CHAPTER 4: SUPERVISION OF AIFMs
Registration and Transparency
Requirements
103. The Directive would introduce increased
transparency and disclosure requirements to identify the risks
caused by AIFMs to both the financial markets and investors, as
part of the registration requirements. The Directive does not
intend to eliminate risk, and as FEPS noted, "risk will remain
and is a normal part" of Alternative Investment Fund Managers'
activities (Q 279). The Directive would also provide tools
for supervisors to act to reduce excessive risk where it is identified.
We examine these elements of the Directive in this chapter.
BOX 7
Disclosure and transparency requirements
| The Directive differentiates between disclosure to regulators and transparency for investors.
To supervisors, AIFMs would be required to disclose:
- Performance data;
- Data on concentrations of risk;
- The markets and assets in which an AIF will invest;
- Risk management arrangements; and
- Organisational arrangements.
The Directive aims to ensure a minimum level of transparency of AIFs to ensure investor protection and facilitate due diligence. This would involve providing:
- A description of investment policy;
- Descriptions of use of assets and leverage;
- Redemption policy;
- Valuation, custody, administration and risk management procedures; and
- Fees, charges and expenses associated with the investment.
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Disclosure requirements
104. Witnesses agreed that AIFMs reporting this data to supervisors
would help identify and so reduce risks posed to the financial
markets by hedge funds. AIMA welcomed the approach already undertaken
by the FSA to collect information relating to systemic risk from
the largest hedge funds and to compile and consolidate this data
in order to track exposures and leverage (Q 157). The Wellcome
Trust told us that further disclosure to supervisors would reassure
the investor that the supervisor understood the overall situation
in the investment industry (Q 252). Other witnesses including
Mr Rasmussen (p 293), AFME (Q 478) and Deutsche
Bank (Q 454) agreed that further disclosure to supervisors
was, in principle, a positive step. Sharon Bowles MEP summed up
the opinion of most witnesses when she argued "that to have
more light shone on everything has to be a good thing" (Q 395).
Arcus Investment, a small investment management firm, agreed that
greater transparency was a "constructive avenue" for
regulation to pursue (p 189).
105. Many industry bodies, however, told us that the Directive
was overly prescriptive in terms of what data was collected from
managers, and risked overwhelming supervisors with large amounts
of information irrelevant to the stability of financial markets.
CMS Cameron McKenna told us that AIFMs were not sure what all
the information to be disclosed would be used for (Q 125).
AIMA argued the Directive should not contain excessive disclosure
requirements which led to supervisors "being inundated with
information which they have requested, but which they may not
have adequate resources or expertise to analyse and/or process"
(p 61). AFG described some of the disclosure requirements
as disproportionate (p 194).
106. When we put this to the Commission they told us that
supervisors would not be overwhelmed with information. They hoped
that the information requested would be "appropriate"
to enable supervisors "to identify where potential risks
occur" (Q 366). The Commission acknowledged that part
of the problem of the regulation of AIFMs was that previously
supervisors had not had the right information. The disclosure
requirements of the Directive aimed to ensure that supervisors
had enough information to make informed decisions on risk management.
This would enable supervisors to spot where risk was building
up in the system (p 128). The European Systemic Risk Board
would also have a role in highlighting concerns of a build up
of risk in a particular sector or member state (Q 367).[30]
107. The FSA told us that if the Directive allowed the right
information to be gathered in the right way then it would reduce
the risk to market stability posed by AIFs (Q 209). The FSA
has, over the last year, trialled both a hedge fund manager survey
and a prime brokerage survey which have provided information on
the impact of funds on the market and their use of leverage.[31]
If the foundations for information gathering and sharing across
Europe were implemented by the Directive, "that would be
a very good thing". This information, when used effectively,
would allow the supervisor to see a build up of leverage across
the system or in a specific fund or identify crowded trades. Action
could then be taken where necessary to reduce excessive risk (Q 210).
