By Ed Gander, Weil
This article is a transcript of a talk given by Ed Gander, Head of Weil’s European Private Funds Group, at the Ipes Breakfast Seminar on Wednesday 5 July 2017.
I want to draw on some of my experiences across the private funds industry over the past twenty years (both as a fundraising lawyer and, previously, as a fund manager) to offer a few perspectives on what I see as the "rise of conflicting interests" that face managers and investors today. I will argue that these conflicting interests are holding back what most of us would assume should be basic market efficiencies in the industry in which we all work – whether we are managers, investors or indeed advisers (lawyers, administrators, placement agents etc).
A number of you may be concerned that I will be talking to you about ‘conflicts of interests’ as you munch on your cornflakes. Rest assured, this is not my intention. Rather, I would like to start by posing an open question to the floor: as private investors and pension fund holders, as we all are, could we agree on some basic ideals for the process of investing?
You will undoubtedly have your own answers to this question. My top five would be something along the lines of: (1) short and simple offering documentation that I can understand; (2) a simple fund structure that is established, as a rule, where the majority of the investment professionals are based; (3) simple fund subscription documents for me to sign and which are broadly the same regardless of the particular fund that I choose; (4) a tax transparent fund, with my liability limited to the amount that I have invested (just the same as being a shareholder in a company); and (5) the frictional costs of investing (above the management fee and carried interest that I agree to pay) should be as low as possible and not materially different between funds – smaller funds should not be prejudiced on a cost basis against larger funds, and vice versa.
My contention is that the private funds industry is behind the curve of where it could be in terms of achieving these goals due to a plethora of what I call ‘conflicting interests’ from the ever-growing number of stakeholders within our industry – be they jurisdictions themselves, regulators and industry bodies etc. It remains to be seen whether broadly accepted principles of market efficiency can overcome these conflicting interests to ultimately create a private funds market that is truly fit for purpose and which would look quite different from the one in which we all operate in today. I believe this would be a market that would be welcomed by private fund managers, investors and advisers alike in this industry. I plan to cover this morning why I believe this isn’t currently happening.
Let me begin by giving you some concrete examples of what I mean by "conflicting interests". You won’t find any definition of ‘conflicting interests’ in any regulatory guidance or legislation. However, the narrower concept of ‘conflicts of interest’ has been around and regulated for many years now. These might include situations where a manager: (1) makes a financial gain or avoids a loss at the expense of one or more of its investors; or (2) receives a financial or other type of incentive which favours one investor over another; or (3) engages in a related party transaction etc. These conflicts of interest, through regulation, are required to be both disclosed and managed by consent between managers and investors and I don’t intend to say any more about them today.
By contrast, the "conflicting interests" or, to use a different phrase, the competing interests which I am referring to are either not currently regulated, or the regulators are only just beginning to think about the issues at hand. What do I mean? At the macro level, I am talking about the fairly recent rise in overt competition between jurisdictions and supranational bodies that have vested interests in the private funds industry: between the regulators themselves (ESMA v SEC v FCA v GFSC etc); between regulations and their potential impact on investment behaviour (e.g. Solvency II, which I will come back to); and even between LPs in the same fund themselves. This is to name just a few.
I would like to explore in a little more detail how conflicting or competing interests manifest themselves in practice. Firstly, let us take a look at conflicting interests between jurisdictions. It is increasingly apparent that BREXIT may provide the catalyst for an attack on the UK’s current pre-eminence in the financial services sector in Europe. As a result of this, the UK private fund industry’s centre of gravity may gradually move away from the UK to one or more other European Member States. This would be fine if investors, globally, would be better served by this development. I am not sure that this will always be the case. I think movement, where it is happening, is occurring due to regulations (current or proposed) that arguably are not driven primarily by investors’ interests (as they should always be) but rather by non-investment considerations, such as politics.
Recently we held a debate at Weil’s offices with a large number of industry participants about the pros and cons of establishing private funds in some of the leading jurisdictions - UK vs. Luxembourg vs. Channel Islands vs. Ireland. This debate would not have been held even two years ago: local jurisdictions, unlike ever before, are now overtly positioning themselves to take advantage of a changing European order. Increased competition is generally a good thing. But increased structuring and operational costs do no-one any good over the long-term, except the lawyers.
Legislation that could be argued to be protectionist (e.g. Solvency II) is on the rise. One of the effects of Solvency II, if it can be summarised in no more than a few lines, is to require European insurance companies to hold varying amounts of capital depending upon the perceived riskiness of the product in which they invest. Solvency II generally gives a lower risk weighting to AIFMD compliant managers than to non-AIFMD compliant managers. Why is this so? Why is more weight given by the regulation to the regulatory authorisation status of any particular manager rather than, for example, the reference currency of a particular fund? The latter, arguably, has a far greater impact on the risk of an investment product to an insurer that needs to meet its liabilities in a particular currency.
