Introduction
The discussions and debate on the Alternative Investment Fund Managers Directive (AIFMD) have gone on for so long (over three years) that it is easy to lose track of the main provisions of the directive. The directive sets out rules for the authorisation, ongoing operation and transparency of alternative investment fund managers (AIFMs) managing or marketing alternative investment funds (AIFs) in the European Union (EU). Although there has been much criticism of the directive it should present new opportunities by creating a European passport for alternative funds, similar to the very successful UCITS passport. Pending the release of Level 2 guidelines by the European Commission the following sets out the current position.
General provisions – which entities will be subject to AIFMD?
The requirements of the directive will apply to:
- EU based AIFMs
- Non-EU AIFMs who manage an EU AIF
- Non-EU AIFMs which market AIFs in the EU (whether or not such AIF’s are EU domiciled)
UCITS are excluded from the AIFMD regardless of the investment strategy which is pursued. For example UCITS funds which follow an alternative investment strategy are clearly outside the scope of AIFMD. An AIF can be open or closed ended and constituted as a company, as a trust or under contract
An AIFM is any entity managing one or more AIFs.
1. SCOPE OF THE DIRECTIVE
Requirement for authorisation of AIFMs
The general rule is that an AIFM cannot manage an AIF unless it obtains authorisation under the directive. However the following exemptions are included:
1. The directive does not apply to an AIFM which only manages AIFs whose only investors are other entities belonging to the same group as the AIFM.
2. The following also fall outside the directive
(i) AIFMs where the cumulative assets in AIFs under management fall below a threshold of €100 million;
(ii) If the AIF is not leveraged and has a lock-in period of 5 years this threshold is raised to €500 million. It is however possible for these AIFMs to “opt in” to the directive if they wish to avail of the passport.
Under the directive each AIFM will be regulated in its homemember state. The process is expected to be similar to the procedure applicable to UCITS management companies which requires detailed business plans and risk management process documents. The directive imposes new capital requirements which are equivalent to those imposed for existing UCITS management companies:
(i) Self-managed AIFs must have capital of at least EUR 300,000
(ii) An AIFM appointed as an external manager of AIFs must have capital of at least EUR 125,000
The AIFM must have its head office and registered office in the same EU member state. The owners and senior management of the AIFM will be subject to vetting by the regulator.
2. OPERATING CONDITIONS
Operating conditions for the AIFM
The directive imposes general principles on the AIFM which would be regarded as standard for regulated investment management entities. In summary the AIFM must:
(i) Act honestly , fairly and with due care and diligence
(ii) Act in the best interests of the AIF or its investors
(iii) Employ the proper resources and procedures to run the business
(iv) Avoid conflicts of interest or where they cannot be avoided manage them appropriately.
(v) Comply with all regulatory requirements
(vi) Treat all AIF investors fairly.
Remuneration
With regard to remuneration, the AIFM is required to have specific policies consistent with the general requirement that excessive risk taking must not be encouraged.
Conflicts of Interest
With regard to conflicts of interest the directive specifically requires the AIFM to take all reasonable steps to identify conflicts that might arise between the AIFM and other funds that it manages or its (the AIFM’s) other clients. The Directive requires the AIFM to separate tasks and responsibilities that might be regarded as incompatible with each other or might potentially generate systematic conflicts of interest.
Risk Management
The directive introduces requirements in relation to risk management which are similar to those which are applied to UCITS Funds. The AIFM must separate the risk management function from the other operating units, including portfolio management. The AIFM must implement a risk management system addressing all the risks relevant to the investment strategy and this system must be reviewed at least once per year. The AIFM must also operate an appropriate liquidity management system and monitor liquidity risk.
Valuation
AIFMs are required to ensure the proper and independent valuation of the AIF’s assets at least once per year. An AIFM can undertake the valuation itself but only if the valuation function is “functionally independent” from the portfolio management function and conflicts of interest are mitigated. It is also possible for an external valuer to be appointed. This area has generated substantial discussion and it has been clarified that existing administration companies, which calculate the Net Asset Value (NAV) for funds are not automatically regarded as valuers.
