  requires.  It  requires  CA  for  such 
leveraged  funds  to  aggregate  and  share,  with  other  CA,  information  that  is  relevant  for  monitoring  and 
responding to the potential consequences of AIFM activity for systemically relevant financial institutions across 
the  EU  and/or  for  the  orderly  functioning  of  the  markets  on  which  AIFM  are  active.  The  proposed  Directive 
requires that this information be transmitted on quarterly basis to the Economic and Financial Committee (or to 
the  yet  to  be  created  European  Systemic  Risk  Council)  and  without  delay  in  the  event  of  threat  of  imminent 
instability or counterparty failure. 

Specific requirements for AIFM acquiring controlling stakes in companies: 
The proposal provides for disclosures of information to other shareholders and interested parties at the time that 
the AIFM acquires a controlling interest. It also foresees provision whereby the AIFM issues annual disclosure 
on  the  investment  strategy  and  objectives  of  its  fund  when  acquiring  control  of  companies,  and  some  general 
disclosures  about  the  performance  of  the  portfolio  company  following  acquisition  of  control.  These  reporting 
obligations are introduced in view of the need for private equity and buy-out funds to account publicly for the 
manner  in  which  they  manage  companies  of  wider  public  interest,  control  of  which  they  have  acquired.  The 
information  requirements  address  the  perceived  deficit  of  strategic  information  about  how  private  equity 
managers  intend  to, or have  managed portfolio  companies  which  they own.  For reasons  of proportionality  the 

EN 

44 

   EN 

 
draft proposal does not extend these requirements to acquisitions of control in SMEs. The draft proposal requires 
that delisted companies temporarily continue to be subject to reporting obligations for listed companies.  

Rights of AIFM under the Directive:  
In order to facilitate the development of the single market, an AIFM authorised in its home Member State will be 
entitled to market its funds to professional investors in any Member State. Member States will not be permitted 
to  impose  additional  requirements  on  AIFM  domiciled  in  another  Member  State  insofar  as  marketing  to 
professional investors is concerned. The cross-border marketing of AIF would be subject only to a notification 
procedure, under which relevant information is provided to the host Member State and transmitted to the host. 
The proposed Directive does not provide rights in relation to marketing AIF to retail investors. Member States 
may allow for marketing to retail investors within their territory and may apply additional regulatory safeguards 
for this purpose. Such requirements shall not discriminate according to the domicile of the AIFM. 
AIFM shall also be entitled to freely provide management services in Member States other than their Member 
State of domicile, subject to a notification procedure. 

Supervisory cooperation and information sharing:  
In  order  to  ensure  the  secure  functioning  of  the  AIFM  sector,  CA  of  the  Member  States  will  be  required  to 
cooperate whenever necessary so as to achieve the aims of the Directive. 
Given the cross-border nature of risks arising in the AIFM sector, a prerequisite for effective macro-prudential 
oversight will be the timely sharing of relevant macro-prudential data at the European level. The CA of the home 
Member State will thus be required to transmit relevant macro-prudential data, in a suitably aggregated format, 
to public authorities in other Member States.46 

To  address  the  risks  identified  and  to  achieve  the  specific  objectives  outlined  above,  the 
provisions  of  a  potential  Directive  would  have  to  be  targeted  at  the  particular  risk  and  the 
actor  and  activity  behind  it.  This  is  in  recognition  that  a  crude  'one-size-fits-all'  approach 
carries risks. Yet, as the discussion above has shown, there are a number of risks and concerns 
that  are  common  to  the  various  types  of  AIF  and  AIFM.  This  holds  in  particular  for  the 
authorisation  and  registration  requirements  and  the  limitation  and  monitoring  of  micro-
prudential risks and the development of an internal market for AIF and AIFM. This has to be 
reflected in general provisions applicable to all AIFM that fall under the Directive. The other 
specific  objectives,  macro-prudential  oversight,  investor  protection  and  greater  public 
accountability of AIFM  holding  controlling stakes in companies are arguably more relevant 
with regard to some specific activities.  

Most  of  the  provisions  would  therefore  be  relevant  to  all  AIFM.  This  includes  minimum 
capital, organisational, and transparency requirements as well as rules on conflict of interest 
and  conduct  of  business  but  also  management  of  risks  and  liquidity.  The  initiative  would 
require  AIFM  to  ensure  that  these  requirements  are  fulfilled  on  an  ongoing  basis  from  the 
time  of  their  authorisation  by  their  home  supervisor.  Depending  on  its  activities  the  AIFM 
might have to comply with additional requirements as explained below. 

The following table summarises the main provisions of the potential measure.  

46  

EN 

Depending on the outcome of the ongoing revision of financial supervision in the EU this might include 
future  EU-level  body  like  the  European  Systemic  Risk  Council  (ESRC)  proposed  by  the  report  on 
financial 
group. 
de 
http://ec.europa.eu/internal_market/finances/docs/de_larosiere_report_en.pdf 

supervision 

Larosiere 

EU 

the 

the 

by 

in 

45 

   EN 

 
                                                 
Table 11: General and specific provisions of the prospective proposal and objectives addressed 

Coverage: 

Provision: 

Examples: 

General provisions: 
All AIFM with AuM 
above 250mn€ 

Exempts the majority of 
AIFM, in particular AIFM 
of smaller funds, e.g. 
most venture capital funds 

Requirements specific to: 
AIFM of leveraged 
AIF 

AIFM acquiring 
controlling stakes in 
companies which are 
not SMEs 
AIFM delisting 
companies 

Primarily hedge fund 
managers, but potentially 
also others like AIFM of 
commodity funds 
AIFM of private equity 
funds 

AIFM of private equity 
funds 

Requirements: 

Objectives addressed: 

- all specific objectives 

- Capital requirements (125.000€ + 0.02% of AuM in excess of 250mn€) 
- Organisational requirements (adequate and appropriate resources; independent or 
independently acting valuator, minimum frequency of valuation; depositary subject 
to prudential regulation and on-going supervision, liable to AIFM and investors) 
- Conflict of interest 
- Risk and liquidity management 
- Conduct of business 
- Transparency requirements (annual report, accounting information; disclosure to 
investors; regular reporting to competent authorities)  
- Internal market rights: cross-border provision of AIFM services and cross-border 
marketing of AIF managed 

- Disclosure to investors: maximum level of leverage; total amount of leverage of 
relevant AIF  
- Reporting to CA: aggregate level of leverage; amount of leverage by major 
sources 
- Disclosures of information to other shareholders and interested parties at the time 
of acquisition; 
- Annual disclosure on the investment strategy and objectives; 
- General disclosures about the performance of the portfolio company 
- Delisted companies to continue to be subject to reporting obligations for listed 
companies for two years 

- limitation and monitoring of 
macro-prudential risks 
- investor protection 

- investor/stakeholder protection 

- investor/stakeholder protection 

EN 

46 

EN 

 
  
Proportionality and administrative burden 

Compliance with an EU Directive would constitute a potential administrative burden, primarily 
in  the  form  of  reporting  requirements.  As  they  are  currently  already  regulated  in  one  way  or 
other at national level, not all of these provisions create new, additional burden. In any case, but 
especially when using a horizontal approach for AIFM, it is essential to ensure that any measure 
is proportionate and reasonable. The benefit of achieving the objectives of the measure and the 
administrative  burden  that  comes  with  it  have  to  be  balanced.  In  the  current  case  it  would  be 
achieved by a combination of quantitative thresholds and the use of an activity/behaviour-based 
approach. 

Activity/behaviour-based approach 

The consistent use of an activity/behaviour-based approach is of crucial importance in ensuring 
proportionality and efficiency. This approach is based on the fact that the risks to be addressed 
do not stem from the activity rather than the type of fund. It follows from the fact that an 'all 
encompassing'  approach  has  to  be  followed  in  order  to  avoid  regulatory  arbitrage  and  gaming 
and serves to ensure that it does not turn into an 'one-size-fits all' that would not be sensitive to 
the  specific  features  of  the  types  of  AIFM  and  AIF  covered.  Its  major  advantage  vis-à-vis 
AIF/AFIM-type specific measures is its comprehensive nature.  

Even the general provisions of a Directive would not apply to the same degree to every AIFM 
independent of its size and activities. Rather, the more risk an AIFM takes the more developed 
its organisational and risk management provisions would have to be. Competent authorities will, 
for example, assess the liquidity management systems and procedures of an AIFM against the 
liquidity of its investments (risk-based approach).  

However, the activity/behaviour-based approach will also apply more specifically to a number 
of activities listed in the table above. In these cases there is a clear line drawn between AIFM 
who  use  a  specific  technique  or  undertake  specific  activities  and  those  who  do  not.  Only  the 
former will have to comply with the respective requirements. 

Only  AIFM  that  use  leverage  systematically  and  on  a  relevant  scale  (leverage  exceeding  the 
value of the equity capital of the AIF) will have to comply with the respective requirements. The 
initiative would require them to disclose to (prospective) investors, among others, the maximum 
potential  and  the  current  level  of  leverage  and  to  report  to  the  competent  authority,  among 
others, the level of leverage and the amount of leverage by major sources (prime brokers, banks 
etc).  Competent  authorities  would  have  emergency  powers  to  restrict  the  use  of  leverage  in 
respect  of  individual  managers  and  funds,  if  the  stability  and  integrity  of  financial markets  so 
requires.47  This  requirement  would  be  needed  as  the  use  of  a  systematically  high  level  of 
leverage implies that the impact of that activity on the financial system is likely to be amplified.  

For all other AIFM no additional burden will be created. The use of this activity-based approach 
ensures that all relevant AIFM will be covered without any regard to the name or label under 
which  its  AIF  are  being  marketed,  while  AIFM  that  do  not  use  leverage,  or  only  to  a  limited 
degree, that does not pose any major potential threat to financial stability and the functioning of 
the financial system, will not have to bear unnecessary burden. Competent authorities will not 

47 

Competent authorities for such leveraged funds would also be required to aggregate and share, with other 
competent  authorities,  information  that  is  relevant  for  monitoring  and  responding  to  the  potential 
consequences of AIFM activity for systemically relevant financial institutions across the EU and/or for the 
orderly functioning of the markets on which AIFM are active. The proposed Directive requires that this 
information  be  transmitted  on  quarterly  basis  to  the  EFC  (or  yet  to  be  created  European  Systemic  Risk 
Council) and without delay in the event of threat of imminent instability or counterparty failure. 

EN 

47 

   EN 

 
                                                 
be  confronted  with  vast  amount  of  information  that  they  do  not  necessarily  need  for  proper 
macro-prudential oversight.  

The same logic applies to AIFM acquiring stakes in companies: Only if the respective AIF reach 
a  controlling  stake  in  a  company  will  they  be  required  to  ensure  compliance  with  additional 
information  and  disclosure  requirements  that  should  allow  other  stakeholders  to  accurately 
scrutinise  related  activities.  In  order  to  address  problems  related  to  public  accountability  the 
measure would require an AIFM who manages one or more AIF that acquire controlling stake in 
a  company,  to  comply  with  disclosure  and  reporting  requirements  vis-à-vis  other  shareholders 
and  interested  parties  (e.g.  annual  disclosure  on  the  investment  strategy  and  objectives  of  its 
fund; performance of the portfolio company following acquisition of control). These disclosure 
and reporting obligations are introduced in view of the need for private equity funds to account 
publicly  for  the  manner  in  which  they  manage  companies  of  wider  public  interest.  The 
information  requirements  address  the  perceived  deficit  of  strategic  information  about  how 
private equity managers intend to, or have managed portfolio companies which they own. 

The same applies to AIFM that invest in listed companies that are then subsequently delisted: 
If as an immediate  result of an acquisition of  controlling stake in a listed company the AIFM 
declares its intention to delist this company, the AIFM will have to ensure that these companies 
continue with their reporting obligations as required for listed companies for two years after the 
delisting. This is in reaction to concerns raised with regard to the delisting of public companies 
owned  by  private  equity  funds  and  the  subsequent  reduction  of  transparency.  The  measure 
would ensure that AIFM can be held publicly accountable for a transitional period so that any 
sudden change in strategy or performance continues to be publicly disclosed.  

Like most of the provisions of the Directive, details regarding reporting requirements would to 
some  degree  be  elaborated  at  levels  2  and  3  of  the  Lamfalussy  procedure.  A  review  of  their 
appropriateness  and  effectiveness,  including  public  consultation,  will  be  foreseen  in  the  final 
provisions of the Directive.  

De minimis thresholds  

AIFM  that  manage  AIF  of  less  than  250  million  euro,  on  aggregate,  will  prima  facie  be 
excluded  but  have  the  right  to  'opt-in'.48  This  provision  should  ensure  that  no  unnecessary 
administrative burden is imposed on AIFM that do not pose relevant risks to financial stability 
and market efficiency. It has been determined on the basis of an analysis of the size distribution 
of  AIFM  distributing  AIF  in  the  EU.  This  has  been  done  for  open-ended  non-UCITS  and 
separately  for  hedge  funds  because  of  their  particular  importance  for  market  efficiency  and 
integrity and their systemic relevance. The results of this analysis are summarised in the charts 
and  tables  below.  In  reading  them  it  has  to  be  kept  in  mind  that  they  refer  to  AIFM,  not  to 
individual  AIF,  as  the  de  minimis  rule  under  consideration  would  apply  on  the  basis  of  total 
assets managed by AIFM, not on the assets invested in any individual AIF.  

In the case of hedge funds, it can be seen that a threshold of 250mn€ would cover about 70% of 
the net assets. This could be achieved by covering only some 14% of the hedge fund managers. 
Doubling the proposed threshold to 500mn€ would cover about half  of net assets and only less 
than  10%  of  the  managers.  Lowering  it  to  100mn€  would  more  than  double  the  share  of 
managers covered while increasing the net assets covered by around 20% only.  

48  

The net assets under management of an AIFM have been used as proxy as systemic risks and impacts on 
market efficiency are closely correlated with size. Furthermore, data availability renders the use of more 
sophisticated indicators impossible. 

EN 

48 

   EN 

 
                                                 
Chart 2: Size distribution of Hedge Fund Managers 

Managers of hedge funds are available for sale in at least one EU Member State; based on almost 500 funds with 
the  necessary  information  available  in  the  database;  managed  by  more  than  200  managers.  The  distribution  in 
terms  of  net  assets  is  plotted  against  the  scale  on  the  right-hand  side;  the  distribution  in  terms  of  number  of 
managers covered is plotted against the scale on the left-hand side. 
Source: Commission services calculation on the basis of Morningstar Direct database. 

Table 12: Hedge funds: Share of net assets under management and share of fund managers covered 

Net assets, EUR, above threshold of: 

Share of net assets covered 

Share of fund managers covered 

1.000.000.000 
500.000.000 
250.000.000 
200.000.000 
100.000.000 
Total 

See footnotes on previous chart. 

33% 
51% 
71% 
74% 
87% 
100% 

2% 
6% 
14% 
16% 
30% 
100% 

The concentration of managers of open-ended investment funds that are not UCITS distributed 
in the EU is much greater due to the fact that this includes some of the major asset management 
firms  in  the  EU  which  manage  a  multitude  of  often  relatively  big  funds.  Here  a  threshold  of 
250mn€ would cover more than 90% of the assets under management, but only a bit more than a 
quarter of the managers. Increasing the threshold to 500mn€ would lower the share of managers 
covered to around one quarter. Lowering it to 100mn€ would not dramatically change the share 
of  assets  covered;  but  would  increase  the  share  of  managers  covered  to  around  half  of  the 
managers.  

EN 

49 

   EN 

 
 
Chart 3: Size distribution of open-ended non-UCITS fund managers 

Managers of open-ended investment funds that are not UCITS and are available in at least one EU Member State; 
based  on  a  sample  of  more  than  4000  funds  (out  of  more  than  13.000  funds  with  the  necessary  information 
available in the database; this sample excludes hedge funds, it mainly consists of equity, money market, commodity 
and fixed income funds), managed by about 350 managers. The distribution in terms of net assets is plotted against 
the  scale  on  the  right-hand  side;  the  distribution  in  terms  of  number  of  managers  covered  is  plotted  against  the 
scale on the left-hand side. 
Source: Commission services calculation on the basis of Morningstar direct database. 

Table 13: Open-ended non-UCITS funds: Share of net assets under management and share of fund managers 
covered 

Net Assets, EUR, above threshold of: 

Share of net assets covered 

Share of fund managers covered 

1.000.000.000 
500.000.000 
250.000.000 
200.000.000 
100.000.000 
Total 

See footnotes on previous chart. 

86% 
92% 
96% 
97% 
98% 
100% 

18% 
26% 
36% 
37% 
48% 
100% 

Capturing the 'big players' ensures that the over-arching objectives of proper macro-prudential 
oversight and market efficiency and integrity can be achieved. These AIFM are also those with 
the greatest interest in cross-border distribution. However, the 'opt-in' clause would also allow 
smaller AIFM to benefit from the Internal Market rights provided by the measure.  

As regards these smaller AIFM the additional benefits resulting from achieving the objectives 
relating  to  investor  protection  and  micro-prudential  oversight  are  not  felt  to  outweigh  the 
additional  costs  in  form  of  administrative  burden  on  these  AIFM,  especially  if  activities  were 
limited to national markets. As said before, most of these AIFM would not remain unregulated 
but would be covered by national rules. Given that, in many cases, their focus would mainly be 
local this seems more appropriate. Finally, it should be recalled that the investors concerned are 
predominantly sophisticated investors. 

EN 

50 

   EN 

 
 
Besides  this  general  exemption,  the  measure  would  use  de  minimis  thresholds  also  in  the 
application  of  specific  provisions.  For  example,  AIFM  acquiring  controlling  stakes  in 
companies  would  be  exempted  from  the  relevant  information  and  disclosure  provisions 
mentioned above if the portfolio company falls under the EU definition of a small- or mid-sized 
enterprise (SME) as defined in Commission Recommendation 2003/361/EC of 2003.49 Obliging 
AIFM  to  comply  with  comprehensive  information  and  disclosure  provisions  would  be  a 
disproportionate  burden  in  the  case  of  small-scale  investments  and  could  even  result  in  a 
reduction of the already relatively low venture capital activity in the EU. This would run counter 
to  the  Commission  policies  with  regard  to  SME  and  the  Lisbon  objectives  of  the  European 
Union. 

In  order  to  avoid  unnecessary  compliance  costs,  it  would  be  foreseen  that  an  AIFM  using 
leverage in its investments only has to comply with the relevant provisions if leverage is used 
extensively.50 A low degree of leverage is common and accepted practice for most types of AIF. 
Obliging all AIFM to report on leveraged investments would therefore result in a vast amount of 
information  'thrown'  on  competent  authorities.  It  would  then  be  difficult  to  deal  with  this 
information and to analyse it properly. The marginal additional benefit from full coverage would 
be achieved against considerable costs for competent authorities and AIFM.  

It has to be recognised that the use of any threshold bears the risk of circumvention. However, 
this  has  to  be  weighed  against  the  burden  imposed  on  the  AIFM  covered.  The  principle  of 
proportionality,  increasing  costs  versus  decreasing  additional  benefit,  has  to  be  applied  with 
caution. In order to avoid or minimise circumvention thresholds refer to the AIFM entity as a 
whole and not only to individual AIF. 

Competitiveness and employment 

The prospective Directive will affect AIFM, positively and adversely, through various channels:  

•  Firstly, AIFM that have to comply with the provisions will face additional administrative 

burden.51 These costs will affect their competitiveness negatively. Although the extent of this 
effect cannot be quantified it seems very likely that, in the light of the mechanisms installed 
to ensure proportionality, it will not be extremely high and certainly not excessive.  

•  Secondly, some of the provisions might result in an improved public image of AIFM in the 
EU. This could increase its attractiveness to institutional investors and increase investor 
confidence in AIFM and financial markets more generally.  

•  Thirdly, the improved conditions for cross-border marketing of AIF and cross-border service 

provision by AIFM should allow the industry to become more efficient by using 
specialisation advantages and exploiting economies of scale.  

•  Finally, the creation of an EU level framework could result in the emergence of an EU 'AIFM 
label'. This could attract fund managers to domicile in the EU. A widely recognised fund 
manager label could also have positive impact on softening buy-side restrictions that 
currently restrict cross-border investments of institutional investors like pension funds. 

49 

50  

51 

Commission  recommendation  concerning  the  definition  of  micro,  small  and  medium-sized  enterprises; 
http://europa.eu/eur-lex/pri/en/oj/dat/2003/l_124/l_12420030520en00360041.pdf 
There is no commonly agreed understanding of what constitutes an excessive level of leverage not at least 
because  this  depends  on  the  way  it  is  being  used  and  controlled  for.  And  what  is  more,  this  "ideal 
threshold" would certainly change over time in such a dynamic industry. There are good reasons, however, 
not to set the threshold at zero. It can also be argued that a leverage that exceeds own funds might change 
perception of risks as one operates with more 'foreign' than 'own' money.  
However,  as  mentioned  above,  for  some  AIFM  the  administrative  burden  might  be  lower  than  under 
current national regimes.  

EN 

51 

   EN 

 
                                                 
Overall,  despite  the  inherent  difficulty  of  assessing  the  net  impact  of  such  a  Directive  on  the 
competitiveness of the EU AIFM industry, it seems most likely that the effect of the measure as 
proposed  will  be  relatively  limited.  The  objective  to  ensure  a  complete  and  consistent 
framework  for  the  supervision  and  prudential  oversight  of  AIFM  cannot  be  achieved  without 
imposing some administrative burden. These would only be higher than in the current situation 
('do  nothing')  for  AIFM  domiciled  in  Member  States  with  a  significantly  lower  level  of 
supervision and oversight. Furthermore, as the measures proposed are in line with what is being 
discussed  at  international  level  it  is  likely  that  even  in  the  short-  to  mid-term  administrative 
burden will be similar or even higher in other major financial centres.52  

Under  this  scenario  there  might  also  be  a  positive  employment  effect:  If  international  AIFM 
come to the conclusion that the benefits of the new regime would outweigh the (administrative) 
costs,  they  could  be  inclined  to  step  up  their  EU-based  activities.  This  would  bring  not  only 
additional  employment  in  the  AIFM  but  most  likely  also  to  ancillary  service  providers  in  the 
EU. However, in the case that AIFM should see the new framework as an excessive burden and 
move  out  of  their  EU  domiciles  as  a  reaction  this  could  result  in  a  detrimental  effect  on 
employment and economic activity in the EU AIFM sector. It is difficult to assess the likely net 
effect  at  this  stage.  Given  the  cost  sensitivity  of  the  industry  and  that,  like  most  services,  the 
management of AIF is 'footloose', the net effect will be sensitive to the concrete provisions of 
the measure. The analysis is made even more difficult by the fact that the United States, as well 
as other third countries, also consider changing their regulatory framework for (most types of ) 
AIFM.  

Impacts on investors and SME 

As discussed in the previous section, the measure should result in a harmonisation of protection 
of investors in AIFM in the EU and thereby increase legal certainty. Retail investor protection 
would  be  ensured  through  clauses  that  prohibit  the  distribution  of  these  types  of  AIF  to  retail 
clients as long as national rules do not provide a respective framework and safeguards. This is 
justified by the fact that AIF are generally not seen as (fully) suitable for retail investors.53  

Furthermore,  the  development  of  an  Internal  Market  for  AIFM  for  professional  investors 
should  benefit  these  investors  as  they  would  have  a  wider  choice  of  AIF  at  potentially  lower 
costs  due  to  specialisation  gains  and  increased  competition.  Here  again  the  right  balance 
between strict oversight and regulation on the one hand and sufficient  flexibility  and ensuring 
the  functioning  of  the  AIFM  business  models  is  crucial:  Too  strict  regulation  would  not  only 
drive the AIFM industry out of the EU but would also force EU professional investors who want 
to acquire AIF to buy them off-shore with only low legal protection or at least higher costs in 
enforcing it.  

It  should  be  kept  in  mind,  however,  that  MiFID  rules  regarding  the  test  of  suitability  and 
appropriateness would still apply for the marketing of AIF in the EU. This means that an AIFM 
or its intermediaries would not be allowed to market an AIF to a professional investor without 
ensuring that the AIF is suitable and appropriate for this particular investor. The obligation for 
sellers/intermediaries to test suitability was the main reason for the choice of the 'professional 
client'  category  as  defined  in  the  MiFID  Directive  as  the  basis  for  the  proposed  Directive.54 
Limiting eligibility to 'eligible counterparties' would be too restrictive as would exclude a large 

52 

53 
54 

See,  for  example,  the  IOSCO  Consultation  Report  "Hedge  Funds  Oversight"  of  March  2009 
(http://www.iosco.org/library/pubdocs/pdf/IOSCOPD288.pdf). 
See chapter 3 above. 
On the different definitions of investors in EU Directives see Annex. 

