The Alternative Investment Fund Managers Directive (the “AIFMD”)1, which will become effective on 22 July 2013, will radically change the regulatory regime relating to alternative investment funds in Europe. This directive, which seeks to regulate alternative fund managers, affords the potential for a new pan-European “passport” similar to the highly successful one currently afforded to UCITS but which can be accessed by compliant alternative funds. Accordingly it is expected to lead to a significant boost for the alternative funds industry within Europe once it becomes operational. On the other hand it also imposes new obligations on alternative investment managers and these will also impact the marketing of such funds in Europe, including by US managers.
It is anticipated that US managers who wish to take advantage of the opportunities created by the AIFMD will predominantly seek to do so through the use of the delegation provisions provided for in this legislation and therefore this article explores the specific requirements in regard to this key issue.
Background to the AIFMD
The European Commission (the "Commission") first published a proposal for a directive regulating alternative investment fund managers ("AIFMs") at a European level in April 2009 in the wake of the global financial crisis. Fundamental aims of this proposed directive were stated to be to assist in securing investor protection and to limit the potential for alternative products to pose a systematic risk to financial systems.
Following numerous counter-proposals and amendments, a draft directive was ultimately agreed in October 2010. However, the AIFMD was prepared as a principle-based framework document under the “Lamfalussy Process” and accordingly, following its adoption, much of the fine detail remained to be determined as "Level 2" measures.
The European Securities and Markets Authority (“ESMA”), which replaced the Committee of European Securities Regulators ("CESR"), prepared advice in 2011 to assist in finalising the relevant details for the ultimate implementation of relevant aspects of this directive and a regulation which reflects Level 2 was prepared and approved on 19 December 2012 (the “Regulation”). Member states of the European Union (“EU”) are required to implement the AIFMD before 22 July 2013.
Overview of Delegation
The delegation model of fund management, whereby self-managed investment vehicles or their management companies appoint third party investment managers and advisers to carry out actual portfolio management, has proven highly successful and indeed has been a key basis upon which the success of the funds industry in domiciles such as Ireland has been built.
There are currently in excess of 5,000 Irish domiciled funds and sub-funds, with assets in excess of 1 Trillion Euro, which have been established by over 400 fund promoters based in over 50 countries.
An incredible 98% of these promoters are based outside Ireland and in most cases investment management services are provided from the promoter’s home jurisdiction, clearly showing the attraction of the delegation model for international fund managers. US based managers are the single largest user of this model, and comprise in excess of 50% of the total2.
Overview of Delegation under the AIFMD
The AIFMD does note in its preamble3 that, depending on their legal form, it should be possible for alternative investment funds falling under the AIFMD (“AIFs”) to be either externally or internally managed and that AIFs that do not appoint an external AIFM will themselves constitute the AIFM. AIFs structured as self-managed investment companies, for example, will typically fall into this category. The AIFMD does specifically address the right of AIFMs to delegate their functions subject to applicable conditions4 and this general concept is further addressed and expanded upon in Section 8 of the Regulation5, which clarifies the applicable requirements and sets them out in greater detail.
The issue is addressed under a number of headings, including general principles, reasons for the delegation, the nature of the delegate, potential conflicts of interest and the effective supervision of the delegate. The relevant “General Principles” include ensuring that the delegation structure does not allow for the circumvention of the AIFM’s responsibilities, obligations or liability (including in relation to its authorisation).
Delegation of portfolio or risk management
Although the boards of alternative funds in Europe can currently appoint delegates at their discretion, it will be a requirement under the AIFMD to justify a decision to delegate portfolio or risk management by reference to “objective reasons”6. Examples of reasons which would be deemed acceptable for this purpose are included in the Regulation7 and these include: (a) cost savings; (b) expertise of the delegate in specific markets or investments; or (c) access of the delegate to global trading capabilities. It will be necessary for the AIFM to provide the competent authorities with a detailed description of the delegate and an explanation of the objective reasons for any delegation with supporting evidence.
