Key Immediate Considerations for US Managers
On 19 December 2012 the European Commission published the proposed “Level 2” implementation rules of AIFMD. As Level 2 will be implemented by a European Union (EU) Regulation its provisions will take effect across the EU member states without any transposition by national governments or regulators.
Level 2 covers a significant number of areas in great detail. In this article we focus on two generic scenarios from the perspective of a US investment manager ((i) US manager of an EU domiciled alternative investment fund (AIF) and (ii) US manager of a non-EU AIF e.g. Cayman) and describe the key issues which must be considered. We also look at the specific requirements in respect of US managers or sub-investment managers of regulated hedge funds domiciled in Ireland.
For simplicity we have not considered the consequences of a US manager undertaking investment management functions through EU based subsidiaries.
Under AIFMD a US investment manager cannot be authorised and thereby cannot obtain the benefit of the EU marketing passport prior to July 2015 at the earliest. Thus marketing will be on either a reverse solicitation or private placement basis. We assess the impact of AIFMD on each of these marketing options.
Scenario 1: US based Investment Manager, managing an EU domiciled AIF
(i) Reverse Solicitation – reverse solicitation is often referred to as passive marketing or “reverse enquiry”. It is not restricted by AIFMD and can continue after 22 July 2013 without any requirement for the manager to be authorised under AIFMD.
Individual EU member states currently apply different tests to define reverse solicitation and this is likely to remain the case. Individual states also retain the ability to unilaterally amend the reverse solicitation tests from time to time.
(ii) Private Placement – the majority of US alternative investment fund managers (AIFMs) currently market their funds into the EU by way of private placement. The rules relating to private placement vary on a country by country basis. AIFMD permits, but does not require, the retention of private placement regimes until at least 22 July 2018. However AIFMD also permits individual EU member states to introduce more restrictive private placement regimes. Germany has indicated that it plans to withdraw its private placement regime in July 2013. It is significant that AIFMD allows a state to apply a more restrictive regime to non-EU AIFMs and non-EU AIFs than to those based in the EU.
Post 22 July 2013 a US based manager of an EU AIF, marketing into the EU, must continue to comply with the relevant private placement regime of any target EU member state. The manager must also comply with a number of additional new conditions;
- There must be a bi-lateral co-operation agreement in place between the US and the target EU country. Furthermore the US must not be listed as non-cooperative by the Financial Action Task Force (FATF). The US currently satisfies this second condition however bi-lateral co-operation agreements are not yet in place between the US and any EU countries. Template co-operation agreements are under consideration and it is anticipated that such agreements will be finalised in advance of the 22 July 2013 deadline.
- There must be compliance with the detailed AIFMD transparency requirements principally (a) pre-investment disclosure to investors, (b) on-going reporting to investors including publication of an annual report and (c) reporting to national regulatory authorities.
i. Pre-investment disclosure to investors – Prospectus/Offering Memorandum:
The investment manager must make detailed information available to investors before they invest in the AIF. This will normally be done by including the information in a prospectus or offering memorandum. Most disclosures required by AIFMD are consistent with what is currently disclosed by EU AIFs. However, some notable new disclosures are (i) the details of how the AIFM complies with the requirements relating to professional liability risks (e.g. additional own funds or professional liability insurance), (ii) information on any arrangement made by the depositary of the AIF to contractually discharge itself of liability, (iii) information regarding liquidity risk management and (iv) details of preferential treatment afforded to or available to particular investors or categories of investors.
The information which must be disclosed is set out in Appendix I.
ii. On-going reporting to investors including publication of an annual report
It is necessary to make periodic disclosures to investors. At a minimum the periodic reporting must be delivered at the same time as the annual report.
The annual report must be made available to investors and to the national regulators of each EU member state where the AIF is marketed (even if no actual sales have occurred) no later than 6 months following the end of the financial year.
There is a new requirement for detailed remuneration information to be included in the annual report as follows:
(i) total amount of remuneration, split into fixed and variable remuneration, paid by the investment manager to its staff
(ii) total amount of remuneration paid to senior management and members of staff of the investment manager whose actions have a material impact on the risk profile of the AIF
Where a US Manager is responsible for assets not subject to AIFMD as well as assets which are subject to the directive it may opt to disclose the required remuneration information only in so far as it relates to AIFs established in or marketed in Europe. No precise rules exist determining how remuneration attributable to AIFMD impacted funds is to be calculated. Possible methods of calculation where individuals within a firm are responsible for both AIFMD exempt and AIFMD assets include allocations based on assets under management or based on fee income generated from the various AIFMD/nonAIFMD activities of the investment manager.
