At the time of writing, the Commission is yet to publish its draft implementing measures (officially, at least), ESMA is yet to publish its guidelines on sound remuneration policies, which are required under Article 13(2), and the UK authorities have only recently issued high level discussion papers about UK implementation of the AIFMD.
It is likely that final rules will not be in place until the beginning of 2013, leaving AIFs and AIFMs with less than seven months to implement the requirements. Whilst the known knowns still require further detail and there are a number of known unknowns (but hopefully no unknown unknowns), UK-based hedge fund managers know enough to start planning now for the implementation of the AIFMD in the UK on the 22 July 2013.
Between now and implementation, a UK-based manager of a hedge fund needs to:
- Work out whether it is an AIFM and whether it is caught by the AIFMD
Does it “manage” any “AIFs” (as defined Article 4(1)(a) and (w))? Could anyone else (including the AIF itself) be the AIFM of those AIFs?
It should be noted that Article 5(1) provides that each AIF shall have a single AIFM.
Is the AIFM exempt under Article 3? For example, does it manage AIFs whose assets under management (including any assets acquired through leverage) do not exceed 100 million? If it is exempt, the AIFM will need to determine whether it would want to opt-in under Article 3(4).
It should be noted that the UK authorities may still require some UK-based AIFMs who are exempt under Article 3 to comply some or all of the AIFMD.
- Apply to the FCA for authorisation as an AIFM or register with the FCA as an exempt AIFM
Article 61(1) provides that “AIFMs performing activities under [the AIFMD] before 22 July 2013 shall take all necessary measures to comply with national law stemming from [the AIFMD]”, although such AIFMs have until 22 July 2014 to submit an application to the FCA for authorisation as an AIFM.
Article 7 (as supplemented by regulatory and implementing technical standards) sets out the information that will need to be provided in an application for authorisation.
An authorised AIFM that manages an EU AIF in another EU member state (e.g. a Luxembourg or Irish AIF) will also need to submit an application for the management passport in accordance with Article 33.
This may pose timing complications unless the UK and the relevant EU member states, in which the EU AIFs that are managed by the UK AIFM are domiciled, implement appropriate transpositional provisions in respect of the period from 22 July 2013 to 22 July 2014.
The information that will need to be provided by an exempt AIFM at the time of registration is set out in Article 3(3) (as supplemented by delegated acts).
- Check that it can continue to provide the same services after authorisation as an AIFM
Article 6 provides that an authorised AIFM may only engage in certain activities and certain combinations of those activities.
- Check whether (a) its internal systems and controls satisfy the conditions for authorisation set out in Article 8, (b) it can satisfy the operating conditions set out in Article 12, (c) it can satisfy the organisational requirements set out in Article 18 and (d) it can satisfy the reporting obligations to the FCA that are set out in Article 2
- Review its regulatory capital and professional indemnity insurance
The basic regulatory capital requirement for authorised AIFMs under Article 9 is likely to be higher than the existing requirement. Own funds are required to be invested in liquid assets or assets readily convertible to cash in the short term (and not speculative positions).
An authorised AIFM must either have additional own funds which are “appropriate to cover potential liability risks arising from professional negligence” or hold professional indemnity insurance against liability arising from “professional negligence which is appropriate to the risks covered” (see Article 9(7)).
- Review arrangements in relation to conflicts of interest to ensure compliance with Article 14
- Check whether it needs to functionally and hierarchically separate the functions of risk management from the operating units, including from the functions of portfolio management (Article 15(1))
Where such separation is not required the AIFM must, in any event, be able to “demonstrate that specific safeguards against conflicts of interest allow for the independent performance of risk management activities and that the risk management process satisfies the requirements of Article  and is consistently effective”.
- Review its risk management systems and processes to ensure compliance with Articles 15(2) and (3)
- Set a maximum level of leverage for each AIF it manages
Article 15(4) requires this and Article 25(3) expands on this requirement so that an AIFM must demonstrate that the leverage limits set by it for each AIF it manages are reasonable and that it complies with those limits at all times.
This maximum level (and any material changes to it) must be disclosed to investors in accordance with Article 23.
The actual amount of leverage employed by an EU AIF or any AIF marketed in the EU will also have to be disclosed “on a regular basis” (Article 23(5)).