Where delegation of portfolio management or risk management is proposed, the Regulation sets out the types of EU regulated entities to be deemed to be appropriately authorised for such purpose8. It also notes that non-EU entities authorised under the AIFMD or those authorised or registered for the purpose of asset management and effectively supervised by a competent authority in their home country would also qualify, subject to certain condition9. Specifically, there must be a written agreement between the competent authorities of the home Member State of the AIFM (the “Competent Authority”) and the supervisory authorities of the delegate which allows the Competent Authority to carry out effective supervision, including to:
- obtain on request information and documents necessary to carry out their supervisory tasks as provided for under the AIFMD;
- receive information from the supervisory authority in the third country for the purpose of investigating apparent breaches of the AIFMD and Regulation as soon as possible; and
- obtain cooperation with regard to enforcement matters in accordance with applicable local law in cases of any such breaches.
It can be noted that ESMA announced on 30 May 2013 that it has centrally agreed relevant cooperation agreements with 32 non-EU regulators10. Among those included were the following US regulatory bodies: the Federal Reserve Board, the Office of the Comptroller of the Currency and the Securities and Exchange Commission and accordingly US entities regulated by these authorities should also be eligible to act as delegates. However, as one of the stated aims of the AIFMD is to ensure more effective oversight of the alternative sector, the directive makes it clear that delegation should not be permitted where it prevents effective supervision and the Regulation clarifies that delegation shall be deemed to prevent this where the delegate does not cooperate with the Competent Authority in connection with the delegated functions11.
Delegates will be required to have sufficient resources and to employ sufficient personnel with the skills, knowledge and expertise necessary (including appropriate training and previous experience) for the proper discharge of the tasks delegated. Personnel of the delegate are also required to be of sufficiently good repute and examples of the research to be undertaken to confirm such matters are detailed, for example specific attention is required to be paid to any previous convictions for dishonesty or fraud12.
One of the specific concerns of the AIFMD is to prevent the use of “letterbox” entities13. Such concerns have previously been considered in Europe relation to UCITS, where the “four eyes” principle now applies. It can be noted that the AIFMD itself specifies that measures would be adopted detailing when an entity would be deemed to constitute a letter-box entity for the purposes of the AIFMD and no longer be considered to be the manager of the relevant AIF. Accordingly the Regulation14 sets out a series of such relevant circumstances and key considerations in this regard include where:
- the AIFM no longer retains the necessary expertise and resources to supervise the delegated tasks effectively and manage the risks associated with the delegation;
- the AIFM loses its contractual rights to inquire, inspect, have access or give instructions to its delegates or the exercise of such rights becomes impossible in practice; or
- the AIFM delegates the performance of investment management functions to an extent that exceeds by a substantial margin the investment management functions performed by the AIFM itself. A series of criteria are included in the Regulation to be used as a guide in this regard.
It can be noted that “investment management functions” are defined in the AIFMD to include both portfolio and risk management, so it is expected that the AIFM would retain one of these functions to ensure it meets this requirement and in fact the explanatory memorandum to the Regulation 2 specifically provides that when appointing a delegate the AIFM:
“has to perform at least functions relating to either risk or portfolio management”.
In practice, it would be anticipated that most AIFMs operating the delegation model would retain the risk management function to meet this requirement, especially in funds with a high level of trading. The manner in which this obligation was met on an on-going basis will be detailed in the POA of the relevant AIFM applicable to a given AIF. In cases where relatively few investment decisions are made, such as private equity, property or venture capital schemes it may be determined not to appoint a third party investment manager as a delegate and instead to appoint it in an ancillary capacity, with the AIFM itself retaining responsibility for discretionary investment management decisions, provided the necessary requirements can be met.
At the same time, the Regulation provides that determinations regarding whether an entity is a mere “letter box” will be based on the structure as a whole, bearing in mind a range of factors including the types of assets held by the relevant AIF15.
It can be noted that the Commission intends to monitor the application of this Article in the light of market developments and shall review the situation after two years to see if it is necessary to further specify conditions under which an AIFM shall be deemed to have delegated its functions to the extent that it becomes a letter box entity16. ESMA may also issue guidelines to ensure a consistent assessment of delegation structures across the European Union17.
Compliance with these requirements will entail (a) ensuring that the delegation agreement affords sufficient oversight powers to the AIFM and that the delegation only pertains to portfolio or risk management and not both; and (b) ensuring that the AIFM has the necessary expertise and resources, details of which are documented appropriately.