The information to be disclosed to investors either within the annual report or otherwise is set out in Appendices II and III.
c) Reporting to national regulatory authorities
Reporting must be provided to the national regulator in each EU member state into which the AIF is marketed (regardless of whether or not any actual sales occur). Semi-annual reporting is required, though in certain circumstances e.g. for those managers whose assets under management exceed EUR 1 billion (or for an individual AIF with assets in excess of €500mls), quarterly reporting is required. Such information must be provided as soon as possible and not later than one month after the relevant period end. The threshold is measured by reference to the AIFs marketed into the EU rather than the total assets under management by an investment manager.
There is a particular focus on leverage under AIFMD. Where an AIFM manages AIFs employing leverage on a substantial basis (i.e. three times NAV on a commitment basis) additional reporting is required. In such circumstances the AIFM is required to disclose the overall level of leverage employed by each AIF it manages, distinguishing between leverage arising from borrowing of cash or securities and leverage embedded in financial derivatives. It is also necessary to disclose the extent to which assets have been rehypothecated. The identity of the five largest sources of borrowed cash or securities and the amounts of leverage received from each source must also be disclosed.
AIFMD also includes reporting requirements regarding investments in EU nonlisted companies. The regulator in each jurisdiction in which the AIF is marketed must be notified when there are changes in voting rights held by the AIF in an EU non-listed company, passing up or down through various percentage thresholds.
The information which must be provided to the competent authorities is set out in Appendix IV.
While there is significant overlap with the US regulatory reporting Form PF there are differences and thus it is not possible to use Form PF as the reporting format under AIFMD.
3. Restrictions an “Asset Stripping”
AIFMD also contains restrictions on “asset stripping” in situations where an AIF gains control (50%) of either an unlisted EU company or a listed EU company. These provisions restrict the disposal of such positions within a two year timeframe.
For the private placement of an EU domiciled AIF, by a US investment manager, the AIFMD does not impose immediate depositary requirements. However, it should be expected that the local regulator in the country where the AIF is domiciled and/or the country in which private placement is taking place may require compliance with certain depositary obligations.
It is important for US investment managers to note that it is open to individual EU member states to apply AIFMD equivalent rules to AIFs which are domiciled in that EU member state, even if the investment manager is a non-EU AIFM and is unable to obtain the benefits of the passport.
Scenario 2: US based Investment Manager, managing an AIF which is domiciled outside the EU e.g. Cayman Islands
(i) Reverse Solicitation – the regime in respect of reverse solicitation for AIFs domiciled outside the EU is equivalent to that applicable to EU based AIFs.
(ii) Private Placement – the rules relating to private placement for such funds AIFs are equivalent to those for EU domiciled AIFs subject to noting that not alone must the investment manager be in a country which has a bilateral co-operation agreement with the EU country which is the target of the private placement, the country in which the AIF is domiciled must also have such a bi-lateral co-operation agreement in place. Furthermore the domicile of the AIF must not be listed as non-cooperative by FATF. The Cayman Islands currently meets this FATF test. However no bi-lateral co-operation agreements have been finalised with the Cayman Islands.
The transparency and reporting requirements applicable to EU AIFs marketed on a private placement basis i.e. pre-investment disclosure to investors, on-going reporting to investors including publication of an annual report and reporting to national regulatory authorities apply to non-EU AIFs in the same way as for EU AIFs. The restrictions on asset stripping also apply.
US Managers of AIF’s domiciled in Ireland
As noted above individual EU member states may apply AIFMD equivalent rules to AIFs which are domiciled in a member state, even if the investment manager is a non-EU AIFM and is unable to obtain the benefits of the passport.