However, supervisors should be able to take a flexible approach
to "gather the right data and gather it themselves."
The Directive should not be over prescriptive in its data collection
requirements and should only require that which is relevant to
systemic risk (Q 233).
108. The Minister expressed the Government's support for enhanced
oversight of managers through the Directive, the requirements
for which were broadly consistent with industry best practice
(QQ 33, 54). However, he argued the FSA should be able to
choose to collect only what it regarded as systemically relevant
data from AIFs. The Directive as originally drafted would mean
"that all UK fund managers would be forced to provide the
prescribed information to the FSA—irrespective of whether
the FSA believes that the information is important for the monitoring
of systemic risk" (p 152).
109. The Swedish Presidency put forward a compromise on this
issue, which would require all AIFMs to provide a basic data summary
to their supervisor. Supervisors would then request further information
from those AIFMs from whom data was systemically relevant, in
order to build up an analysis of systemic risk without receiving
large amounts of irrelevant data. The Government support this
approach and the Minister also told us it was "only right"
for the ESRB to request information from supervisors to build
up an EU wide picture of the investment market (p 152).
110. We have heard near unanimous support in principle for
the requirement for disclosure of key information on the activity
of funds to supervisors. This will enable supervisors to use the
information to compile an overall view of the market and the investments
of alternative investment managers, to identify crowded trades
and to take action to reduce the risks and leverage levels of
individual funds where necessary. We agree that these requirements
could enable supervisors to identify where AIFMs pose excessive
risk to financial stability, which should enable steps to be taken
to reduce this risk.
111. It is, however, crucial that supervisors are able to
use the information they receive from managers effectively and
that they act, where necessary, to tackle risk. We welcome
the work of the FSA to date on their survey of hedge fund managers
and prime brokers to build up an overall view of the UK alternative
investment industry. We also agree with the Government's support
for the Swedish Presidency's compromise to help ensure that only
systemically relevant data is collected. The Government should
consider whether this can most successfully be achieved through
setting detailed disclosure requirements at Level 2, which allows
flexibility, or through another alternative.
112. The Government should ensure that national supervisors
take on the role of data analysis and intervention. National supervisors,
including the FSA in the UK, are likely to be most effective at
analysing systemically relevant data and taking action to reduce
risk. The Government should also work to put in place systems
to require national supervisors to provide relevant data to the
ESRB and bodies at a global level (in particular the Financial
Stability Board) to help ensure that these bodies can identify
systemic risks at an EU and global level respectively.
Transparency requirements
113. Most witnesses welcomed in principle the minimum level
of transparency of AIFs required by the Directive to provide investor
protection and enable investors to carry out due diligence. Deutsche
Bank argued that the requirements would mean "that investors
understand more about what they are investing in and what those
risks are, and therefore it is good for the industry and, I hope,
good for investors as a result" (Q 477). The Wellcome
Trust agreed, welcoming the transparency requirements although
they noted that they "feel generally comfortable" with
the level of transparency already provided by the funds they invest
in (QQ 251-252). FEPS argued that greater transparency of
AIFs would increase public understanding of the working of the
funds and would therefore be good for the public at large (Q 284).
114. We heard, however, serious criticism of the transparency
requirements in relation to private equity funds. The Directive
would require private equity firms to disclose their business
plans for portfolio companies and other information on shareholders
and employees. These requirements would apply to around 500 companies
owned by private equity funds but not to the other 6,000 companies
not owned by private equity funds. US-based private equity funds
with no EU investors would also be exempt. The BVCA argued "this
would be a huge competitive disadvantage" for companies owned
by private equity funds and therefore for the funds themselves
(p 13). CMS Cameron McKenna noted that other funds, including
sovereign wealth funds, which carry out very similar activities
to private equity funds, would also be exempt from the requirements
(Q 126). The Association of Investment Companies agreed that
it is unclear why "sovereign wealth funds, rich individuals
and conglomerates" who operate in a similar way to private
equity funds, are not covered by the Directive (p 195).