In Ireland, the Central Bank has identified a series of 16 managerial functions which the board of an AIFM shall be responsible for in accordance with good corporate governance principles18 and responsibility for these items should be maintained regardless of any delegation to minimise the potential for the structure to be viewed as a “letter-box” entity.
Conflicts of interest
The AIFMD also precludes delegation in circumstances where it conflicts with the interests of the AIFM or investors in the relevant AIF19. The Regulation clarifies that determining this shall include consideration of a range of factors including20:
- the extent to which the delegate controls the AIFM or has the ability to influence its actions, where there is any other contractual relationship between them;
- the extent to which the delegate itself is controlled by an investor in the relevant AIF where there is any other contractual relationship between them;
- the likelihood that the delegate makes a financial gain, or avoids a financial loss, at the expense of the AIF or the investors in the AIF;
- the likelihood that the delegate has an interest in the outcome of a service or an activity provided to the AIFM or the AIF;
- the likelihood that the delegate has a financial or other incentive to favour the interest of another client over the interests of the AIF or the investors in the AIF;
- the likelihood that the delegate receives or will receive from a person other than the AIFM an inducement in relation to the collective portfolio management activities provided to the AIFM and the AIFs it manages in the form of monies, goods or services other than the standard commission or fee for that service.
The appointment of a strong independent board to the AIFM would ensure that the “control” test in (a) above would be satisfied. It can be noted that for Irish domiciled AIFs the “Corporate Governance Code for Collective Investment Schemes and Management Companies” adopted by the Irish Funds Industry Association in consultation with the Central Bank of Ireland (the “Central Bank”), and which is currently applicable, does require the appointment of at least one entirely independent board member.
In relation to concerns regarding potential gains or losses, options to minimise the likelihood of any issues arising on these grounds would include addressing these concerns in the conflicts section of the delegation agreement itself, as well as including disclosures and representations in the offering document of the relevant AIF. The exemptions discussed below are also relevant.
There are exemptions to the general prohibition on delegation which arise due to concerns regarding potential conflict of interest included in the AIFMD itself21.
These include instances where (a) the portfolio or risk management function may be considered to be functionally and hierarchically separated from other potentially conflicting tasks and (b) where potential conflicts of interest are deemed properly identified, managed, monitored and disclosed to the investors of the AIF. The Regulation addresses these considerations further and includes examples of how concerns in this regard can be satisfied22.
Delegation arrangements must be documented in written agreements between the AIFM and the delegate and there are significant requirements relating to the specific contents of such agreements23 including obligations to set out the following in the agreement:
- the respective rights and obligations of the parties, including rights of information, inspection, admittance and access for the AIFM and its instruction and monitoring rights with regard to the delegate in order to ensure effective supervision;
- terms requiring the delegate to properly supervise the performance of the delegated functions and adequately manage associated risks internally;
- instruction and termination rights, including a requirement that subdelegation can take place only with the consent of the AIFM;
- a requirement on the delegate to disclose to the AIFM any development that may have a material impact on the delegate's ability to carry out the delegated functions effectively and in compliance with applicable laws and regulatory requirements;
- an obligation to protect any confidential information relating to the AIFM, the relevant AIF itself and the investors in that AIF; and
- a requirement to ensure that the delegate establishes, implements and maintains an appropriate contingency plan for disaster recovery and periodic testing of backup facilities.
Where an existing self-managed fund wishes to comply with the AIFMD it will be necessary to examine its existing relevant contractual arrangements, i.e. the investment management agreement, and this will typically need to be revised to address all of these points. In addition to specific requirements, such as those above, required to be included in the actual delegation contract itself, a series of on-going obligations are also imposed on the AIFM by the applicable general principles. It would be appropriate for these to be addressed and documented separately in the Program of Activity (the “POA”) of the AIFM24. Examples of these obligations include25:
- establishing methods and procedures for reviewing on an on-going basis the services provided by delegates to ensure that they carry out the delegated functions effectively and in compliance with applicable law and regulatory requirements to an appropriate quality standard;
- setting out the appropriate action to be taken if it appears that the delegate cannot carry out the functions effectively or in compliance with applicable laws and regulatory requirements;
- ensuring that the AIFM has the necessary expertise and resources to supervise the delegated functions and in fact effectively supervises the delegated functions and manages the risks associated with the delegation; and
- instructing the delegate regarding implementation of the investment policy of the AIF and monitoring compliance on an on-going basis.
