In May 2009 we reported on the European Commission's draft proposal for a directive on Alternative Investment Fund Managers (the Commission's Proposal). The publication of the Commission's Proposal was immediately followed by fierce criticism and intense lobbying from a wide variety of stakeholders pressing for changes. The lobbying has been successful - to a degree.
Before leaving office at the end of last year, the Swedish Presidency of the Council issued a compromise proposal (the Council's Proposal) and shortly afterwards the European Parliament (acting by Jean-Paul Gauzès, the Rapporteur) has issued a detailed report providing its view on each article of the Commission's Proposal (the Parliament's Proposal).
This note briefly outlines some of the key similarities and differences between the three different proposals (the proposals) and what might be expected next.
Who is (or should be) concerned about the Directive?
The Directive introduces proposals for increased regulation of managers of alternative investment funds (AIFs). AIFs are defined broadly as "any collective investment undertaking" not required to be authorised as Undertakings for Collective Investment in Transferable Securities (UCITS). The Directive will, as a result, affect the managers of most hedge funds and private equity funds and it will extend to funds investing in other asset classes such as commodity and real estate (including REITs).
An important exception contained in the Commission's Proposal and extended in the Council's Proposal is to exclude managers of AIFs with an aggregate asset value under management of €100 million (or, if the AIF has no leverage and no redemption rights for the first five years, this minimum increases to €500 million). It is argued by some that this threshold is too low. It is also unclear what is to happen if a fund value occasionally goes above or below the threshold. The Parliament's Proposal does not include a de minimis threshold. In its view, all AIF managers should be subject to the Directive although it notes that the Directive should not be unduly burdensome on smaller fund managers.
So, what do the Proposals have in common?
All three Proposals provide that AIF managers falling within the Directive will be subject to increased regulation, with the aim of reducing risks, increasing transparency and stability across the market. In particular AIF managers will need to:
- register and obtain authorisation: Various documents/information must be supplied to the regulator of the relevant home state, and the AIF manager will need to demonstrate that he is sufficiently experienced to provide the requisite services;
- produce offering documents to investors that meet minimum disclosure standards;
- report on a regular basis to the regulator of the relevant home state on a variety of matters and make disclosures to investors on matters such as risk, return and liquidity, fees, conflicts of interest, the identity and ability of service providers and the risk management systems to be employed. Any preferential treatment provided to one investor must be disclosed in the fund rules or instrument of incorporation;
- comply with minimum capital requirements. The three proposals are similar in a number of respects with regard to setting minimum capital requirements of the AIF manager. It is reasonable to conclude that the final draft Directive will include provisions on capital adequacy. By way of example, the Council's Proposal requires a minimum commitment of €125,000 which could go as high as €10 million. If the funds under management are not leveraged, have no redemption rights exercisable during the first five years and make investments and divestments on a non-frequent basis, then the requirement may be reduced to €50,000 or €60,000;
- have robust risk management systems in place to manage risk, liquidity and conflicts of interest.
Key criticisms of the Directive are that:
- it applies a 'one size fits all' approach to all fund managers, regardless of their different qualities and requirements;
- the costs of managing such funds will increase and as a result significantly hit the returns that investors may expect to receive;
- the choice of investments available to investors (and in turn their ability to diversify a portfolio) will be reduced, which increases rather than decreases the risk.
Principal areas of debate
The provisions of the Directive which are currently attracting particular attention are:
- Remuneration Policy. The Council's Proposal introduced this concept and requires AIF managers to maintain a remuneration policy aligning compensation to performance and deferring (in part) variable remuneration (including carried interest). It also proposes that details relating to the remuneration paid to certain individuals (including carried interest) should be disclosed in the annual report. The Commission's Proposal was silent on this issue but the Parliament's Proposal confirms that AIF managers should establish remuneration policies that are compatible with credit institutions. We can expect that the next draft of the Directive will include provisions in this area, designed to align the regulation with that of the financial services industry generally.
- Marketing EU Funds. An authorised AIF manager will be entitled to market interests in an EU domiciled fund to professional investors across Europe.
- Management and Marketing of Non-EU funds. The Commission's Proposal regarding the funds established in countries falling outside the EEA (set out in articles 35-39) have received particularly fierce condemnation as being protectionist and anti-competitive. The Council's Proposal has deleted those articles and replaced them with a square bracketed provision, indicating that AIF managers can manage non-EEA AIFs if the legislation of the country where the AIF is established is in line with certain standards and an appropriate co-operation agreement with such country is in place. The Commission's Proposal generally supports the proposition that an AIF manager may market a fund to professional investors across Europe. The Council's Proposal and the Parliament's Proposal seem to limit this to EU domiciled funds.
- Marketing to Retail Investors. All three Proposals allow Member States the discretion to permit the marketing of AIFs to retail investors. Each proposal contains certain specific additional requirements.
- Marketing by Non-EU AIF managers. The three Proposals differ significantly in this area and this topic has been subject to heavy debate. If such activity is permitted, then it is expected that co-operation and information exchange agreements would be required with the country involved.
- Valuation. The Commission's Proposal required each AIF manager to appoint an independent valuer. This is supported by the Parliament's Proposal although it recognises that private equity funds may not require frequent valuations. The requirement is removed and replaced in the Council's Proposal with a general requirement to ensure that appropriate procedures are in place to provide a proper valuation and ensure independence of the valuation.
- Depositaries. The Commission's Proposal that, essentially, only banks could act as depositaries was an understandable reaction to Madoff. However, many have considered this proposal as impracticable. The Swedish Presidency agreed. It said that "given the global character of the many market players, the current draft does not seem workable". It would also give rise to difficulties with nominee holding structures. The Council's Proposal as a result accommodates a number of comments made in the response issued jointly by the Financial Services Authority and HM Treasury to the Commission's consultation paper. The Parliament's Proposal also proposes extending the category of persons that are able to act as depositaries.
The Council's Proposal and Parliament's Proposal do not replace the Commission's Proposal - they are now all subject to simultaneous consideration. Almost every article contained within the Proposals is subject to intense lobbying. It is politically very sensitive. The next few months will be very interesting.
A revised draft of the Directive will be issued in due course after tripartite meetings of the Commission, the Parliament and Council. We can expect the lobbying to continue and it is expected that significant changes will be made before the final Directive is put to the European Parliament for approval, possibly by mid-late 2010. Domestic implementing measures will then be required and the Council's Proposal indicates that Member States will have 24 months to do this.
We will continue to keep a close eye on the Directive as it progresses. If you have any immediate queries or concerns then please contact us.
Wragge & Co's Funds team is a specialist team comprising tax, corporate, finance, regulatory and dispute resolution experts advising on every aspect of a funds lifecycle. The team is involved in a mix of domestic and international fund structures. It provides advice to investors (including pension funds), fund managers, the fund vehicles, sponsors and operators.