EN 

52 

   EN 

 
                                                 
number of potential investors which are established investors in many types of AIF at national 
level.  

It is also essential to remain cognisant of the benefits of the AIFM industry and not to destroy 
the  benefits  AIFM  can  bring  to  the  'real  economy'.  Such  concerns  are  most  prominent  with 
regard  to  private  equity.  In  a  number  of  Member  States  private  equity  represents  an 
(increasingly) important source of finance for SME. The financial resources and the know-how 
of  private  equity  managers  are  considered  as  important  factors  for  a  turn-around  of  the  EU 
economy in the current crisis. 

Impact on third countries 

For  AIF  that  are  domiciled  in  a  third  country  the  competent  authority  of  the  domicile  of  the 
AIFM  managing  the  respective  AIF  will  have  to  ensure  that  its  supervisory  functions  are  not 
compromised by the regulatory and supervisory framework in this country. An AIFM would not 
receive  authorisation  if  the  laws,  regulations  or  administrative  provisions  of  a  third  country 
governing one or more natural or legal persons with which the AIFM has close links (including 
the AIF) prevent the effective exercise of their supervisory functions. The AIFM and its primary 
depositary will be regulated and supervised onshore, they will be required to furnish information 
on  the  offshore  AIF  and  management  of  offshore  funds  is  only  permitted  subject  to  strict 
controls. 

AIFM of AIF domiciled in particularly uncooperative countries might therefore not be able to 
obtain  authorisation  to  manage  and  market  these  funds  in  the  EU.  This  should  ensure  that  no 
additional  risks  arise  from  the  fact  that  an  AIF  managed  by  an  EU  AIFM  but  domiciled  off-
shore poses additional risks for investors or markets.  

The  ongoing  discussions  in  the  various  international  forae  (G20,  IOSCO,  FSF,  mentioned 
above) should help to minimise the disruptive effects that might result from these provisions. It 
could  be  hoped  that  this  EU  level  initiative  will  give  these  discussions  a  further  impetus  and 
contribute to an international agreement on principles at least. 

AIFM domiciled in a third country will not be covered by the measure and will therefore not be 
able  to  market  their  AIF  or  to  provide  AIFM  services  in  the  EU  under  this  Directive  unless 
established/authorised in the EU in accordance with the proposed Directive.  

Effectiveness and enforcement 

To ensure the effectiveness of the provisions outlined above, an authorisation and supervisory 
regime has to be implemented. In order to be allowed to provide its services and to market funds 
managed by it in the EU an AIFM will have to be authorised by the competent authority in its 
domicile.  For  this  the  AIFM  will  have  to  provide  the  authority  with  relevant  documentation. 
Authorisation will only be granted if the competent authority is satisfied that the AIFM fulfils 
the conditions of this Directive. This authorisation will then be valid for all Member States.  

This  means  that  the  AIFM  will  only  have  to  notify  the  competent  authority  of  another  EU 
Member  State  in  which  it  wants  to  provide  its  services  or  market  its  AIF  to  professional 
investors.  As  a  corollary  of  the  high  common  regulatory  standard  achieved  by  the  proposed 
Directive,  Member  States  will  not  be  permitted  to  impose  additional  requirements  on  AIFM 
domiciled in another Member State insofar as marketing to professional investors is concerned. 
Member States may allow for marketing to retail investors within their territory and may apply 
additional  regulatory  safeguards  for  this  purpose.  Such  requirements  shall  not  discriminate 
according to the domicile of the AIFM. 

The competent authority may withdraw the authorisation if is not used, if false statements have 
been  made,  if  the  conditions  are  no  longer  fulfilled;  or  if  the  provisions  are  seriously  and/or 

EN 

53 

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systematically  infringed.  This  withdrawal  would  then  have  immediate  effect  in  all  Member 
States. 

Competent  authorities  would  be  given  all  supervisory  and  investigatory  powers  necessary  for 
the  exercise  of  their  functions  vis-à-vis  an  authorised  AIFM.  They  would  have  access  to 
documents and records, and have the right for on site inspections and to request information. 

In  order  to  ensure  the  secure  functioning  of  the  AIFM  sector,  competent  authorities  of  the 
Member States will be required to cooperate whenever necessary so as to achieve the aims of 
the Directive. Given the cross-border nature of risks arising in the AIFM sector, a prerequisite 
for effective macro-prudential oversight will be the timely sharing of relevant macro-prudential 
data at the European, or even global, level. The competent authorities of the home Member State 
will thus be required to transmit relevant macro-prudential data, in a suitably aggregated format, 
to public authorities in other Member States. 

Colleges  of  supervisors  could  in  principle  be  envisaged  as  well.  However,  this  idea  has  been 
disregarded  as  it  would  imply  relatively  high  costs  while  bringing  only  marginal  benefits. 
Organisational  and  distribution  patterns  of  AIFM  change  more  frequently  than  those  of,  say, 
global banks, this would require supervisors to review and reorganise colleges frequently as well 
which would involve relatively high organisational costs and would distract staff from focussing 
on the actual supervisory tasks. 

Overall, it is likely that the onus on competent authorities will increase. This will be the case in 
particular  in  the  implementation  phase  of  the  Directive  when  all  AIFM  will  have  to  request 
authorisation  and  competent  authorities  will  have  to  check  the  requests.  In  the  long-term 
additional burden might result from the higher number of AIFM to be supervised compared to 
the status quo and the additional obligations regarding supervisory cooperation. However, it can 
be assumed that most of these costs would also occur if Member States would have to step up 
their supervisory duties unilaterally to better take into account the risks that have materialised in 
the financial crisis.  

6. 

COMPARING THE OPTIONS: CONCLUSIONS 

The analysis of the different options at the various stages led to the conclusion that the preferred 
option would be an EU level Directive targeting the fund manager and key service providers as 
the  ones  taking  decisions  and  carrying  responsibility.  For  the  other  options  it  could  not  be 
ensured  that  the  objectives  set  would  be  achieved  or  achieved  in  a  timely  and  effective  way. 
Given the fragile current economic climate, doing nothing or delayed action can not be regarded 
as appropriate measures. The proposal would be based on Article 47(2) of the EC Treaty. 

Addressing  the  AIF  market  as  a  whole  when  some  of  the  problems  lie  in  particular  with  a 
limited range of fund type (e.g. leveraged funds) might not appear proportionate at first glance. 
The  above  analysis  has  shown  that  a  narrow  approach  might  lead  to  evasion  and  therefore  be 
ineffective or might not be future-proof in being flexible enough to deal with related problems 
that  might  appear  in  the  future.  The  preferred  'all  encompassing'  approach,  on  the  other  hand, 
would be flexible enough to accommodate for the specificities of different fund types and future 
developments.  

The Lamfalussy approach combined with a risk-based framework can ensure proportionality of 
the requirements with regard to the risks posed by specific activities or mechanisms, again the 
example of leverage can be used: the more leveraged a fund is the higher the reporting and other 
prudential obligations of the AIFM are.  

EN 

54 

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Furthermore, 'de minimis' clauses would be used to avoid or minimise administrative burden for 
managers of smaller funds which do not pose particular risks.55 This would also ensure that the 
administrative burden that comes along inevitably with the objective of complete and consistent 
prudential oversight does not impact adversely on other objectives of the Community like a high 
level of employment or promotion of SME.  

The intended approach would also be proportionate in the sense that it does not try to address all 
the issues that have been identified as problematic in chapter 3. Some of these issues are already 
being  addressed  by  other  initiatives  or  cannot  be  reasonably  addressed  by  an  AIFM  specific 
measure, e.g. due diligence and risk management at the prime broker or at the buy side (pension 
funds, insurances, local authorities, etc.).  

7. 

MONITORING AND EVALUATION 

The  proposed  EU  Directive  would  include  a  final  provision  stating  that  a  review  of  its 
appropriateness and effectiveness, including public consultation, should take place a few years 
after its implementation. This could cover the following issues:  

•  How  much  use  is  being  made  of  the  scheme  (how  many  AIFM  have  registered  with  the 

competent authorities in Member States)? 

•  Survey AIFM, investors and supervisors about their experience so far:  

– 

– 

– 

– 

– 

– 

Administrative burden on AIFM 

Satisfaction of investors with information they receive 

Increase in cross-border business 

Satisfaction  of  supervisors  with  information  they  receive  and  the  responsiveness  of 
AIFM 

Functioning of supervisory cooperation 

Impact on third countries.  

55 

Rough calculations on the basis of the Morningstar database showed, for example, that a de minimis rule 
of 100mn€ for hedge funds would exempt 70% of funds but would still cover about 85% of the market 
size (net assets).  

EN 

55 

   EN 

 
                                                 
AIMA:  

BVI: 
CESR:  

CIS:  

Closed-ended 
fund: 

EFAMA:  

ESC:  
ESME:  
Eurohedge: 
EVCA:  

Expert  group 
on OEREF: 
FoHF: 
IAB:  
ICI: 

INREV: 

IORP 
Directive: 
IPO: 
HNWI:  

HFR: 
Lipper/Feri: 
MiFID:  

NHF:  

Open-ended 
fund 
PD:  

PWC I: 

PWC II: 

SEC: 
SFC: 
SME: 
UCITS:  

ANNEX I: Acronyms  

Alternative Investment Management Association; trade association for Hedge Funds, Managed 
Futures and Managed Currency Funds; http://www.aima.org/ 
Bundesverband Deutscher Investment-Gesellschaften; http://www.bvi.de 
Committee  of  European  Securities  Regulators;  an  independent  body  of  regulators  from  EU 
Member  States  that  advises  the  European  Commission  on  securities  policy  issues; 
http://www.cesr.eu. 
Collective  investment  schemes;  arrangements  that  enable  investors  to  pool  their  assets  and 
have these professionally managed by an independent manager 

Investment funds with restrictions on the amount of shares the fund will issue. 

European  Funds  and  Asset  Management  Association;  European  association  of  national  fund 
associations and corporate members; http://www.efama.org/ 
European Securities Committee 
European Securities Markets Expert Group 
http://www.hedgefundintelligence.com/eh/ 
European Private Equity and Venture Capital Association; European association of the private 
equity and venture capital industry; http://www.evca.eu/ 
http://ec.europa.eu/internal_market/investment/other_docs/index_en.htm#group 

Funds of hedge funds 
Impact Assessment Board 
Investment  Company  Institute,  national  association  of  U.S.  investment  companies,  including 
mutual funds, closed-end funds, ETFs, and unit investment trusts; http://www.ici.org/ 
European  Association  for  Investors  in  Non-listed  Real  Estate  Vehicles;  representing  market 
players in the sector 
Directive  2003/41/EC  on  the  activities  and  supervision  of  institutions  for  occupational 
retirement provision 
Initial public offering 
High net worth individuals; individual investors disposing of a significant wealth to invest in 
financial assets of one million Euro or more  
Hedge fund research; https://www.hedgefundresearch.com/ 
http://www.feri-fmi.com/FERIFMI/default.aspx 
Directive  2004/39/EC  of  the  European  Parliament  and  of  the  Council  of  21  April  2004  on 
markets in financial instruments 
Non-harmonised funds; investment funds that do not benefit from the EU passport of UCITS 
because they do not comply with the provisions of the Directive  
Investment  funds  where  the  number  of  units/shares  in  issue  increases  as  more  people  invest 
and decreases as people take their money out. 
Prospectus Directive; "Directive 2003/71/EC of the European Parliament and of the Council of 
4 November 2003 on the prospectus to be published when securities are offered to the public 
or admitted to trading and amending Directive 2001/34/EC" 
Study, February 2008: "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 
Study 2008:  "The retailisation of non-harmonised  investment  funds  in  the  European Union"; 
not 
http://ec.europa.eu/internal_market/investment/other_docs/ 
published yet 
US Securities and Exchange Commission 
Hong Kong Securities and Futures Commission 
Small and medium-sized enterprises 
Undertakings for collective investment in transferable securities; EU-regulated retail investor 
funds 

index_en.htm#studies; 

EN 

56 

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

i) Main product categories  

The non-UCITS sector currently accounts for about 2.152 bn€ in assets under management. The 
main types of fund are hedge funds, real estate funds, private equity and venture capital funds, 
commodity  funds,  and  funds  of  funds  for  most  of  these  fund  categories,  e.g.  funds  of  hedge 
funds.  

Chart A1: Breakdown of non-UCITS funds within the EU, bn€, end 2007  

French 
occupational 
funds
85

UK trusts
83

Institutional funds
936

Luxembourg part 
II funds
102

Other
157

Real estate funds
199

Private equity 
funds
200

Hedge funds
390

Source: Figures provided by EFAMA, AIMA, EVCA. 
Investors in PEF: http://www.evca.eu/publicandregulatoryaffairs/default.aspx?id=86  

The  Non-UCITS  world  also  comprises  some  funds  that  invest  primarily  in  traditional  asset 
classes  (such  as  equities,  bonds  and  derivatives)  and  pursue  traditional  investment  strategies. 
Typical  examples  are  structured  funds  and  guaranteed  funds.  In  this  impact  assessment  these 
funds  are  not  considered  as  separate  fund  types  but  categorised  according  to  their  respective 
investment policies, i.e. as equity funds, bond funds, etc. Many of these funds comply with the 
UCITS  Directive.  For  those  that  do  not  comply,  it  can  be  assumed  that  they  use  investment 
strategies that are not suitable for retail investors, e.g. extended leverage, short-selling etc. They 
are, therefore, out of the scope of this impact assessment. 

EN 

57 

   EN 

 
 
 
 
The  same  holds  for  funds  which  have  been  established  under  particular  national  regimes  for 
institutional  investors,  e.g.  German  'Spezialfonds'.  These  funds  are  by  definition  not  open  to 
retail investors and have deliberately opted for this status. They are, therefore, out of the scope 
of this impact assessment. 

By contrast, alternative investments can be broadly understood as referring to investments other 
than a long position in stock or bond related holdings. The various alternative asset classes are 
very  distinct  in  terms  of  core  investment  strategy  and  markets  in  which  they  invest,  fund 
structure, investment technique (use of leverage through derivatives or borrowing) and investor 
base.  This  makes  any  attempt  to  discuss  them  as  a  single  bloc  problematic.  In  fact,  the  only 
uniting  element  is  the  non-compliance  with  the  UCITS  Directive  in  at  least  one  (and  usually 
several) significant respects.  

The following table describes the main categories of funds which comprise Europe's non-UCITS 
fund sector. 

Table A2: Main constituents of the non-UCITS/alternative investment sector  

Product name 

Real estate funds 

Private equity funds 

Hedge funds 

Fund  of  alternative 
investment funds 

Commodity funds 

Infrastructure funds 

Product characteristics 

Real  estate  funds  provide  investors  with  exposure  to  investments  in  property,  land  and  other 
property related assets. They can be both closed end (fund units cannot be regularly redeemed) 
or open ended funds (units can be regularly redeemed, as per UCITS). Property and land are not 
eligible assets for UCITS. 
Private equity funds provide investors with the opportunity to invest in non-listed companies. 
By  contrast  to  UCITS  equity  funds  private  equity  funds  are  allowed  to  actively  influence  the 
management of the company 
Hedge funds pursue absolute returns on their investments, i.e. profits both in rising and falling 
markets. They can invest in any asset classes, including asset classes ineligible for UCITS (such 
as commodities or real estate) and apply non-traditional portfolio management techniques such 
as uncovered short selling or excessive borrowing.  
Funds  of  funds  hold  a  portfolio  of  other  investment  funds  rather  than  investing  directly  in 
securities. Funds of Hedge Funds, funds of Real Estate funds or funds of private equity funds 
are the main non-UCITS funds of funds. 
Commodity funds invest in stocks or derivatives that are correlated with the prices of physical 
commodities such as oil, metals or foodstuffs or other agricultural assets. UCITS may not invest 
in physical commodities, but may gain commodity exposure through stocks or derivatives. 
Infrastructure funds are funds that invest in assets that support an economy, often in conjunction 
with,  or  acquiring  stakes  from,  local  or  central  government.  Examples  could  include 
investments  in  roads,  railways,  bridges,  ports,  airports,  power  assets,  transmission  lines, 
pipelines, or communications networks. UCITS may not acquire such illiquid assets. They can 
however invest in companies engaging in infrastructure projects. 

The following table analyses the different non-UCITS funds with reference to the five criteria. 

Table A3: Features of non-harmonised fund types 

Open ended real estate funds (OEREF) 

Business model  
Market size  
Retail suitability 

No, UCITS may not invest in real estate 
Yes, growing EU retail market in excess of 110 bn € 
Yes,  OEREF  deviate  from  certain  UCITS  investor  protection  safeguards,  but  have  equivalent 
other safeguards in place, provided that they are obliged to redeem units at least quarterly  

Proven track record   Yes,  in  Germany  OEREF  have  a  track  record  of  more  than  40  years.  OEREF  have  been 
operating in 11 other Member States since the 1990s. In Germany and the Netherlands OEREF 
experienced liquidity crises and proved to be able to cope with it. Regulatory frameworks and 
liquidity and risk management have been improved in the aftermath. The UK market seems also 
to recover from a break-down in 2007. 
Yes, retail investors in 12 Member States have shown increasing appetite in domestic OEREF, 
whereas investors in 15 Member States still have no access to OEREF 
Closed ended real estate funds (CEREF) 

Interest 
in  cross-
border distribution 

EN 

58 

   EN 

 
 
 
 
Business model  

Market size  
Retail suitability 

No, UCITS may not invest in real estate and must be open-ended. Please note, however, that, 
under certain conditions, CEREF can be distributed cross-border through the passport provided 
by the Prospectus Directive. 
About 90-100bn€ 
Partially,  e.g.  investments  in  typical  CEREF  are  usually  locked  in  for  seven  years  or  more, 
whereas the UCITS are characterised by frequent redemptions. 

Proven track record   No,  there  is no  EU  retail  market for  CEREF.  Retail  investments  in  CEREF  seem  to  be rather 

Interest 
in  cross-
border distribution 

marginal. 
N/A, there are neither clear indications for sufficient retail demand nor for interest on the supply 
side for cross-border distribution to retail investors 

Business model  

Market size  
Retail suitability 

Single hedge funds (SHF) 
No,  most  SHF  invest  in  assets  and  use  investment  strategies  which  are  not  permissible  for 
UCITS. 
No, in almost all Member States retail investors are not allowed to invest in SHF. 
No,  only  rudimentary  investor  protection  safeguards,  significantly  higher  risk  exposure, 
insufficient transparency. 

Proven track record   No, there are no retail markets for SHF 
in  cross-
Interest 
border distribution 

Partially, there is some evidence for retail investor demand for indirect exposure to SHF (e.g. 
through  substitute  products  (certificates)).  The  industry  did  not  show  any  interest  in  EU  level 
action for retail access. 

Business model  

Market size  

Retail suitability 

Funds of hedge funds (FoHF) 
No, FoHF do not comply with the fund of funds rules for UCITS since their target funds do not 
invest at least 70% of their assets in UCITS. 
Yes, FoHF have an EU market size of approximately 68 bn €; note however that less than half 
of the investors are retail investors. 
Partially, depends on the national regulatory regime. Often FoHF deviate from UCITS investor 
protection safeguards and it is hard to say whether the safeguards in place are equivalent. 

Proven track record   Partially, the FoHF market is still relatively young and untested. 

Interest 
border distribution 

in 

cross 

Business model  

Market size  
Retail suitability 

Yes, both direct and indirect investments through substitute products (e.g. certificates) indicate a 
growing retail investor demand. 

Private equity funds (PEF) 
No, UCITS may neither predominantly invest in non-listed companies nor exercise significant 
influence over the management of target companies. 
No, there is currently no significant retail market for PEF. 
No,  the  investor  protection  standard  of  PEF  is  not  comparable  with  that  of  UCITS,  e.g.  high 
exposure to few companies, illiquidity of assets (due to the lack of a listing, no or very limited 
redemptions), partly because PEF have not been designed for retail investors. 

Proven track record   No, no track record as a retail product. 
Interest 
border distribution 

No, there are neither clear indications for sufficient retail demand nor for interest on the supply 
side for cross-border distribution to retail investors 

cross 

in 

Business model  

Commodity funds 
No,  UCITS  may  not  directly  invest  in  commodities.  However,  UCITS  may  indirectly  invest 
through shares in commodity companies or derivatives. 
No, no retail market for commodity funds yet. 
No, such funds are significantly more volatile and more difficult to value than retail funds. 

Market size  
Retail suitability 
Proven track record   No, this type of fund has only evolved recently.  
Interest 
border distribution 

cross 

in 

No,  there  is neither  clear  indication for  sufficient  retail  demand nor for  interest on  the supply 
side for cross-border distribution to retail investors. 

Infrastructure fund 

No, UCITS may not invest in infrastructure projects/real estate rights. 
N/A 
No, these funds are very illiquid, difficult to value and less diversified than UCITS funds. 

Business model  
Market size  
Retail suitability 
Proven track record   No, this type of fund has only evolved recently. 
Interest 
border distribution 

No,  there  is neither  clear  indication for  sufficient  retail  demand nor for  interest on  the supply 
side for cross-border distribution to retail investors. 

cross 

in 

EN 

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ANNEX III: European Private Equity activity in 2007 

 Table 1: 

Private equity funds raised by country of 
management 2007

other 11 
EU MS 
20%

NL 4%

SE 6%

DE 7%

FR 9%

 Source: EVCA 

 Table 2: 

UK 54%

Investments by location of private equity firm 2007

other 13 
EU MS 
14%

NL 5%

SE 6%

DE 10%

FR 17%

Source: EVCA 

UK 48%

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ANNEX IV: Key UCITS investor protection safeguards 

The following table shows a summary of the key investor protection safeguards which are put in 
place for UCITS funds when offered to the public: 

Criteria established in the UCITS Directive to ensure retail investor protection 

Authorisation and supervision of the fund 
• 

In  order  to  be  authorised  the  fund  has  to  meet  all 
requirements which ensure, inter alia, a high level of 
investor protection 

•  Supervision  ensures  that  the  fund  meets  these 

requirements on a continual basis 
Fund structure and redemption policy 
•  open-ended structure, i.e. investors may continually 
locked-up 

buy  and  sell  units  without  being 
excessively 

•  unlimited  duration,  i.e.  investments  in  asset  classes 
with  long-term  investment  focus  (e.g.  real  estate 
funds) is possible 

The fund unit price 
•  corresponds  with 

• 

the  net  asset  value  of  all 
underlying  assets.  This  ensures  that  investors  can 
buy and sell the fund at its fair value 
the  net  asset  value  has  to  be  calculated  and 
published  whenever  investors  buy  and  sell  units. 
Only then can investors rely on buying or selling the 
fund at its current value 

The assets the fund may invest in  
have to be sufficiently liquid, i.e. the fund must be able 
to sell the assets within relatively short notice, notably 
in  order  to  be  able  to  satisfy  redemption  requests  by 
investors 
can be valued at any time; this is indispensable in order 
to allow the fund to calculate its net asset value  
High level of disclosure obligations  
• 

to enable investors to make an informed investment 
decision  the  fund  must  offer  them  free  of  charge  a 
disclosure document (usually a full prospectus and a 
simplified  prospectus;  the  latter  summarises  the 
main characteristics of the fund) 

• 

• 

Investment policy/risk management 

• 
•  diversification  of  the  portfolio  reduces  the  fund's 
exposure  to  risks  inherent  to  each  single  underlying 
asset56 
the fund may not exceed a threshold for investing in 
assed of the same issuer in order to reduce the issuer 
risk (e.g. the insolvency risk) 
the  fund  does  not  have  to  invest  all  money  into 
assets, but may hold ancillary liquidity which allows 
it to satisfy redemption requests by investors 
the fund may only invest directly into assets to avoid 
in transparent structures  
restricted  use  of  derivatives  to  reduce  the  risk  of 
losses  
in  principle  no  borrowing  is  allowed  to  reduce  the 
risk of losses  

• 

• 

• 

•  no assets can be sold which the fund does not own to 

reduce the risk of losses 

•  Depositary 
•  Funds  usually  have  to  entrust  their  assets  to  a 
depositary  (i.e.  credit  institution)  in  order  to  ensure 
that  they  are  ring-fenced  against  the  insolvency  risk 
of the fund or its management company 
the  depositary  checks  whether  the  fund  complies 
with  the  laws  and  the  fund  rules  and  protects  the 
interests of investors 

• 

•  The fund's management company57  
•  needs to be duly authorised  
•  must  have  sound  administrative  and  accounting 

procedures 

•  conflicts of interest must be minimised 
•  capital requirements ensure that it is financial sound 

and capable of performing its tasks 
•  Specific rules for funds of funds (FoFs) 
•  FoFs  may  only  invest  in  target  funds  which  are 

In  addition  the  fund  must  publish  on  an  ongoing  basis 
an  annual  (and  usually  also  a  half-annual)  report 
certified  by  an  auditor  which  inter  alia  contains  a 
statement  of  assets  and  liabilities  as  well  as  of  income 
and costs 
Source: European Commission services own summary, not exhaustive, not legally binding. 

least five target funds 

authorised and subject to ongoing supervision 

•  FoFs must diversify their portfolio by investing in at 

56 

57 

For  instance,  if  a  real  estate  fund  invested  only  in  one  property  (e.g.  a  hotel),  it  would  be  completely 
dependent on the fate of that property and its tenant(s). In case the tenant terminates the lease contract or 
gets  bankrupt  and  no  new  tenant  willing  to  pay  an  adequate  rental  price  can  be  found,  the  fund's  value 
would  significantly  decrease.  Such  risks  can  be  significantly  reduced  by  investing  in  many  properties 
having different tenants. 
Except for self-managed investment companies. 

