Investors turn up heat against EU plan

Institutional investors are adding to the pressure to amend a European regulatory proposal that opponents say would sharply cut investor choice in alternative strategies and possibly traditional ones, too, while restricting the ability of U.S.-based alternatives managers to conduct business in the EU.

They warn that the proposal, if not substantially altered, would damage returns for European pension funds and other institutional investors.

Consultants, pension funds and industry groups say the Alternative Investment Fund Management directive will restrict access to non-European markets and some of the best money managers worldwide.

Although originally thought to be aimed at stepping up regulation on hedge fund and private equity managers, experts now say the proposal could extend to long-only strategies as well, if not amended.

“This will affect more than just alternatives managers if not rewritten,” said Robert Howie, a principal and alternatives researcher at Mercer LLC in London.Reduction of choice — whether it be among strategies, geographies or managers — along with added compliance costs will lower returns for European investors, opponents say.

The Alternative Investment Management Association pegged the annual loss for European pension funds at e25 billion ($36 billion). In its estimate, AIMA assumed 20% of the e5 trillion in total European pension assets would be affected by the directive and that the regulations as proposed would take a 250-basis-point bite out of returns on affected investments. The London-based AIMA is a global hedge fund industry group with more than 1,100 members.

“If your choice is restricted, you're going to have a return drag,” Mr. Howie said. “On the cost side, there's an acknowledgement that some of the regulations are going to cost more. Some of it will have to be borne by the industry, but some of it will be passed on to the investor.”

The proposed regulation — written by the European Commission, the executive branch of the European Union — would affect all managers of pooled funds that don't fall under the Undertaking for Collective Investment in Transferable Securities directive, a set of rules affecting European mutual funds that has proven too restrictive for most hedge fund or other alternatives managers (Pensions & Investments, May 18).

The proposal now goes to the European Parliament and the European Council, which comprises leaders of EU member states. Using the EC's directive as a guide, both bodies must develop a single proposal and then approve it to become law. The earliest that could happen would be mid-December, in which case the regulation would be implemented in 2011.

In addition to non-EU managers, the directive would affect non-EU custodial banks and possibly managers of emerging markets equities or debt, barring them from delegating work to subcustodians or units on the ground in countries around the world, said Andrew Baker, CEO of the AIMA. It would affect U.S.-based custody providers such as State Street Corp. and Northern Trust, but it also would affect EU-domiciled providers using subcustody providers in other countries.

The AIMA wants to see amendments in five key areas, one of which is “delegation” or restrictions on EU managers using non-EU resources even within their own companies, Mr. Baker said.

Using the emerging markets example, Mr. Baker said that even an EU-based manager might be barred from marketing in the EU if the firm uses managers or subcustody in a non-EU country. That part of the directive aims at stopping a “post-box” scenario where a manager would be EU-based in name only. “Unfortunately that measure has been badly worded or (it) is too onerous,” Mr. Baker said.

But most pension fund executives have not drilled down to that level of detail. In fact, Mr. Baker said the “awareness” phase of AIMA's efforts is still under way — and it is taking longer than expected. Last week, he met with single-country and pan-European association counterparts. “It's worth our while to explain that there are very significant consequences that extend beyond” hedge funds and private equity, he said.

Pension funds and consultants are most concerned about their freedom to choose the investments they deem best.

“The directive, if passed in its current form, will reduce investment choice and mean that the return pension schemes can get for any level of risk will be reduced,” a spokeswoman for the National Association of Pension Funds said in an e-mail response to questions. “Even a small reduction in return will have an impact on the affordability of defined benefit pension schemes.” The NAPF, which represents 1,200 pension funds with assets of about £800 billion ($1.36 trillion), will begin lobbying in the EU capital later this month.

“The directive in its current form would result in our choice being severely curtailed,” said Kathryn Graham, a director and hedge fund specialist at Hermes Pension Fund Management, the investment arm of the £31.3 billion BT Pension Scheme, London. “The first thing we wish to stand up and talk about is the restriction on choice. If we are able to come to the table with (those responsible for amending regulations), obviously we will get into the specifics.”

Hermes has drafted a letter “to all parties concerned” that will be sent “very shortly” so that its voice will be heard, Ms. Graham said. About 20% of Hermes assets are targeted to alternative investments.

Pension fund and money management executives as well as consultants and industry group officials don't oppose regulation, but feel the process to develop the directive was rushed and that the European Commission did not adequately consult institutional investors, consultants and managers.

“It is extremely important to us that there is a transparency to investors,” Hermes' Ms. Graham said. “And yet, I'm not sure our concerns are fully aligned with the directive as written.”

Richard McIndoe, head of pensions at the £8 billion Strathclyde Pension Fund, Glasgow, Scotland, said: “It looks like regulatory overreaction to me. I haven't called for any (increased) regulation to private equity. I'm pretty happy with how it's regulated now. (Any new regulations) will inevitably involve costs, and those costs will inevitably end up with the investor. They always do.” Strathclyde has about £550 million in private equity strategies.

EC spokeswoman Catherine Bunyan did not respond to a request for comment by press time. However, the EC's website states the consultation period began in January 2006, with the latest consultation, which “concerned the activities of hedge funds,” taking place in February 2009.

The £1.1 billion Buckinghamshire County Council Pension Fund, Aylesbury, England, recently appointed Partners Group AG — based in Zug, Switzerland, which is not an EU member — for an approximately £55 million unconstrained alternatives mandate. In doing so, the impact of the directive was a concern for pension executives, who discussed the matter with Partners Group staff. “Those discussions will continue,” said Clyde Palfreyman, assistant head of finance at Buckinghamshire. “Ultimately, our priority is protecting the assets of our fund.”