- Review its liquidity management systems and procedures to ensure compliance with Article 16(1)
See 17 below for more requirements relating to liquidity management.
- Confirm that the external valuer (most likely the existing administrator) satisfies Articles 19(4) and (5)
- Review and probably amend the existing investment management agreement(s) relating to the AIF
For example, the investment management agreement(s) may need to be amended to reflect the following:
- under Article 14(3), “AIFMs shall exercise due skill, care and diligence in the selection and appointment of prime brokers with whom a contract is to be concluded”
- under Article 19(4), AIFMs shall ensure that the valuation function is either performed by an external valuer or the AIFM itself
- under Article 19(10), “AIFMs are responsible for the proper valuation of AIF assets, the calculation of the net asset value and the publication of that net asset value” and the AIFM’s liability towards the AIF and its investors shall not be affected by the fact that the AIFM has appointed an external valuer
- under Article 19(8), “The valuation shall be performed impartially and with all due skill, care and diligence”
- any delegation by an AIFM, and any contractual power of an AIFM to delegate, to third parties of the task of carrying out functions on behalf of the AIFM must comply with Article 20 (Delegation)
See below for how delegation arrangements need to be reviewed/amended in general but, in particular:
- where the delegation concerns portfolio management or risk management, “it must be conferred only on undertakings which are authorised or registered for the purpose of asset management and subject to supervision or, where that condition cannot be met, only subject to prior approval by the competent authorities of the home Member State of the AIFM” (Article 20(1)(c)) and where the delegation concerns portfolio management or risk management and is conferred on a third-country undertaking, in addition to the requirements of Article 20(1)(c), “cooperation between the competent authorities of the home Member State of the AIFM and the supervisory authority of the undertaking must be ensured” (Article 20(1)(d))
- “no delegation of portfolio management or risk management shall be conferred on the depositary or a delegate of the depositary or “any other entity whose interests may conflict with those of the AIFM or the investors of the AIF, unless such entity has functionally and hierarchically separated the performance of its portfolio management or risk management tasks from its other potentially conflicting tasks, and the potential conflicts of interest are properly identified, managed, monitored and disclosed to the investors of the AIF” (Article 20(3))
- the AIFM cannot delegate its functions “to the extent that, in essence, it can no longer be considered to be the manager of the AIF and to the extent that it becomes a letter-box entity” (Article 20(3))
- Review investment management agreements with non-AIF clients
For example, Article 12(2)(a) provides that an authorised AIFM is not be permitted to invest all or part of a non-AIF client’s portfolio in units or shares of the AIFs it manages, unless the AIFM receives prior general approval from the non-AIF client.
- Review and probably amend the AIF’s administration agreement
If the administrator will act as the AIF’s external valuer then the administration agreement will probably need to be amended to comply with the requirements of Article 19 (Valuation). For example:
- the AIFM should be added as a party to the administration agreement as the appointment of the external valuer is a delegation by the AIFM (see Articles 19(5)(c) and 19(10))
- the administration agreement will also need to be amended to reflect Article 19(6) (“The appointed external valuer shall not delegate the valuation function to a third party”), Article 19(8) (“ The valuation shall be performed impartially and with all due skill, care and diligence”) and Article 19(10) (“… irrespective of any contractual arrangements providing otherwise, 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 tasks”)
Even if the administrator will not act as the AIF’s external valuer, the appointment of an administrator is likely to be a delegation by the AIFM (and will, inter alia, require the AIFM to be a party to the administration agreement) given ESMA’s view that “Notwithstanding the fact that the AIFM may choose not to perform itself [the administration functions set out in Annex I of the AIFMD]…in such a case these functions should be considered as having been delegated by the AIFM to a third party. Therefore, the AIFM should be responsible for the activities carried out by the delegated entity in relation to [these functions], in compliance with both the rules on liability in case of delegation ... and the principle ... according to which the single AIFM appointed for an AIF is responsible for the compliance with the AIFMD (i.e. also for [these functions])”.
See below for how delegation arrangements need to be reviewed/amended to comply with Article 20 (Delegation).