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ANNEX V: Qualified Investor vs Professional Client vs Eligible counterparty 

Qualified Investor 
(Prospectus Directive58, Article 
2(1)(e)) 

Professional Client 
(MiFID59, Annex II, Section I) 

Eligible Counterparty 

(MiFID, Article 24(2)) 

Includes entities carrying out 
characteristic activities authorised or 
regulated by a non-Member State 

May include third country entities 
equivalent to those mentioned 

Credit institutions 

Investment firms 

Insurance companies 

Pension funds and their management companies 

Central banks 

National governments  

Other authorised or regulated financial institutions 

Regulated collective investment schemes  
and their management companies 

UCITS 
companies 

and 

their  management 

Commodity and commodity derivatives dealers 

Locals 

Undertakings exempted from MiFID 
under Article 2(1)(l)60 

Public bodies which deal with/manage debt 

Regional governments 

International and supranational institutions 
 e.g. IMF, ECB, EIB 

Large undertakings 

Supranational organisations 

Other regulated institutional investors  

Legal  entities  not  authorised  or 
regulated 
the 
to  operate 
financial  markets  whose  corporate 
purpose  is  solely  to  invest  in 
securities 

in 

Other  institutional  investors  whose 
main  activity  is  to  invest  in  financial 
instruments, 
entities 
dedicated 
the  securitisation  of 
assets or other financing transactions 

including 

to 

58 
59 
60 

Directive 2003/71/EC of the European Parliament and of the Council of 4 November 2003. 
Directive 2004/39/EC of the European Parliament and of the Council of 21st April 2004. 
Firms  which  provide  investment  services  and/or  perform  investment  activities  consisting  exclusively  in 
dealing on own account on markets in financial futures or options or other derivatives and on cash markets 
for the sole purpose of hedging positions on derivatives markets or which deal for the accounts of other 
members of those markets or make prices for them and which are guaranteed by clearing members of the 
same markets, where responsibility for ensuring the performance of contracts entered into by such firms is 
assumed by clearing members of the same markets. 

EN 

62 

   EN 

 
 
 
 
 
 
 
 
 
                                                 
Opted-up eligible counterparty 
(Implementing Directive MiFID62, 
Article 50) 

For professional investors only. 

Opted-up qualified investors 

Opted-up professional clients61 

(Prospectus Directive, Articles 
2(1)(e)(iv) and (v) 

(MiFID, Annex II, Section II) 

medium-sized 

Small 
enterprises63 

and 

Natural persons65  

Investors  who  meet 
certain 
specified  criteria  relating  to  the 
possession  of  adequate  expertise, 
experience and knowledge to make 
their own investment decisions and 
to understand the risks involved in 
relation 
transactions  or 
to 
services envisaged. 
Criteria66: 

the 

-  the  investor  has  carried  out 
transactions  of  a  significant  size 
securities  markets  at  an 
on 
average  frequency  of,  at  least,  10 
per quarter over the previous four 
quarters; 

the 

size  of 

investor's 
- 
securities  portfolio  exceeds  EUR 
0.5 million; 

the 

- the investor works or has worked 
at  least  one  year  in  the  financial 
sector  in  a  professional  position 
which 
requires  knowledge  of 
securities investment. 

Clients  other  than  the  ones  listed 
above (including public sector bodies 
and private individual investors) who 
meet specified criteria and have been 
assessed  as  possessing  adequate 
expertise,  experience  and  knowledge 
to  make 
investment 
their  own 
decisions  and  to  understand  the  risks 
involved 
the 
transactions or services envisaged 
Criteria64: 

relation 

to 

in 

-  the  client  has  carried  transactions, 
in  a  significant  size,  on  the  relevant 
market at an average frequency of 10 
per  quarter  over  the  previous  four 
quarters; 

-  the  size  of  the  client's  financial 
instrument  portfolio,  defined  as 
including cash deposits and financial 
instruments, exceeds EUR 500 000; 

-  the  client  works  or  has  worked  in 
the  financial  sector  for  at  least  one 
year in a professional position, which 
the 
knowledge 
requires 
transactions or service envisaged. 

of 

61 

62 
63 
64 
65 
66 

Client  can  opt-up  in  a  general  manner  or  in  respect  of  a  particular  investment  service  or  transaction,  or 
type of transaction or product. 
Commission Directive 2006/73/EC of 10th August 2006. 
If provided for under national law (option left to Member States, subject to mutual recognition). 
Two of these criteria should be satisfied to opt for the "professional investor" status. 
If provided for under national law (option left to Member States, subject to mutual recognition). 
Two of these criteria should be satisfied to opt for "qualified investor" status. 

EN 

63 

   EN 

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

VI.1 Macro-prudential (systemic) risks 

The experience of recent years requires reviewing the common understanding prior to the crisis 
that investment funds are traditionally not to be considered as systemically relevant. The lessons 
learnt  from  the  LTCM  collapse  focused  on  prudential  rules  placed  on  prime  brokers  and 
sufficient collateralization of their lending to hedge funds. As a consequence, a failure of funds 
was  supposed  to  be  confined  to  investors  and  not  to  spill  over  to  other  financial  institutions. 
However, there are two channels through which AIF/M can transmit systemic risks – the credit 
channel and the market channel. 

Systemic risks of non-harmonised funds may crystallise through two broad channels: 

 'Credit  channel':  exposures  to  funds  are  an  important  source  of  counterparty  risk  for  the  providers  of 
leverage,  namely  the  prime  brokers.  These  exposures  are  subject  to  prudential  rules  and  are  typically 
fully collateralised. However, risk management failures are possible, particularly if a fund borrows from 
multiple prime brokers and hence individual lenders may not have a global picture of a fund's leverage.  

 'Market  channel':  as  large  players  in  markets  for  many  financial  assets,  leveraged  funds  have  the 
potential to move markets, in particular in the event of the herding of positions in common trades. This is 
of  particular  concern  in  stressed  conditions,  where  the  disorderly  unwinding  of  large,  similar  positions 
may fuel the collapse of asset prices and market illiquidity. This was seen in the recent financial crisis, 
where  a  vicious  spiral  was  created:  falling  asset  prices  caused  prime  brokers  to  tighten  lending 
conditions, forcing leveraged funds to sell assets, which in turn pushed prices down further. 

In both cases, the risk is a function of the degree of leverage employed, since this will amplify the scale 
of  both  returns  and  losses.  Within  the  universe  of  institutional  funds,  the  use  of  leverage  varies  vary 
considerably  and  is  on  average  considerably  less  than  in  some  other  financial  sectors.  Since  the 
beginning  of  the  crisis  many  funds  that  initially  had  a  high  leverage  ratio  have  been  forced  by  market 
conditions to reduce it in various ways.  

Credit channel 

Since many funds have recently employed leveraged investment strategies the systemic risk can 
materialize  due  to  credit  exposure  ('credit  channel')  of  the  systemically  important  financial 
institutions.  If  these  strategies  fail,  there  is  a  risk  that  the  fund  will  not  be  able  to  reimburse 
creditors/investors.  To  the  extent  that  systemically  relevant  counterparties  encounter  difficulty 
because of large exposures to investment funds, failure of one or more investment funds could 
indirectly threaten financial stability. Close links between hedge funds and private equity funds 
and banks, insurance companies and pension funds combined with leverage can create systemic 
risks  in  the  form  of  domino  effects.  This  risk  would  seem  to  be  greatest  for  the  prime  broker 
banks which have been heavily committed to supporting hedge funds (through lending of cash 
and securities), and banks which have extended credit lines to private equity owned companies.  

The  crisis  has  highlighted  important  parallels  and  similarities  between  the  different  types  of 
investment funds (substitution effects between equity funds, money market funds, deposits etc), 
and  their  strong  interdependencies  with  the  wider  financial  system.  These  linkages  need  to  be 
taken  into  account  by  macro-prudential  policy  if  the  latter  is  to  be  effective  in  achieving 
financial stability. Having said that, the different fund types can be broadly differentiated on the 
basis of their investment techniques and assets. With regard to systemic risk the use of leverage 
is of particular importance. As leverage is most extensively (but not exclusively) used by hedge 
funds, these funds are in the focus of this sub-section. 

Hedge funds were particularly active in markets for innovative instruments – e.g. over 30% of 
credit  default  swaps  (CDS)  were  bought  by  hedge  funds.  Hedge  funds  might  have  played  a 

EN 

64 

   EN 

 
particularly pro-cyclical role: as such funds aggregate positions that are a multiple of underlying 
assets,  they  must  close  a  larger  number  of  positions  when  assets  (whether  equity  capital  or 
borrowing)  decrease.  Similar  effects  may  have  operated  on  other  funds  employing  leveraged 
investment  strategies.  The  pronounced  tightening  of  credit  by  banks  and  prime  brokers  might 
have had an impact on the sector by forcing leveraged funds to sell assets to return cash.   

Funds  of  funds  have  helped  to  propagate  risk  from  one  impacted  fund  to  wider  set  of 
funds/investors.  The  capacity  of  funds  of  funds  to  spread  financial  damage  across  a  wider 
segment  of  the  market  has  been  underlined  by  the  Madoff  scandal:  a  much  larger  number  of 
funds  were  affected  indirectly  than  directly  (through  their  investments  in  the  four  directly 
impacted funds whose assets were entrusted to Madoff). 

Leverage 

One of the key features of many AIF strategies is worth highlighting at this stage. A common feature of 
many types of AIFs is the use of leverage. This typically occurs when investments are partly financed by 
credits from banks or other financial institutions in addition to the equity of the fund. Leverage can also 
be  achieved  in  other  ways,  for  example  through  the  use  of  derivative  products.  Such  products  contain 
embedded leverage, which means that the exposure of the investor to profits and losses is greater than the 
variation  in  the  value  of  the  underlying  asset.  The  use  of  derivatives  can  thus  increase  volatility 
considerably and result in very complex effects on the value of an asset. 

The  use  of  leverage  increases  the  volatility  of  an  investment  and  is  used  in  the  hope  of  amplifying 
investment  returns.  However,  it  also  increases  the  risk  of  major  losses  for  AIFs  and  of  counterparty 
default  for  the  providers  of  leverage.  Leverage  also  introduces  an  additional  systemic  vulnerability, 
namely  the  impact  of  involuntary  deleveraging.  Under  pressure  from  lenders  and  investors,  leveraged 
AIFs  may  be  forced  to  sell  off  assets  rapidly,  with  a  consequent  impact  on  asset  prices  and  market 
liquidity.  The  impact  of  deleveraging  is  likely  to  be  greater  if  AIFs  are  forced  to  exit  from  similar 
positions (‘crowded trades’) simultaneously. 

Observed levels of leverage in the AIF sector increased dramatically in stressed conditions as a result of 
the collapse in the value of an AIF's assets. This was the case at the time of the near-collapse of LTCM in 
1998. Steady-state leverage levels in the AIF sector are however much lower and have fallen in recent 
months as a result of tighter credit conditions.  

However,  leverage  remains  an  integral  part  of  the  investment  strategies  of  certain  types  of  AIF,  in 
particular hedge funds. The use of extensive leverage is typically associated with the hedge fund sector, 
particularly  those  employing  arbitrage  strategies.  However,  most  AIFs  have  access  to  leverage  and  as 
such the risk concerns are not limited to the hedge fund sector. An risk assessment limited to the hedge 
fund sector – however defined – would be too narrow. 

The  use  of  leverage  is  by  no  means  confined  to  the  AIF  sector;  in  recent  times,  observed  levels  of 
leverage in other parts of the financial system have been much higher. 

EN 

65 

   EN 

 
Chart VI.1: Hedge fund leverage  

ECB, Financial Stability Review, December 2008 

Chart VI.2: Estimated hedge fund leverage measures  

Market channel 

The  systemic  impact  of  investment  funds  –  especially  alternative  investments  –  need 
increasingly to be viewed from another angle: their contribution to driving market momentum or 

EN 

66 

   EN 

 
 
 
fuelling asset bubbles/deflation. During the bubble phase, the increasing asset prices increase the 
value  of  collateral  and  allow  AIF  to  obtain  more  leverage.  The  new  credit  fuels  demand  for 
assets which pushes asset prices further up. There has been some tendency towards crowding of 
investment fund trading in certain markets and instruments. Coupled with a market sentiment, 
this can create a situation where price momentum is self-fuelling, until sentiment turns in which 
case funds can lead a 'stampede for the exit'. The mechanics works in reverse during the phase 
of  deflation  as  illustrated  in  the  chart  below.  This  amplifies  the  pro-cyclical  behaviour  of  the 
financial system.  

In addition, the burst of the asset price bubble is usually accompanied by tightening of the credit 
conditions which reinforce the process of deleveraging. The abrupt unwinding of positions can 
cause  market  disruptions  -  the  asset  prices  collapse  and  market  liquidity  disappears  suddenly. 
This has serious impacts on other market participants. 

Turmoil in credit markets deepened in early March [2008], setting the stage for the pronounced 
shift  in  market  sentiment  later  during  the  period.  Pressures  on  bank  balance  sheets  had  been 
accumulating  throughout  the  crisis,  but  further  intensified  early  in  the  month.  As  banks 
continued to cut their exposures across business lines, tightening repo haircuts (Chart VI.1-A.3) 
caused a number of hedge funds and other leveraged investors to unwind existing positions. As 
a result, concerns about a cascade of margin calls and forced asset sales accelerated the ongoing 
investor  withdrawal  from  various  financial  markets.  In  the  process,  spreads  on  even  the  most 
highly  rated  assets  reached  unusually  wide  levels,  with  market  liquidity  disappearing  across 
most fixed income markets. This included assets, such as certain US student loan securitisations, 
whose  underlying  exposures  are  almost  entirely  protected  by  federal  guarantees,  as  well  as 
mortgage-backed  securities  underwritten  by  US  government-sponsored  enterprises.  (BIS 
Quarterly Review, June 2008) 

Mutual contagion through the market channel: banks and hedge funds

Recapitalisation /
Reduction of the 
banlance sheet

Bank Deleve raging

Weaker balance sheet /
Reintermediation

Risk premium increase /
Volatility increase

Mark-to-Market 
contagion

Asset sell-off

Hedge Fund Deleveraging

Prime Broker 
Margin Calls 

Source: Banque de France

EN 

67 

   EN 

 
 
 
Chart VI3: Tightening of repo 'haircuts' is illustrated in the following table: 

Source: IMF Global Financial Stability Report (October 2008) 

It has been very hard to put together a complete picture of fund positions in key markets over 
recent years. However, there are reasons to believe that funds – and hedge funds in particular – 
have  been  an  important  contributor  to  asset  prices  dynamics  in  a  number  of  financial  (and 
possibly even non-financial)67 asset markets. AIF may play a greater role in this respect due to 
their specific investment techniques (e.g. intensive use of leverage; trading size, short-selling), 
their  dominant  role  in  many  financial  markets  (complex  products)  and  their  role  as  (one  of) 
active traders.68 Hedge funds have been leading traders in complex products, notably sub-prime 
mortgages, and structured instruments (CDOs, CDS) that were arguably the root of the crisis.  

Herding behaviour 

Many  investors,  including  fund  managers  seem  to  have  bought  funds  and  other  investment 
products  (that  might  have  used  funds  as  underlying)  that  they  did  not  understand  properly. 
Institutional investors, in particular, seem to have neglected due diligence and followed general 
trends instead - "herding". Trust in counterparties, products and external ratings had replaced 
proper  own  assessments.  A  lack  of  understanding  of  the  complexity  of  structured  financial 
products and market  developments  may have hindered  an  early  detection  of  the  developments 
that  led  to  the  crisis  and  a  better  protection  of  the  EU  markets  from  the  consequences  of  the 
crisis.  

The  similarity  of  hedge  fund  investment  exposures  and  the  associated  risk  of  an  abrupt 
collective  exit  from  crowded  trades  can  be  estimated  by  using  correlations  across  individual 
hedge fund returns within various hedge fund investment strategies. The moving median pair-

67  

68  

In commodity markets, the role of financial arbitrageurs or traders cannot lead to a fundamental deviation 
from  the  equilibrium  price  derived  from  supply  and  demand.  However,  it  can  lead  to  short-term  price 
spikes. 
Hedge funds are frequent traders accounting for half of the trading volume. 

EN 

68 

   EN 

 
 
                                                 
wise correlation coefficients of some of the more popular investment strategies shown in Chart 
VI.1-A.4 increased, not least because of funding liquidity pressures resulting from cuts in bank 
financing and investors’ withdrawals and the fact that broad-based and often correlated changes 
in  various  asset  prices  made  differences  across  hedge  funds’  investment  portfolios  less 
relevant.69 

Chart VI.4: Medians of pair-wise correlation coefficients of monthly global hedge fund returns within 
strategies70 

However, problems were not confined to hedge funds or leveraged funds: some money market 
funds – traditionally a fail-safe and ultra-liquid asset class became over-exposed to asset backed 
securities and encountered liquidity and valuation problems when these markets dried up. Their 
systemic  relevance  also  deserves  some  particular  consideration.  Money  market  funds  play  an 
important role in maturity transformation in financial markets – buying bank and corporate debt 
or securities with slightly  longer maturities (up to one year) in return for cash. Money market 
funds  have  grown  to  become  an  important  alternative  source  of  liquidity  for  financial  and 
corporate  borrowers  and  a  mainstay  of  commercial  paper  and  short  term  bank  paper  markets. 
They  are  also  widely  regarded  as  a  liquid  investment  vehicle  for  corporate  treasury 
management.  The  sudden  contraction  of  liquidity  in  markets  for  commercial  and  bank  paper 
meant  that  these  funds  could  no  longer  sell  their  assets  to  meet  cash  demands  from  their 
investors.  Money  market  funds  could  no  longer  play  their  role  of  liquidity  provider  and  even 
struggled  to  meet  redemption  demands  from  investors.  This  exacerbated  the  existing  liquidity 
tensions in money markets.  

69 ECB, Financial stability review, December 2008 
70 ibid 

EN 

69 

   EN 

 
 
 
                                                 
Failure  of  some  big  money  market  funds  could  have  triggered  very  serious  effects  for  many 
parts of the economy that make heavy use of these funds: many companies of the 'real economy' 
as  well  as  financial  institutions  such  as  banks,  insurances  or  pension  funds.  There  is  a 
considerable risk that failure of the money market fund sector could result in illiquidity of many 
of these investors.  

Box: Oil markets and role of speculators and financial investors 
Gilbert  (2007)  observes  that  "when  markets  become  tight,  inelastic  supply  and  demand  make  prices 
somewhat arbitrary, at least in the short term. There will always be a market clearing price but its level 
may depend on incidental and not fundamental features of the market"71 
Till (2008) tries to assert that there were plausible incidental factors behind the 2008 rally in oil prices: 
spike in diesel imports by China in advance of the Beijing Olympics, purchases of light sweet crude by 
the US Department of Energy for the Strategic Petroleum Reserve, instability in Nigeria,  and tightening 
environmental standards in Europe.72 However, the author acknowledges that in the short term it is very 
plausible for the actions of traders to influence the price of a commodity, especially one that is exhibiting 
scarcity. The author also provides several examples of periods of financial de-risking and deleveraging 
where both the equity market and the commodities (except gold) behaved as one market. The theme of 
commodity investment as a store-of-value is also elaborated. 
IMF  Global  Financial  Stability  Report,  October  2008,  addresses  the  possible  causal  relationships 
between  increased  financial  market  participation  and  commodity  prices.  The  analysis  finds  there  is 
correlation  between  prices  and  positions  in  some  commodities  markets.  However,  the  analysis  was 
unable to detect causality from financial positions to prices for major commodities used in the study. 

Chart VI.5: NYMEX Crude Oil Front Month 

71  Gilbert,  C.,  2007,  "Commodity  Speculation  and  Commodity  Investments",  University  of  Trento  and  Birkbeck 

College. 

72 Till, H., October 2008, The Oil Markets: Let the Data Speak for Itself, EHDEC Business School 

EN 

70 

   EN 

 
 
                                                 
Chart VI.6: Investment in commodity indexes: store of value and inflationary hedge 
Investment into commodity indexes73 

E/$ vs. Crude Oil (in $) (17/8//06 to 2/5//08)74 

Source: Heap and Tonks (2008), "Great Bulks of Fire 
IV", Citigroup Global Markets Equity Research, April 
7. 

VI. 2 Micro-prudential risks 

Market risks - the risk of adverse movement in interest rates, exchange rates, and the prices of equities 
and commodities. 

Credit risks - the risk of loss caused by a counterparty or debtor's failure to make a promised payment 
(default  risk);  settlement  risk  –  risk  of  payment  to  a  counterparty  to  settle  a  transaction  (eg.  while  the 
counterparty  is  declaring  bankruptcy  or  loss  of  assets  posted  as  collateral  and  then  re-used  (re-
hypothecated) by broker who then declares bankruptcy). 

Liquidity risks - 

-  funding  liquidity  risk:  the  risk  that  liabilities  funding  long  asset  positions  cannot  be  rolled  over  at 
reasonable costs (i.e. the issue is the liquidity  (maturity) mismatches between  assets and liabilities and 
availability of cash) 

- market liquidity risk: risk that a financial instrument cannot be purchased or sold without a significant 
concession  in  price  because  of  the  market's  potential  inability  to  efficiently  accommodate  the  desired 
trading size. 

Operational risks – risk of loss from failures in a company's systems and procedures or from external 
events. 

The  financial  crisis  has  exposed  weaknesses  in  risk  management  and  control  throughout  the 
financial  system,  in  particular  with  regard  to  the  management  of  funding  liquidity  risks.  The 
institutional fund sector is no exception. The quality of the internal risk management processes 
of institutional funds is of concern both to their investors and – to the extent that they grow to 
become of systemic relevance – to the financial system at large. It is vital that the robustness of 
internal risk controls is commensurate with the role that (in particular, leveraged) funds play in 
the financial system and the complexity of the investment strategies they employ. Institutional 
fund management companies typically hold capital to allow for an orderly winding down of the 
company in the event of bankruptcy. However, investor funds are not retained as capital against 
losses in the investment portfolio. A proper risk management is also crucial for the timeliness 
and reliability of reporting to supervisors and investors. Both need reliable information on the 
risks the fund and the management company are taking to be able to get a complete picture of 
the risks and the risk-adjusted return profile of the fund. 

73 ibid 
74 ibid 

EN 

71 

   EN 

 
 
                                                 
The  curtailed  availability  of  leverage  may  not  always  have  implied  lower  counterparty  credit 
risk  for  banks  since  net  flows  from  investors  and  the  investment  performance  of  many  hedge 
funds continued to suffer amid turbulent conditions in the global financial markets and is likely 
to  lead  to  a  higher  liquidation  rate  in  the  period  ahead.  As  shown  in  Chart  VI.2-A.1,  the 
estimated  total  net  asset  value  (NAV)  and  the  proportion  of  single-manager  hedge  funds 
breaching typical triggers of total cumulative NAV decline have increased markedly. Triggers of 
total  NAV  cumulative  decline  represent  contractual  termination  events  which  allow  banks  to 
terminate transactions with a hedge fund and seize the collateral held.75 

Chart  VI.7:  Estimated  total  net  asset  value  (NAV)  and  proportion  of  hedge  funds  breaching  triggers  of 
cumulative total NAV decline76 

After  the  problems  encountered  by  several  large  US  prime  brokers,  hedge  funds  and  other 
institutional investors, particularly the larger ones, are reportedly paying increasing attention to 
the  safety  of  the  funds  and  securities  kept  with  prime  brokers,  and  are  thus  asking  for  the 
segregation of those assets. This reduces the ability of banks to recycle hedge funds’ assets for 
their  own  purposes.  Moreover,  in  the  wake  of  recent  events,  more  hedge  funds  are  likely  to 
establish additional dealing relationships, possibly favouring banks with stronger balance sheets. 
More generally, this highlights another dimension  of  counterparty risk, which is related to the 
willingness  of  counterparties  to  transact  and  can  prove  crucial  for  the  destiny  of  a  strained 
financial institution. As highlighted by recent events, even good collateral may not be sufficient 

75 ECB, Financial stability review, December 2008 
76  

ibid 

EN 

72 

   EN 

 
 
                                                 
to obtain funding if the counterparty is concerned that it will need to liquidate posted collateral 
in potentially far less liquid markets.77 

Settlement risk associated with short selling transactions 
Uncovered  (naked)  short  selling78,  where  an  investor  has  not  confirmed  the  availability  of  a 
stock to borrow, may lead the investor to fail to deliver the stock on its settlement date. Short-
selling may be accompanied by a parallel stock-borrowing transaction. This provides the short-
seller  with  some  additional  assurance  that  he/she  can  source  the  asset  needed  to  meet  its 
settlement obligation at the agreed date, on the agreed terms. 