Delegation of Functions
There must be an objective reason for an AIFM to delegate its functions. Due diligence of any delegate will be required. Portfolio management and risk management can be delegated only to an authorised asset management firm. An AIFM is not permitted to delegate so many functions that it is deemed to be a “letter box” entity. There is significant uncertainty in this area which needs to be clarified by the detailed level 2 provisions. Given the existing situation where AIFs are structured as self-managed investment companies it is critical that a workable resolution is achieved.
Depositary
For each AIF which it manages, the AIFM must ensure that a depositary is appointed in accordance with the provisions of the directive. A depositary can be any of the following:
(i) An EU Credit Institution
(ii) An EU investment firm which also provides the ancillary service of safe-keeping and administration of financial instruments
(iii) A firm that meets the requirements to be a depositary under the UCITS directive
An AIFM is not permitted to act as a depositary. The responsibilities of the depositary are similar to those which apply to the depositary of a UCITS Fund and include safe-keeping of the assets and monitoring of the AIF’s cash flows. The depositary is required to hold in custody those assets which can be registered on the depositary’s books and instruments that can be physically delivered. For all other assets, such as derivatives, the depositary is required to verify the ownership of such assets. The depositary is permitted to delegate the safe-keeping of assets to a third party so that sub-custodial networks will be permitted.
Use of Prime Brokers
The directive also provides for the use of prime brokers but a prime broker acting as counterparty to an AIF is not allowed to act as depositary for that same AIF unless it has functionally and hierarchically separated the performance of its depositary functions from the functions it performs as prime broker. Also, potential conflicts of interest must be properly identified, managed, monitored and disclosed to investors.
3. SPECIFIC ITEMS TO BE CONSIDERED
Reporting requirements
A key objective of AIFMD is to ensure that EU regulators obtain detailed information on the investments held by AIF’s. There are extensive requirements for the AIFM to make regulatory reports covering instruments traded and on which markets. The reports must detail the principal exposures and also specify the risks arising from illiquid assets. The rationale is that the regulators will use this information to identify the extent to which the use of leverage contributes to the build-up of systemic risk.
EU Member states require that where an AIF acquires or disposes of shares of a non-listed company the AIFM which manages the AIF needs to notify its home regulator of the proportion of voting rights held by the AIF where it reaches, exceeds or falls below the following thresholds – 10%, 20%, 30%, 50%, 75%. There are also requirements to notify shareholders where a controlling interest is acquired. There are also detailed provisions included in the directive designed to prevent asset stripping
Another objective of AIFMD is to provide appropriate information to investors. Annual audited accounts must be produced by the AIFM for each AIF it manages. The AIFM must also make detailed information available to investors in respect of each AIF it manages. This includes a description of investment objectives and policies, the fund rules, and the types of assets to be invested in. This obligation would generally be satisfied by a prospectus or offering document
Depositary Liability
The directive states that a depositary shall be liable for the loss of assets. There is a clear distinction between loss of financial instruments held in custody and loss of “other assets”. Where assets held in custody are lost, the depositary shall be liable unless it can prove that the loss is the result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary. This has been a very contentious issue and is being interpreted as imposing a liability standard on depositaries which is very close to strict liability. It is also clear that there is a reversal of the burden of proof – i.e. the depositary has to prove that it is not liable. It is recognised that depositaries will delegate custody tasks and use sub-custodians. The depositary will also be liable for the loss of financial instruments held in custody by third parties. There is provision for the liability to be transferred to the third party by way of contractual discharge. However, the depositary must prove that the discharge is “objectively justified” and that it has properly performed its due diligence duties on the third party.
Examples of other assets would include physical assets (which cannot be delivered to the depositary), financial contracts – e.g. derivatives, and cash deposits. The same standard of liability does not apply to these other assets but the depositary is subject to record keeping requirements. Generally, the depositary will be liable for the loss of other assets only in situations where the depositary has been negligent.
It is also clear that a similar standard of liability for depositaries will be introduced for UCITS funds under the forthcoming UCITS V Directive. Otherwise there may be more protection for professional investors / hedge funds than for UCITS funds which can be sold to retail investors.