115. The Minister told us that the Government "strongly
oppose the Commission's proposals to impose stringent and costly
disclosure requirements on portfolio companies of EU private equity
funds". He said that these proposals would place EU businesses
owned by private equity funds at a competitive disadvantage compared
to both non private equity owned businesses and US private equity
owned firms. He went on to describe these proposals as "nonsense."
He did acknowledge, however, that further limited transparency
requirements for the industry addressed "some of the misunderstandings
and fears about private equity" (Q 54).
116. Transparency requirements could in principle help
provide protection to investors in AIFs and increase public understanding
of the industry. However, the Government must ensure that such
requirements set out in the Directive reflect the variations of
different types of alternative investment funds to prevent them
placing companies owned by private equity funds at a competitive
disadvantage.
Supervisory tools
117. If it is to be effective in reducing the risks that AIFM
pose to market stability, the Directive must provide tools for
supervisors to reduce risk where it is identified. The Directive
provides controls on leverage used by AIFMs, capital requirements
of AIFs and control over AIFMs' stake in companies. Our inquiry
focused on leverage requirements as this element provoked the
most controversy amongst witnesses, though we also heard some
evidence on capital requirements. The Swedish Presidency compromise
also introduced the possibility of a cap on remuneration levels
of AIFMs. We have received little evidence on the subject. We
set out what evidence we have received below.
Leverage cap
118. The Directive would implement a leverage cap, set by
the Commission, for all AIFMs within its scope. The Commission
argued that while leverage was a "very crude" measure
of risk, it was easily measurable and therefore could work in
practice (Q 364). FEPS acknowledged that leverage levels
used by hedge funds had fallen but argued they may rise again.
Therefore, a cap was an appropriate way to prevent hedge funds
employing levels of leverage in the future that would create systemic
risks (QQ 324-330). Mr Rasmussen agreed that it was
right for the Directive to include proposals on leverage (p 293).
119. Although most witnesses were sympathetic to supervisors
having some control over leverage levels there was much opposition
to using leverage as a measure of risk and also including a leverage
cap within the Directive. CMS Cameron McKenna felt that "most
people would believe that there should be some restrictions on
leverage", but argued that the Directive and its cap did
not recognise the differences in uses of leverage across funds
(Q 134). The Wellcome Trust agreed, arguing "the number
of instances in which an individual fund takes on such leverage
as to pose a risk to the system will be very few, and I think
it is appropriate that, in that instance, the regulators do step
in to prevent it" (Q 259).
120. Whilst agreeing with the application of leverage limits
where necessary, the FSA told us that a cap on leverage
set by the Commission was the wrong approach in principle. They
argued that it was important to give national supervisors flexibility
in their attitude towards excessive leverage. It would be more
effective for the national supervisor to take a position on individual
funds when they had aggregated information, than for a leverage
level to be set across the EU by the Commission (QQ 223-5).
AIMA (QQ 146-8), Sharon Bowles (Q 383) and Deutsche
Bank (Q 468) also agreed that leverage limits should be set
where appropriate by national supervisors.
121. Some witnesses argued that applying a leverage cap would
increase systemic risk. AIMA said that appropriate leverage levels
were "critically dependent on the stage of the cycle."
A leverage cap could force many funds to unwind in a crisis, when
the value of assets fell, producing a similar risk to that seen
with crowded trades. In this case a simple leverage cap would
increase the risk to market stability. AIMA concluded that a single
leverage cap would be "counterproductive" (QQ 146-148).
122. Blackrock, in contrast, argued that leverage limits should
not be part of this Directive at all and were most appropriately
dealt with at supplier or bank level and in the Capital Requirements
Directive.[32] They suggested
that leverage levels did not play an important part in determining
the risk posed by a fund manager, so should not be included as
a provision to ensure financial stability (Q 198). The Commission
confirmed that they had hoped to bring forward proposals on leverage
as part of further amendments to the Capital Requirements Directive
(Q 364).
