The AIFM Directive effectively introduces a regulatory framework for managers of any collective investment undertaking other than those covered by the UCITS Directive (85/611/EEC), if the manager is domiciled in the EU, or if the fund is domiciled or marketed within the EU. This is subject to de minimis thresholds which exempt managers of smaller alternative investment funds (AIFs) and attempt to carve out a larger exemption for private equity funds (see box “De minimis thresholds”).

The Commission estimates that roughly 30% of hedge fund managers, managing almost 90% of the assets of EU-domiciled hedge funds, will be caught by the Directive, and that the Directive will also apply to almost half the managers of other non-UCITS funds.

While public and media focus has been primarily on hedge and private equity funds, the Directive's drafting means that it also extends to managers of other types of fund, such as commodity, real estate and infrastructure funds and investment trusts. The Commission argues that it would be "ineffective and short-sighted" to limit new regulation to hedge and private equity funds alone, as any particular definitions might not capture those at whom the legislation is aimed, and, in the Commission’s view, many of the underlying risks which the Directive attempts to tackle are present in other types of AIF.

However, as Owen Watkins, a consultant at Kaye Scholer LLP, comments, this represents a substantial shift from the Commission’s previous approach, which focused on hedge funds alone: "I am surprised the proposal treats private equity and hedge funds the same way, as the Commission consultation launched in December 2008 was all about hedge funds. The Directive now even covers non-UCITS retail funds: no one seriously suggests these present any risk to the financial system." Indeed, as the British Private Equity and Venture Capital Association points out, the Commission's own press release states that it does not consider that private equity poses a systemic risk.

In addition, the Directive’s application to those players who are involved with AIFs but do not manage them remains unclear, as Watkins points out: "If the AIFM can passport, for example, can the distributor do likewise? 'Pass' is the only answer we can give at the moment."

The Directive imposes a number of requirements on AIFMs that fall within its scope, including authorisation, capital requirements, conduct of business and organisational requirements (including the appointment of service providers; an independent "valuator" and depository for each AIF), and specific initial and ongoing disclosure to investors and regulators (see box “Detailed requirements”). These basic authorisation and organisational requirements will apply to all AIFMs, but will be varied dependent on the type of AIF. On top of these common requirements sits another layer of bespoke provisions for those AIFMs employing high degrees of leverage or acquiring controlling stakes in companies.

Although fund management is already extensively regulated by the Financial Services Authority (FSA), Simon Witney, a partner at SJ Berwin LLP, confirms that there are a number of important differences between the status quo and the regulation proposed in the Directive, as, "The FSA regulation tends to be a lot more focused on areas of risk that are inherent in the business model." As well as the new conduct of business requirements, many in the industry see the introduction of a blanket requirement for service providers as an additional cost burden, which may not suit all AIFM circumstances.

Even where the Directive does address areas already covered by existing regulation, the detail is often very different, as Witney highlights: "The capital requirements are a long way from the existing flat rate requirements applied by many UK private equity firms. Currently most firms operate a much lower capital requirement, as set out by the FSA, and it is at this level because the FSA has judged that this matches the liquidity risk".

Once AIFMs have met these regulatory requirements, they will be rewarded with the possibility of being able to market funds to professional investors throughout the EU through a passporting regime (for background on passporting, see “The Prospectus Directive: business as usual a year on?”, www.practicallaw.com/0-202-3764). However, permission to market to retail investors will be a matter for individual national authorities, which can choose to impose stricter requirements on the AIFM and the marketing concerned.

Perhaps most controversially, the Directive also regulates the marketing of non-EU funds and the authorisation of non-EU AIFMs. While this provision will not take effect until three years after the rest of the AIFM Directive comes into force (so, in all likelihood, at least 2014), it will create substantial hurdles for third country funds and managers.

An AIFM wishing to market a non-EU fund may only do so if the country of origin has signed an agreement with the relevant EU member state(s) agreeing to an effective exchange of information in tax matters. Even more stringently, a non-EU AIFM wanting to market within the EU must apply for authorisation by a member state, which will only be granted if the AIFM’s own country has in place prudential regulation and ongoing supervision equivalent to those of the Directive, effectively enforced, and has tax and co-operation agreements in place with the relevant member state’s regulators.

As a result, it appears unlikely that a non-EU AIFM could gain authorisation. "There will be a big political focus on this, but as things stand in the current draft, it would seem to be very hard for third country funds to be marketed in the EU unless their manager was authorised under the Directive", says Witney.

The Commission claims that this approach is consistent with the G20's objective of enhancing the transparency and quality of regulation in offshore jurisdictions. However, the Alternative Investment Management Association (AIMA) feels that the Directive conflicts with the G20’s global plan for recovery and reform which, it points out, calls for regulators and supervisors to "reduce the scope for regulatory arbitrage" and "resist protectionism".

The Directive now proceeds to the European Parliament and EU Council of Ministers for further scrutiny. The Commission is open in anticipating "intense political discussion and negotiation" of the Directive. However, as Watkins points out, the Directive falls within the Lamfalussy process; as a result, it only sets out the high-level framework at level 1; "We don’t know at this stage what the level 2 implementing measures will look like". It is these implementing measures, and the political "horse trading" in the European Parliament and EU Council, that will establish how radically the final Directive alters the landscape for AIFMs.

If the Directive stays as currently drafted, Watkins predicts that "things may be markedly different from what pertains now, particularly for overseas managers of overseas funds. Given that the AIF industry by and large operates outside the EU (whether the funds, the managers, or both), the key issue from 2014 will be the extent to which the non-EU part of the industry will be prepared to accommodate itself to the Directive, or whether it will seek to avoid dealing with the EU as far as possible."

In its present form, it is possible the Directive might give rise to a growth in EU-based AIFMs, as it would be difficult for offshore managers or managers of offshore funds to continue business within the EU. However, the risk identified by bodies such as AIMA is that AIFMs currently domiciled in the EU will be prompted to move business outside the EU to avoid being disadvantaged by the Directive’s more stringent requirements.

As Witney says: "It will clearly have a negative impact on EU fund managers. There are lots of factors to consider when deciding where to be based, and this is just one of them: but it is obviously an important one. These things are cumulative rather than individual, but together might mount up to make the UK and London less attractive as a location for investment funds."