The POA will be a corporate governance type document or manual required as part of the authorisation process of an AIFM. It will be similar in many ways to the Business Plan and Procedures Manual prepared for entities currently authorised as Undertakings for Collective Investment in Transferable Securities (UCITS), although naturally reflecting the specific provisions of AIFMD instead. In Ireland the Central Bank’s AIF Rulebook requires the preparation of the POA and provides that an identified board member or other individual, a “designated person”, will be required to be identified in the POA and assigned responsibility to monitor and control, on a day to day basis, relevant activities which have been delegated26. It further provides that where an AIFM delegates activities that the POA shall include requirements for a range of reports to be received by the designated person.
The AIFMD includes a range of provisions relating to the remuneration of AIFMs27 and these have attracted considerable attention in the US in particular. It can be noted that in order to ensure that the principles governing remuneration will not be circumvented through the delegation of activities to external service providers, entities to which portfolio management or risk management activities have been delegated are required to either be subject to regulatory requirements on remuneration that are equally as effective as those directly applicable to AIFMs or else appropriate contractual arrangements must be put in place in order to ensure that there is no circumvention of the remuneration rules28.
The overriding aim of these provisions is stated to be to limit the “potentially detrimental effect of poorly designed remuneration structures on the sound management of risk and control of risk-taking behaviour”29. Details regarding the manner in which remuneration policies and practices are to be determined are set out in the AIFMD30 and further detailed guidelines have been issued on this topic by ESMA to assist clarity31.
The provisions relating to remuneration relate to all staff whose professional activities have a material impact on the risk profiles of AIFs they manage, including senior management, risk takers and control functions32.
Remuneration in this regard is widely defined to refer to “remuneration of any type paid by the AIFM” and also to “any amount paid directly by the AIF itself”33.
Some of the key principles set out in relation to remuneration in the AIFMD are to ensure that the remuneration policies (including relating to pensions) are consistent with and promote sound and effective risk management and do not encourage risktaking which is inconsistent with the risk profiles, rules or instruments of incorporation of the AIFs they manage. However, in addition to generic type overriding principles there are also more prescriptive ones, such as a general prohibition on guaranteed variable remuneration except in limited circumstances.
It will be necessary for an appropriate structure to be established to ensure that there is an annual independent review of remuneration, that conflicts are managed by control staff being rewarded separately and, where the entity is large enough to warrant it, that a remuneration committee be established.
There are principles applicable to the manner in which any bonus payments are calculated – including that performance for such purposes be calculated over a multi-year framework appropriate to the life-cycle of the AIFs managed, that the assessment of performance reflects not only the individual but also the business unit or AIF concerned and the overall results of the AIFM, and that financial as well as non-financial criteria are taken into account when assessing individual performance. Such calculations are also required to take account of future risks an AIF is exposed to and the fixed and variable components of total remuneration should be appropriately balanced.
Finally, there are fairly prescriptive requirements relating to the actual payment of bonuses. For example at least 50 % of any variable remuneration should consist of units or shares of the AIF concerned and a substantial portion, (at least 40 %), of the variable remuneration component should be deferred over a period which is appropriate in view of the life cycle and redemption policy of the AIF.
In addition the deferred portion will only be paid if this is sustainable according to the financial situation of the AIFM as a whole, and justified according to the performance of the business unit, the AIF and the individual concerned. There will be scope for reductions in deferred payments where subsequent subdued or negative financial performance occurs. There are also anti-avoidance provisions.
As mentioned in the section addressing general principles, it will be a requirement for any sub-delegation to be subject to the prior approval of the AIFM34. It can be noted that the Regulation clarifies that a general consent will not be acceptable and instead a specific approval will be needed from the relevant AIFM for any given sub-delegation by its delegate35. The AIFM in turn will be subject to a requirement to notify its Competent Authority and provide it with details of the delegate, the name of the competent authority where the sub-delegate is authorised or registered, the delegated functions, the AIFs affected by the subdelegation, a copy of the written consent by the AIFM and the intended effective date of the sub-delegation36. The provision in the delegation agreement providing for subdelegation should accordingly reflect this or provide that sub-delegation will only be permitted in accordance with applicable law.