Fails to deliver are disruptive to a fund’s trading program because they interfere with a fund’s 
risk  management  calculation  and  introduce  another  layer  of  uncertainty—the  risk  of  a  trade 
being  cancelled  by  the  clearing  broker.  In  addition,  a  fund  is  likely  to  face  significant 
operational  difficulties  when  there  is  a  failure  to  deliver  a  security,  including  a  potentially 
lengthy trade reconciliation process, the task of updating its books and records, the impairment 
of voting rights, friction  with its prime broker and the uncertainty and risk  of a costly buy-in. 
Funds that conduct algorithmic trading strategies may place thousands of orders to buy and sell 
various  stocks.  It  would  be  very  costly  and  operationally  burdensome  for  such  a  fund  to 
reconcile its trades and update its books and records, among other things, if its clearing broker 
cancels trades, so these firms have a strong incentive to locate the stocks they intend to borrow 
in advance of any short sale. (MFA, Response to Commission consultation on hedge funds) 

For  example  in  the  United  States,  under  Reg  SHO  of  the  SEC,  a  broker-dealer,  prior  to 
accepting  a  short  sale  order,  must  “locate”  securities  available  for  borrowing.  Rule  203(b)  of 
Reg SHO prohibits a broker-dealer from accepting a short sale order in any equity security from 
another  person,  or  effecting  a  short  sale  order  for  the  broker-dealer's  own  account  unless  the 
broker-dealer  has:  (1)  borrowed  the  security,  or  entered  into  an  arrangement  to  borrow  the 
security; or (2) has reasonable grounds to believe that the security can be borrowed so that it can 
be delivered on the date delivery is due. 

 VI. 3  Investor protection and fund governance 

Institutional  funds  are  marketed  predominantly  to  sophisticated,  professional  investors.  This 
investor base has grown in recent times, as so-called 'alternative' investments have become more 
mainstream. Exposures to hedge funds and private equity, for instance, are now commonplace in 
the investment portfolios of pension funds, insurance companies and some public authorities. 

It  is  commonly  assumed  that  these  investors  have  the  capacity  to  understand  and  to  bear  the 
risks  that  their  investments  entail.  The  experience  of  the  financial  crisis  is  a  challenge  to  this 
assumption.  The  manifest  failure  of  due  diligence  in  some  cases  has  fuelled  doubt  over  the 
transparency of some investment vehicles vis-à-vis their investors, as well as the capacity and 
willingness of investors to process the information and to react accordingly. 

Disclosure 

Regardless of their market standing, all investors require information on the nature and the risks 
of  the  investment  into  which  they  are  entering.  The  appropriate  content  and  form  of  this 

77  
78  

ECB, Financial stability review, December 2008 
The IOSCO Technical Committee on short selling describes “naked” short selling as broadly referring to 
situations where the seller does not own the stock he is selling and has made no provision, [at the point of 
sale], to borrow or otherwise for delivery of stock to the purchaser by settlement date. 

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information  will  vary  according  to  the  degree  of  sophistication  of  the  investor.  In  the  case  of 
public offerings, pre-contractual disclosures are typically highly regulated.79  

When  banks,  investment  firms  or  other  intermediaries  distribute  funds,  they  are  subject  to  the 
existing  MiFID  rules  concerning  the  provision  of  investment  services  (such  as  information 
requirements  and,  where  required,  appropriateness  or  suitability  assessment  depending  on  the 
service  provided).  However,  these  disciplines  apply  primarily  to  distribution  to  less 
sophisticated investors. 

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.80  However,  in  the  course  of  the  current  crisis  concerns  mounted  that 
professional investors did not apply sufficient due diligence and did have sufficient information 
to properly assess and manage their investments but either relied on external ratings or trusted 
and followed the trend.81 A potential reason for this might be that investors did not get sufficient 
information from the fund managers and did not have sufficient bargaining power to force them 
to provide it. The logical consequence, namely to exit the fund, however, might be understood 
as  a  sign  of  weakness  or  incompetence  while  staying  in  the  fund  did  not  raise  any  doubt  and 
seemed  to  be  of  low  risk  –  other  investors  would  certainly  apply  due  diligence  and  thereby 
ensure proper management of the fund. 

Conflict of interest and fund governance: Valuation, administration and delegation 

The  relative  opacity  of  many  institutional  fund  structures  and  the  absence  of  a  prescriptive 
regulatory framework raise concerns over the oversight of internal processes. Fair treatment of 
the  investor  requires  that  processes  such  as  valuation  and  administration  are  conducted 
prudently  and  fairly;  and  that  any  conflicts  of  interest  are  managed  effectively.  Investors  also 
rely on fund managers to ensure that their assets are held safely in custody. 

The valuation of complex assets has proved to be problematic in stressed conditions when many 
asset  markets  become  illiquid.  However,  even  in  benign  market  conditions,  the  valuation 
process  can  be  beset  by  conflicts  of  interest,  in  particular  when  the  remuneration  of  the  fund 
manager is driven  by  the  performance of the fund.  This  may  create  an  incentive to inflate the 
value  of  the  fund's  assets.  This  is  a  particular  risk  when  assets  are  hard-to-value  and/or 
infrequently traded, since the valuations are then difficult to verify. An element of independence 
in the valuation function is therefore desirable. 

Non-harmonised funds are often by their nature less liquid than retail funds. Investor funds are 
locked in for relatively long periods to allow the fund to take advantage of the premium on less 
liquid investments, such as property and lightly (or non-) traded financial assets. The financial 
crisis  has  seen  many  hedge  funds  but  also  real  estate  and  money  market  funds  suspending 
redemptions. Surprising fund closures or adjustments to valuation can produce dramatic effects 
not  only  for  the  fund  concerned  but  also  for  other  funds  in  that  category  if  investors  start  to 
mistrust them and try to withdraw their money on short notice. 

79  
80  

81  

At EU level, the Prospectus Directive 2001/34/EC applies. 
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. 
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 

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VI. 4  Market efficiency and integrity  

It  is  commonly  held  that,  in  normal  market  conditions,  rapid  trading  and  the  diversity  and 
relatively unconstrained nature of hedge fund strategies help to boost market liquidity; and the 
recourse by many hedge funds to short-selling techniques may help to correct the prices of over-
valued securities. 

However, experience in the recent stressed market conditions has raised a number of concerns 
about the impact of funds, particularly hedge funds, on the efficiency and integrity of financial 
markets.  

Some  of  these  concerns  have  crystallised  around  the  issue  of  short-selling,  an  investment 
technique heavily, but not exclusively, used by hedge funds. Short-selling is widely recognised 
as a legitimate hedging or trading technique and is central to the risk management processes of 
many market participants. However, recent fears that short-selling could drive the stock price of 
systemically  relevant  financial  institutions  to  exaggeratedly  low  levels  and  thereby  undermine 
their  viability  prompted  the  introduction  of  temporary  curbs  on  the  practice  in  many 
jurisdictions  around  the  world.  In  addition,  concerns  have  been  voiced  that  short-selling  was 
sometimes  being  used  in  conjunction  with  abusive  practices,  such  as  the  spreading  of  false 
adverse rumours or manipulative actions.  

Abusive practices and market manipulation are illegal. However, it seems that current rules did 
not provide sufficient basis for effective legislative action. To the extent that there is substance 
to these allegations, this is primarily a matter of improving monitoring and enforcement. More 
fundamental  concerns  with  short-selling  warrant  further  analysis  and  may  necessitate  greater 
transparency  in  stock  borrowing  and  short  positions.  It  is  important  to  note  that  institutional 
funds are by no means the only financial market participants to make use of these practices. 

VI. 5  Impact on market for corporate control 

The business models of so-called ‘activist’ hedge funds and of some private equity funds entail 
the acquisition of minority equity stakes in listed companies. These funds represent a relatively 
small proportion of the hedge fund and private equity funds universe, respectively.82 Yet their 
activities  have,  in  some  cases,  attracted  adverse  publicity  as  a  result  of  the  perceived 
disproportionate and aggressive nature of the tactics used to re-orient corporate strategy. 

In  common  with  all  shareholders  in  listed  companies,  these  funds  are  entitled  to  exercise  the 
voting rights on their shareholdings. It can also be presumed that changes in corporate strategy 
or management advocated by activist funds will benefit other shareholders and possibly improve 
the  performance  of  the  company  to  the  ultimate  benefit  of  all  stakeholders.  It  is  alleged, 
however, that the exercise of these rights may be used to influence company management with a 
view  to  maximising  short-term  return  on  the holding, but possibly at the expense of the long-
term health of the company. 

Further, practices such as the use of derivatives, securities lending or voting agreements could 
be used to exercise disproportionate influence over the company, in relation to the voting rights 
attached  to  the  shares  which  hedge  funds  own.  Moreover,  the  use  of  derivative  positions  or 
securities  lending  allow  investors  to  increase  their  stake  in  a  public  company  in  a  way  which 
may  not  be  sufficiently  transparent,  or  which  confers  a  voting  right  without  a  long-term 
economic interest in the company. This is potentially a source of conflict of interest and renders 
it  difficult  for  management  and  market  participants  to  identify  the  'owners'  of  the  company. 

82  Source: OECD. 

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While  these  techniques  may  be  deployed  by  hedge  funds,  they  are  available  to  all  market 
participants.  

To the extent that these concerns in relation to transparency towards issuers derive from widely-
available techniques, the possible failures described are not specific to the activities of certain 
categories of institutional fund. [Evidence from IOSCO, OECD] 

VI. 6  Acquisition of control of companies by AIFM  

Some  forms  of  institutional  fund,  most  notably  private  equity,  acquire  majority  stakes  in 
companies and seek to deliver returns to investors by enhancing the profitability of the company 
and at a later stage disposing of the company. In this way, institutional investment can have a 
very direct impact on the real economy and on employment. 

Provided  that  the  interests  of  the  private  equity  firm,  the  companies'  management  and  other 
relevant  stakeholders  (employees,  other  stakeholders)  are  well-aligned,  no  failure  is  apparent. 
However,  a  common  accusation  is  that  there  is  a  fundamental  misalignment  between  the 
interests of the private equity investors and the long-term health of the portfolio companies. In 
particular,  the  pressure  to  deliver  returns  to  investors  may  induce  short-termism,  where 
decisions are taken to maximise short-term profits but which are not consistent with the long-
term health of the company. 

Examples of such practice might include the disposal of assets (so-called 'asset stripping') and 
heavy  recourse  to  debt  financing.  The  ability  for  portfolio  companies  to  finance  this  debt  has 
been severely tested by the prevailing credit conditions. 

VI.7 General overview of the principles of the present regulatory status quo 

The following table provides general overview of principles underpinning the present regulatory 
status quo and their current critique which highlights the need for comprehensive review of the 
financial  system.83  The  specific  risks  related  to  the  activities  of  AIFM  that  were  illuminated 
during the financial crisis are described in more detail in the preceding sections. 

83 Adapted from the Turner Review: A regulatory response to the global banking crisis, FSA, March 2009 

EN 

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Table: General overview of principles 

Principles of present regulatory 
status quo 

Market prices are good indicators 
of rationally evaluated economic 
value. 

The development of securitised 
credit, since based on the creation 
of new and more liquid markets, 
has improved both allocative 
efficiency and financial stability. 

The risk characteristics of financial 
markets can be inferred from 
mathematical analysis, delivering 
robust quantitative measures of 
trading risk. 

Market discipline can be used as an 
effective tool in constraining 
harmful risk taking 

Financial innovation can be 
assumed to be beneficial since 
market competition would winnow 
out any innovations which did not 
deliver value added. 

Need for review: 

Efficient markets can be irrational: 
- Market efficiency does not imply market rationality. The fact that prices 
move as random walks and cannot be predicted from prior movements in no 
way denies the possibility of self-reinforcing herd effects and of prices 
overshooting rational equilibrium levels. 
- Individual rationality does not ensure collective rationality. If determined 
in conditions of imperfect information and/or determined by particular 
relationships between end investors and their asset manager agents, result in 
market price movements characterised by self-reinforcing momentum. 
- Individual behaviour is not entirely rational. 
- Allocative efficiency benefits have limits. 
- Empirical evidence illustrates large scale herd effects and market 
overshoots 
Securitization has increased systemic risk: 
- all liquid traded markets are capable of acting irrationally, and can be 
susceptible to self-reinforcing herd and momentum effects. 
- increased reliance on 'liquidity through marketability'. Simultaneous 
liquidation of positions dries up market liquidity. 
- swings in prices of credit securities have larger impact on the stability of 
financial system and real economy than swings in prices of equity securities. 
Undue reliance on (faulty) mathematical models: 
- short observation period introduced pro-cyclicality 
- non-normal distributions: underestimation of chances of small probability 
high impact events; need for stress tests 
- systemic risk (network effects) not considered: the models implicitly 
assume that the actions of the individual firm, reacting to market price 
movements, are both sufficiently small in scale as not themselves to affect 
the market equilibriums, and independent of the actions of other firms. But 
this is deeply misleading: herding effects and feedback loops present in 
markets; According to VAR measures, risk was low in spring 2007: in fact 
the system was fraught with huge systemic risk: need for stress tests 
- non-independence of future events: underlying methodological assumption 
is insecure: the analysis of past price movement patterns may not deliver 
statistically robust inferences relating to the probability of price movements 
in future. 
The failure of market discipline: 
- conflicts of interest of investors can lead to slack in due diligence 
- conflicts of interests of prime brokers can lead to insufficient 'indirect' 
supervision 
- market prices (CDS, equities) did not signal problems ahead. 
- Illusory mark-to-market profits in a rising market create incentives to take 
further risks through the bonus structure. 
- Extraction of economic rents was made possible by opacity of margins, the 
asymmetry of information and principal-agent problems. Financial services 
grew to a size unjustified by the value of its service to the real economy. 

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

What is private placement? 

Private  placement  is  an  officially  recognised  distribution  method  through  which  designated 
market  participants  can  buy  and  sell  financial  instruments  to  each  other  without  having  to 
comply  with  rules  that  would  usually  apply  when  the  same  instruments  are  offered  to  the 
public/retail investors. It provides participants with a flexible cost-effective tool to sell and buy 
tailor-made  financial  instruments.  Participation  in  private  placements  is  usually  reserved  to 
financial 
appropriately  qualified  market  participants; 
intermediaries, including placement agents, banks or investment funds/firms, pension funds, life 
insurance companies, in some cases also high net wealth individuals and corporate investors. 
Private  placement  is  particularly  suitable  for  the  distribution  and  marketing  of  investment 
propositions  which  may  be  considered  less  suitable  for  wider  public  offer.  This  could  include 
distribution  of  new  types  of  investment  strategy,  such  as  single  hedge  funds,  private  equity 
funds or some commodity funds, whose risk-reward profile may make them less appropriate for 
retail investors.  
Problems and objectives 

these  are  authorised 

typically 

Within  Europe,  Member  States  have  developed  different  arrangements  to  support  private 
placement  between  local  buy-side  and  sell-side  participants.  Differences  between  national 
private placement regimes mean that it is often not possible to extend private offerings across 
EU  Member  States  without  adjusting  the  marketing  material  or  even  the  offer  itself.  Offerors 
also  have  to  be  careful  in  determining  the  potential  investors  they  can  approach.  This  legal 
uncertainty  is  aggravated  by  frequent  changes  to  national  rules  and  conditions  as  reported. 
Offerors  therefore  have  to  bear  substantial  costs  in  order  to  identify  and  comply  with  the 
relevant  rules.  These  may  lead  to  self-imposed  restrictions  on  the  Member  States  where 
investments  are  privately  placed.  This  means  lost  business  opportunities  for  placement 
intermediaries. It restricts investment choices or increases costs for potential qualified investors 
in  other  Member  States.  Investors  may  be  deprived  of  important  portfolio  diversification 
opportunities. Financial markets in smaller Member States might suffer from reduced liquidity 
in relevant financial instruments. 

Problems  with  cross-border  private  placements  result  primarily  from  inconsistencies  between 
and insufficient transparency of, national regimes with respect to the boundaries of the regime: 
Who  can  participate?  Which  products  can  be  placed?  Which  rules  have  still  to  be  complied 
with?  These  shortcomings  prevent  potential  participants  from  profiting  from  the  benefits  of 
private placement, with the adverse consequences for financial markets and the wider economy 
as described above. An EU private placement regime84 should help to overcome these problems. 

Options and assessment 

Options for developing such a regime feature in the substance or coverage of such a regime and 
the appropriate instrument or technique to be used to give effect to it. The former set of options 
focuses on the eligibility of investors, offerors and products. The latter includes both legislative 
and  non-legislative  forms  at  industry,  national  and  EU  level.  The  analysis  of  the  potential 
impacts of the options has revealed that, at this stage, there are not sufficient available data and 
information to come to a substantiated assessment and recommendation of the best way forward. 
Instead,  the  impact  assessment  work  should  be  continued,  with  this  report  serving  as  a 
interested  partners.
stocktaking  and 

information  document  for  all  stakeholders  and 

84 

The term 'EU private placement regime' is used in a very broad sense here. A regime does not necessarily 
have to be a legal framework but could as well consist of a common understanding of the concept only. 

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

GENERAL REMARKS ON CONSULTATION PROCEDURE AND FEEDBACK: 

The  financial  crisis  has  led  to  renewed  debate  about  the  impact  of  hedge  funds  on  the 
functioning  of  financial  markets.  The  de  Larosière  High  Level  Group  has  summarised  the 
situation as follows: 'Concerning hedge funds, the Group considers they did not play a major 
role  in  the  emergence  of  the  crisis.  Their  role  has  largely  been  limited  to  a  transmission 
function, notably through massive selling of shares and short-selling transactions. We should 
also  recognise  that  in  the  EU,  unlike  the  US,  the  great  bulk  of  hedge  fund  managers  are 
registered  and  subject  to  information  requirements.  This  is  the  case  in  particular  in  the  UK, 
where  all  hedge  funds  managers  are  subject  to  registration  and  regulation,  as  all  fund 
managers  are,  and  where  the  largest  30  are  subject  to  direct  information  requirements  often 
obtained on a global basis as well as to indirect monitoring via the banks and prime brokers.'85 

Notwithstanding  this,  there  is  a  desire  to  provide  a  common  regulatory  and  supervisory 
framework to underpin the oversight of, inter alia, hedge funds. The European Parliament has 
clearly expressed this view in its reports of September 2008 (Rasmussen & Lehne reports).  The 
move  towards  closer  regulatory  engagement  with  hedge  funds  has  also  been  evident  in 
international  discussions  concerning  the  regulatory  response  to  the  financial  crisis.  The  G20 
(November 2008) summit issued a call to extend regulatory oversight to all financial markets, 
institutions and products – including private pools of capital. This has been followed quickly 
by the creation of an IOSCO task force on hedge funds.    

It  was  against  this  backdrop  that  the  Commission  published  a  consultation  paper  on  hedge 
funds  on  December  18th  2008.  This  consultation  document  sought  views  and  evidence  on  a 
range of hedge fund related issues so as to inform the preparation of an appropriate regulatory 
initiative. The issues on which the Commission invited views included: 

•  Systemic  risks.  The  consultation  asked  whether  existing  systems  of  macro-prudential 
oversight were sufficient to allow regulators to monitor and react to risks originating in the 
hedge 
through 
counterparties, including prime brokers, and through the impact on asset prices.  

fund  sector  and  subsequently 

the  wider  market 

transmitted 

to 

•  Market  integrity  and  efficiency.  The  consultation  asked  whether  and  under  what 
circumstances the activities of hedge funds posed a threat to the efficiency and integrity of 
financial markets.  

•  Risk  management.  The  consultation  asked  whether  public  authorities  should  concern 
themselves more  with  the  way  in  which  hedge  funds  manage  the  risks  to  which  they  and 
their investors are exposed, value their asset portfolios and manage any potential conflicts of 
interest.  

•  Transparency towards investors and investor protection. The consultation invited views on 
whether  hedge  fund  investors  are  adequately  protected  and  receive  the  information 
required for sound investment decisions. 

85 Point 86, p. 24, Report of High-level Group on financial supervision in the EU, published 25.02.09. 

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The deadline for responses to this consultation paper was January 31st 2009.  One hundred and 
four  answers  to  the  consultation  have  been  received:  71  %  from  private  sector  organisations 
and representative bodies, 8% from citizens and 21% from public authorities.  

The principal messages and issues highlighted by the respondents are: 

-  Hedge funds are complex products best reserved for sophisticated investors;  

-  Hedge  funds  represent  a  very  heterogeneous  class  of  asset  and  investment  strategies  so  there  are 
inherent  difficulties  to  be  overcome  in  designing  an  operational  regulatory  response  that  avoids  a 
'one size fits all' solution. Most respondents believed that an international or global response would 
be  superior  to  an  EU  response.  However,  a  small  majority  of  respondents  believe  that  it  is 
nevertheless appropriate to come forward with EU level action; 

-  A  considerable  number  of  respondents  see  concerns  ranging  from  the  need  for  more  effective 
monitoring  of  hedge  fund  impacts  on  financial  stability  and  market  efficiency,  through  risk 
management systems, organisational arrangements and use of particular investment techniques (e.g. 
short selling); 

-  Much comment centred on the impact of hedge funds on financial stability. Currently, the potential 
systemic impact of hedge funds is addressed primarily through oversight of systemically important 
hedge  fund  counterparties  (investment  banks,  prime  brokers).  This  approach  was  widely  seen  as 
important  –  but  only  part  of  the  solution.  Various  respondents  observed  that  supervision  of  hedge 
fund counterparties does not protect financial markets from cyclical impacts of herding behaviour by 
hedge  funds,  hedge  fund  trading  concentrations  in  particular  market  segments  and  deleveraging. 
Recent developments have revealed the capacity for hedge funds to impact overall market functioning   
through  the  market  channel,  i.e.  through  impacts  on  market  prices  and  liquidity.    62%  of 
respondents  (to  this  question)  believe  that  supervisors  and  macro-prudential  authorities  should  be 
provided  with  more  information  on  hedge  funds  to  monitor  the  systemic  effect  their  activities  may 
have on EU/global markets.   

The issues raised by the consultation were discussed at a high-level conference in Brussels on 
27th  February 2009.86 Those discussions and responses to the consultation will contribute to the 
preparation  of  a  regulatory  proposal  on  hedge  funds  and  private  equity  funds  which  the 
Commission will present before the end of April 2009. 

Responses to this consultation will also serve as the basis for European input into the parallel 
reflections on hedge funds at international level by the G20.  

I. 

 OVERVIEW OF RESPONSES TO THE CONSULTATION 

The  consultation  was  launched  on  18th  December  2008  and  closed  on  31st  January  2009. 
Responses were invited from all interested parties on the questions relating to the activities of 
hedge funds, their impact on financial markets, and their interactions with investors and other 
market participants.  

One  hundred  and  four  answers  to  the  consultation  were  received  from  a  wide  range  of 
organisations  and  professional  representatives,  citizens  and  national  and  European  public 
authorities. Figure 1 provides a more detailed presentation of the status of responses received 

86  

EN 

The 
http://ec.europa.eu/internal_market/investment/index_en.htm. 

proceedings 

conference 

published 

are 

on 

Commission 

web-site. 

80 

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broken-down into the following categories: fund administrators, asset managers, asset manager 
associations,  banking  associations,  trade  unions  and  trade  union  groupings,  consultants, 
insurance  companies,  insurance  associations,  investor  associations,  lawyers,  pension  fund 
associations,  prime  brokers,  professional  associations,  and  stock  exchanges.    Responses  were 
received from a large number of EU Member States (15) and 4 non-Member States (figure 2). 

