European Union under fire over hedge fund rules

The European Union's attempt to regulate hedge funds will affect other classes of alternative investment such as property funds and investment trusts, lawyers studying the fine print of the new rules have warned.

The rules could also lead many offshore hedge funds to relocate to the EU by raising the compliance costs for managers selling into Europe.

The benefits of operating from places such as the Cayman Islands will be eroded by forcing fund managers selling to the EU to operate under EU rules, lawyers say.

The plan to regulate all managers of alternative investment funds sold into the EU for the first time was unveiled last Wednesday, but not published in detail until Friday following fierce political debate, and some heated 11th-hour amendments in Brussels.

The City of London, where much of the hedge fund industry is based, has criticised the added regulatory burden, while left-leaning European politicians say it does not go far enough to control an industry they blame for triggering the credit crunch.

The directive covers managers of all alternative investment funds selling to the EU, unless they have very small portfolios. They will have to seek authorisation and meet regulatory, governance and disclosure standards, including minimum capital requirements.

The added disclosure, as expected, will be to regulators and investors, rather than the public at large, and fund managers who comply with the directive will be able to market to professional investors across the 27-country bloc.

So-called pan-EU passporting arrangements will also come into force for EU-domiciled and authorised managers who want to market funds domiciled in third countries three years after the new regime starts. But they will have to meet certain conditions and the third country itself must agree to exchange tax information. Existing national rules, under which some EU countries allow marketing of third country funds and others do not, will continue to apply until the three-year deadline. Those conditions, say lawyers, will make it more expensive to run funds from offshore centres and may drive many of these onshore.

"If the costs rise it might make more sense to domicile your funds onshore," says Michael Newall at law firm Norton Rose.

However, because of the new rules' broad scope, Mr Newall predicts a potential difficulty for offshore funds that have their own management boards, also based offshore and where policy is largely determined, and only light management or administrative functions onshore.

This is a structure used by many mezzanine debt funds, for example, and also some closed-end investment companies, but is less prevalent in the hedge fund sector.

Mr Newall suggests Brussels was focused on the hedge fund and private equity structures and failed to pay much attention to other models in the alternative investment fund industry. The concern is shared by James Greig at PricewaterhouseCoopers. "From an international perspective, the draft gives rise to serious competitive concerns, given the lack of clarity and detail about the position of EU resident administrators, asset managers and advisers servicing non-EU fund complexes."

The proposals will need the backing of the European parliament and member states, and is unlikely to get that before mid-2010.

Managers' dos and don'ts

*All managers of alternative investment funds must be authorised and regulated to sell to professional investors in the EU*'De minimis' exemption for managers with portfolios worth less than €100m for most hedge funds or less than €500m for private equity *Managers must meet regulatory, governance and disclosure standards, including minimum capital requirements *Manager based in the EU that meet the standards will be able to market EU funds to investors across the 27-country bloc *A similar "passport" will apply for offshore funds managed by EU-approved companies three years after the directive takes effect, subject to certain conditions