In November 2011 we issued a client briefing note on the Alternative Investment Fund Managers Directive (the “Directive”). This new briefing note follows the somewhat delayed release, on 19 December 2012, of the level 2 regulation (“Level 2 Regulation”) and is intended to update you on the principal issues affecting funds domiciled in the British Virgin Islands (BVI), the Cayman Islands, Guernsey and Jersey. It does not cover the application of the Directive for passporting funds post-2015 when non-EU managers may become authorised under the Directive as alternative investment fund managers (“AIFMs”), nor does it attempt to analyse the application of the Directive to fully authorised AIFMs.
Regulatory Strategy in Guernsey and Jersey – Full Optionality With an Opt-in Approach
From July 2013, AIFMs domiciled in Guernsey and Jersey will, under proposed new regulations to be introduced in both islands, be able to elect to comply with regulations equivalent to those corresponding to the Directive whether on a select basis, to comply with the transparency/disclosure and control provisions of the Directive, or more generally. Clearly it will be unnecessary to opt-in to any such Guernsey/Jersey AIFM regulations where the relevant AIFM is not marketing into the EU. Furthermore, the opt in will only occur where the effect of the Directive or changes to the relevant Member State private placement regime, following a Member State’s transposition of the Directive, is to require compliance with specific equivalent Directive provisions.
From July 2013 AIFMs domiciled in the EU will need to apply to be authorised under the Directive and to comply fully with its terms subject to certain grandfathering provisions, minimum thresholds (€500m ungeared/€100m geared AUM) and exemptions.
Non-EU AIFMs in the BVI, the Cayman Islands, Guernsey and Jersey will be unaffected by the Directive in relation to non-EU funds marketed to non-EU countries. Under the Directive, marketing non-EU funds to professional investors in Member States can continue to be effected by non-EU AIFMs through the national private placement regime of each EU Member State, so long as certain basic transparency requirements and disclosures are respected. It is expected that the private placement route will be available until at least 2018, when it will be further reviewed.
For the funds industry, the final provisions of the Directive and the Level 2 Regulation are not as bad as was originally expected. The one-size-fits-all approach to regulating AIFMs was always going to present serious challenges. There are still significant problems around the depositary (strict liability and operational issues), organisational, delegation, remuneration, professional indemnity insurance and capital adequacy requirements, which in turn will have material cost implications on the operation of AIFMs’ businesses. Consequently, AIFMs with non-EU fund structures will take a keen interest in determining whether or not they are caught by the Directive.
This note examines how to identify who the AIFM is in a typical BVI, Cayman Islands, Guernsey or Jersey fund structure and what constitutes an AIF. A non-EU AIFM wishing to market non-EU AIFs into the EU will have a significantly reduced regulatory burden under the Directive as it will need to comply with only a handful of the Directive’s requirements.
What is an AIF?
Whilst the Directive regulates AIFMs rather than funds themselves, in order to understand what funds will be considered as managed by an AIFM, one needs to understand how the Directive defines a fund. The concept of “fund” (or “AIF”, under the Directive) is broader than domestic law definitions of fund under the laws and regulations in the BVI, the Cayman Islands, Guernsey and Jersey. The Directive defines an AIF as a collective investment undertaking (other than a UCITS fund) which raises capital from a number of investors and which invests in accordance with a defined investment policy for the benefit of those investors.
As the Directive definition of an AIF does not require a spread of risk, arrangements in respect of a limited number of assets may come within the scope of the Directive. There is also no de minimis in terms of the number of investors which an AIF attracts. Consequently, there may be investment vehicles which are not currently classified as funds in the BVI, the Cayman Islands, Guernsey or Jersey that may well constitute an AIF for the purposes of the Directive. These AIFs may need to be able to avail themselves of the relevant Directive compliant regime applicable (if any) in each of the Islands, to the extent AIFMs market, such AIFs to professional investors in the EU.
An AIF can be open-ended or closed-ended, take any legal form and can be listed or unlisted. The definition of an AIF for Directive purposes does not include managed accounts, joint ventures, insurance contracts, certain securitisation SPVs, employee participation schemes or holding companies. Investment undertakings, such as family office vehicles which invest the private wealth of investors without raising external capital, would also not be considered to be AIFs. Other exemptions include various supranational institutions and AIFMs which manage funds where only the AIFM or the AIFM’s group companies constitute the investors (provided that the group companies are not themselves funds) are also exempted.
Who is the AIFM?