Figure 1: 

Answers from Organisations - by type

9%

1%

14%

19%

5%

3%

8%

3%

5%

4%

1%

3%

3%

11%

11%

ADMINISTRATOR
BANKING ASSOCIATION
INSURANCE ASSOCIATION
PENSION FUNDS ASSOCIATION
STOCK EXCHANGE

ASSET MANAGER
CONSULTANT
INVESTORS ASSOCIATION
PRIME BROKER
TRADE UNION 

ASSET MANAGER ASSOCIATION 
INSURANCE 
LAWYER 
PROFESSIONAL  ASSOCIATION
TRADE UNION ASSOCIATION  

Figure 2: 

HF consultation: answers by country

1%

2%

1%

1%

6%

1%

2%

6%

13%

21%

1%

3%

2%

6%

2%2%

5%

17%

1%

9%

AT
BE/ EU
DE
DK
FR
IE
IT
LU
NL
ES
SE
CH
UK
US
FI
NO
CZ
MT
PT
AE

For the purposes of this feedback statement, answers from respondents have been classified in 
four sub-groups: 

EN 

81 

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(1) 

(2) 

(3) 

(4) 

Public  authorities:  22  public  authorities  responded  to  the  consultation.  This  includes 
market  regulators,  prudential  supervisors,  ministries  of  finance,  Member  States' 
parliamentary  groups  or  individual  MEPs,  European  parliamentary  groups  and  the 
European  Central  Bank  (Eurosystem).    Some  Member  States'  public  authorities  have 
provided a single collective answer.  

Citizens:  8  answers  from  this  group  comprise  contributions  from  citizens,  authors, 
researchers or research centres or universities.  

Asset  management  and  financial  sector  organisations:  51  answers  from  this  group 
representing  fund  administrators,  asset  managers  and  their  associations,  prime  broker 
and  banking  associations,  consultants,  lawyers,  and  other  professional  associations 
(such as associations of lenders or derivatives practitioners). 

Other  stakeholders  comprising  investor  representative  bodies  (both  institutional  and 
retail),  labour  and  listed  company  representatives  (23  answers):  organisations  such  as 
pension  funds  and  their  associations,  insurance  companies  and  their  associations, 
investors  and  their  associations,  trade  union  and  trade  union  associations,  one 
consultant and an issuers' association. 

2. 

Detailed analysis of responses: 

The feedback statement presents a broad summary of responses to each of the eleven questions 
raised  in  the  consultation  paper.    The  tables  provide  a  quick  overview  of  the  balance  of 
respondent opinions. These opinions have been categorized into 'yes/no' categories of answers 
wherever  possible.    Some  respondents  have  also  provided  qualitative  commentary  to 
supplement or nuance their 'yes /no' answers. In this case, the explanations have been grouped 
under  a  number  of  sub-headings  ("For  one  or  more  of  the  following  reasons:")  to  enable  a  more 
detailed analysis of the respondents' views.  

Please note that some respondents have sometimes expressed more than one opinion in answer 
to a question. Therefore the cumulative total of answers to a question may sometimes exceed 
100% of answers received. 

QUESTION 1 

Are  the  above  considerations87  sufficient  to  distinguish  hedge  funds  from  other  actors  in  financial 
markets (especially other leveraged institutions or funds)? If not, what other/additional elements should 
be taken into account? Do their distinct features justify a targeted assessment of their activities?  

87 For information, criteria identified in the consultation paper were: Hedge funds focus on delivery of absolute returns; Hedge 
funds  have  a  relatively  high  and  systematic  use  of  leverage;  Hedge  funds  are  confined  to  institutional  or  other  sophisticated 
investors; Hedge funds are exempt from direct regulatory87requirements.87 

EN 

82 

   EN 

 
                                                 
 
Opinions expressed:

Ye s, these criteria  are sufficient

No, these criteria are not sufficient 
because the hedge funds class of 
asset is too heterogeneous

Additional detailed views :

(cid:131)         Criteria identified also 
apply to other entities 
which are not considered 
as hedge funds

(cid:131)        Other criteria are 
relevant

(cid:131)        Hedge funds are not 
"Unregulated". This criteria 
is not relevant

(cid:131)        Hedge funds are not 
necessarily highly 
leveraged. This criteria is 
not relevant

Number of 
opinions 
expressed 
on  question  
n°1

% ove r the 
to ta l numb er 
of 
c o ntribu tion s 
rec eived to 
the  
c on sulta tion  

Organisations

Public 
authorities

Citizens

Total

Industry 
organisations

Other 
organisations

5

82

5%

79%

1

22

22

21%

3

45

7

43%

14

7%

15

14%

2

4

0

1

0

1

0

0

4

59

1

45

19

18

30

5

11

24

5

11

3

14

1

6

0

0

A  majority  of  respondents,  including  most  regulators  and  organisations  from  the  financial 
industry,  did  not  consider  the  criteria  identified  in  the  consultation  paper  as  sufficient  to 
distinguish hedge funds from other actors in financial markets: 

(1) 

(2) 

(3) 

(4) 

The criteria identified in the consultation paper also apply to other entities which are not' 
hedge funds', such as (retail) collective investment schemes (130/30, market-neutral and 
long/short  mutual  funds).  Proprietary  trading  desks  of  investment  banks  or  institutions 
(SPV)  should  also  be  taken  into  account  when  supervising  leverage.  These  entities 
engage in similar behaviours and give rise to the same risk for underlying investors and 
financial system; 

Other criteria should also be taken into consideration in defining hedge funds, such as 
structured performance fees, use of 'alternative strategies', engagement in 'short selling 
activities',  'Absolute  return',  use  of  specific  liquidity  &  redemption  rights,  etc…  It  is 
worth  recalling  that  hedge  fund  managers  also  use  a  wide  range  of  legal  structures 
(collective investment schemes, managed account, feeder/master structures etc.); 

Leverage  criteria  were  seen  as  not  necessarily  the  most  relevant  criteria.  Some 
respondents perceived hedge funds as being highly leveraged entities. However, some 
respondents have provided data showing that the average leverage of hedge funds lies 
in  a  range  of  1.3-1.8  times  capital.  They  observe  that  this  leverage  is  significantly  less 
than  that  witnessed  in  some  investment  banks.  However,  it  is  difficult  to  be  precise 
about  the  level  of  leverage  used  by  hedge  funds.  Figures  supplied  by  respondents  do 
not include leverage embedded in financial instruments; 

Some  respondents  contest  the  perception  of  hedge  funds  as  unregulated.  Even  at  EU 
level, aspects of hedge fund business and hedge funds themselves are subject to MiFID, 
the  Transparency  Obligations  Directive  and  the  Market  Abuse  Directive.  When  they 
become  members  of  trading  systems  (Regulated  Markets  or  Multilateral  Trading 
Facilities)  they  are  also  subject  to  the  rules  of  that  platform  including  all  relevant 
transaction reporting rules  

EN 

83 

   EN 

 
 
(5)  Hedge  funds  do  not  form  a  homogeneous  group.  A  large  majority  of  participants 
consider that the hedge fund industry is fast moving. A rigid definition of the "Hedge 
fund" class of asset would therefore become quickly obsolete.  

QUESTION 2 

Given the international dimension of hedge fund activity, will a purely European response be effective? 

Opinions expressed:

No, a 'pure'  EU action won't be 
effective. 

For one or more of the following 
reasons :

(cid:131)        EU action in isolation will 
have adverse effects, and/or

(cid:131)        International work  (IOSCO, 
G20) should b e tak en into 
consideration

but Ye s,   EU should act

For one or more of the following 
reasons :

(cid:131)        EU should tak e the 
leadership, and /or

(cid:131)        EU action will enhance 
international cooperation

Number of 
opinions 
expressed 
on  question  
n°2

% ove r the 
to ta l numb er 
of 
c o ntribu tion s 
rec eived to 
the  
c on sulta tion  

Organisations

Public 
authorities

Citizens

Total

Industry 
organisations

Other 
organisations

71

68%

17

43

46

53

19

15

41%

44%

51%

18%

14%

13

9

14

6

7

2

1

1

3

0

2

52

39

29

36

36

13

6

23

26

22

7

5

13

6

10

14

6

1

A majority of respondents are not convinced that a "purely" European response is likely to be 
successful. They feel that it may even have adverse effects on the European asset management 
industry,  exposing  it  to  regulatory  arbitrage.  Initiatives  taken  by  the  G20,  FSF  and  IOSCO 
should also be integrated into ongoing reflections at the European level. A heavy-handed EU 
response which would not be matched by action elsewhere could simply drive business away 
and  reduce  the  competitiveness  of  the  EU  asset  management 
industry.  Given  the 
interconnectedness of global financial markets and the international dimension of hedge funds, 
any effective answer must be taken at international/global level.  

However, the argument that only globally-harmonized regulation works is regarded by other 
respondents as too simplistic. Over 50% of respondents insist that superiority of international 
action  must  not  be  an  excuse  for  European  passivity.  Europe  is  home  to  a  major  alternative 
investment management industry and represents a substantial client base for this industry. It is 
perceived as a big player in the world economy and offers a vast market for all financial actors 
including  hedge  funds.  Therefore,  many  respondents  believe  that  Europe  can  play  an 
instrumental role in shaping a global regulatory regime for hedge funds through the creation of 
a  "European  label".  An  EU  framework  could  serve  as  a  reference  for  global  regulation  of 
alternative investment management activity. It would help to enhance the attractiveness of the 
European asset management industry and to foster the spread of standards of best practice. It 
could  also  ensure  the  effectiveness  and  competitiveness  of  the  single  financial  market.  Some 
respondents call on the European Commission to establish an adequate and proportionate EU 
framework. European Single Market for hedge funds would abolish regulatory fragmentation 
and strengthen Europe’s position in negotiations of international standards. Some respondents 

EN 

84 

   EN 

 
 
perceive  a  European  initiative  as  a  first  step  towards  international  consensus  on  hedge  fund 
regulation. 

QUESTION 3 

Does recent experience require a reassessment of the systemic relevance of hedge funds? 

Opinions expressed:

Number of 
opinions 
expressed 
on  question  
n°3

% ove r the 
to ta l numb er 
of 
c o ntribu tion s 
rec eived to 
the  
c on sulta tion  

Organisations

Public 
authorities

Citizens

Total

Industry 
organisations

Other 
organisations

Ye s, recent experience requires a 
reassessment of the systemic relevant 
of hedge funds.

35

34%

(cid:131)       But systemic relevance 
should also b e reassessed for 
all other leveraged mark et 
participants.

23

22%

No, reassessment is not necessary

31

30%

8

7

9

2

1

0

25

16

15

13

22

17

9

2

5

Respondents generally acknowledge that hedge fund activities are an integral and valued part 
of  the  financial  market  due  to  their  contribution  to  market  liquidity  and  market  efficiency.  A 
number  of  industry  and  public  sector  respondents  feel  that  there  is  insufficient  empirical 
evidence to support the view that hedge funds have a particular systemic relevance. However, 
a slightly larger number of respondents consider that the recent financial crisis has raised new 
questions about the effects of hedge fund activity, in times of general market distress which call 
for  consideration.  In  support  of  this  view,  these  respondents  argue  that  the  process  of  hedge 
fund  deleveraging  has  added  to  downward  pressure  on  already  falling  asset  prices  in  recent 
months and caused distress to other market participants. Hedge funds may constitute a source 
of  counterparty  risk  to  core  financial  institutions  and  the  broader  financial  system  as  a 
consequence of sudden and large scale liquidation of hedge fund positions.  

Hence,  for  most  respondents  the  analysis  of  the  systemic  risks  of  hedge  funds  should  focus 
more  on  leverage.  This  work  should  not  focus  on  hedge  funds  exclusively,  but  also  on  the 
banking sector and other market participants making extensive use of leverage.   

In  assessing  possible  stability  impacts,  this  perspective  should  take  account  of  assets  under 
management, number of counterparties, level of leverage, and volume of trading. 

QUESTION 4 

Is the 'indirect regulation' of hedge fund leverage through prudential requirements on prime brokers still 
sufficient  to  insulate  the  banking  system  from  the  risks  of  hedge  fund  failure?  Do  we  need  alternative 
approaches? 

EN 

85 

   EN 

 
 
Opinions expressed:

Number of 
opinions 
expressed 
on  question  
n°4

% ove r the 
to ta l numb er 
of 
c o ntribu tion s 
rec eived to 
the  
c on sulta tion  

Organisations

Public 
authorities

Citizens

Total

Industry 
organisations

Other 
organisations

Ye s, indirect regulation insulates the 
banking system from the risk 

51

49%

But, No it also can be improved

46

44%

13

10

0

2

38

34

31

20

(cid:131)        Prime b rok erage 
regulation needs to b e 
reviewed.  

(cid:131)        Indirect prudential 
regulation is insufficient to 
isolate financial system 
from hedge funds' failure. 
Additional direct prudential 
requirement (such as a 
minimum capital 
requirement for the asset 
manager) should apply.

28

27%

8

0

20

17

26

25%

7

2

17

4

13

7

14

3

To date, regulatory attention has been focussed on ensuring that hedge fund bankruptcy does 
not jeopardise the viability of systemically relevant credit institutions. A significant number of 
respondents expressed the view that the banking industry seems sufficiently well capitalized to 
withstand a hedge fund failure. A number of respondents, including public authorities, noted 
that some hedge funds have been liquidated without destabilizing the banking system.  

Respondents  feel  that  prime  brokers  are  subject  to  strict  prudential  requirements  and  have 
their  own  risk  management  tools  to  protect  themselves  from  counterparty  risks.  Banks  are 
required to make robust assessments of credit risk and to set aside sufficient capital to absorb 
reasonably  foreseeable  counterparty  losses.  In  the  view  of  many  respondents,  bank  risk 
assessment  systems  have  recently  undergone  severe  stress  test  and  so  far,  they  have  proved 
robust  with  respect  to  counterparty  risks.  However,  some  respondents  also  perceive  that  this 
remains  only  a  preliminary  assessment,  based  on  the  initial  phases  of  the  crisis.  Since  credit, 
counterparty and market risks can materialize quickly, some respondents believe that it may be 
necessary  to  further  strengthen  the  prime  broker  management  of  hedge  fund  related  risk  in 
order to limit the potential for failure of a very large fund to trigger a systemic impact.  

Some  respondents  expressed  concerns  regarding  the  need  for  more  specific  and  targeted 
regulatory requirements for prime brokerage business. Concerns related to practices such as re-
use by prime brokers of hedge fund collateral, and sometimes the assets of the fund they hold 
in custody. Other respondents also pointed to the conflicts of interest faced by prime brokers 
when  dealing  with  hedge  funds.  Prime  brokers  may  not  have  the  incentives  to  impose 
constraints on their exposure to hedge funds given that hedge funds contribute substantially to 
the revenues of prime brokers. The effectiveness of indirect (prime broker) regulation may also 
be limited by the fact that most large hedge funds use multiple prime brokers. Consequently no 
single broker has all the information necessary to assess creditworthiness and soundness of its 
hedge fund client. A similar problem derives from the fact that banks conduct stress-testing of 
exposures with individual hedge funds. However, this stress-testing does not sufficiently take 
account of the fact that many hedge funds implement similar or highly correlated investment 
strategies.  These  respondents  therefore  conclude  that  the  'indirect'  regulation  approach  is 

EN 

86 

   EN 

 
 
inherently limited in its effectiveness. It does not sufficiently protect the financial system, since 
it does not take into account the fact that different hedge funds sometimes imitate each other’s 
strategies and can generally be affected by common market developments. 

Some  respondents  have  also  expressed  their  concern  that  the  prime  broker's  prudential 
requirements only mitigate risk transmitted via the banking system. This neglects the potential 
impact  of  the  collective  impact  of  hedge  funds  on  market  conditions.  Reference  was  made  to 
the  fact  that  hedge  funds  account  for  50%  of  trading  on  financial  markets  and  can  play  a 
determining role in price formation. The indirect prudential approach needs to be strengthened 
and  be  supplemented  by  direct  surveillance  measures  to  take  account  of  these  wider  market 
effects.  Some  respondents  suggested  that  minimum  capital  reserves  should  be  part  of  the 
regulatory "tool-box". 

QUESTION 5 

Do prudential authorities have the tools to monitor effectively exposures of the core financial system to 
hedge  funds,  or  the  contribution  of  hedge  funds  to  asset  price  movements?  If  not,  what  types  of 
information about hedge funds do prudential authorities need and how can it be provided? 

Opinions expressed:

Ye s, supervisors do have enough 
information to monitor effectively 
exposures 

No, supervisors do not have enough 
information to monitor effectively 
exposures 

Additional comment:

(cid:131)        Even with the 
information, supervisors 
may not have sufficient 
tools to adequately monitor 
the risk

Number of 
opinions 
expressed 
on  question  
n°5

% ove r the 
to ta l numb er 
of 
c o ntribu tion s 
rec eived to 
the  
c on sulta tion  

Organisations

Public 
authorities

Citizens

Total

Industry 
organisations

Other 
organisations

19

64

18%

62%

4

18

0

3

15

43

13

26

2

17

11

11%

5

0

6

4

2

Although  some  prudential  reporting  to  prudential  supervisors  is  currently  required88,  a  large 
majority  of  respondents,  including  most  public  authorities,  financial  organisations  and 
investors, feel that supervisors do not have enough information to monitor hedge fund trading 
activities.    To  that  extent,  transparency  and  disclosure  by  hedge  funds  to  the  supervisory 
authorities  could  be  improved  and  harmonized.  A  single,  global  registration  procedure  for 
hedge  funds  and  their  managers  is  proposed  by  some  respondents  as  a  starting  point  for 
improved  transparency  towards  authorities.  Hedge  funds  could  also  be  required  to  deliver 
periodic regulatory reports of appropriate information on, for example, size, investment style, 
exposures,  leverage  and  performance.  It  is  suggested  that  the  information  collection  process 
could involve hedge fund managers as well as prime brokers, the valuator, the clearing broker 
or other central counterparties.  Some respondents also feel that prudential authorities may not 

88 Regulation (EC) No 958/2007 of the European Central Bank (ECB) of 27 July 2007 concerning statistics on the assets and liabilities 
of  investment  funds  (ECB/2007/8),  all  investment  funds  including  hedge  funds  in  the  European  Union  have  to  notify 
important information to the National Central Banks (NCB) as of December 2008. 

EN 

87 

   EN 

 
 
                                                 
be sufficiently equipped to monitor effectively exposures of the core financial system to hedge 
funds, or the contribution of hedge funds to asset price movements. 

QUESTION 6 

Has  the  recent  reduction  in  hedge  fund  trading  (due  to  reduced  assets  and  leverage,  and  short-selling 
restrictions), affected the efficiency of financial markets?  (…) 

Opinions expressed:

No, the reduction of the hedge funds 
activity had a negative impact on the 
markets.

Ye s, the reduction of the hedge funds 
activity has affected trading efficiency. 

Number of 
opinions 
expressed 
on  question  
n°6

% ove r the 
to ta l numb er 
of 
c o ntribu tion s 
rec eived to 
the  
c on sulta tion  

Organisations

Public 
authorities

Citizens

Total

Industry 
organisations

Other 
organisations

18

59

17%

5

57%

15

2

1

11

43

3

33

8

10

Most  respondents,  including  most  public  authorities,  believe  that  markets  function  less 
efficiently  since  hedge  funds  have  scaled  back  their  trading.  Against  this,  many  respondents 
believed  that  'forced  selling'  by  hedge  funds,  triggered  by  a    swift  tightening  of  credit 
conditions  by  prime  brokers  and  redemption  requests  from  investors,  has  tended  to  amplify 
downward pressure on the price of assets. This outcome could be exacerbated when different 
hedge funds are pursuing the same or correlated strategies.  

Most  financial  organisations  argue  that  hedge  funds  were  not  the  immediate  cause  of  the 
current  financial  crisis.  They  observe  that  all  market  participants  facing  liquidity  pressures 
have  been  going  through  the  process  of  deleveraging.    For  most  respondents  (public 
authorities, organisation, investors, pension funds), there is no clear evidence that hedge fund 
activity  impairs  markets.  The  market  is  perceived  to  have suffered  from  the decline  in  hedge 
fund trading, because hedge funds have not been able to act as liquidity providers to the same 
extent.  

European equity market trading volume (measured in number of shares traded) has decreased 
substantially during the fourth quarter of 2008. This reduction has continued in early 2009; as a 
result of this reduced trading and liquidity, markets are less able to absorb buying and selling 
pressure.  There  is  anecdotal  evidence  showing  that  primary  liquidity  at  the  touch  (i.e.  the 
amount of shares available at the best bid and offer) in European financial stocks has decreased 
since  the  short  selling  restrictions  were  introduced  and  average  spreads  (i.e.  the  difference 
between best bid and offer) have increased. 

QUESTIONS 7 & 8 

Are there situations where short-selling can lead to distorted price signals? Are there situations where 
restrictions on short-selling might be warranted? 

Are  there  circumstances  in  which  short-selling  can  threaten  the  integrity  or  stability  of  financial 
markets? 

EN 

88 

   EN 

 
 
Opinions expressed:

Number of 
opinions 
expressed 
on  question  
n°7

% o ve r th e 
total n umber 
of 
c o ntribution s 
rec eived to 
the 
c onsultation  

Organisations

Public 
authorities

Citizens

Total

Industry 
organisations

Other 
organisations

No, short selling is normal market tool 
under normal market situation.

59

57%

12

0

47

33

14

57% of all respondents to the consultation generally expressed broad support for short selling 
as  a  legitimate  investment  technique  under  normal  market  conditions.  Many  respondents 
regard it as being generally beneficial to the efficient operation of the market. 17 respondents 
believe that there is no evidence that short selling has distorted prices against just 3 expressing 
the view that short selling can distort prices. 

Opinions expressed:

No, they are no situations were short 
selling may be restricted: short selling 
bans had negative  impact on the 
market.  

Ye s,  there are situations where short 
selling ban may be warranted under 
exceptional cicumstances.

Ye s,  there are situations where short 
selling ban may be warranted: when 
short selling transactions can be used 
as part of abusive strategy

Ye s, short selling may be restricted; 
short selling positions should be 
disclosed.

Ye s,  short selling should be restricted; 
all short selling transactions should be 
regulated or limited

Naked short selling should be 
regulated or limited.

Number of 
opinions 
expressed 
on  question  
n°7

% ove r the 
to ta l numb er 
of 
c o ntribu tion s 
rec eived to 
the  
c on sulta tion  

Organisations

Public 
authorities

Citizens

Total

Industry 
organisations

Other 
organisations

9%

14%

0

8

46%

10

8%

8%

14%

1

0

5

0

0

0

0

2

1

9

7

8

3

1

4

38

24

14

7

6

9

6

2

7

1

4

2

9

15

48

8

8

15

However,  a  large  number  of  respondents  consider  that  there  are  a  range  of  circumstances  in 
which  short  selling  restrictions  could  be  justified.  This  compares  to  just  9  respondents  who 
believe that restrictions would never be justified.  

46% of respondents to the consultation consider that short selling could potentially be used as a 
part  of  an  abusive  strategy.  Respondents  argued  that  where  this  is  the  case,  the  focus  of 
regulatory  attention  should  be  on  the  abuse,  not  on  short-selling  itself.  15  respondents 
observed that short-selling may also be problematic in the midst of a loss in market confidence. 
For  example,  some  respondents  mentioned  that  in  a  context  of  a  credit  crisis  where  some 
entities  face  liquidity  challenges,  but  are  otherwise  solvent,  a  decrease  in  their  share  price 
induced by short-selling may lead to further credit tightening for these entities. In a worst case 
scenario  this  could  result  in  bankruptcy.  When  such  entities  are  systemically  relevant,  there 
may be a case for shielding them from short selling, leading to further downward pressure on 
price and erosion of confidence.  

EN 

89 

   EN 

 
 
 
15 respondents were of the view that naked short selling is a practice that could be detrimental 
to market integrity and efficiency. It was suggested that this issue could be addressed through 
appropriate regulation of clearing and settlement.  

 In  combating  these  practices,  does  it  make  sense  to  tighten  controls  on  hedge  funds,  in  particular,  as 
opposed to general tightening of market abuse disciplines? 

Opinions expressed:

Number of 
opinions 
expressed 
on  question  
n°8

% ove r the 
to ta l numb er 
of 
c o ntribu tion s 
rec eived to 
the  
c on sulta tion  

Public 
authorities

Citizens

Organisations

Total

Industry 
organisations

Other 
organisations

No, short selling is not a HF specific 
issue

40

38%

12

0

28

24

4

Those  who answered  this  question  took  the  view  that  short  selling  is  used  by  a  wide  rage  of 
market participants – and that therefore it made little sense to address the use of this technique 
by hedge funds in isolation.  