123. The Government agreed that determining uniform EU leverage
limits could in some circumstances increase systemic risk by forcing
a fund or a manager to sell assets. The Minister described the
cap as "brutal and blunt" (Q 60). The national
supervisor would need to exercise a high degree of judgement in
applying leverage caps to individual funds where appropriate,
informed by the information collected under the disclosure requirements
(Q 413).
124. The Swedish Presidency compromise would remove the simple
leverage cap, but maintain requirements for leverage disclosure
and give national supervisors the power to impose leverage limits
on individual funds or across the board if financial stability
was threatened.
125. Leverage ratios are not an absolute measure of risk and
so a leverage limit or cap, as proposed by the Directive as drafted,
will not automatically cap risk. Indeed, leverage caps have the
potential to create systemic risk, rather than reduce it. We
agree with the Financial Services Authority and the Government
that supervisors should have the power to impose leverage caps
where appropriate, based on the aggregated information they receive
from fund managers. We welcome the Swedish compromise on this
issue and the Government's support for this proposal.
Capital requirements
126. The Directive would require AIFMs to hold a minimum level
of capital. This is intended to ensure that AIFMs have an appropriate
capital base on which to build their investment. Capital requirements
did not give rise to a great deal of debate amongst our witnesses,
but those views we heard were divided.
127. Mr Rasmussen and FEPS (pp 296 and 115) both
expressed support for such capital requirements. Others, however,
did not agree a capital requirement should be included in the
Directive and felt instead that it should be included in other
legislation. The FSA told us that they did not object, in principle,
to the Directive setting minimum capital requirements, as long
as they were appropriate, differentiated appropriately between
different types of AIF manager, and were consistent with other
relevant EU capital adequacy regimes (p 95). It was suggested
by some witnesses that a cap of €10 million on capital requirements—in
line with the UCITS Directive—would be appropriate (Blackrock,
p 81).
128. The Minister told us that it was appropriate for fund
managers to hold enough capital to ensure they were creditworthy.
The requirements however should be more differentiated between
the different types of funds covered by the Directive to ensure
that they were appropriate (Q 60). We agree that if capital
requirements are set in the Directive, they must differentiate
sufficiently between different types of funds covered by the Directive.
The Government should also consider whether it will be more appropriate
to enforce capital requirements through the Capital Requirements
Directive.
Remuneration of fund managers
129. AIFMs have historically been highly remunerated and continue
to be so, and this has given rise to general resentment and anxiety
and specific concern of regulators on the basis that large incentives
cause financial managers to take risks that contribute to financial
instability. The Directive as originally published contained no
provision to regulate remuneration, but a clause along the lines
of that recently discussed by the G20 was introduced into the
deliberations as part of the Swedish Presidency compromise. "Member
States shall require AIFM to have remuneration policies and practices
that are consistent with and promote sound and effective risk
management and do not encourage risk-taking that exceeds the level
of tolerated risk of the AIFM or which is inconsistent with the
risk profiles, fund rules or instruments of incorporation of the
AIF it manages."
130. As the provision was introduced late in our inquiry we
took only limited evidence on remuneration, principally from Blackrock,
Citadel and John Chapman. The two hedge funds argued that alternative
investment managers in effect entered into a contract with a limited
number of professional investors under which they were remunerated
only if the investors achieved their target rate of return over
the life of the fund (Citadel Q 437). In short they only got paid
if and when investors had already been paid out over the life
of the fund. Blackrock said "managers are paid and participate
in performance: you gain with good performance, you lose with
bad performance" (Q 187). On this basis it was argued
that detailed regulation was unnecessary and inappropriate since
in effect the investors were the regulators. Dr Syed Kamall
MEP agreed that hedge fund managers have an incentive to act prudently
in their investments as failure will result in a loss for them
as well as the investor" (p 258).