The Central Bank of Ireland (CBI) has indicated that it will apply the AIFMD regime to all Irish domiciled AIFs, notwithstanding that a US manager cannot apply for authorisation under AIFMD until 2015 at the earliest. The CBI has published a detailed draft handbook which sets out the requirements for Irish AIFs giving effect to the requirements of AIFMD. The model proposed under this regime envisages that the AIFM will either be the management company in Ireland where one exists or, in the case of funds structured as selfmanaged investment companies, the fund itself. AIFMD provides for delegation and it is possible for an AIFM based in Ireland to appoint a US investment manager which will contract with the AIFM. In order for the entity in Ireland to be authorised as the AIFM it must not be a “letter box entity”. Various tests apply but most significantly it may not delegate investment management to the extent that the “investment management” delegated exceeds by a “substantial margin” that which is retained. The definition of “investment management” and “substantial margin” resides with the national regulator. The CBI has identified a programme of activity which each AIF/AIFM or management company/AIFM (where relevant) will be required to undertake. The programme of activity requires actions in respect of sixteen separate managerial functions and the CBI requires that a document be produced detailing this programme. In addition the CBI requires that each AIF/AIFM in Ireland establish written policies and procedures addressing various key issues relating to the managerial functions including conflicts of interest, liquidity management, remuneration and risk management.
The managerial functions to be addressed, with supporting policies and procedures where appropriate, are set out in Appendix V.
It should be noted that US managers appointed as delegates of Irish AIFMs will not necessarily avoid the remuneration provisions of the AIFMD since look through provisions may apply requiring delegates to have remuneration policies which are “equally effective” in deterring excessive risk taking and remuneration disclosure in the annual report of the AIF is required at a delegate level.
While AIFMD sets specific terms regarding the manner in which bonus amounts should be paid it does not explicitly limit the magnitude of bonus payments.
AIFMD requires that; “the remuneration policy is consistent with and promotes sound and effective risk management and does not encourage risk-taking which is inconsistent with the risk profiles, rules or instruments of incorporation of the AIFs they manage”
It should be noted that the requirement is not that remuneration discourage risk taking per se, rather that it does not encourage risk taking which is inconsistent with the stated risk profile of the AIF. An AIF may well be established which is intended to operate with a high risk/high reward profile.
Furthermore there is provision for the operation of a proportionality test which may alleviate some of the directive requirements applicable to bonuses e.g. requiring that 50% of bonus/variable remuneration be in equity linked AIF shares and the requirement that at least 40% of the bonus amount be subject to a three year plus deferral period. Generally if the AIFs subject to AIFMD represents less than half of the total assets managed by the AIFM the requirements that a minimum of 50% of bonus/variable compensation be paid by way of equity in the relevant AIF is waived (as is the requirement for deferral of at least 40% plus of any bonus amount). Thus while it is the case that remuneration policies at the US investment manager should discourage excessive risk taking, there is no clear limit on salary or bonus amounts.
While this regime imposes certain substance requirements on AIFs domiciled in Ireland together with additional requirements set by AIFMD itself it does offer US managers the possibility of having Irish AIFs benefit from the EU marketing passport. This will allow such funds to be sold cross border to professional investors effective 22 July 2013.
Immediate actions/considerations
- If operating a Cayman domiciled fund
a) Review your existing distribution strategy and identify reverse solicitation versus private placement arrangements, paying particular attention to precisely how each of these terms are defined in your target markets.
b) If distributing by private placement
– Monitor the regulatory developments in each target market. Note any planned restriction or withdrawal of the private placement regime in such countries. Identify country specific requirements applicable to the AIF as a result of engaging in private placement.
– Review the prospectus / offering memorandum against the AIFMD disclosure and transparency requirements and update as necessary
– Establish a process to facilitate the required periodic reporting to investors / regulators
2. If operating an EU AIF (additional considerations)
a) Monitor the detailed requirements in the country in which the AIF is domiciled
b) Assess the impact of the remuneration provisions – in particular assess the extent to which current remuneration practice is aligned with the risk level that the relevant AIFs are seeking to achieve. Document the rationale for the non-application, if any, of the rules covering the manner in which bonus / variable remuneration is paid.
c) If the AIF is domiciled in Ireland determine how the AIF/AIFM will comply with the substance requirements of the programme of activities.
d) Ensure that procedures are implemented to monitor all delegates and that all delegates have the necessary processes and procedures in place
AIFMD will allow US investment managers to continue to market their funds by reverse solicitation and private placement subject to the various requirements set out above. For AIFs domiciled in Ireland immediate access to the EU marketing passport can be obtained when the AIF itself becomes authorised as the AIFM. Managers must take the necessary steps now to address several new issues and to fundamentally evaluate the trade-off between the distribution opportunities and the costs of complying with AIFMD related operational, governance and compliance requirements.