Summary of key compliance steps for delegation under AIFMD
The following is a brief overview of the key points to be addressed to ensure compliance with the requirements relating to delegation under the AIFMD:
- ensure the delegation is objectively justified based on the criteria in the Regulation and document this rationale;
- ensure the proposed delegate meets the relevant requirements under the AIFMD;
- ensure the draft written delegation contract (typically an investment management agreement) reflects the specific relevant requirements under the AIFMD;
- ensure on-going obligations of the AIFM are addressed and documented in the POA of the AIFM;
- ensure on-going obligations of the delegate under the AIFMD are addressed and documented in its procedures manuals, where necessary;
Status of the AIFMD in Ireland
The Central Bank announced that it was accepting applications for AIFMs on May 15th 2013. It also published the relevant Application Forms, as well as its AIF Rulebook, making it the first regulator in Europe to provide such clarity on its approach to applications under AIFMD. The AIF Rulebook details the requirements relating to AIFs, AIFMs, AIF management companies, fund administrators and depositaries in Ireland. The Central Bank also issued a Q&A document clarifying the structures and processes that will allow investment managers to comply with the AIFMD as well as the relevant timelines.
All of this AIFMD related documentation is currently available on the Central Bank’s website as well as draft application forms for new AIFMD compliant AIFs- Qualifying Investor AIFS (“QI AIFs”). To further assist with a smooth transition to the post AIFMD regime the Central Bank has held a series of workshops with relevant law firms in order to answer queries regarding its new documentation and its general approach in this regard.
Ireland enjoys a position as a leading jurisdiction for the domiciliation and servicing of hedge funds (catering for over 40% of alternative funds globally). Accordingly, the Irish funds industry took a proactive approach in actively engaging with fund managers around the world for the purpose of ensuring that Ireland was AIFMD ready at an early stage and the Central Bank’s AIFMD documentation reflects this preparatory work.
Ireland’s Qualifying Investor Fund (“QIF”) is already deemed to be the most AIFMD ready product currently available and a total of 1,664 were established as of December 2012. As a result, and in anticipation of the introduction of the AIFMD, total assets held in QIFs have doubled since 2009, when the first draft of the AIFMD was published. The QI AIF, which is essentially the AIFMD compliant version of the QIF, is expected to be a vehicle of choice for alternative managers under the AIFMD.
The announcement by the Central Bank that it is now in a position to accept applications for AIFs and AIFMs under the AIFMD will enable AIFMs which wish to avail of the passport under the AIFMD to be able to do so without delay from 22 July 2013. With regard to the issue of delegation, it can be noted that the Central Bank has stated that while it may be relying on confirmations and representation in relation to aspects of new applications when processing new applications for authorisation, it will be subjecting any delegation provisions to a detailed review in every case prior to any authorisation being granted. Generic wording will not be approved and a case-by–case approach will be adopted to all individual applications.
The AIFMD will be implemented in Ireland by means of secondary legislation which will be signed in to law prior to 22 July 2013. The specific legislative instrument will be a statutory instrument in the following form: European Communities (Alternative Investment Fund Managers) Directive (S.I. [ ] of 2013). Ireland is also to proceed to ratify the co-operation agreements agreed by ESMA with the competent regulatory authorities of non-EU countries including the US in advance of 22 July 2013.
What this means for you?
Fund Managers wishing to take advantage of the new pan-European passport available under the AIFMD may now wish to proceed to review their existing contractual arrangements and internal policies and procedures in order to consider any necessary revisions of existing documentation to ensure compliance with the AIFMD.
Fund Managers who had been postponing the launch or addition of a new European, AIFMD compliant, structure to their offering pending clarity on the relevant issues, may wish to now proceed to explore such options with greater confidence.
Given the increased preference evident from institutional investors for regulated on-shore products ever since the financial crisis of 2008, and the potential pan-European passport under the AIFMD, it is anticipated that AIFMD compliant funds will afford considerable benefits to alternative managers from a marketing perspective.