A number of respondents noted that overnight introduction of short-selling restrictions created 
significant  operations  and  compliance  problems  for  market  participants.  This  was  especially 
the case as actions across different jurisdictions were not coordinated. Some respondents called 
for a unified, global regime for short selling; the IOSCO task force on short selling was referred 
to as a promising development in this respect. 

QUESTION 9 

Should the internal processes of hedge funds be improved, particularly with respect to risk management?  

EN 

90 

   EN 

 
 
Opinions expressed:

No, short selling is not a HF specific 
issue

(cid:131)        It can b e achieved 
through codes of conduct, 
and/ or

(cid:131)        There is a need for 
additional direct regulatory 
initiatives

Risk management can be improved in 
1 or more of the following ways :

(cid:131)        Measurement & 
portfolio risk  management 

(cid:131)        Liquidity risk  
management should b e 
more clearly disclosed and 
explained to investors

(cid:131)        There is a strong 
need for hedge fund 
corporate governance 
regulation

(cid:131)        There is a strong 
need for hedge fund 
valuation regulation

(cid:131)        Voting policy of the 
fund should b e made 
pub lic, and more clearly 
explained

Number of 
opinions 
expressed 
on  question  
n°8

% ove r the 
to ta l numb er 
of 
c o ntribu tion s 
rec eived to 
the  
c on sulta tion  

Public 
authorities

Citizens

Organisations

Total

Industry 
organisations

Other 
organisations

0

0%

19

18%

29

28%

15

14%

5

5%

0

4

8

3

3

37

36%

12

30

29%

5

5%

6

3

0

0

0

0

15

21

0

12

10

0

12

10

0

2

2

0

2

23

22

2

2

21

21

0

0

3

11

2

0

2

1

2

There  was  considerable  discussion  relating  to  risk  management  by  hedge  funds.  Most 
respondents  saw  the  need  for  enhancing  risk  management  standards  employed  by  hedge 
funds. Respondents differed as to whether this could best be achieved through self-regulatory 
codes of conduct or statutory regulation. 

A  minority  of  respondents  (19  out  of  48)  answering  this  question  believe  that  best  practice 
initiatives,  led  by  market  participants,  are  viewed  as  a  good  starting-point  for  effective 
regulation.  

29  (out  of  48)  respondents  believe  that  there  is  a  need  for  some  regulatory  intervention  in 
respect  of  hedge  fund  risk  management.  In  support  of  this  it  is  argued  that  experience  with 
self-regulatory  codes  has  raised  questions  relating  to  compliance  and  enforcement  which 
undermine their effectiveness. The existence of these codes has not been sufficient to prevent 
the  emergence  of  concerns  relating  to  this  industry.  Indirect  supervision  (through  prime 
brokers)  cannot  fully  substitute  for  the  required  direct  regulation  and  supervision  of  hedge 
fund – and that this regulation should extend to some aspects of hedge fund risk management. 

Respondents also provided many suggestions as to how hedge fund risk management could be 
improved.  Some  respondents  underlined  that  some  hedge  funds  already  implement  high 
standards  and  processes  of  risk  management.  However,  a  number  of  respondents  remain 
concerned that there has been excessive reliance on theoretical models for assessing risk. Other 
respondents consider that initiatives on hedge fund risk management should be directed at the 

EN 

91 

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internal  governance  and  organisation  of  hedge  funds.  Managers  should  be  required  to  have 
adequate  resources  to  support  their  trading  strategies  and  to  demonstrate  that  they  have  the 
appropriate risk management systems and reporting mechanisms.  

Responses  highlight  concerns  relating  to  the  risk  management  process.  Respondents  call  for 
more  transparent  and  independent  valuation  controls,  liquidity  management  and  corporate 
governance.  Separation  of  functions  is  viewed  as  a  way  to  reduce  operational  risk  and  the 
possibility of fraud, and misappropriation of assets. Thus valuator, administrator, auditors and 
custodian  functions  should  be  separated  in  order  to  avoid  possible  conflicts  of  interest.  In 
addition, some respondents insist that the assets of the fund should be segregated from those of 
the prime broker. If not, the interests of the former are exposed to the risk of the bankruptcy of 
the latter. 

QUESTION 10 

Do investors receive sufficient information from hedge funds on a pre-contractual and ongoing basis to 
make sound investment decisions? If not, where do the deficiencies lie? What regulatory response if any 
is needed to complement industry codes to make a significant contribution to the transparency of hedge 
fund activities to their investors? 

Opinions expressed:

Ye s 

No

Number of 
opinions 
expressed 
on  question  
n°10

32

37

% ove r the 
numb er o f 
to ta l 
c o ntribu tion s 
rec eived to 
the  
c on sulta tion  
31%

36%

Organisations

Public 
authorities

Citizens

Total

Industry 
organisations

Other 
organisations

5

15

0

0

27

22

21

16

6

6

A significant proportion of the respondents from industry organisations believe that the hedge 
fund business is responsive to investor needs. If an investor is not satisfied, he/she should not 
invest.  The client/investor remains responsible for its decision and should undertake its own 
due  diligence.  Hedge  funds  were  originally  targeted  towards  institutional  investors  able  to 
assess complex risk profiles and absorb occasional large losses.  

However,  a  majority  of  respondents  underline  that  the  level  and  the  quality  of  information 
available to investors often depends on the targeted investors and is quite unbalanced.  Some 
report deficiencies in the information provided which are either incomplete or not available on 
an on-going basis. Most information transparency concerns relate to transparency of the fund 
liquidity  management89,  redemption  policy  and  on  the  equal  treatment  of  shareholders  (e.g. 
side letter practice).  

QUESTION 11 

In light of recent developments, do you consider it a positive development to facilitate the access of retail 
investors, subject to appropriate controls, to hedge fund exposures? 

89 e.g. disclosing information on the proportion of the portfolio invested in non-marketable securities and hard-to-

value assets 

EN 

92 

   EN 

 
 
                                                 
Opinions expressed:

Ye s

No 

(cid:131)        b ut with strong 
regulatory safeguards 

Number of 
opinions 
expressed 
on  question  
n°11
33

% ove r the 
to ta l numb er 
of 
c o ntribu tion s 
rec eived to 
the  
32%

27

40

26%

38%

Public 
authorities

Citizens

Total

Industry 
organisations

Other 
organisations

Organisations

6

3

12

0

0

2

27

24

26

23

21

15

4

3

11

Most  respondents  do  not  view  retail  investor  access  to  hedge  fund  exposures  as  a  positive 
development.  Several  respondents  also  expressed  some  concerns  about  exposure  of  pension 
funds and individuals' investors to hedge funds – given that the assets of individual pension-
holders or retail investors are at stake.    

Those respondents in favour of access to retail investors recognise that any such access should 
be accompanied by strong regulatory safeguards.  

*  *  *

EN 

93 

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

To deliver responsible and reliable financial markets for the future, the Commission will propose an 
ambitious new reform programme, with five key objectives: 

(1)  To provide the EU with a supervisory framework that detects potential risks early, deals with 
them effectively before they have an impact, and meets the challenge of complex international 
financial  markets.  The  Commission  will  present  a  European  financial  supervision  package 
before the end of May 2009, for decision at the June European Council. The legislative changes 
to give effect to these proposals will follow in the autumn and should be adopted in time for the 
renewed supervisory arrangements to be up and running in the course of 2010. The package will 
include two elements: 

•  Regarding  macro-prudential  supervision,  measures  to  establish  a  European  body  to 

oversee the stability of the financial system as a whole 

•  Regarding micro-prudential supervision, proposals on the architecture of a European 

financial supervision system 

(2)  To  fill  gaps  where  European  or  national  regulation  is  insufficient  or  incomplete,  based  on  a 

'safety first' approach. The Commission will propose: 

•  A  comprehensive  legislative  instrument  establishing  regulatory  and  supervisory 
standards  for  hedge  funds,  private  equity  and  other  systemically  important  market 
players(April 2009) 

•  A White Paper on tools for early intervention to prevent a crisis (June 2009) 
•  On  the  basis  of  a  report  on  derivatives  and  other  complex  structured  products  (June 
2009), appropriate initiatives to increase transparency and ensure financial stability 
•  Legislative  proposals  to  increase  the  quality  and  quantity  of  prudential  capital  for 
trading  book  activities  and  tackle  complex  securitisation  (June  2009)  and  to  address 
liquidity risk and excessive leverage (Autumn 2009) 

•  A rolling programme of actions to establish a far more consistent set of supervisory 

rules (to be launched in 2009) 

(3)  To ensure that European investors, consumers and SMEs can be confident about their 

savings, access to credit and their rights as concerns financial products, the Commission will 
come forward with: 

•  A Communication on retail investment products to strengthen the effectiveness of 

marketing safeguards (April 2009) 

•  Further measures to reinforce bank depositor, investor and insurance policy holder 

protection (Autumn 2009) 

•  Measures on responsible lending and borrowing (Autumn 2009) 

(4)  To improve risk management in financial firms and align pay incentives with sustainable 

performance. To this end, the Commission will: 

•  Strengthen its 2004 Recommendation on remuneration of directors (April 2009) 
•  Bring forward a new Recommendation on remuneration in the financial services 

sector (April 2009) followed by legislative proposals to include remuneration schemes 
within the scope of prudential oversight (Autumn 2009) 

(5)  To ensure more effective sanctions against market wrongdoing. To this end, the Commission 

intends to: 

•  Review the Market Abuse Directive (Autumn 2009) 
•  Make proposals on how sanctions could be strengthened in a harmonised manner and 

better enforced (Autumn 2009) 

EN 

94 

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

1. 

Private equity –  role in economy  

Private equity business model  

Private equity provides risk capital to unlisted companies including those that are de-listed as 
part of a public to private transaction. Private equity incorporates wide variety of investment 
strategies ranging from buy-out deals (acquisition of majority of shares in a company) to early 
stage investments (i.e. seed, start-up), also known as venture capital. The proportion of buy-
out investments to venture capital in Europe has for the last five years fluctuated around 70%-
80%  to  30%-20%  divide.  As  such,  private  equity  expands  the  range  of  financing  options 
available  to  European  businesses  and  creates  new  portfolio  diversification  opportunities  for 
investors.  Private  equity  funds  represent  alternative  asset  allocation  possibility  for  investors 
who are looking for investment diversification with enhanced returns and usually medium to 
long term investment holdings. Investors are usually tied into their investments until the end 
of the life of the fund. This usually spans to 10 years, after which all investments are exited 
and total fund profits calculated and distributed among investors and the fund manager. 

Most  private  equity  funds  take  a  form  of  limited  partnerships  to  raise  capital  and  target 
predominantly sophisticated and institutional investors. Private equity funds differ from other 
types  of  investment  funds  in  that  where  their  fund  managers  often  play  a  direct  role  in  the 
decision  making  and  management  of  their  portfolio  companies.  Private  equity  funds 
themselves  are  not  leveraged  but  the  investments  done  by  private  equity  managers  deploy 
considerable levels of leverage. The debt financing is provided by credit institutions and has 
played a key role for majority of buy-out transactions up until 2007 in which an average buy-
out deal consisted of 30% equity and 70% debt financing. Venture capital deals rely less on 
debt financing in this respect.  

Private  equity  funds  make  only  a  few  investments  each  year,  due  to  the  time  it  takes  to 
complete due diligence and general assessment of the potential target company before making 
an investment. It can take up to three years for a fund to fully invest its capital raised from 
investors  -  Limited  Partners.  Once  a  suitable  portfolio  company  is  selected  the  investment 
takes on average 4-5 years. Additional 2-3 years are then needed for realising an appropriate 
exist  strategy  for  the  portfolio  company,  be  it  via  initial  public  offering  (IPO),  a  secondary 
buy-out by another private equity investor or a strategic corporate merger. Assets of private 
equity  funds'  are  therefore  illiquid  and  they  can  not  be  easily  traded  or  sold.  To  align  the 
interests,  fund  managers  invest  their  own  money  into  the  fund  (usually  1%  -  5%  of  total 
commitments  raised  from  investors)  and  they  receive  their  share  back  together  with  the 
proportion  of  the  profit  only  once  an  exit  of  portfolio  company  is  realised  and  only  after 
investors profit share is paid out. 

The constrained credit market had a considerable impact on private equity business model in 
particular  in  the  area  of  large  buyouts,  since  these  can  not  be  effectively  realised  without 
leverage.  However,  the  bulk  of  companies  concerned  by  buyout  transactions  are  actually 
small  and  medium  size  enterprises  –  the  mid  market  -  and  here,  despite  the  difficulties  to 
access new credit this business segment continued to work. The only problem common to all 
types of transactions at the moment is the lack of any feasible exist strategy. For this reason, 
private equity is for the time being undertaking very few if any new deals as it will need to 
stay longer in current portfolio companies and focus more on their sustainability. What recent 
events  shown  as  well,  is  that  private  equity  firms  are  willing  to  put  in  higher  amounts  of 
equity, and deals that emerge as a result have an equal equity-debt ratio or have no debt at all. 
However  the  potential  of  defaults  remains  high  and  its  full  scale  is  yet  to  be  seen  in  the 

EN 

95 

   EN 

 
coming years. Inevitably, we will see decreased levels of funds being raised, the number of 
private  equity  companies  will  also  be  driven  down  and  so  will  the  returns  of  this  particular 
asset class to their investors. 

The growth of private equity  

The highest concentration of private equity activity, measured either by private equity firms 
or  portfolio  companies,  is  in  the  United  Kingdom,  France,  Germany  and  Sweden  who 
represent more than 50% of the market in either category – private equity firm or the portfolio 
company. The remainder of the top ten countries includes Spain, Italy, The Netherlands and 
Finland.  

The  asset  class  grew  four-fold  in  the  space  of  a  decade.  The  great  deal  of  private  equity 
transactions (leveraged buyouts, secondary buyouts etc.) took place at the peak period of 2006 
and  first  quarter  of  2007,  the  buyout  funds  being  the  best  performers  in  2007.  The  assets 
under management of private equity and venture capital funds in 2007 reached €222 billion 
compared to €180 billion in 2006 90. Having the prospect of strong and stable returns private 
equity investments attracted even more sophisticated professional investors. In 2006, private 
equity represented globally less than 1.5% of GDP (including leverage)91. 

Between 2003 and 2007 European private equity firms raised €317bn. The considerable jump 
in  raising  funds  occurred  in  2005  when  €72bn  was  raised  compared   to  €27bn  in  2003  and 
2004. The fundraising peaked in 2006 with €112bn and scaled down in 2007 to €79bn. The 
share  of  expected  allocation  of  funds  between  venture  capital  and  buy-out  transactions 
remained stable, 25%-75%. Capital raised with view to be allocated to a buy-out deal tripled, 
from €20bn in 2003 to €60bn in 2007, whereas the cap ital raised for venture deals less than 
doubled.  Insurance  companies  and  especially  pension  funds  formed  more  than  30%  of  the 
investor  base  in  this  period,  after  banks  (15%)  and  fund  of  funds  (14%).  As  at  the  end  of 
2007, the retail exposure based to private equity and venture capital funds was approximately 
2%, of sales volumes.92 

In  the  same  five-year  period,  European  private  equity  firms  invested  domestically  about 
€258bn. Out of the amount that European privat e equity firms invested in 2006 (€71bn) and 
2007 (€74bn) more than 86% were investments in  companies with fewer than 500 employees 
however the share of the total amount invested in such companies was just about 30%. From 
the perspective of European portfolio companies, about 5200 of them received private equity 
investments  in  2007.  On  the  buy-out  side,  about  1300  companies  were  targeted  in  2007, 
representing  only  26% of the  total number of companies receiving private  equity  financing, 
but  79%  of  amounts  invested.    UK  companies  received  29  per  cent  of  the  total  amount 
invested, followed by France (16.4 per cent) and Germany (14.7 per cent). 

Given that about two thirds of total equity investments are devoted to buy-outs, and that buy-
outs are themselves leveraged significantly whereby the leverage represents two thirds in the 
capital  structure  of  a  buy-out  investment,  it  can  be  estimated  that  between  2003  and  2007 
European private equity firms invested more than €600bn (see also Annex X.A-6) 

Private equity in focus 

90  

91  
92  

The  retailisation  of  non-harmonised  investment  funds  in  the  European  Union,  October  2008, 
http://ec.europa.eu/internal_market/investment/docs/other_docs/study_non-harmonized_funds.pdf 
Based on EVCA/Thomson Financial/PriceWaterhouseCoopers  
The  retailisation  of  non-harmonised  investment  funds  in  the  European  Union,  October  2008, 
http://ec.europa.eu/internal_market/investment/docs/other_docs/study_non-harmonized_funds.pdf 

EN 

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As  a  result  of  its  considerable  growth,  private  equity  became  and  important  market  player. 
Many  stakeholders  and  governments  question  the  impact  of  private  equity  activities  on  the 
well-being  of  companies,  their  employees  and  society  as  whole.  The  exponential  growth  of 
private equity activity  in the leveraged  buyout (LBO) sector  and  the 'public to private' buy-
outs in particular has focused stakeholder attention on these issues. Indeed, having completed 
public to private takeover, the pressure on maintaining the same level of socially responsible 
business  practices  (generally  known  as  corporate  social  responsibility  –  CSR)  by  de-listed 
companies disappears.  

There is nothing inherent to the private equity model that should mean that privately owned 
businesses must be less sustainable or less responsible than public companies. However, there 
has  been  growing  coverage  of  the  negative  impact  of  LBOs  resulting  from  their  perceived 
short-term interest, their use of financial engineering, the excessive debt burden that private 
equity  puts  on  its  portfolio  companies,  while  having  limited  positive  impact  on  companies' 
future performance and employment.  

Governments  in  the  European  Union  provide  individual  national  frameworks  under  which 
private  equity  business  operates.  Private  equity  is  subject  to  general  company  law  and  civil 
law  that  applies  at  the  Member  State  level  and  in  some  areas  also  EU  level  regulatory 
framework  applies.  In  addition,  some  issues  are  addressed  directly  through  European 
regulatory  frameworks,  i.e.  EU  legislation  on  market  abuse  or  provision  of  investment 
services. However, the behaviour and actions of many alternative investors, to which private 
equity belongs, and their impact on the rest of the financial system and economy as a whole, 
are tackled in different ways, and to varying degrees in different Member States.  

Historically,  private  equity  investments  were  of  a  local  character  focusing  in  principle  on 
creation of profit and returns for their shareholders. In the past 20 years, the development of 
information  technologies  and  increased  international  character  of  private  equity  activities 
contributed  to  a  greater  awareness  of  private  equity  as  well  as  its  scrutiny  by  variety  of 
stakeholders. As noted only few years ago "the private equity firms themselves are starting to 
realise that greater transparency and disclosure – over important issues such as performance, fees, 
and even compensation – might be in their own self interest"93.  

To  some  extent  number  of  issues  is  addressed  by  the  industry  in  the  voluntary  codes  and  best 
practice guidelines developed at national, European or international level. Their ultimate aim 
is  to  codify  behaviour  or  agree  on  best  practices  in  order  to  increase  the  awareness  and 
acceptance of private equity business in the society. It has been argued that, it is in the interest 
of the companies to adopt and promote responsible behaviour since it is one of the key assets 
that effectively help to build reputation and trust, an essential element for success of private 
equity firms as well.  

The  key  question  today  remains  whether  the  current  combination  of  national  rules,  tax 
treatments  and  industry  codes  and  standards  developed  creates  a  sound  environment  for 
further development of private equity. Does this set of overlaps respond to the growing key 
concerns relating to the impact of private equity on the economy and financial system overall? 
This document aims to provide additional input to steer the discussion on the above questions 
by  assessing  the  effectiveness  of  existing  legislative  frameworks  and  industry  codes  against 
the concerns raised recently in relation to activities of private equity. 

93  

http://www.finance.ox.ac.uk/file_links/finecon_papers/2008fe17.pdf 

EN 

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Currently a number of European and national codes governing private equity behaviour exist 
in  parallel,  all  covering  a  wide  range  of  issues  (e.g.  ethics,  valuation,  transparency  and 
reporting  to  investors,  portfolio  companies  and  the  public).    This  section  aims  to  provide  a 
qualitative analysis to determine the level of compliance, the scope and effectiveness of the 
various codes and best practice guidelines that have been developed at European or national 
level. It will address the various risks posed by the private equity business model and evaluate 
to the extent possible, whether the professional standards and codes of conduct as they stand 
today,  provide  for  an  effective  mechanisms  through  which  the  risks  are  enforced  and 
mitigated,  i.e.  to  what  extent  they  can  be  expected  to  make  a  difference  on  the  ground  for 
stakeholders (investors, portfolio companies, supervisors, and the public). This analysis will 
employ  criteria  to  assess  whether  specific  risks  are  effectively  addressed  by  the  codes  and 
applied by those who engage in private equity business. 

2.  How are concerns relating to private equity addressed by national and European 

regulatory frameworks? 

Number  of  issues  was  raised  in  the  past  couple  of  months  in  relation  to  the  impact  of 
unregulated  entities  and  other  actors  in  the  financial  markets.  There  is  no  private  equity 
specific regulatory framework either at national or European level to gauge the behaviour and 
impact  of  these  entities  under  a  common  regulatory  oversight.  However  private  equity  is 
subject  to  general  national  legislation  and  in  some  areas  also  European  level  regulatory 
framework governs directly or indirectly some areas of private equity activities.  

This section will map the relevant regulatory frameworks in place and match them against the 
concerns and risks mostly linked to the activities of private equity. 

2.1  Financial stability 

It has been acknowledged that private equity has not been among the drivers exacerbating the 
financial crisis and as such it does not pose any macro-prudential concerns to the economy. 
Leverage is an integral part of private equity transactions and it has become a common place 
for  any  buy-out  transaction  to  employ  a  considerable  level  of  leverage.  And  as  a  result  of 
favourable economic  environment  we  have seen on the markets in the past couple of years, 
leverage  levels  increased  exponentially  along  with  the  number  and  size  of  large  and  mega 
buy-outs. However the leverage of this part of the corporate sector did not reach the size nor 
does  it  have  the  characteristics  of  creating  negative  spill-over  to  the  financial  system  and 
economy  as  a  whole.  In  2007,  it  was  reported  that  banks  with  exposure  to  leverage  buyout 
loans had less than 1% of their total assets invested in these instruments94.  

Leverage employed  by  private  equity firms and the risks linked to it are rather isolated and 
limited the lending institution, the portfolio company and the private equity fund investing in 
it. The risks are limited to the quality of the buy-out transaction in which both private equity 
and lending institutions play their part. If a leveraged buy-out transaction does not work out, 
private  equity  investors  incur  decreased  returns  on  their  overall  investments,  private  equity 
managers  can  also  loose  part  of  their  own  money  and  it  is  the  portfolio  company  that  will 
suffer  the  biggest  consequences  –  loosing  the  prospects  of  restructuring,  re-energising, 
exploring  new  market  possibilities,  etc..  The  level  of  debt  is  a  function  of  the  portfolio 
company's ability to repay it. Lending institutions have  at their disposal monitoring tools to 
inform  them  about  an  on-going  performance  of  the  company  and  the  prospects  of  the  debt 
being serviced according to the plan. The instrument that serves this purpose is the so called 
'covenant'.  It  sets  out  performance  thresholds  of  portfolio  companies  that  if  breached,  the 

94 ECB, Monthly Bulletin, August 2007 

EN 

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lending  institutions  can  ultimately  force  such  company  into  foreclosure.  Lightly  negotiated 
covenants were a common practice in recent years, which ultimately loosened the power of 
lenders to act when portfolio companies did not perform according to the covenant.  

Given  the  diverse  nature  of  private  equity  investments  in  various  sectors  and  in  companies 
with varying strategies there are no systemic consequences for the economy and other market 
players other than those involved in a particular transaction since it would take a large number 
of  portfolio  companies  to  default  at  the  same  time.  In  addition,  the  risks  stemming  from  a 
failed buy-out transactions can not be solely assigned to the role of leverage as it is in addition 
the quality of the business strategy and development plan employed by the private equity firm 
that play a key  role in a private equity investment to be successful.  

However  from  the  perspective  of  the  portfolio  company,  the  use  of  leverage  has  been 
challenged  recently  and  belongs  to  one  of  the  key  policy  concerns  relating  primarily  to  the 
sustainability  of  debt  assumed  by  private  equity  portfolio  companies  and  its  use  to  amplify 
short term returns to private equity funds. This concern will then further be discussed below 
under the 'acquisition of control of companies by Private Equity fund managers' chapter. 