131. The purpose of the G20 recommendation was to avoid the
sort of remuneration practices that would give rise to financial
instability but just as we found that AIFMs had not threatened
the credit channels it is clear that where AIF investors lost
money, so did the managers. They were working on the basis that
the investment had to remunerate investors first and had to be
calculated over the life of the fund. This was in sharp contrast
to many bankers who were highly remunerated on the basis of a
one year performance and not penalised when the positions they
had taken in order to achieve short term performance redounded
to the disadvantage of investors and depositors in the next year.
Banks allowed their employees to receive large bonuses after booking
short-term unrealised profits on transactions that turned out
to be hugely loss making in the long-term. The bank bonuses were
not clawed back from employees after it became apparent that their
actions led to large losses.
132. It was however put to us by John Chapman that the AIFMs
had been a malign influence on the whole financial system. The
levels of remuneration achieved by the successful had been well
beyond the aspirations of professional bankers and had given rise
to a culture where they all felt entitled to achieve those levels,
taking huge risks with the deposits and investments in their charge
and engaging in "hazardous financial innovations". In
short the hedge fund culture had infected the system (p 34).
Some of his concerns were felt by other observers and undoubtedly
contributed to the general unease about AIFMs, who in background
and training do not greatly differ from managers in corporate
and investment banks. Some argue, however, that AIF investors
made arrangements with their managers that ensured that they were
only highly remunerated on the basis that they achieved a high
rate of return for the investors over a number of years, in precisely
the manner recently proposed by the G20. The perception of AIFM's
pay, however, is a different matter and it may well have had some
influence on managers in conventional institutions whose employers
were less inclined to take a long and proprietorial view of their
assets.
133. The Minister noted that it was necessary to impose controls
on bonuses at all significant institutions, in line with G20 agreements.
He argued, however, that it was inappropriate to apply the same
structure of regulation in both the Capital Requirements Directive
and the AIFMD. The Government were therefore seeking to change
the requirements on the deferment of bonuses (pp 152-3).
Role of prime brokers
134. When we discussed the supervision of AIFMs with our witnesses,
many referred to the role which prime brokers play in the supervision
of hedge funds. Prime brokers lend capital to hedge fund managers
to invest alongside their assets, and in doing so have an interest
in the hedge funds' activities and success.
135. Deutsche Bank explained that prime brokers offered a
range of services to hedge funds including clearing, custody,
asset servicing, client reporting, financing, securities lending,
capital introduction, consultancy and risk management advice.
In lending to hedge funds, prime brokers carried out due diligence
on the fund to manage the risk they took in lending to that fund.
They agreed that prime brokers in effect supervise the funds they
lend to, as part of managing their own exposure (QQ 454,
475-6). AFME recognised that prime brokers knew hedge funds were
high risk customers and therefore undertook low-risk lending in
relation to them. This included refusing to lend to a fund manager
if their activities were considered too risky (Q 491). Lord
Myners also recognised the role of the prime broker, and argued
that effective regulation of the prime broker would help prevent
hedge funds employing excessively risky leverage levels (Q 413).
136. Whilst neither this Directive, nor this report, comments
on the regulation of prime brokers, it is important to recognise
the role of supervision they play in the system through due diligence.
The effectiveness of this is shown by the small amount of money
lost by prime brokers through the failure of hedge funds during
the financial crisis (Deutsche Bank, Q 471). Lending to hedge
funds is done normally at high margins and is more profitable
than much of the lending book. As Deutsche Bank told us, these
departments are very well resourced (QQ 470, 475).
30 The Committee has previously discussed the role
of the European Systemic Risk Board (ESRB) in European Union Committee,
14th Report (2008-09), The future of EU financial
regulation and supervision (HL Paper 106). Back
31
The FSA told us that these surveys have enabled them to know the
positions of all major funds in the UK market. They reassured
us that "there is nobody out there that looks anything at
all like LTCM" (QQ 214-216). Back
32
The Capital Requirements Directive sets EU rules on capital requirements
for credit institutions and investment firms Back
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