'Politically-motivated' attempt to regulate alternative investment industry set to dominate advisers' intrays

Lawyers to London's leading hedge funds and private equity houses are braced for a prolonged period of uncertainty and lobbying as the alternative investment industry wrestles with controversial European Commission (EC) reforms.

With the fuss regarding the EC's draft directive on alternative investment fund managers (AIFMs) showing no sign of abating since it was unveiled on 29 April, legal advisers are expecting a high-stakes battle to influence reforms seen as a politically motivated assault.

While the directive is nominally a reaction to the claimed contribution of hedge funds and private equity to the prolonged crisis in credit markets, the industry view is it marks a political attack from continental Europe that has previously decried such institutions as 'locusts'.

The directive looks set to require most of the larger hedge funds and private equity houses to register and seek government authorisation in the EU as well as ushering in new standards on reporting, leverage, risk management and new minimum capital requirements (see below).

Much angst has also focused on proposals to allow "additional emergency powers" to national authorities to restrict the use of leverage in respect of individual funds in "exceptional circumstances", a move that in theory could see regulators deciding acceptable levels of debt for managers.

Peter Astleford (pictured), European head of financial services at Dechert, told Legal Week: "The biggest problem is the leverage limit. How the EU might use this power to cap leverage is a scary thought."

Many advisers fear that the directive could severely damage London's position as a leading centre for the alternative asset management industries, encouraging funds to set up in less stringent centres like Zurich, Dubai or Singapore.

Simon Gleeson, regulatory partner at Clifford Chance, said: "The basic theory is that it is euro funds for euro investors – pretty explicitly ousting foreign investors in the process. As a piece of investor protection it sounds absurd but if it was not there the directive would be a dead letter."

There has also been con≠fusion over how US fund ≠managers will be able, if at all, to target European investors, of if the EC's stance would lead to restrictions on EU-registered funds tapping US markets.

James Perry, regulatory partner at Ashurst, commented: "The problem is that we know for a fact that at least one condition, relating to equivalent regulation, won't be satisfied. So, US funds would be locked out of Europe – and, if that happens, European funds would be locked out of the US too. This point isn't getting the air-time it deserves."

James Cole, hedge fund partner at Weil Gotshal & Manges, warned: "This will be the nail in the coffin for many smaller funds in the current environment, not able to pay for the extra regulation."

There are also concerns regarding the costs of complying with the directive. The BVCA, the main UK body for private equity, has estimated that costs incurred per portfolio company will be in the region of £30,000, a move likely to hit mid-market buyout houses the hardest.

Other bodies like Alternative Investment Management Association and the European Venture Capital Association are also lobbying for major concessions, while the UK financial services minister Paul Myners this month called for "major surgery" to the directive.

What is certain is that the directive faces a grilling by the European Parliament and the Council of Ministers and much industry debate before it is expected to come into force in 2011.

In the meantime, lawyers expect the regulatory demands on hedge funds and buyout houses to increase with some forecasting that such clients may beef up their in-house legal teams.

Tom Whelan, private equity partner at Lovells, commented: "The increase in regulation could see more regulatory specialist lawyers moving in-house with the creation of new jobs."

Despite general opposition, some advisers welcomed moves to improve disclosure.

Astleford added: "This will help restore investor confidence, in turn helping to improve the volume of work for lawyers, not least because of the new rules and regulations which will need to be considered when setting up funds."

EC directive on alternative investment fund managers – the key points

• Approved AIFMs to hold initial capital of at least €125,000 (£106,000) where investment portfolio at least €250m (£212m)
• Individual funds required to have independent valuer
• Greater disclosure requirements to investors
• AIFMs must have registered office within the EU to market to European investors
• Regulators to have emergency powers to restrict funds leverage
• Expanded disclosure and risk management requirements