The financial crisis ushered a wave of new regulations aimed at mitigating systemic risk to the financial system. While no-one has been able to rationally point a finger at private funds as a cause of the crisis, the industry has nonetheless seen a dramatic rise in the level of regulation and scrutiny. As legal and compliance costs soar, one is hard-pressed to find a private fund manager or – perhaps more importantly – an investor welcoming these changes.
In Europe, the Alternative Investment Fund Managers Directive (AIFMD) came into force in July 2013 and imposed a wide range of requirements on private fund managers in areas ranging from marketing, conduct of business, custody and safe-keeping of assets, capital requirements and reporting, and disclosures to investors and regulators. These regulatory requirements have largely been imposed using a one-size-fits-all approach, under which a single set of rules applies to funds with significantly different operating models (eg buyouts, venture capital, real estate, credit/debt funds, hedge funds). This, together with the vagueness of the legislation and the differing interpretations of its provisions among EU member states, has resulted in a complex and unwieldy regime, which has created significant legal uncertainty for private fund managers looking to market their fund into the EU or seeking to manage an EU fund.
On the other side of the Atlantic, the major legislative response to the financial crisis has been the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Dodd-Frank eliminated the ‘private adviser’ exemption that many investment advisers to private funds relied on and replaced it with several narrower exemptions so that Securities and Exchange Commission (SEC) registration requirements now extend to virtually all US-based private fund managers and many foreign fund managers with US operations. SEC registration requires compliance with a number of onerous obligations, including the requirement to have a chief compliance officer, and the requirement to comply with extensive reporting (eg Form ADV and Form PF filings) and record-keeping obligations.
Both AIFMD and Dodd-Frank have come under heavy fire from participants in the private funds industry. While resistance to change is to be expected, there are legitimate concerns that the regulatory burden imposed on private funds is not matched by a public policy benefit. It is likely too soon to tell if the new regulatory regimes provide an effective framework to oversee and mitigate systemic risk; what is clear, however, is that the new regulations are having a transformative (and not necessarily welcome) effect on the private funds market with likely lasting consequences.
IMPACT ON PRIVATE FUND MANAGERS
The cumulative weight of new regulation has inevitably meant the cost of doing business has increased significantly. The increase in costs is principally a function of an increase in back-office compliance staff and in services provided by outside legal counsel, consultants and third-party services providers (eg depositories), as well as investment in additional technology to enable private fund managers to improve their data management and reporting processes.
The increase in regulation has also resulted in firms having to institutionalise their operations to cope with more bureaucracy and red tape. This has resulted in a more systematic approach to operations and a greater emphasis on process, checklists and prompts to ensure that all boxes are checked correctly and on time.
IMPACT ON THE PRIVATE FUNDS INDUSTRY
While many larger firms already have much of the infrastructure in place to absorb incremental compliance work, smaller and mid-size firms are having to employ new dedicated resources to manage the increased burden. As a consequence, the increased compliance burden is likely to have a disproportionately adverse effect on smaller/mid-size firms, who are likely to see a greater impact on profitability. In turn, such incremental costs may serve as a force to drive a consolidation of assets under management in an effort to exploit administrative economies of scale, resulting in less choice for investors. Further, as the private funds industry becomes a more capital-intensive business with greater upfront working capital requirements, barriers to entry will increase. As such, we are likely to witness fewer first-time fundraisings and team spin-outs in future, again to the detriment of investors. In addition, the prospect of complying with AIFMD has also deterred a number of non-EU fund managers from actively marketing their funds in Europe, again resulting in less choice for European investors.
Whether the new regulations will play a role in preventing or in formulating an effective response to the next financial crisis remains to be seen. In the meantime, as the frictional costs of doing business increase and are ultimately passed onto investors, the impact on returns for traditional investors in private funds will be negative. Private fund managers will continue to seek solutions to streamline their compliance operations to meet regulatory obligations more efficiently. It seems clear, however, that the larger fund managers have an opportunity to entrench their dominant positions and increase their competitive advantages over smaller rivals. Conversely, the future outlook for managers of small and mid-size private funds looks distinctly more challenging.
Jason Glover is a partner in Simpson Thacher & Bartlett’s London office.