For EU AIFs, the depositary may need to be added as a party to the administration agreement in order to carry out its functions properly. For non-EU AIFs that are to be marketed in the EU, the administration agreement may also have to change as a result of Article 36(1)(a) (see 17 below).
- Review all of its delegation/outsourcing
and sub-delegation arrangements Any delegation by an AIFM to third parties of the task of carrying out functions on behalf of the AIFM and any subdelegation must comply with Article 20 (Delegation).
As described above, Article 20 will have an impact on any delegation of portfolio management or risk management but may also have an impact on delegation of any of the tasks set out in Annex I of the AIFM. The appointment of an administrator might therefore be a delegation by the AIFM.
The power to delegate, the delegation and the delegate will all need to satisfy the requirements of Article 20 and any agreement that amounts to a delegation by the AIFM (possibly including the administration agreement) will need to be reviewed and probably amended.
For example, the AIFM must be in a position to “withdraw the delegation with immediate effect when this is in the interest of investors” (Article 20(1)(f)), “ The AIFM’s liability towards the AIF and its investors shall not be affected by the fact that the AIFM has delegated functions to a third party, or by any further sub-delegation” (Article 20(3)) and any sub-delegation must comply with Article 20(1) and (4) (and (5), if portfolio management or risk management are being delegated).
- Review and probably amend the AIF’s prime brokerage and custody agreements
Article 14(3) provides, “[w]here the AIFM on behalf of an AIF uses the services of a prime broker, the terms shall be set out in a written contract. In particular any possibility of transfer and reuse of AIF assets shall be provided for in that contract and shall comply with the AIF rules or instruments of incorporation. The contract shall provide that the depositary be informed of the contract”.
For EU AIFs, an existing custodian or, less likely, an existing prime broker may be appointed as the AIF’s depositary. If so, the relevant agreement would need to be replaced with terms of appointment that comply with Article 21 (Depositary). Where a separate depositary is to be appointed, the existing custodian and prime brokerage agreements will still need to be amended to reflect the primacy of the depositary and to ensure that the depositary can carry out its functions properly.
For non-EU AIFs that are marketed in the EU, the existing custody and prime brokerage agreements may also have to change as a result of Article 36(1)(a) (see 17 below).
- Review the structure of the AIF and the AIF documents
An EU AIF will need to appoint a depositary and there will be a number of changes to the AIF’s documents (e.g. prospectus and existing custody/prime brokerage agreements (see 16 above)).
An EU AIF that is currently marketed into an EU member state (including the EU member state in which it is domiciled) will also need to submit an application for the AIF passport in accordance with Articles 31 and 32.
This may pose timing complications unless the relevant EU member states implement appropriate transpositional provisions in respect of the period from 22 July 2013 to 22 July 2014.
The AIFM will also need to review the prospectus/offering document and other pre-investment disclosures to investors to ensure compliance with Article 23 (Disclosure to investors).
Non-EU AIFs that are marketed in the EU
Whilst these AIFs do not need to appoint a depositary, the AIFM does need to ensure that one or more entities are appointed to carry out the duties referred to in Article 21(7), (8) and (9), namely monitoring of cash flows and the payment of subscription monies etc, holding financial instruments of the AIF in custody, verifying the ownership of assets of AIF that cannot be held in custody, monitoring subscriptions/redemptions, valuation, transaction settlement etc. and related record keeping (see Article 36(1)(a)).
One or more entities can be appointed to perform these functions and it should be possible to appoint existing service providers perform them. Existing administration, custody and prime brokerage agreements may therefore need to be amended to effect, and/or to reflect, any such appointment.
Any such AIF must also be in jurisdiction (i) whose supervisory authorities have appropriate cooperation arrangements with the competent authorities of the AIFM’s home member state of the AIFM in accordance with Article 36(1)(b) and (ii) which is not listed as a Non-Cooperative Country and Territory by FATF.
The AIFM will also need to review the prospectus/offering document and other pre-investment disclosures to investors to ensure compliance with Article 23 (Disclosure to investors).
Non-EU AIFs that are not marketed in the EU
These AIFs do not need to appoint a depositary and the AIFM does not need to ensure that one or more entities are appointed to carry out the duties referred to in Article 21(7), (8) and (9).
