10/08/2011 Author: Will Wainewright

Risks and reward

The content of the AIFM Directive continues to pose as many questions as it answers. With its remuneration proposals yet to be clarified, HFMWeek looks at what they might mean for hedge funds

The Alternative Investment Fund Management Directive (AIFMD) consultation paper, published by the European Securities and Markets Authority (Esma) last month, gave a nasty jolt to those who breathed a sigh of relief when the UK’s Financial Services Authority left hedge fund pay largely unscathed this year. It was a reminder that the AIFMD contains a number of yet-to-be-clarified provisions on remuneration which could, in theory, impact the industry significantly.

The pay proposals contained within AIFMD, the final text of which was published on 1 July, largely mirror those issued Europe-wide by the Capital Requirements Directive (CRD III) and implemented in the UK by the FSA this year. Both include provisions designed to align the interests of fund managers with investors, featuring clauses encouraging share payments, pay deferral and carried interest. However, the system of proportionality applied under the FSA Code means hedge funds are excluded from many of these sanctions.

By and large, hedge funds affected by the FSA Code have not had to change anything fundamentally, apart from the administrative headache of registering staff that fall under the Code.

However, it is not clear that the FSA Code’s tiered structure, which gave hedge funds ‘tier-four proportionality’ and shielded them from most of the new rules, will be replicated under AIFMD. In fact, “it is the great unanswered question,” says Paul Ellerman, a partner at law firm Herbert Smith.

“As AIFMD only applies to fund managers, it is uncertain that a tiering system based on types of activity or licence would be possible.” Whether or how proportionality is introduced will be clarified in the coming months. Esma’s paper started their two-month consultation process on AIFMD, while the FSA is set to undertake a similar process, during which things should become clearer. Opinion is split on whether or not hedge funds will escape the worst again. The Directive as it stands certainly leaves the door open for a flexible approach by taking account of the “size of the fund manager and the size of the funds they manage, their internal organisation and the nature, scope and complexity of their activities.”

So far, so obtuse, but that may be a good thing in allowing maximum interpretation until implementation. As Scott Cochrane, funds partner at Herbert Smith, points out, European law-making is anything but quick-fire: “The process of developing the Directive, and people becoming cognisant of its impact, has been stretched out over almost two years now and has over two years to go until we reach the full point of implementation.”

But what will it mean for hedge funds if they are forced to abide by rules similar but not identical to those they avoided under the FSA Code? Service providers in the field are quick to stress this remains a distant possibility – and have been accordingly hesitant to give out concrete advice to funds – but are nonetheless keen to remain on top of developments. PricewaterhouseCoopers undoubtedly led the warning cries, with reward director Tim Wright saying: “The (AIFMD) rules will mean sweeping changes to the pay policies and practices of many asset management firms. Many thought they’d escaped the brunt of banking pay regulations but they’re coming back to bite.”

And how might they bite? Dale Gabbert, a partner at law firm Reed Smith, thinks there are multiple potential dangers for hedge funds.  “The tentacles of this could reach into the alternative funds industry in a lot of different ways,” he says. “Applying these principles to illiquid funds will be a nightmare, things like carried interest – you don’t know what the equity is going to be worth until its realised.” He adds that the Directive’s section on pensions could, in theory, be “particularly nasty.”

The possibility of deferring pay to managers for a number of years seems a strange one and also throws up the possibility that so much income is deferred that the manager is unable to pay his share to the taxman, as HMRC, the UK’s tax authority, does not recognise deferrals. London’s status as a hedge fund hub means the whole issue is a very material one for the FSA, who will be aware the Directive will affect proportionately more managers in the UK than the rest of the EU.

Unanswered questions abound at this stage, leaving fund managers perplexed, and frustrated. “Contrary to a lot of opinion in Europe, we are not all a bunch of cowboys looking to trouser a load of cash and then run off to the beach,” said one $2bn manager to HFMWeek. But there is a long way to go, and it is perfectly possible the eventual outcome will prove tolerable to hedge funds. Until then, however, the waiting game has some way to run.