The AIFM directive was drafted by the EU in response to what it saw as an absence of common regulatory standards for non-Ucits investment vehicles and there are six key issues that specifically affect the UK-listed closed-ended fund sector.
Readers may, over recent months, have heard about the Alternative Investment Fund Managers directive (AIFM). This directive has been drafted by the EU (EU), in response to what it saw as an absence of common regulatory standards for investment vehicles that do not fall under the Ucits regime.
Released earlier this year, the AIFM directive has been written to attempt to regulate a number of industries such as private equity and hedge funds.
Some industry commentators have seen it as an attempt to reduce the size of two sectors seen as having disproportionate power, and who are mainly based in the UK.
The legislation is targeted at non-Ucits compliant funds managed within Europe. These are known as Alternative Investment Funds (Aifs). This means anything other than Ucits compliant open ended funds, such as investment trusts, fall within its scope. There are a number of key issues which specifically affect the UK-listed closed-ended fund sector:
1. No share issuance by entities not authorised by the directive. Clearly, this is a key problem to the investment trust industry. In focusing on legislating and regulating at the fund manager level, the directive unintentionally prevents any new issuance of shares by an investment trust or closed end fund, which is a company legally separate from the fund management group managing the assets. This would clearly prevent any new company launches in the sector, and as shares are bought back and funds wind up, so the industry would slowly atrophy.
2. Increased regulation at the fund manager level. A key difference of investment companies compared to open ended funds is that a board is responsible for the company's activity. Regulation increasing greater regulatory friction between the board and the fund manager may be to the detriment of the consumer's best interest.
3. Preventing use of non-EU service providers. Stopping fund managers from using non-EU service providers has a whole raft of implications. Funds would be prevented from outsourcing management of, for instance, US equities to a dedicated US based fund manager, who has no presence in the EU. Companies that use non-EU based depositaries for their assets would be prevented from doing so. This would cause significant problems when investing in countries where local legislation forces assets to be held with local institutions. Finally, tax efficient structures where a fund manager is based offshore but runs a UK listed company investing in assets in another country would be prevented.
4. The proposed leverage cap has a number of unintended consequences. In order to prevent breaches of such a cap, an investment company may be forced to sell assets into a falling market, so exacerbating any asset price decline.
5. The current proposals require Aifs to have a liquidity profile of assets which require them to offer redemption on demand. This is irrelevant to investment companies, where there is no link between the sale and purchase of shares and the underlying portfolio.
6. The addition of another layer of regulation would be duplicating those obligations under which investment companies are already subject, such as the Transparency and Prospectus directives.
In its current form, the proposed legislation is highly detrimental to the sector, and could see it cease to exist in its current form.
The AIC has gone into bat for the industry, as have the likes of the Association of British Insurers (ABI) and the British Venture Capital Association (BVCA).
Despite the unfortunate timing of the AIC's chief executive stepping down earlier this year, the association has and continues to lobby hard in both the UK and in Europe against what are clearly detrimental proposals.
It may well be helpful that Lord Myners, the UK's Financial Services Secretary, is a former fund manager and stated fan of the investment trust sector.
In its position as current president of the EU, Sweden wrote an issue note in September which outlined the issues many countries had with the regulations as they stand.
The issue relating to closed-ended funds is prominent and proposals to exclude them on the basis of being regulated already by the Prospectus and Transparency directives is one proposed resolution.
Issues relating to valuation of illiquid assets and the impracticality of the non-EU depositary proposal are well covered: "The current draft does not seem workable" is its conclusion. Finally, the pro-cyclical effect of selling assets to reduce leverage, potentially leading to increased market instability is recognised as a problem with the current proposals.
The European Central Bank (ECB) was asked to comment on the directive, and did so on 18 October. In its note it states 'the provisions of the proposed directive could be tailored in a way that better reflects fundamental differences between Aifs'. We would hope that such a comment from an organisation such as the ECB would be considered very carefully by those responsible for the redrafting of the directive.
So, what can be done by investors? While the likes of the AIC have been responsible for representing the industry, we understand representations from the end consumer are well received. The AIC provides a lot of information on their website for those interested in knowing more.
While the Retail Distribution Review is currently taking up the time and thoughts of many in the industry, there is a risk the AIFM issue is forgotten about as being too technical. It would be a shame if this was the case given the seriousness of the situation for the future of the UK's investment companies industry.