Any such AIF must, however, be in jurisdiction whose supervisory authorities have appropriate cooperation arrangements with the competent authorities of the home Member State of the AIFM in accordance with Article 34(1)(b).
The AIFM will need to, amongst other things:
- ensure that the investment strategy, the liquidity profile and the redemption policy of the AIF are consistent (Article 16(2))
- ensure that, where the rules applicable to the valuation of assets and the calculation of the net asset value per unit or share of the AIF are not laid down in the law of the country where the AIF is established, that such rules are laid down in the “AIF rules or instruments of incorporation”. (See Article19(2))
- ensure that any listing on an EU stock exchange (e.g. the Irish Stock Exchange) can continue. Recital 60 provides, “[i]t should be possible for units or shares of an AIF to be listed on a regulated market in the Union … only if the AIFM which manages the AIF is itself permitted to market the units or shares of the AIF in that Member State”
Between now and implementation, a UK-based manager of a hedge fund may need to:
- Review and possibly amend side letter arrangements etc and the disclosure of preferential treatment of investors
Article 12(1)(d) and (1)(f) requires authorised AIFMs to treat investors in an AIF fairly. Article 12(1)(f) requires authorised AIFMs to disclose any preferential treatment in the AIF’s “rules or instruments of incorporation”.
Article 23(1)(j) requires authorised AIFMs, for each of the EU AIFs that they manage and for each of the AIFs that they market in the EU, to “make available to AIF investors, in accordance with the AIF rules or instruments of incorporation, the following information before they invest in the AIF, as well as any material changes thereof… a description of how the AIFM ensures a fair treatment of investors and, whenever an investor obtains preferential treatment or the right to obtain preferential treatment, a description of that preferential treatment, the type of investors who obtain such preferential treatment and, where relevant, their legal or economic links with the AIF or AIFM”.
- Review their remuneration policies and related agreements
Article 13 requires AIFMs to “have remuneration policies and practices for those categories of staff, including senior management, risk takers, control functions, and any employees receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers, whose professional activities have a material impact on the risk profiles of the AIFMs or of the AIFs they manage”.
Any such policies and practices must be determined in accordance with the principles set out in Annex II.
The headline AIFMD principles are:
- the assessment of performance is set in a multi-year framework appropriate to the life-cycle of the AIFs managed by the AIFM in order to ensure that the assessment process is based on longer term performance
- the actual payment of performance-based components of remuneration is spread over a period which takes account of the redemption policy of the AIFs it manages and their investment risks
- subject to the legal structure of the AIF and its rules or instruments of incorporation, a substantial portion, and in any event at least 50% of any variable remuneration consists of units or shares of the AIF concerned, or equivalent ownership interests, or share-linked instruments or equivalent non-cash instruments (unless the management of AIFs accounts for less than 50% of the total portfolio managed by the AIFM, in which case the minimum of 50 % does not apply)
- a substantial portion, and in any event at least 40%, of the variable remuneration component (increasing to 60% of the variable remuneration component where the variable remuneration component is a “particularly high amount”), is deferred over a period which is appropriate in view of the life cycle and redemption policy of the AIF concerned and is correctly aligned with the nature of the risks of the AIF in question (i.e. at least three to 5 years unless the life cycle of the AIF concerned is shorter)
- remuneration payable under deferral arrangements should vest no faster than on a pro-rata basis
Not only will policies and practices have to be reviewed but, for example, partners and employees may need to receive individual advice, agreements with employees/partners may have to be varied, the performance fee arrangements between the AIFM and the AIF may have to be amended, the structure of the manager may have to be amended and the allocation of performance-related profit in an LLP will have to be carefully considered.
It should also be noted that Articles 22(2)(e) and (f) may require “the total amount of remuneration for the financial year, split into fixed and variable remuneration, paid by the AIFM to its staff, and number of beneficiaries” and “the aggregate amount of remuneration broken down by senior management and members of staff of the AIFM whose actions have a material impact on the risk profile of the AIF” to be disclosed in the AIF’s annual report. Finally, between now and implementation, a UK-based manager of a hedge fund will need to:
- Decide whether it should become a non-EU AIFM and/or whether its EU AIFs need to become non-EU AIFs
The AIFMD may not offer any alternative.