I turn to AIFMD. Born from competing interests within the European Parliament, Commission and Council, my contention (which is not contentious to most people working in the private funds industry) is that the resulting legislation is simply not fit for purpose in a number of areas, working neither for hedge funds, private funds nor investors in both types of products. AIFMD has led to prescriptive on-going obligations at huge costs (great for lawyers, administrators, compliance specialists and recruitment consultants etc.) but which ultimately reduce net returns to investors (most of whom are ultimately pensioners, and the very people that the legislation was originally supposed to protect).
Are the current state of affairs for investors significantly better since AIFMD’s implementation? What real, tangible benefits have there been in sacrificing thousands of trees to create long, detailed and complex reports that very few people actually read? There is an information overload in this respect and we are all in danger of missing the woods from the trees. One of the ultimate (and potentially beneficial) objectives of AIFMD was to increase the freedom for managers to market funds across Europe. Much of this benefit (whilst acknowledging some significant improvements with the introduction of the authorised marketing passport system) has been lost in a host of different local rules appearing alongside complex regulations and exemptions that really bear no resemblance to free-market logic. In short, private placement remains far too difficult in practice. It is needlessly complex, time consuming and expensive to undertake.
Another example is beneficial owner checks. Absolutely necessary as they are, these checking requirements are governed by a plethora of differing AML regulations across the world. How much time, effort and expense could be saved if all market participants could adhere to, and only have to comply with, a single, standardised, global set of AML standards. Is it really beyond the realms of possibility to provide for this on a global basis at a legislative level?
If you believe (broadly) in free trade, as I do, do you also believe in free investment? By which I mean investment with reduced barriers to entry, rather than no fees! No lawyer in the world can explain the nuances between all of the private fund limited partnerships that are available in the fifteen or so main jurisdictions in which they are offered. But all private funds lawyers, including me, can tell you that they are all designed to do basically the same thing – provide investors with limited liability and the fund vehicles themselves with tax transparent treatment, so that investors are only taxed upon their returns rather than at the level of the vehicle in which they invest.
In the context of an increasingly globalised private funds market, why can there not be a small number of globally accepted and available investment vehicles, adapted for both retail and professional investors respectively to reduce the significant frictional costs associated with investing in underlying companies and assets? If investors’ (and managers’) interests are put first, why does this have to be so difficult to achieve?
Unfortunately, my current belief is that conflicting interests driven by protectionism and somewhat misguided public policy considerations will perpetuate the proliferation of fund vehicles, despite them having little or no intrinsic value to the global investment community.
It seems odd to me that in an increasingly globalised fundraising market, very little time seems to be spent by regulators discussing together whether a common, proportionate and reasonable approach to issues affecting the private funds industry can be taken. Take, for instance, recent pronouncements from the SEC on topics such as fee disclosures, the computation of fund returns and the methodology of track record construction etc. All of these issues relate to the disclosure of fund financials and thus could easily be transposed into all major regulators’ standards and principles (similar to the approach taken with GAAP in the accountancy field). This would enable both managers and investors to operate on a level playing field, where the rules are understood by all involved without the need for ongoing, complex legal advice that differs substantially from region to region. Provided the rules were adequately crafted, this would benefit all private funds stakeholders and, ultimately, investors globally.
I struggle to understand why, over the past thirty years, it has been impossible to agree collectively on a global basis a simple, singular definition of "Professional Investor" which would immediately slash time and cut costs worldwide for both managers raising capital and investors investing in private funds. Will the day come when PPM selling and securities legends can be reduced to simply a couple of lines setting out the minimum thresholds that need to be met to invest in a particular fund? Further, it must be possible for regulators to agree a standard one page, easy-to-understand set of risk factors that should be disclosed to all investors investing in all private funds. The key risks are almost always the same, for example, lack of liquidity; risk that key investment people leave etc.
Again, as frustrating as it is, my contention is that these simple and obviously logical reforms that could easily be made on a global basis will probably never be made, such is the weight of conflicting interests (jurisdictions, regulators, market participants, political processes etc.) that seek to maintain the status quo, again ultimately at the expense of investors.
I would like to conclude with a few observations on where the private funds industry currently stands as a result of these conflicting interests: managers, particularly new and smaller managers, are finding it increasingly difficult and expensive to keep up with an ever-changing regulatory landscape that often seems to be driven more by short-term political expediency, than the long-term interests of investors. Ultimately, in my view, conflicting interests will prevent certain developments that should be welcomed by both investors and managers worldwide – such as a move towards standardised global fund vehicles, framework offering materials, logical regulations and cross-jurisdictional definitions of professional and retail investors.
All of us should never lose sight of the fact that investment is crucial to the lifeblood of the global economy. Great strides have been made in a whole range of regulatory areas over recent years, as the private funds industry has moved away from infancy into maturity. But I would argue that a new drive is now needed, on a global basis, to simplify investment vehicles and to reduce the frictional costs of investing. This would result in increasing amounts of capital being attracted to a simplified private funds industry, with the strong potential for higher overall returns to be achieved if these measures were to be introduced. Surely, if this were to happen, then everybody would win.
Weil, Gotshal & Manges (London) LLP