Marketing
If the AIFM is authorised under the AIFMD, any EU AIF it manages will benefit from a marketing passport and can be marketed to professional investors. This passport will become available on date of implementation of the AIFMD which is 22 July 2013. Individual EU member states may also allow marketing of AIFs to retail investors.
There are also specific rules in relation to AIFs established outside the EU or managed by non-EU asset managers. The table below gives a high level summary of the marketing rules:
[table id=1 /]If ESMA advises that it is appropriate to do so, the Directive contains provisions to facilitate the abolition of the private placement regime in 2018. However, it may be expected that certain member states will change or close down their individual private placement regimes in advance of that.
4. WHAT IS THE LIKELY IMPACT?
Impact on Asset Managers
The impact on asset managers will very much depend on their existing status. For those firms which are already regulated under MiFID or the UCITS Directive – a number of the AIFMD provisions are very similar to the existing requirements. However, there will be significant new obligations for less regulated firms. There are also requirements which will be new for everyone e.g. the extensive reporting requirements to regulators – detailed quarterly reports will need to be submitted for the vast majority of funds.
Managers will also have to review the way in which they market their funds. Even if they continue to market under private placement regimes – there are new transparency requirements and cooperation agreements which need to be in place. In 2015 there will be a review of the regime which could result in non-EU AIFMs needing to be authorised and to meet the requirements of the directive
Impact on Trustee / Custodian
The most significant impact on trustees/custodians, referred to as depositaries under the directive, is the increased liability. It is expected that this will lead to increased costs for custody services. With increased responsibility for sub-custodians certain trustees may refuse to offer services in less developed markets. It is also expected that there will be some consolidation and the larger providers with proprietary custody networks will benefit.
AIFMD makes it clear that the custodian must conduct due diligence and on-going monitoring of any sub-custodian to which it has delegated safe-keeping of assets. For example, the custodian must monitor the sub-custodian’s performance and its compliance with AIFMD. It must ensure that the sub-custodian exercises reasonable care, prudence and diligence in the performance of its tasks, and the custodian must review custody risks and notify the AIF/AIFM of any changes
The AIFMD also introduces increased obligations on the custodian for those assets categorised as “other assets”. These include verifying that the AIF is the legal owner of the assets by having access to the relevant information and keeping a record of the non-custody assets of the AIF. The custodian must also ensure that changes of ownership do not occur without the custodian being informed. It is critical that a clear distinction is made between custody assets and other assets.
Impact on Administrators
The main requirements for valuation are based on the existing requirements for UCITS funds. However, there are still some uncertainties. An AIFM is required to have proper and independent procedures for the valuation of the assets of each AIF it manages. The valuation may be performed by either the AIFM itself or a regulated third party valuer. It has been clarified that a third party administrator that performs the NAV calculation, but does not provide valuations or exercise judgement, would not be considered as the external valuer. Third party pricing vendors are also not considered to be external valuers. As a general rule valuation of financial instruments must take place every time a NAV is calculated. It remains to be seen if administrators will offer to provide the valuation service.
With regard to liability, the external valuer shall be liable to the AIFM for any losses suffered by the AIFM as a result of the external valuer’s negligence or intentional failure to perform its task. This potentially uncapped liability could make it difficult for valuation firms to obtain insurance and may also increase costs.
Considerations for Directors
With the increased focus on corporate governance and director’s duties it is very important for Fund Boards to be aware of the new requirements of AIFMD. In particular, the Board will need to be satisfied that the AIFM is authorised and has put in place the necessary policies and procedures to comply with the directive. The increased liability imposed on custodians is also a very important development and the Board will need to assess the implications of same.
CONCLUSION
This paper gives only a high level overview of the main issues which need to be considered by the various entities which will be subject to the provisions of AIFMD. As noted above it will impact on the funds themselves, the investment managers and also the various service providers. Although the final text of Level 2 was to be published in July 2012, it now seems that this will be available in September. Given that the directive will take effect in July 2013 time is running out and firms need to consider the implications of this new regime.