LPs on the hook for EU regulatory costs

In addition to increasing barriers and regulatory burdens for fund managers on both sides of the Atlantic, new proposals coming up for debate in the EU Parliament would likely force investors to bear much of the increased compliance costs of private fund managers, according to law firm Dechert.

If passed the “Directive on Alternative Investment Fund Managers” would create a comprehensive regulatory framework for hedge and private equity fund managers in the European Union. The new disclosure rules would apply to leveraged fund managers with more than €100 million in assets, and more than €500 million in assets for unleveraged funds with a lock-in period of more than five years.

The directive would also require managers to provide detailed information on their funds’ activities, governance, internal risk management, valuation, asset safe-keeping arrangements and audit arrangements.

Lobbying groups on the continent are already warning against several negative consequences, including on the fund-marketing side. European- and non-European-authorised managers will be limited to only being able to market to “professional investors”, but to qualify as a professional investor one must demonstrate that it has done a number of transactions in the relevant asset space within a certain period.

By placing new barriers to entry for foreign funds, the new rule would also hurt European LPs who would also lose of access to certain top-performing alternative investment managers from the US.

Meanwhile, despite the fact that the directive increases the level of investor protection, opposition from the LP community may increase due to the likelihood that additional costs as a result of the new regulations will get passed on to them. An update by the financial services group at Dechert identified several potential impacts, including:

– Many funds will be required to implement one-off structural changes, such as appointing an EU depository, manager or independent valuator. This will likely be charged to the LPs.
– Ongoing compliance costs will arise for funds directly or through their service providers, including fund manager/depositary costs associated with the reporting requirements.
– Increased fees for investors could also result due to additional costs resulting from the segregating of management and risk functions, the strict liability obligations imposed by the directive and difficulties created by the restrictions on delegation outside the EU.

Dechert adds that other harmful consequences could include adverse changes to how manager meetings are planned and investor communications and investor relations are conducted, largely due to marketing restrictions on non-EU managers.
 
The ability to negotiate side letter terms may be restricted due to requirement that identities of holders of preferential terms be disclosed.