Robert Whiteway 9 September 2009 Clerk of EU Sub-Committee A Committee Office House of Lords London SW1A 0PW House of Lords European Union Committee Call for Evidence on Directive on Alternative Investment Fund Managers Who is BlackRock? BlackRock is one of the world’s premier providers of global investment management, risk management and advisory services to institutional and retail clients around the world. As of 30 June 2009, BlackRock’s assets under management totalled $1.37 trillion across equity, fixed income, cash management, alternative investment and real estate strategies. Through BlackRock Solutions®, the firm offers risk management, strategic advisory and enterprise investment system services to a broad base of clients with portfolios totalling more than $7 trillion. BlackRock manages assets on behalf of clients in over 60 countries around the world and is a leading provider of alternative investment funds in the EU. As such, we would like to take this opportunity to thank the House of Lords European Union Committee for this opportunity to respond to the Call for Evidence and hope that our responses are of use in the Committee’s deliberations. If we can be of any further assistance, then please do not hesitate to contact us. The views we express in our response are provisional only, as we are continuing the process of analysing the impact of the Directive both on EU investors and markets, and on our business. Yours faithfully Joanna Cound Managing Director Detailed response to Questions 1. What economic benefits arise from Alternative Investment Funds? What risks to financial markets arise from Alternative Investment Funds? Will the Directive help reduce these risks? 1.1 Benefits of private equity The common misconceptions about private equity are that it is focused on short term gains and associated with the loss of jobs or breaking up of companies and sale of their various parts. Private equity has actually been shown by many studies to be beneficial for European growth and job creation: • Private equity has a particularly beneficial effect on the economy during downturns when access to capital is scarce 1 ; • Between 2003 and 2007 private equity investments had been associated with the creation of one million jobs in Europe; In 2007, companies backed by private equity capital employed 6 million people in Europe, which represented at the time 25% of total employment in the top 600 European public companies 2 . • A study 3 on French leveraged buyouts concluded that there is “some evidence that leveraged buyouts may alleviate credit constraints and be an engine for growth in small and medium sized enterprises” and that “…in France, LBO targets experience a very strong growth in sales, assets and employment after the deal, in particular when they were previously more likely to be credit constrained.” • The private equity sector can play a “constructive and important role during the current recession and…initial recovery”. There is evidence that companies backed by private equity create jobs during the initial stages of economic recoveries, whereas generally employment tends to contract 4 . 1.2 Economic benefits of alternative asset classes The benefits arise from a number of different sources: a) Private equity funds and hedge funds help in the distribution of capital to those that can use it most productively. b) Hedge funds contribute to the liquidity of financial markets. c) Hedge funds contribute to the efficiency of financial markets d) Alternative assets have contributed to employment and tax revenues in the UK (and more widely in the EU). e) Hedge funds have their place in creating diversity in the markets: they are mostly small and medium-sized businesses; dominant players are rare; diverse in their investments (e.g. hedge funds were both long and short of Northern Rock into its demise). f) AIFs can improve risk-adjusted returns and increase diversification for investors. By restricting access to AIFs, investors lose the ability to invest in funds that historically have less beta and more idiosyncratic returns Than many other asset classes. 1.3 Risks to financial markets arising from AIFs The de Larosiere and Turner reports state that alternative investments did not contribute materially to the liquidity crisis and are not a systemic risk. BlackRock believes that market 1 “The Economic and Social Impact of Private Equity in Europe: Summary of Research Findings”, June 2009, Per Strömberg, Professor of Finance, Stockholm School of Economics, Director, Institute for Financial Research (SIFR) 2 A study by AT Kearney in 2007 3 World Economic Forum paper: “The Global Economic Impact of Private Equity Report 2009”. The section referenced is section 3: “Leveraged Buyouts – Evidence from French Deals” 4 “The role of the private equity sector in promoting economic recovery”, Robert Shapiro, March 2009. practice has changed significantly since the demise of Long Term Capital Management and the systemic risk which it brought to the market place in 1998. Space prohibits full details of that situation but many lessons have been drawn from LTCM’s demise and this has helped the industry since prosper: • Improved understanding of leverage. • Improved measurement of liquidity: in some sense LTCM was the market in some assets and derivatives; hedge funds in total may have been the dominant participants in some market sectors but no single hedge fund enjoyed dominance on its own. • Improved understanding of credit risks (in both directions). The prestige of LTCM was such that banking counterparties were keen to lend to LTCM without full due diligence