Applicable legislative framework 

From the perspective of the fund managers, existing national legislation requires managers to 
put down a minimum of own capital to set up a company depending on the legal form of the 
vehicle.  In  addition,  in  some  Member  States95  management  companies  need  to  maintain  a 
certain level of regulatory capital to cover operational risk that is proportionate to the value of 
portfolio  under  management.    There  are  no  other  direct  risk  based  capital  requirements 
imposed at national level neither at the level of a management company nor at the level of a 
fund. No legislation poses a specific cap as to how much leverage (debt) can private equity 
use in the acquisition of a portfolio company. 

At  European  level,  Existing  Capital  Requirements  Directive  2006/48/EC  and  Capital 
Adequacy Directive 2006/49/EC already require risk based capital for investment firms and 
credit  institutions.  Private  equity  is  therefore  exposed  to  these  regulations  indirectly  via 
requirements imposed on the lending institutions for the purposes of private equity leveraged 
acquisitions.  

2.2  Market Integrity and Market Efficiency  

Market integrity 

A further set of issues relate to the integrity of financial markets and the potential threat posed 
by  the  activities  of  private  equity.  This  might  be  the  case  in  particular  where  a  public  to 
private  buy-out  transactions  are  in  play.  Since  these  transactions  involve  a  considerable 
exchange  of  price  sensitive  information  a  potential  for  market  abuse  exists.  These  concerns 
were  fuelled  in  particular  given  the  steep  rise  of  the  European  LBO  market  along  with  the 
complexity and size of the transactions.  

Applicable legislative framework 

Private  equity  firms  are  subject  to  existing  market  abuse  and  market  conduct  rules.  At 
European  level  the  Market  Abuse  Directive  applies  directly  to  any  participant  in  a  private 
equity  transaction.  In  addition  private  equity  is  also  directly  covered  by  existing  EU  anti-
money laundering regulation. 

Market efficiency 

95 France, Italy, Spain, The United Kingdom 

EN 

99 

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There are number of concerns that question the impact of increased private equity activity on 
the  efficiency  of  public  markets.  The  key  aim  of  private  equity  transactions  is  to  target 
companies that are undervalued but who carry the highest potential to create substantial gains 
in  relatively  short  period  of  time.  Given  the  substantial  growth  of  private  equity  takeovers 
where  predominantly  large  public  companies  were  targeted  number  of  concerns  is  being 
raised:  

•  The  scale  of  public  to  private  buy-outs  substantially  decreases  proportion  of  public 
markets in given Member State. As a result new public markets' structure emerges and 
includes  only  particular  types  of  firms  that  are  either  too  risky  or  too  mature  and 
shareholders are loosing out their dividends' share in companies when they experience 
highest growth, i.e. under private equity ownership. 

•  Other concerns relate to the distortion of managers' behaviour as a result of the large 
scale  of  private  equity  public  to  private  LBOs  that  we  have  experienced  recently.  
Being  afraid  to  become  a  target  of  a  buy-out,  managers  of  public  companies  start 
focusing their strategies on short term maintenance of relatively high and stable share 
prices at the expense of long-term growth and strategic perspective of the company. 

Applicable legislative framework 

There is no regulatory framework that would define the right proportion of private to public 
markets in the economy. It is the market forces that determine the situation at a point in time 
and  it  is  constantly  changing.    The  benign  economic  environment  allowed  for  transactions 
where  number  of  big  public  companies  has  gone  private.  Nowadays,  the  time  of  highly 
leveraged deals is the past and we see that new market forces are moving towards different 
equilibrium, ultimately reflecting current economic environment. 

2.3  Corporate Governance 

Another set of concerns arise from stake-building and empty voting by minority shareholders. 
Although  private  equity  investors  typically  take  controlling  stakes  in  companies  and  aim  to 
enhance  their  performance  in  order  to  earn  a  return  on  their  investment  they  also  invest  in 
minority  stakes  in  listed  companies.  The  criticism  of  activist  shareholders  is  that  they  may 
seek disproportionate influence over company management with a view to maximising short-
term gains at the expense of the target company's long term health and prosperity. At the heart 
of this concern is the use of derivatives and borrowed stock that effectively allows minority 
shareholder  to  exert  disproportionate  influence  on  company's  management.  However,  these 
concerns are not limited to the activities of private equity, in fact are more typically used by 
activist minority shareholders.  

The genuine concern in this respect are techniques that allow private equity managers to build 
stakes that are not sufficiently transparent to the company's management and may potentially 
give rise to abusive behaviour and cause harm to a company's key stakeholders (employees, 
customers, suppliers, etc). Examples of these techniques include (1) the use of derivatives that 
impacts shareholder notification/disclosure, (2) securities lending and borrowing to influence 
voting rights and (3) shareholders' information obligations towards portfolio companies. 

From the perspective of the portfolio company there are also concerns as to the behaviour of 
their  managers  and  executives  in  particular  before  the  take-over  by  private  equity  occurs. 
Examples of current practice include directors and executives accepting various incentives in 
the form of bonuses, share option plans or other benefits from private equity managers. The 
opaqueness  of  executives  incentive  pay  raises  questions  as  to  the  loyalty  of  the  portfolio 
company's  managers  towards  its  shareholders  before  the  take-over  by  private  equity  is 
finalised. 

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Applicable legislative framework 

A  review  of  some  Member  States  legislation  reveals  that  the  provisions  of  corporate  law 
apply, in particular fiduciary duties of directors in portfolio companies and provisions dealing 
with the misuse of their power are the most relevant reference provisions in this case.  

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. 

2.4  Transparency, Disclosure and Investor Protection  

The  investment  landscape  changed  considerably  in  the  past  couple  of  years.  Private  equity 
established  its  position  as  an  important  market  player  and  became  a  standard  source  of 
investors' portfolio diversification.  

Although  private  equity  remains  the  domain  of  professional  and  sophisticated  investors,  the 
number  of  investors  has  increased  and  so  have  their  requirements  to  receive  appropriate 
information  on  time.  This  is  marked  in  particular  by  the  sharp  rise  of  pension  funds  and 
insurance companies as investors in private equity funds, forming together more than 30% of 
investors' base in the past five years in Europe. There is a need to ensure that members of the 
pension scheme are appropriately informed about the way in which pensions are invested and 
the associated risks.  

Private  equity  investors  receive  already  substantial  level  of  information  from  private  equity 
managers before and after investments are made and the level and detail of the reporting and 
disclosure  to  investors  has  also  increased  in  time.  However  the  quality  and  content  varies 
considerably, depending in particular on the manager providing this information. Today, the 
new investors are seeking to have the same or comparable level of information and therefore 
assurance about associated risks and processes and other related indicators as they get from 
traditional asset managers. 

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Significant areas of dissatisfaction among investors can be observed across a range of issues 
associated in particular with reporting, risk management and disclosure.96 Investors complain 
that  lack  of  transparency  makes  it  difficult  to  compare  or  benchmark  performance  between 
various funds, understand the investment risks and  strategies, others voice their concerns as 
regards  standardised  valuation  reporting  and  reliability  and  consistency  of  valuations  for 
ongoing investments. The latter became topical during the financial crisis. 

Applicable regulatory framework 

In  many  national  frameworks  disclosure  to  investors  is  governed  by  provisions  of  company 
law.  The  disclosure  requirements  are  usually  specified  in  the  fund  rules  and  subject  to 
contractual  obligations  and  enforcement  between  the  fund  and  its  investors.  The  same 
company  law  applies  in  cases  of  disclosure  of  information  to  supervisors  which  in  many 
instances  takes  a  form  of  filing  audited  annual  or  semi-annual  reports  with  the  relevant 
national authority.  

At  European  level,  securities  legislation  already  provides  for  a  mandatory  information  and 
disclosure  requirements  which  apply  to  different  financial  instruments  (funds,  securities 
issued  by  listed  entities)  and  intermediaries  selling/recommending  these  instruments,  i.e. 
Directive 2004/39/EC (MiFID). Also Prospectus Directive provides for harmonised disclosure 
document  when  securities  are  offered  to  the  public  or  admitted  to  trading  on  a  regulated 
market. 

In  general,  information  requirements  to  members  of  pension  schemes  are  governed  by 
Member States' social and labour law. The Occupational Pension arrangements that are under 
the remit of the European IORP Directive 2003/41/EC have fairly advance regime as far as 
investment rules and information obligations are concerned. As regards the investment rules, 
they  are  to  a  large  extent  based  on  the  "Prudent  Person  Rule".  As  to  the  information 
requirements, the Directive provides for obligations to the occupational pension institution to 
provide certain information to the members of the scheme/employees.  

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 private equity fund managers. 
Many aspects of their activity and the way in which they are organised impact directly on the 
interests of their investors. For example, the processes for valuing the fund'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 managers 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 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 (see chapter 3). Variation in disclosure 
standards is thus an additional source of concern for investors operating cross-border.  

96  

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

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2.5  Acquisition of control of companies by Private Equity  

One  of  the  key  policy  concerns  relate  primarily  to  the  sustainability  of  debt  assumed  by 
private equity portfolio companies. Some evidence suggests that leverage levels have indeed 
been increasing especially in buy-out transactions above certain size97. If the pressure is than 
too high on the portfolio company to service its debt it can lead it to financial distress which 
ultimately negatively affects its employees and the society as a whole. And as reported in mid 
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. As a result some irregularities 
in  behaviour  by  those  involved  in  such  transactions  were  brought  to  public  attention  and 
criticism.  

From the perspective of employees, concerns arise that in cases where company is acquired 
by private equity employees do not enjoy the same protection and rights as is the case when a 
transfer of undertaking occurs. Underlying this concern is the legitimate desire to ensure that 
labour  forces  are  treated  sensitively  and  carefully  about  major  changes  in  the  life  of  their 
company – especially those concerning their own job tenure and employment conditions.  

Applicable regulatory framework 

At national level, general provisions of corporate law apply in all Member States, in particular 
fiduciary duties of directors and provisions dealing with the misuse of their power. 

However, 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.98 

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 of 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 

97  

98 

2006 ECB survey of leveraged buyout activity demonstrated that leverage levels were rising steadily in 
larger transactions in Europe (typically > €1bn). 
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. 

EN 

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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. 

Analysis of private equity codes of conduct and other applicable guidelines 

Currently a number of European and national codes governing private equity behaviour exist 
in  parallel,  all  covering  a  wide  range  of  issues  (e.g.  ethics,  valuation,  transparency  and 
reporting to investors, portfolio companies and the public).  The Commission has indicated on 
several occasions that effective self-regulation is a possible avenue to be exploited. 

This  chapter  will  therefore  engage  in  a  qualitative  analysis  to  determine  the  level  of 
compliance,  the  scope  and  effectiveness  of  the  various  codes  of  conduct  that  have  been 
developed at European or national level. It will address the various risks posed by the private 
equity business model and evaluate to the extent possible, whether the professional standards 
and codes of conduct as they stand today, provide for an effective mechanisms through which 
the  risks  are  enforced  and  mitigated,  i.e.  to  what  extent  they  can  be  expected  to  make  a 
difference on the ground for stakeholders (investors, portfolio companies, supervisors, and the 
public).  This  analysis  will  employ  criteria  to  assess  whether  specific  risks  are  effectively 
addressed by the codes and applied by those who engage in private equity business. 

3.1 

Criteria  for  assessing  the  effectiveness  of  private  equity  codes  and  best  practice 
guidelines 

Before  going  into  a  more  detailed  discussion  as  to  how  effective  current  professional  codes 
and  guidelines  applicable  to  private  equity  are,  it  is  essential  to  set  out  clearly  criteria  that 
should allow us to draw such conclusions. Experience shows that voluntary codes can work 
only effectively if there is a strong enforcement and oversight mechanism built in the codes. 
In assessing the effectiveness of industry codes and best practice guidelines, we applied the 
following criteria that help to guide our analysis as regards the overall credibility of existing 
self-regulatory framework in the EU.  

1/ Content/Focus:  

Currently  there  are  six  different  codes  of  conduct  and  industry  guidelines  developed  at 
European or national level that apply to private equity businesses and those who are directly 
impacted by their activities. For the purpose of this analysis the issues covered by all of these 
codes will be looked at.  

The  following  codes  and  best  practice  guidelines  are  therefore  considered:  EVCA  Code  of 
Conduct,  EVCA  Corporate  Governance  Guidelines,  EVCA  Governing  Principles,  EVCA 
Reporting Guidelines, International Private Equity and Venture Capital Valuation Guidelines 
and  other  Transparency  and  Disclosure  Guidelines  that  so  far  have  been  developed  only  at 
national level and we will consider the following EU Member States – the United Kingdom, 
Denmark, Germany and Sweden. 

Benchmark for purpose of this analysis: What issues are covered and what is the level of 
detail  –  prescriptive  or  rather  principle-based  content?  Are  the  codes  sufficiently  well 
specified  to  provide  clear  basis  for  influence  in  behaviour?  Is  the  content  of  the  particular 
code/guidelines focused enough to address concerns raised in relation to the impact of private 
equity on society and economy as a whole? 

2/ Scope/Coverage:  

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When assessing the effectiveness of the existing codes and guidelines one of the key criteria is 
the  extent  to  which  the  number  of  entities  that  comply  with  the  guidelines  and  codes  is 
representative of the industry and the market where such code applies. For the purpose of this 
analysis,  coverage  will  be  assessed  taking  into  account:  (1)  number  of  private  equity 
companies that are full members of EVCA99, (2) number of private equity firms in existence 
in given Member State, (3) of which number of private equity firms with headquarter in given 
Member  State,  (4)  number  of  private  equity  companies  as  full  members  of  national  private 
equity  and  venture  capital  association  (see  Table  1).  The  number  of  private  equity  firms  in 
each  category  (1-4)  can  not  be  summed  up  since  one  company  and  its  subsidiaries  are 
members  of  more  national  associations.  Coverage  can  therefore  to  a  limited  degree  be 
assessed at the level of each Member State100.  

Benchmark  for  purpose  of  this  analysis:  the  extent  to  which  all  possible  private  equity 
firms are covered by the codes or guidelines. 

3/  Compliance:  There  are  three  main  categories  of  compliance  that  can  be  distinguished: 
voluntary, comply or explain and mandatory. 

Benchmark for purpose of this analysis: level of compliance 

4/ Monitoring:  

How  is  the  compliance  with  existing  codes  monitored?  Companies  that  subscribe  to 
compliance  with  any  code  should  establish  within  their  internal  organisational  structures 
functions  that  engage  in  regular  monitoring  of  compliance  with  the  code,  such  monitoring 
would  be  internal.  Additional  or  alternative  level  of  monitoring  -  external  -  could  also  be 
established  at  the  level  of  the  supervisory  authority,  industry  umbrella  organisation  or  any 
other relevant body.  

Benchmark  for  purpose  of  this  analysis:  how  is  monitoring  of  compliance  with  the  code 
organised,  is  it  active  or  passive  type  of  monitoring  and  who  is  responsible  for  compliance 
monitoring.  

5/ Enforcement and Sanctions:  

Although the compliance with codes is in general on voluntary basis, this should not decrease 
the  responsibility  of  an  actor  who  violates  principles  and  rules  to  which  he/she  subscribes. 
Therefore  it  is  an  indispensable  for  any  voluntary  code's  credibility,  to  contain  clauses  that 
deal with the way how violation of code's principles and rules is to be dealt with.  

Benchmark for purpose of this analysis: existence of effective enforcement mechanism and 
sanctions in the body of the code or guidelines 

3.2 

Analysis of existing professional codes applicable to private equity 

99  

Industry data indicate national trade associations' memberships in EVCA captures approximately 80% 
of assets under management in the European Union. 

100  
Example:  the  UK  private  equity  and  venture  capital  association  contains  about  210  full  members 
(associate members usually do not engage in private equity business but provide some support services etc.). The 
industry data report that in 2008 there were more than 400 private equity firms headquartered on UK the market. 
At EU level, 115 private equity firms from the UK register as full members of EVCA. Neither of these numbers 
can  provide  a  definitive  view  of  the  gap  that  might  exist  on  this  market  for  the  reasons  mentioned  above. 
However  this  picture  is  typical  for  many  Member  States  where  private  equity  is  active.  Although  it  is  not 
possible to quantify the gaps, these figures reveal issues that are nevertheless essential for this analysis.  

EN 

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This  analysis  looks  at  codes  developed  by  the  European  private  equity  industry  and  also  at 
codes that were put in place in some Member States at national level. Those codes that exist at 
European  level  draw  their  compliance  through  the  membership  in  the  European  Private 
Equity and Venture Capital Association (EVCA). In 2008 its membership comprised of 1,297 
members  of  which  693  were  full  members,  572  associate  members  and  32  national 
associations  of  which  19  refers  to  EU  national  association  Similarly,  codes  developed  at 
national  level  also  to  some  extent  draw  on  their  compliance  through  membership  of  the 
national  private  equity  and  venture  capital  association  but  their  scope  and  coverage  vary  to 
some degree. 

EVCA has been at the forefront of developing industry standards as we know them today and 
as  such  has  a  key  role  to  play  in  the  management  and  development  of  the  self-regulatory 
framework in the EU101. 

3.2.1   EVCA Code of Conduct 

Content and Objectives 

This  code  sets  out  six  high-level  guiding  principles  that  should  offer  a  framework  for  the 
resolution  of  ethical  dilemmas.  As  of  2009  a  new  Code  of  Conduct  was  adopted  by  EVCA 
based on the IOSCO Model Code of Ethics. Its objectives are: 

1.  To state the principles of ethical behaviour that members of EVCA abide by, 

2.  To  assert  on  behalf  of  the  membership  the  collective  view  that  high  standards  of 
commercial honour and just and equitable principles of trade and investment shall be 
observed, and 

3.  To  provide  the  basis  for  consideration  of  an  dealing  with  lapses  in  professional 

conduct within EVCA 

The following guiding principles form the body of this code: 

1.      Act with integrity 
2.      Keep your promises 
3.      Disclose conflicts of interest 
Assessment  

4.      Act in fairness 
5.      Maintain confidentiality 
6.      Do no harm to the industry 

EVCA  does  no  actively  monitor  compliance  with  the  code.  EVCA  acts  upon  receipt  of 
complaints  that  are  then  dealt  with  but  the  code  contains  reference  to  enforcement  and 
sanction  mechanisms.  As  regards  transparency,  the  code  is  well  publicised  at  the  level  of 
EVCA  (website),  however  a  random  check  of  about  40  private  equity  firms  websites  (full 
members of EVCA) reveals that very few post a reference or link to this code and provide any 
statement about their compliance with the code. It is therefore not possible to assess the extent 
to which individual firms integrate the code into their business practices. Compliance with the 
code is mandatory for all members of EVCA and according to them its members account for 

101 EVCA Code of Conduct, October 2008: "As part of its longstanding objective to provide an appropriate self-
regulatory framework for the industry, EVCA has published several documents that present principles that 
should govern the professional relationship between the three key groups of participants in the industry: the 
General Partner, the Limited Partner, and the investee company. These documents outline the key elements of 
governance,  transparency  and  accountability  that  are  expected  of  the  main  industry  participants  towards  one 
another". 

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over  80%  of  assets  under  management  by  private  equity  firms  in  the  EU.  From  a  different 
angle, we can say that most of the private equity companies in the EU are covered through the 
membership  of  EVCA  or  their  national  trade  association  that  developed  their  own  codes  of 
conduct. However to what extent are all private equity firms active on the EU market captured 
remains questionable since it is not possible to fully quantify the gap as regards entities that 
are active in the EU but are not members of EVCA or other national association (see Table 1). 

In addition, this code of conduct and its principle number six 'Do no harm to the industry' is 
one  possible  reference  in  the  plethora  of  existing  codes  that  should  have  the  potential  to 
effectively  discourage  private  equity  to  engage  in  taking  excessive  leverage  and  capital 
depletion of their portfolio companies. It can be asked whether a high level principle such as 
the one contained in the code of conduct is focused enough to discourage private equity firms 
to burden their portfolio companies with excessive debt, to prohibit disproportionate disposal 
of  portfolio  companies'  assets  and  other  similar  practices.  Overall,  there  are  some  positive 
aspects of the code that refer in particular to the compliance, enforcement and monitoring of 
the  code  of  conduct.  Whether  coverage  via  EVCA  membership  is  sufficient  enough  can  be 
subject  to  discussion  as  well.  However,  it  is  evident  that  the  content  of  this  code  is  not 
focused enough to mitigate concerns raised in relation to the use of leverage in private equity 
buy-out  transactions  and  the  overall  economic  and  social  sustainability  of  portfolio 
companies.  

3.2.2   EVCA Governing Principles 

Content and Objectives 

This  document  is  a  set  of  best  practice  guidelines  that  are  based  on  principles  that  should 
govern  the  interactions  between  private  equity  fund  managers  and  investors.  The  following 
principles are concerned:  

4. Skill, care and diligence  7. Transparency 
5. Adequacy of resources 
6. Investors' interest 

1. The Law 
2. The Contract 
3. Integrity 
On  basis  of  examples,  the  document  goes  through  all  stages  of  the  life  cycle  of  a  fund  - 
ranging  from  fund  raising  and  structuring  of  the  investment  offers,  due  diligence  and 
investment structuring, investment management and monitoring, disposal of investments and 
proceeds distribution and reporting to investors etc. - provides illustrative  explanations with 
the aim to be a useful reference for fund managers as well as to investors as to the application 
of the guiding principles in practice.  

8. Conflicts of interest  
9. Investors' assets 

Assessment  

The examples of best practice behaviour in the various stages of investment is relatively well 
described  and  documented,  although  number  of  exceptions  are  possible  since  one  size  does 
not  fit  all  managers  and  the  funds  they  manage.  The  compliance  with  these  guidelines  is 
voluntary  for  members  of  EVCA.  As  of  today  only  four  national  associations  subscribe  to 
these principles. No other Member State trade association developed its own standards so far. 
It is up to the investors to enforce their contractual rights and managers' compliance since the 
limited  partnership  agreements  constitute  the  legal  framework  for  the  investment  into  the 
fund. 

The  guidelines  require  managers  to  ensure  that  all  investors  receive  the  same  information 
(stipulating  minimum  content)  and  should  be  treated  equally  and  informed  about  reasons  if 
exceptional circumstances arise. Many of the guideline's provisions address issues of concern 
raised  in  relation  to  private  equity  activities  ranging  from  the  levels  of  leverage,  to 
sustainability  of  portfolio  companies,  appropriate  disclosure  of  relevant  information  to 

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investors  including  risks  or  management  and  disclosure  of  conflicts  of  interest.  Given  the 
limited compliance with these guidelines and the private character of the limited partnership 
agreement  it  is  to  be  questioned  whether  such  a  framework  is  sufficient  for  investors  to 
receive appropriate information before and after investments are placed 

3.2.3   EVCA Corporate Governance Guidelines 

Content and Objectives 

Corporate  governance  involves  a  set  of  relationships  between  a  company's  management,  its 
board, its shareholders and other stakeholders. This document is set of best practice guidelines 
that govern relationship between company's management, its board, its shareholders and other 
stakeholders. The guidelines should help managers of portfolio companies to understand the 
nature  and  behaviour  and  expectations  that  the  private  equity  investment  brings  along. 
Examples of such behaviour are described taking into account the following principles: 

Principles  of  Good  Governance  for  Private  Equity  and  Venture  Capital  Investing:     
law  and  regulations,  integrity,  partnership,  the  long  term  view,  respect  for  stakeholders, 
transparency and confidentiality 

Principles of Conduct as Shareholder: e.g. responsibilities in relation to strategy, performance 
information, the board and other shareholders and stakeholders including conflicts of interest 

Principles of Conduct as Board Member: e.g. collective responsibility of board members for 
identification,  assessment  and  management  of  risks,  determination  of  remuneration  of 
executives, 

Principles  of  Conduct  for  Management:  e.g.  responsibilities  of  management  for  control 
activities,  appropriate  communication  with  employees  (strategy,  performance,  risks 
assessment, etc.) 

Assessment  

Corporate governance issues are on top of the agenda in particular as regards the impact of 
private  equity  behaviour  on  various  stakeholders.  These  guidelines  therefore  cover  very 
important  aspects  of  private  equity  behaviour.  They  also  cover  number  of  areas  that  were 
raised as key concerns in relation to the activities of private equity.  

Similarly to the previous guidelines, the compliance is voluntary and only four EU Member 
States' national associations subscribe to these principles with one Member State applying its 
own. It is then a question  how effectively can compliance be enforced either at the level of 
portfolio  company  or  at  the  level  of  the  fund  manager  given  in  addition  to  the  voluntary 
compliance,  the  limited  coverage  and  the  lack  of  sanctioning  mechanisms  that  one  could 
resort to. 