Disclaimer: This briefing document is provided for information purposes only and does not purport to represent legal, regulatory or tax advice.
To discuss any of the issues raised in this briefing note or indeed any questions you may have regarding the practical impact of AIFMD please contact Robert Hennessy Tel: +353 1 613 6391, email: robert.hennessy@kbassociates.ie or any of the KB Associates’ consultants listed below.
Appendix I
Detailed information which must be disclosed to investors prior to investment:
a) a description of the investment strategy and objectives of the AIF; information on where any
master AIF is established; where underlying funds are established, if the AIF is a fund of
funds; the types of assets and investment techniques employed, along with associated risks;
applicable investment restrictions; circumstances where leverage may be used and
information on the maximum level of leverage that the AIFM may employ on behalf of the
AIF
b) a description of the procedures for the AIF to change its investment objectives or policy or
both
c) a description of the main legal implications of the contractual relationship entered into for
the purpose of investment
d) the identity of the AIFM, the AIF’s depositary and auditor and other main service providers
e) details of how the AIFM complies with the requirements relating to professional liability
risks (e.g. requirement for the AIFM to have additional own funds or professional indemnity
insurance)
f) a description of any delegated management function or delegated depositary function
g) a description of the AIF’s valuation procedure and pricing methodology
h) a description of the AIF’s liquidity risk management including redemption rights in both
normal and exceptional circumstances
i) a description of all fees charges and expenses borne by investors including maximum
amounts
j) a description of how the AIFM ensures fair treatment of investors where an investor obtains
preferential treatment
k) the latest annual report
l) the procedure and conditions for the issue and sale of units or shares
m) the latest NAV of the AIF
n) the historical performance of the AIF where available
o) the identity of the prime broker and full details of the material arrangements of the AIF with
its prime brokers including the contract with the depositary and the possibility of transfer
and re-use of AIF assets and any transfer of liability to the prime broker
p) how and when additional information on liquidity and leverage will be disclosed to
investors.
The AIFM shall also inform investors, before they invest in the AIF, of any arrangement made by
the depositary to contractually discharge itself of liability
Appendix II
Information which must be disclosed to investors periodically:
a) the percentage of the AIF’s assets which are subject to special arrangements arising from
their illiquid nature (e.g. side-pockets, gates)
b) any new arrangements for managing the liquidity of the AIF
c) the current risk profile of the AIF and the systems employed by the AIFM to manage those
risks.
For AIF’s employing leverage, the AIFM shall disclose, as part of periodic reporting to investors:
a) any changes to the maximum level of leverage which the AIFM may employ as well as any
right of the re-use of collateral or any guarantee granted under the leveraging arrangement
b) the total amount of leverage employed by the AIF (calculated in accordance with the gross
and commitment methods).
Appendix III
Required information for Annual Report
a) a balance sheet or statement of assets and liabilities
b) an income and expenditure account for the year
c) a report on the activities of the year
d) any material changes in information which was previously disclosed to investors
e) total amount of remuneration, split into fixed and variable remuneration, paid by the
investment manager to its staff
f) total amount of remuneration paid to senior management and members of staff of the
investment manager whose actions have a material impact on the risk profile of the AIF.
Appendix IV
Information which must be disclosed to national regulatory authorities:
a) the percentage of the AIF’s assets which are subject to special arrangements arising from
their illiquid nature
b) any new arrangements for managing the liquidity of the AIF
c) the current risk profile of the AIF and the risk management systems employed by the AIFM
to manage the market risk, liquidity risk, counterparty risk and other risks including
operational risk information on the main categories of assets in which the AIF is invested
d) the results of stress tests performed.
The AIFM shall also, on request from the competent authorities, provide the following documents:
a) an annual report of the AIF
b) where there is more than one AIF, a detailed list of all AIFs which the AIFM manages, at the end of each quarter.
Appendix V
Managerial Functions to be covered in the programme of activities
a) decision making
b) monitoring of investment policy, investment strategies and performance
c) monitoring compliance
d) risk management
e) liquidity management
f) operational risks
g) conflicts of interest
h) supervision of delegates
i) financial control
j) monitoring of capital
k) internal audit
l) complaints handling
m) accounting policies and procedures
n) recordkeeping
o) remuneration
p) AIFMD reporting process