on the contents and riskiness of the fund. By the end, LTCM was approximately100% manager owned showing that even this risk of personal loss did not act as a brake. Nowadays, banking counterparties to hedge funds ask for and receive information about the contents and riskiness of the fund as a prerequisite to credit being extended. • Increased collateralisation of positions. The security of credit has been improved over recent years through the use of collateralisation of debits. Hedge funds borrowing money give the lender first call on assets of the fund. So, were such a fund to default, the lender would be protected from loss by being able to have the first claim on the proceeds from the sale of the collateral. In this way, lenders to hedge funds are protected from significant losses in instances where hedge funds lose money precipitously. Similarly, collateralisation is a tool increasingly used by hedge funds when they lend cash to banks. 2. To what extent is there a need to create a single regulatory regime for Alternative Investment Fund Managers in the European Union? Does the Directive achieve its objectives? Should the objectives of the Directive be modified? 2.1 Extent to which a single regulatory regime for AIFMs is needed in the EU BlackRock is in favour of well-regulated securities markets and believes that they are good for investors and markets. Although it should be noted that professional investors did not request legislation and have increased their allocations to AIFs over recent years, we are in favour of the goals listed below. 2.2 Does the Directive achieve its objectives? We are broadly supportive of the goals of the Directive and believe that the EU can have a positive impact on the alternative investment management industry both in the EU and globally by achieving its stated goals, which we understand to be: • The monitoring and limitation of systemic risk; • Ensuring the appropriate protection of professional investors; • Providing appropriate transparency; • Facilitating the marketing of AIF to professional investors throughout the EU; • Ensuring that regulatory actions are proportionate to risk and reflect different alternative asset business models. Our major concern is that the Directive goes beyond the requirements necessary to meet the goals to the detriment of investor choice and returns. In our view, the objectives of the Directive are appropriate, but it is the means by which the Directive goes about achieving these that we would wish to see moderated / modified. 3. What risks arise from Alternative Investment Funds? Is the Directive proportionate given the role of AIF in the financial crisis? Will the Directive introduce over–stringent regulations or does it not go far enough? 3.1 Role of AIFs in the financial crisis Please see response to Question 1. 3.2 Will the Directive introduce over–stringent regulations or does it not go far enough? BlackRock’s concern is that the Directive: • Is not proportionate to the risks presented by AIFs; • Is in many instances too prescriptive in its approach; • May have unintended consequences which may be detrimental to EU investors and markets. (See also the response to Question 4). • As drafted, allows EU professional investors to hire only EU managers of EU domiciled funds that employ EU custodians and EU auditors. Investors currently are able to exercise their own judgement to select the best managers the world has to offer in pursuit of their investment objectives. • As drafted, does not reflect the market practice and business models of many of the fund types and asset classes in scope. • Is inconsistent with, and in some respects duplicates, requirements in other legislation – for example, the MiFID, Transparency and Prospectus Directives; • May create an unlevel playing field between different types of providers and between funds and securities. 4. Is it appropriate to regulate Investment Fund Managers, rather than the Fund itself? Does the Directive contain appropriate provisions to distinguish between different types of alternative investment? Does the scope of the Directive create a danger of unintended consequences? 4.1 Regulation of Managers rather than Funds BlackRock believes that it is appropriate to regulate Investment Fund Managers, rather than the funds themselves. The problem is that, in applying an all-encompassing approach (what some have termed “one size fits all”) , the Directive is not always proportionate to the risks presented by different types of fund structure or asset class. Proportionality is key to ensure that risks are adequately addressed, but that AIFs that do not present specific risks are not disadvantaged. The difficulty will be in ensuring that there is proportionality, whilst at the same time not straying into product regulation (which the Directive already does in some areas, for example leverage). 