3.2.4   EVCA Reporting Guidelines 

Content and Objectives 

Reporting guidelines set out key requirements that must be applied by fund managers when 
reporting to their investors so that the latter can monitor their investments in an appropriate 
way.  The  guidelines  are  designed  to  complement  and  enhance  the  requirement  of  European 
laws regarding the format and content of statutory accounts. Requirements for reporting refer 
to  some  key  principles  to  be  observed  by  fund  managers,  like  relevance,  transparency  and 
consistency. In addition, the main body of the guidelines lists in a detailed manner the content 
of  what  should  be  reported  in  relation  to  fund,  portfolio,  capital  account,  fees  and  carried 
interest. In order to illustrate practically the way in which such reporting could look like, the 

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document also contains a template with examples. The reporting guidelines were introduced 
in 2000 and were updated in 2006 in order to take due account of the new valuation principles 
adopted in the International Private Equity and Venture Capital Valuation Guidelines.  

Assessment  

In general the requirements on what reporting towards investors should contain is relatively 
detailed and covers all important elements of information that investors should receive from 
their  fund  managers.  Although  compliance with the code is voluntary,  there  are  as  many  as 
eleven  Member  States'  national  associations  that  subscribe  to  these  guidelines.  Non-
compliance  is  not  addressed  in  the  document  through  sanctioning  mechanisms  as  it  is 
perceived  that  investors  will  place  high  expectations  on  managers  who  would  then  comply 
with the guidelines as it is in their best interest to sustain current investors also in the future. 
The question is whether investors are always aware of the fact that fund managers as members 
of one of the eleven national associations, subscribe to these guidelines. In relation to existing 
concerns  in  private  equity  relating  in  particular  to  reporting  on  investment  strategy,  risks, 
valuation  of  assets  or  management  fees,  these  issues  are  in  principle  covered  by  the 
guidelines. To what extend do investors receive information that would be comparable across 
the industry and various investments is however questionable given the still limited coverage 
which abides to diverging application of reporting to investors. Also whether the information 
provided to investors is always relevant, transparent and consistent can not be fully assessed 
given  the  lack  of  independent  information  or  evaluation  of  such  reporting  from  the 
perspective other than the investor. This situation invites to question the lack of some form of 
an  external  monitoring,  enforcement  and  transparency  mechanisms  to  assess  the  overall 
effectiveness of the reporting guidelines.  

3.2.5   International Private Equity and Venture Capital Valuation Guidelines (IPEV) 

Content and Objectives 

The guidelines were put in place in 2005 in a need to foster greater comparability across the 
industry and to ensure consistency with international financial reporting standards (IFRS) and 
US  Generally  Accepted  Accounting  Principles  (GAAP).  Managers  use  IPEV  to  value 
investments  for  their  financial  statements  and  for  reports  they  submit  to  investors.  These 
valuations are used to monitor progress of investments. IPEV guidelines are based on the 'fair 
value' principle. The IPEV board was charged with the revision of the guidelines in the course 
of  2008.  Along  with  the  guidelines,  IPEV  board  was  created  as  an  independent  legal  entity 
that  takes  the  responsibility  for  maintaining,  promoting,  monitoring  and  updating  the 
guidelines. The guidelines contain two parts, the first one outlines principles which represent 
the  best  practice  for  the  valuation  of  investments  and  the  second  section  provide  for  a 
guidance on how the principles and methodologies can be applied in specific cases. 

IPEV were developed together by the British, French and European private equity and venture 
capital associations. These guidelines are of an international impact as number of associations 
active  in  private  equity  and  venture  capital  outside  of  Europe  subscribe  to  them.  The 
guidelines comprise a set of best practices as regards valuation of private equity and venture 
capital investments. Valuation of investment is an important element in the reporting process 
to  investors  and  so  the  guidelines  are  an  essential  element  in  helping  investors  to  make  the 
right decisions. 

Towards the end of 2008, IPEV board re-confirmed its position that 'fair value' remains the 
best  measure  for  valuing  private  equity  portfolio  companies.  The  challenges  for  managers 
today are to demonstrate to regulators and others the appropriateness of the process by which 

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they consistently determine fair value. Fair value should in addition not to be the only sources 
of assessing general performance of fund managers. 

Assessment  

The  international  acceptance  of  the  valuation  guidelines  achieved  so  far  and  the  high 
subscription  rate  by  18  EU  Member  States'  associations  is  an  important  achievement. 
Although  widely  used,  the  gaps  in  their  consistent  adoption  across  the  industry  persist. 
However the same concerns arise as in the case of the reporting guidelines in that it is difficult 
to  assess  their  overall  effectiveness  directly  since  from  the  perspective  other  than  of  the 
investor  (enforcement  and  monitoring  should  be  covered  in  the  fund  agreements)  no 
information exists as to how is compliance with the guidelines monitored and enforced.    

3.2.6   National Disclosure and Transparency Guidelines  

Content and Objectives 

Introduced in November 2007, the UK Walker Guidelines were the first of its kind in Europe 
to require additional disclosure and communication by private equity firms and their portfolio 
companies  using  the  'comply  or  explain'  principle.  Some  other  EU  Member  States  national 
associations  (DE,  DK,  SE)  followed  suit  inspired  by  the  UK  approach  and  in  the  course  of 
2008 introduced similar enhanced disclosure requirements.  

These guidelines were introduced in principle as a reaction to the criticism targeted at private 
equity  activities  in  particular  in  the  past  3  years,  when  European  large  buy-out  activity 
reached  its  highest  levels,  both  in  terms  of  volume  and  number  of  deals.  Governments  and 
stakeholders  started  to  call  for  more  information  as  to  what  was  happening  to  these 
companies.  As  the  new  disclosure  guidelines  emerged  first  in  the  UK  and  the  way  they 
inspired  other  countries  represents  an  important  acknowledgment  by  the  industry  that  more 
openness and transparency was needed and that it does have its merit.  

Assessment  

Although all four transparency and disclosure guidelines developed at national level have the 
same overall objective, their scope, coverage and level of descriptiveness vary considerably. 

The  UK  and  German  guidelines  target  only  the  top  end  of  the  buy-out  market,  thus  only  a 
small proportion of private equity companies are caught by the requirements and obligations. 
Danish approach is also limited and applies to members of DVCA with committed capital of 
at  least  DK500  million  and  those  private  equity  companies  who  do  not  have  their 
headquarters in Denmark fall outside of the full scope of the  guidelines. On the other end is 
Sweden with the widest scope: all private equity companies who are members of SVCA must 
comply with the guidelines. 

At the level of portfolio companies only Sweden applies again the widest thresholds and so all 
companies with their headquarters in Sweden shall comply. All the other three countries have 
more targeted approach and apply combination of thresholds (value of acquisition, number of 
employees, generation of minimum level of revenue in given country) that also wary among 
these  countries,  for  example  in  the  UK  only  portfolio  companies  with  more  than  1000  full 
time  employees  are  subject  to  the  guidelines  whereas  in  Denmark  it  is  applicable  to 
companies with more than 250 full time employees. 

As  regards  the  reporting  obligations  for  private  equity  companies  and  their  portfolio 
companies, here the guidelines differ also considerably. This is in principle due to the fact that 
some countries, like the UK have less comprehensive company law than for example Sweden. 
To that extent, we can see that the UK approach is more prescriptive than the Swedish one, 

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which in effect is limited to one page of recommendations. As an example, we can take the 
disclosure  requirements  of  portfolio  companies  regarding  employment  issues.  In  Sweden, 
trade  unions  are  by  law  given  an  extensive  insight  as  to  the  management  of  portfolio 
companies  regardless  if  these  are  public,  private  or  controlled  by  private  equity.  On  the 
contrary,  Denmark  and  the  UK  do  not  have  such  stringent  statutory  reporting  requirements 
and so their guidelines are more detailed as to the content and form of additional reporting. 
When  compared  the  more  detailed  approach  of  Denmark  and  the  UK,  it  is  evident  that  in 
several aspects the Danish approach goes further. For example, the Danish guidelines require 
portfolio  companies  to  disclose  information  about  employee  turnover,  capital  structure, 
identify  company's  primary  stakeholders,  report  o  the  board's  tasks  and  responsibilities  or 
disclose remuneration of the management and board members. Portfolio companies in the UK 
do not have to disclose such information. 

Overall,  all  of  these  codes  compare  better  to  those  developed  so  far  on  European  level.  In 
particular,  the  stronger  compliance  mechanism  linked  with  the  active  monitoring  done  by 
national  associations  and  underpinned  by  the  obligation  to  disclose  and  publish  the 
requirements adds to the influence and real bite these guidelines have to address some of the 
concerns raised in relation to private equity and induce changes how private equity behaves 
and operates vis-à-vis its key stakeholders as well as the public in general. 

Another  positive  aspect  is  the  increased  role  and  responsibilities  the  individual  national 
associations  are  given.  Among  others,  they  collect  and  consolidate  data  with  the  aim  to 
provide  views  as  to  the  general  trends  in  the  industry.  For  the  first  time  since  the  UK 
guidelines were introduced, BVCA together with Ernst & Young issued its first report based 
on  the  extensive  obligation  of  companies  to  report  to  BVCA.  Overall,  the  UK  companies' 
performance under private equity ownership was encouraging. However, it did highlight that 
a  significant  proportion  of  private  equity  portfolio  company  performance  was  generated  by 
cheap  borrowing  to  finance  activities  rather  than  operational  improvements.  Since  the  other 
three Member States guidelines were put in place in principle a year later, it is yet to be seen 
how effective were they and what information will we get following the data gathering done 
by the national associations. 

To conclude, these codes do play a very important role in the current environment the private 
equity industry finds itself today. So far, we have seen only one to conclude its full cycle of 
implementation,  enforcement,  monitoring  and  reporting.  The  fact  that  the  other  three 
guidelines did not produce yet results does not hinder to assess their potential effectiveness. 
One  could  find  many  other  different  ways  in  which  to  compare  them  than  the  selective 
comparison presented in this chapter. On the other hand, it does not take a much of a detailed 
approach to spot the gaps. Overall, all four guidelines appear to be rather effective and have 
the potential of bringing about desired changes. These guidelines were a result of the industry 
taking  very  first  steps  to  actively  respond  to  the  wide-spread  criticism.  One  year  later,  it  is 
clear that although most welcome, this response is not sufficient, be it because of the limited 
coverage of Member States in which the guidelines apply or the varying approaches to what is 
eventually disclosed to the public, investors, national associations or supervisory authorities.  

4.  Conclusion 

Private equity self-regulatory approach to comply and enforce existing professional codes has 
been subject to increased criticism and so has been the lack of direct regulatory oversight of 
private equity activities. Indeed, there is number of European, national or international codes 
and guidelines in place but strong doubts persist as to their ability to bring about changes in 
behaviour and working practices of private equity business on a wider scale.  

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The  mapping  of  existing  regulatory  framework  and  professional  codes  applicable  to  private 
equity  activities  identifies  clear  gaps  where  concerns  raised  in  relation  to  private  equity  are 
not  subject  to  specific  or  appropriate  regulation  and  the  level  of  effectiveness  of  existing 
professional  codes  does  not  sufficiently  complement  current  regulatory  environment  to 
address  the  concerns  related  to  private  equity  activities  and  its  subsequent  impact  on  the 
economy and key stakeholders. 

Overall there is a reasonable doubt stemming from this analysis as to the level of effectiveness 
through  which  existing  codes  and  best  practices  address  issues  of  concern  expressed  by 
various stakeholders. The same level of doubt persists about the effectiveness of the codes as 
regards issues they are designed to regulate. There is a considerable overlap whereby the same 
issues and concerns are addressed by different guidelines with different coverage, content and 
objectives. As a result it is difficult for various stakeholders to realise who is covered by what 
guidelines and how their application is or can be enforced. It is reasonable to conclude that 
criteria necessary to be fulfilled for a professional code to make a difference in behaviour of 
private equity actors are not complete for most of the codes in question.  

Box  1:  Summary  analysis  of  effectiveness  of  industry  codes  and  best  practice  guidelines  in 
private equity 

To  assess  the  effectiveness  of  self  regulatory  framework  we  focused  our  analysis  on  the  framework 
applicable  to  AIFM  in  private  equity  in  which  we  consider  the  following  codes:  National  Codes  of 
Conduct,  National  Transparency  and  Disclosure  Guidelines,  European  Private  Equity  and  Venture 
Capital  Association  (EVCA)  Code  of  Conduct,  EVCA  Corporate  Governance  Guidelines,  EVCA 
Governing Principles, EVCA Reporting Guidelines, International Private Equity and Venture Capital 
Valuation Guidelines (IPEV). 
Content:  As  can  be  derived  from  the  titles  of  the  codes  in  question,  they  have  different  focus  and 
different level of ambition. Some of them are very generic and wide ranging. This is the case where 
codes  contain  mainly  high-level  principles  (e.g.  EVCA  Code  of  Conduct  or  EVCA  Corporate 
Governance Guidelines). Others are more targeting a particular business activity and accordingly are 
more specific and targeted (e.g. EVCA Reporting Guidelines, International Private Equity and Venture 
Capital Valuation Guidelines – IPEV).  
Scope/Coverage:  The  key  criteria  for  codes  to  have  an  impact,  they  should  be  applied  as  far  as 
possible  by  all  relevant  actors  from  within  the  industry.  Using  the  example  of  private  equity  and 
coverage  of  the  codes  and  guidelines  in  question  we  can  conclude  that  overall  coverage  is  rather 
patchy.  The  strongest  coverage  refers  to  Codes  of  Conduct  both,  national  and  European.  For  other 
codes,  only  few  Member  States  private  equity  associations  subscribe,  for  others,  large  number  of 
national  associations  sign  up.  Regardless  whether  the  subscription  through  national  associations  is 
high or low, doubts persist as to the extent to which all managers are captured, since membership in 
national or European associations is not obligatory in majority of cases. This is based on industry data 
indicating that the number of management companies with their headquarters in a given Member State 
exceeds  considerably  the  number  of  management  companies  that  are  members  of  national 
associations. 
Enforcement: A set of three enforcement criteria help us to determine whether professional codes or 
guidelines have a real impact. Firstly it is the level of compliance (mandatory vs. 'comply of explain' 
vs. voluntary), secondly monitoring of compliance and lastly the existence of sanctioning mechanism. 
Analysis shows that a compliance mechanism has a considerable influence over how is monitoring of 
compliance organised and whether particular code or guidelines provide for a reference to sanctions.    
Here we can conclude that majority of European and international codes, although enjoying relatively 
high coverage via membership in national associations, can not be efficiently enforced. This is due to 
the  fact,  that  their  voluntary  compliance  mechanism  makes  organised  monitoring  or  sanctioning 
mechanisms  irrelevant.  These  codes  in  fact  lack  a  reference  as  to  how  is  monitoring  of  compliance 
organised  and  the  same  is  valid  for  sanctions.  This  is  the  case  in  particular  for  EVCA  Corporate 
Governance Guidelines, EVCA Governing principles, EVCA Reporting Guidelines and IPEV.  

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EN 

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EN 

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ANNEX X.A-6: Supporting tables for the effectiveness analysis of Codes of Conduct in 
private equity 

Table: Effectiveness criteria: coverage/scope: to what extent are all possible actors active on 
private equity markets covered? 

National 
Association 
member of 
EVCA 

N° of 
companies 
receiving PE 
investments 
in 2007 

Number of 
individual 
companies members 
of EVCA 

Number of private equity firms in 
existence in given Member State of 
which N° of those who have 
headquarter in Member State 

Number of full 
members of national 
association 

UK 
FR 
SE 
DE 
NL 
IT 
FI 
ESP 
DK 
AT 
BE 
CZ 
GR 
HU 
IRL 
PL 
PT 
SK 
RO 

963 
661 
514 
1088 
393 
107 
235 
300 
143 
70 
162 
24 
10 
24 
67 
58 
59 

30 

Total number 
of PE firms in 
MS 
432 
266 
174 
305 
99 
117 
54 
139 
62 
62 
77 
23 
15 
21 
33 
52 
29 
6 
23 

Of which -Number 
of PE firms with 
headquarter in MS 
403 
230 
149 
253 
13 
93 
48 
120 
49 
58 
70 
13 
14 
9 
26 
34 
25 
2 
7 

Full members 

210 
240 
110 
217 
85 
130 
37 
90 
48 
20 
43 
13 
na 
28 
15 
34 

6 

115 
81 
32 
87 
41 
34 
18 
32 
19 

4 

5 

14 

10 

Source: EVCA, national private equity and venture capital associations 

European Private Equity investments 2003-2007

n
b
R
U
E

700
600
500
400
300
200
100
0

627

258

550

180

EU industry

of which buy-out

77

77

of which non-
leveraged
investments (VC)

Funds invested by European private equity firms domestically (excluding
leverage)
Funds invested by European private equity firms domestically (including
leverage)

Source: EVCA, own calculation 

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

Existing codes and guidelines for hedge funds: 

1.  Alternative investment Management Association (AIMA): Guide to Business continuity 

Management for Hedge Fund Managers, Guide to Sound Practices for European hedge Fund 
Managers, Guide to Sound Practices for hedge Fund Valuation and Offshore Alternative Fund 
directors' Guide.  

2.  IOSCO: Principles for the valuation of Hedge Fund Portfolios 
3.  Managed Fund Association (MFA): Sound Practices for Hedge Fund Managers 
4.  The Hedge Fund Working Group (HFWG): Hedge Fund Standards 
5.  The Presidents Working Group (PWG) on financial Markets issues report called "Asset 

Managers Committee Report 

IOSCO 

MFA 
+ 
O 
+ 

PWG 
O 
O 
O 

HFSB 
+ 
+ 
O 
O 

Table X.B.-1: Coverage of industry guidelines for hedge fund disclosures 
AIMA 
+ 
+ 
O 

Reporting style 
Valuation framework 
Past returns 
Extreme risks 
Factor exposure 
Portfolio composition 
O 
Leverage risk 
+ 
Liquidity risk 
+ 
Hedge fund structure 
Operational risk 
+ 
+: detailed advice in the guideline; O: topic mentioned in the guideline 
Source: EDHEC Hedge Fund Reporting Survey 2008 
Recently,  in  its  consultation  report102,  IOSCO  issued  an  overview  and  analysis  of  the 
effectiveness of existing codes and guidelines for hedge funds, providing further evidence of 
the weak applicability the existing codes have.  

O 
O 
O 
+ 

O 
O 
+ 
+ 

O 

+ 

+ 

Summary analysis of effectiveness of industry codes and best practice guidelines for hedge funds 
The key issues dealt with in the existing codes and guidelines: 

–  Improved disclosure practices: to make operations of hedge funds more transparent for investors, 

counterparties and governments 

–  Asset valuation: to implement valuation arrangements to address and mitigate conflicts of interest 

in relation to asset valuation 

–  Risk management: sound risk practices are essential to ensure market confidence 
–  Governance: to have an appropriate structure to mitigate the potential of conflicts of interest 
–  Shareholder conduct: to ensure a standardised best practice conduct as a minority shareholder 
–  Trading  and  business  operations:  given  the  complexity  of  operations,  hedge  funds  should  have 

appropriate infrastructures in place 

–  Compliance issues: commitment to highest standards of integrity and professionalism 

Assessment of effectiveness of existing codes and guidelines: 
–  Areas covered are quite comprehensive. However they lack a clear regulatory status and consistent 

implementation.  

–  As to the regulatory status, none of the codes or guidelines has the force of law. They are a set of 
recommendations to be adopted on a voluntary basis. November 2008 survey of one hundred UK 

102 

IOSCO: Hedge Funds Oversight, Consultation Report, March 2009, 
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD288.pdf. 

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hedge  funds  found  that  while  over  60%  supported  the  HFWG  initiative  in  terms  of  establishing 
standards for industry, less than 10% signed up to these standards.103 

–  Some of the industry codes do not converge in the way as to promote the same standards 
and the individual organisations responsible for their development do not necessarily work 
together. 

Source: IOSCO 

Table: Summary of industry recommendations that are to be addressed by industry codes 

Source: IOSCO: Hedge Funds Oversight, Consultation Report, March 2009 

103  

According to the latest report issues by the HFSB in March 2009 the number of Hedge Fund signatories 
increased to 45, including also international hedge fund managers. Compared to the situation in autumn 
2008,  the  number  of  Hedge  Funds  accepting  these  standards  has  by  now  nearly  doubled. 
http://www.hfsb.org/ 

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ANNEX XI: The Lamfalussy process 

The  new  regulatory  structure  of  the  so-called  Lamfalussy  process  has  been  initiated  by  the 
Stockholm  European  Council  Resolution  of  23  March  2001  on  “more  effective  securities 
market  regulation”.  The  Lamfalussy  process  is  based  around  the  four-level  regulatory 
approach  recommended  by  the  Committee  of  Wise  Men  on  the  Regulation  of  European 
Securities Markets, chaired by Baron Alexandre Lamfalussy104. 

The Lamfalussy process was designed to make Community legislation on securities markets 
more flexible, so that it can be agreed and adapted more quickly in response to innovation and 
technological  change  in  financial  markets;  to  allow  the  Institutions  to  benefit  from  the 
technical  and  regulatory  expertise  of  European  securities  regulators  and  from  better 
involvement  of  external  stakeholders;  and  to  focus  more  on  even  implementation  and 
enforcement of Community law in the Member States. 

One of the key innovations of the Lamfalussy process is the creation of two Committees to 
advise  the  Commission  on  Level  2  implementing  measures  –  the  European  Securities 
Committee (ESC) representing the Member States and functioning as a so-called ‘regulatory 
committee’  under  the  Comitology  arrangements105  –  and  the  Committee  of  European 
Securities  Regulators  (CESR).  The  two  Committees  were  set  up  by  Decisions  of  the 
Commission  on  6 June  2001106.  The  ESC  acts  in  its  capacity  as  a  regulatory  committee, 
assisting the Commission in the exercise of its delegated executive powers, within the terms 
defined in the Directives adopted at Level 1. 

Transparency  is  another  important  feature  of  the  process.  The  Lamfalussy  process  has 
established  a  rigorous  mechanism  whereby  the  Commission  seeks,  ex-ante,  the  views  of 
market  participants  and  end-users  (companies,  investors  and  consumers)  by  way  of  early, 
broad  and  systematic  consultation,  with  particular  regard  to  Level  1  proposals,  but  also  at 
Level 2.  

104 

105 

106 

The  Lamfalussy  report,  published  on  15  February  2001,  can  be  found  on  the  Commission’s  website: 
http://europa.eu.int/comm/internal_market/securities/lamfalussy/index_en.htm 
See  Council  Decision  1999/468/EC  of  28  June  1999  laying  down  the  procedures  for  the  exercise  of 
implementing powers conferred on the Commission, OJ L 184, 17.7.1999, p. 23. 
See  Commission  Decision  of  6  June  2001  establishing  the  Committee  of  European  Securities 
Regulators (2001/527/EC), amended by Commission Decision of 5 November 2003 (2004/7/EC), and 
Commission Decision of 6 June 2001 establishing the European Securities Committee (2001/528/EC), 
amended by Commission Decision of 5 November 2003 (2004/8/EC). 

EN 

120 

   EN 

 
                                                 
•  Table 1: The four-level regulatory approach under the Lamfalussy process107 

107 

SEC(2004) 1459; the Level 2 phase will be modified following the entry into force of new comitology 
arrangements, anticipated for the end 2006/ beginning 2007. 

EN 

121 

   EN 

 
 
                                                 
ANNEX XII: References 

•  Consultation on hedge funds and Conference on hedge funds and private equity: 

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

•  White Paper on Enhancing the Single Market Framework for Investment Funds 11/06 

http://ec.europa.eu/internal_market/investment/asset_management_en.htm#white_paper 

•  previous AI EG (HF, PE: Reports of the Expert Groups 07/06; Public Consultation on 

Expert Group Reports feedback statement 10/06; 
http://ec.europa.eu/internal_market/investment/alternative_investments_en.htm#alternative 

•  OEREF report March 08; Public consultation on report: feedback statement July 08) 

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

•  previous conferences: Open Hearing on NHF April 08; 

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

•  Private Placement Workshops Jan Feb 08; call for evidence on PP: summary doc 
September 07 http://ec.europa.eu/internal_market/investment/private_placement_en.htm 

•  IA on PP and NHF http://ec.europa.eu/internal_market/investment/private_placement_en.htm#report;  

•  PricewaterhouseCoopers (PWC) studies 2008: 

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

EN 

122 

   EN