The EU's Next Target: Hedge Funds

Politicians in Brussels are working on tough regulations that might make the Continent less appealing to hedge funds and private equity firms

City workers walk through Canary Wharf in London, England. Daniel Berehulak/Getty Images

By Mark Scott

With European unemployment still rising and consumer confidence at an all-time low, most people don't have much sympathy for the financial sector's Masters of the Universe. And they hold in particularly low regard the whiz kids of private equity and hedge funds who—unfairly or not—have shouldered much popular blame for the global economic crisis.

That antipathy has reached politicians, who are now crafting new rules dictating how firms such as New York-based BlackRock (BLK) or London-based Permira should operate in Europe. The resulting legislation could have major implications for Western economies, reducing the risk associated with alternate investments but also potentially making the Old World a less inviting place for hedge funds and private equity firms to do business.

The European Commission is finalizing tough regulations that would force private equity and hedge funds, whether based in Europe or targeting European investors, to register with EU authorities. The rules would also clamp down on how much capital such funds can borrow, force them to disclose where they're investing, and make them hold larger cash reserves in case their investments go belly up. Now working its way through the European Parliament, the proposed legislation could become law by early 2011.

Reining In Financial Institutions

Policymakers, of course, hope tighter oversight will stop the credit-fueled extravagances that contributed to the global economic crisis. They've already pushed forward other regulations to rein in more conventional financial institutions such as banks, insurers, and money managers. But critics of the pending EU rules argue their impact could be far more negative: By circumscribing how private equity and hedge funds operate, politicians could cut off a major source of financial innovation that Europe sorely needs to jump-start its economy.

Representatives of the alternative investments industry also gripe that the crackdown is politically motivated—driven more by anger and resentment in Continental European capitals over the abuses of "Anglo-Saxon" capitalism than by the reality of the small role such firms actually played in the current downturn.

"What Europe needs is a greater ability to restructure and reinvent itself," says Alastair Milne, a banking and finance expert at City University's Cass Business School in London. "Many parts of Europe, even places like Germany, could benefit from what private equity has to offer."

That's not to say alternative investments were completely blameless in the meltdown. Tighter rules, especially concerning how leveraged firms could become, might have stopped some of the abuses that prevailed two years ago. Increased transparency might also have helped investors make more informed decisions about where to park their money.

Industry experts concede that some changes will be salutary but argue that Brussels' reform attempts could do more harm than good. Under the proposals, managers with funds of more than €100 million ($140 million)—accounting for roughly 90% of assets under management in Europe—must register with regulators, who will scrutinize how companies fund acquisitions.

That and other restrictions could force some financial players to rethink investing in Europe, says Andrew Baker, chief executive of the Alternative Investment Management Assn. (AIMA), a trade body. That's because the regulatory burden will increase the cost of doing business and make Europe relatively less competitive vs. regions such as Asia that aren't following the Old World's lead. "Funds will look at other parts of the world for opportunities," Baker says.

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