4.2 The risk of unintended consequences The Directive risks creating unintended consequences by applying one approach to a vast array of different asset classes and fund structures. The Directive does not cater for the multiplicity of fund governance structures that exist across all in-scope asset classes. It states that the AIFM’s role is that of management and administration, in contrast to existing governance structures which frequently separate out oversight, investment management and administration. We believe that the regulatory aims of the Directive can be achieved by working within existing fund governance and structures without imposing the reorganisation of fund structures. Any reorganisation would not provide any additional protection for investors, and would only potentially add cost and lead to a reduction in returns for EU investors. The Directive needs to appropriately identify the AIFM for different fund structures by defining the AIFM as the entity that controls the day to day management of the fund assets (i.e. portfolio management). The Directive does not reflect current market practice for the many different types of fund and asset classes in scope in relation to delegation, depositaries, valuations and transparency requirements. The Directive does not always reflect the reality of integrated capital markets and risks being considered protectionist, creating an unlevel playing field between EU and third country AIFMs and AIFs: • The equivalence provisions for third country AIFMs are such that it is unlikely that many third countries would be considered equivalent. • There are important divergences between the approach taken by the Directive and that taken by the US Treasury which casts doubt as to whether the US regulatory regime would be considered “equivalent”. • We are concerned that the Directive may provoke regulatory retaliation from other jurisdictions. • The requirement that delegation of portfolio and risk management functions must only be to other AIFMs effectively prohibits the delegation of these functions to non-EU entities. The Directive may also create an unlevel playing field between different types of providers and between funds and securities. Instead of offering further protection to EU investors, the Directive, as currently drafted, may in fact have damaging consequences for them, reducing the scope of opportunities open to them and potentially reducing their returns. (See answer to Question 9). 5. What is your evaluation of the Commission’s consultation in the preparation of the Directive? BlackRock believes the objectives of the AIFMD to be laudable and understands the political imperatives which led to a compressed process in terms of the preparation of the Directive. As a result, however, significant amendments are required to ensure a workable solution and to avoid unintended consequences. Regulatory aspects 6. Will the passport system help create a single market in investments funds within the EU? How will the passport system established affect the EU and the UK industry and particularly their position in the global market? We are supportive of the objective of the EU Commission to develop the single market in AIFs. A passport would theoretically allow AIFMs to distribute their AIFs more widely and more easily cross-border within the EU and will provide EU investors to access to a broader scope of opportunities. However, the passport is unlikely to be a realistic possibility for non-EU AIFMs managing either EU or non-EU AIFs, or for EU AIFMs managing non-EU AIFs for the reasons set out in the response to Question 4. The passport is likely to create a single market for those AIFs that are managed and domiciled in the EU and are not adversely impacted by other requirements of the Directive. However, many of the AIFs in scope are nationally regulated, nationally distributed, and there is no intention or desire to market them more widely within the EU, nor indeed is wider distribution in the EU appropriate for many such funds. This applies to, for example, charity funds in the UK (themselves registered charities in England and Wales, they are also only sold to registered charities in England and Wales) and other nationally regulated and distributed non-UCITS retail-type funds in other EU countries. 7. Is the threshold for defining “systemically relevant” Alternative Investment Funds appropriate? Should the Directive include provisions on capital requirement? Does the Directive contain appropriate rules on leverage? Is the requirement for independent valuation agents and depositaries for Alternative Investment Funds adequate? 7.1 Threshold BlackRock believes that the threshold set out in the Directive is potentially problematic: • It seems inappropriate for all AIFs above a certain arbitrary threshold to have to submit a standard set of information to Home State regulators. • We believe that it would be more appropriate to require that all AIFs, regardless of size, register with their Home State regulator. The AIFMD should then introduce a threshold for the disclosure of systemically relevant data to Home State regulators. This threshold should be based on AUM, should reflect the type of liquidity offered to investors and the size of the AIFM’s programme. 7.2 Capital Requirements In terms of capital requirements, the Directive does not include a cap on the capital requirements of AIFMs. We would propose the introduction of a cap on the capital requirements of EUR 10 million, as per the UCITS Directive. 7.3 Leverage BlackRock believes that the AIFM Directive is not the appropriate place to seek to regulate leverage. Particularly problematic are the standard approach to leverage that the Directive sets out and the ability that it gives to the Commission to intervene in capital markets by imposing limits on leverage. We believe that it would be more appropriately addressed on the supply side, through the forthcoming CRD revisions. If rules around leverage were to be left in the Directive, we would certainly suggest that, at a minimum, the arbitrary caps on leverage should be removed (which we fear may in fact exacerbate procyclicality), and that leverage should be measured on a net basis and at fund level, rather than asset level. 7.4 Depositaries and Valuation Agents For both depositaries and valuation agents, the Directive ignores current market practice. BlackRock has some concerns and recommendations in relation to the provisions on depositaries and valuation agents. 8. Will the provisions strengthening disclosure requirements help to create a more transparent market or do they go too far? BlackRock is supportive of transparency and appropriate disclosure in the context of AIFs, to facilitate the monitoring of risks to the financial system and so as to afford greater protection to investors. We do, however, have concerns in a number of areas, including: • We have concerns about the provisions set out in articles 26-29. They are in many cases not proportionate to the risks presented and also potentially put AIFs at a disadvantage compared to other market participants; • Whilst we believe that disclosing the existence of preferential terms enhances transparency, requiring that the names of investors receiving preferential terms be disclosed is highly problematic and does not afford any additional protection to investors. Impact 9. What effect will the Directive have upon the position of the City of London and the EU as a whole as a leading location for Investment Fund Managers? Could it cause many hedge funds to relocate outside of the EU? What impact would the Directive have upon professional investors and institutions? 9.1 Impact on professional investors and institutions We are concerned that the AIFMD, as currently drafted, will have a detrimental impact on: • Opportunities available to professional investors in Europe • Returns that professional investors will be able to achieve • European markets and economies The AIFMD may have the effect of limiting the choice available to investors making it harder to meet their investment objectives – we are concerned that EU investors will be restricted to only EU managers of EU funds investing in EU assets due to the following: • Choice of assets AIFs can invest in may be limited, likely to EU assets, by requirements that depositaries be EU credit institutions and depositary liability provisions. These provisions may give rise to prohibitive costs. • Restrictions on portfolio management delegation will make it problematic to offer funds with global investment themes (e.g. global hedge funds, private equity funds, real estate funds) and global multi-manager funds. • Significantly reduced investment choice for EU fund of funds as investments are limited to EU domiciled funds. This concentrates investor risks in their home markets. • AIFM will cease to offer AIFs with certain leverage profiles given the restrictive provisions in the AIFMD, despite demand from professional investors. • Investments “at the initiative of the investor” are considered to be marketing and are thus caught by the AIFMD, limiting the ability of investors to approach managers about fund opportunities. • EU investors may be locked out of attractive opportunities due to the proposed more time- consuming regulatory review and clearance process. Examples of opportunities that may not have been possible had the AIFMD been in force include: o TALF Funds / PPiP Funds: US government program to recycle toxic assets from US banks balance sheets; US Manager, Cayman domicile; Levered with cheap financing from US Government; Asset managers look to raise capital from global institutional investors • Private banking channels will no longer be able distribute close ended funds under the Qualified Investor exemption (Prospectus Directive). • The equivalence criteria for non-EU funds and managers are so comprehensive that it is unlikely that other jurisdictions, such as the USA, HK or Singapore, will be considered equivalent. In including provisions such as these, the AIFMD does not reflect the reality of global capital markets. It creates an unlevel playing field between EU funds and third country funds and between funds and securities. In addition to the impact on returns resulting from the above, they may be further reduced by: • The need to make significant changes to the structure and operation of existing AIFs and AIFMs to meet the one size fits all AIF governance, depositary and valuation provisions. • Consequently, pensioners and retail clients as well as institutional investors may suffer lower investment returns and / or the tax payer may pick up the risk of higher pension fund deficits. Investor benefits in terms of increased transparency and protection may thus be outweighed by reduced choice and lower investment returns. It would have a negative impact on the European economy were the AIFMD to be approved as it currently stands: • It would reduce the amount of risk capital currently invested in European companies, making then more dependent on (national) bank capital. • In addition, it would reduce trading activity and liquidity levels leading to less efficient markets and inhibited price discovery. • Competition will also be reduced leading to fewer viable investment managers as small AIFMs may not be able to withstand the greater regulatory / compliance burden. • The EU credit institution requirement (for depositaries) consolidates rather than disperses risk and may exacerbate ‘too large to fail’ risk with respect to depositaries 10. How does the Directive compare to existing or proposed regulation of Alternative Investment Funds outside of the European Union, particularly that of the United States? How will the Directive affect the position of EU Alternative Investment Funds in the global market? Please see Appendix for a comparison of the EU and US regulatory proposals. 11. What effect will the Directive have on flows of capital and financial innovation? No comment at this stage.