An AIFM will be “managing” an AIF when it performs in relation to an AIF at least one of risk management or portfolio management. Accordingly, in reviewing your BVI, Cayman Islands, Guernsey or Jersey structures to ascertain who the AIFM is under the Directive, it is important to identify who is responsible for these functions. The AIFM can be the AIF itself (i.e. self managed), or an external provider.
Non-EU Private Equity LP Structures
In the case of a limited partnership and general partner (“GP”) registered in the BVI, the Cayman Islands, Guernsey or Jersey with an EU or non-EU investment adviser advising the GP, it is likely that the GP will be identified as the AIFM of the AIF for the purposes of the Directive. Investment advice does not constitute investment management under the Directive. The GP is usually primarily and exclusively responsible contractually for the management of the AIF under the limited partnership agreement and, as a matter of law, to the exclusion of any other person. The GP takes its investment decisions in light of investment advice received from an external adviser but nonetheless remains responsible for taking the decision to invest. Furthermore it is nearly always the case that the GP’s management and control takes place entirely outside the EU.
Non-EU AIFs listed on the London Stock Exchange (or other EU exchanges)
For non-EU AIFs listed on the London Stock Exchange the issue of marketing in the EU arises on further fund raisings or where the management is delegated into the EU. In determining who the AIFM is (if the delegation provisions of the Directive apply) the so-called “letter-box” provisions may need to be considered. These are designed to ensure that the AIFM does not delegate to the extent to which it becomes a mere “letter-box”. It is not clear whether the test is relevant to non-EU Directive authorised AIFMs, albeit it is hoped, given the UK’s proposed carve-out for below threshold managers, that it will not apply. The most debated requirement of the letter-box rules is that the AIFM must not delegate performance “to an extent that it exceeds by a substantial margin the investment management functions performed by the AIFM itself”.
As is currently the case, a combination of compliance with companies laws, listing rules and good governance offshore means that the core activities around investment management should be unlikely to slip into a mere box-ticking exercise. Rather, the independent board is likely to be able to demonstrate effective risk and/or portfolio management oversight and clear reporting processes with the result that the non-EU fund should be considered to be the AIFM for Directive purposes.
These rules together with a strong factual matrix of compliance with them and substance in the composition of the board will assist in building the case that the AIF should be considered to be the AIFM. Of course this may not always be possible or, in the case of an externally managed AIF, the AIFM may be required to be fully authorised under the Directive, as a result of other onshore EU AIFs it manages.
Other non-EU AIFs marketed into the EU
The identity of the AIFM will involve bespoke legal advice to determine where the responsibility and activity of management takes place. Nonetheless, one will be able to deploy similar arguments to those set out above in respect of other AIFs domiciled offshore. Clearly, claiming non-EU AIFM status will be more challenging for AIFMs with actively traded asset holdings with little or no substance outside the EU, where the discretionary asset management day-to-day is largely undertaken by an EU service provider. For infrastructure, real estate and private equity funds this will be much less problematic.
Marketing by non-EU AIFM in the EU
Why would it be of interest to establish conclusively that the AIFM is based in the BVI, the Cayman Islands, Guernsey or Jersey? If a non-EU AIFM manages funds above the de minimis set out in the Directive and markets an AIF to professional investors in the EU, it may do so under the private placement regimes of the Member States where marketing is proposed, subject to compliance with Article 42 of the Directive. Article 42 requires basic disclosures to investors and reports to regulators to facilitate transparency. It also imposes certain control and significant holdings disclosures on acquisitions of controlling stakes in EU companies and asset stripping restrictions. The asset stripping restrictions will affect private equity and venture capital AIFMs, who will need to plan appropriately when structuring transactions which involve re-engineering a target’s balance sheet.
With regard to retail investors, Member States are free to impose stricter requirements on the AIFM or AIF than requirements applicable to the AIFs marketed to professional investors in their territory in accordance with the Directive. Accordingly, the Directive’s transposition by each Member State should be closely monitored by AIFMs marketing in those Member States to ensure that compliance with regulatory regimes can be adapted according to investor profiles. It is also important to monitor the restrictions imposed by Member States on the marketing of AIFs to retail investors.
As for the other requirements of Article 42, co-operation agreements must be entered into between each Member State where the AIF is to be marketed, the competent authority where the AIF is established, and the supervisory authority where any non-EU AIFM is established. The islands are in advanced discussions with ESMA to agree the form of co-operation agreement. Once agreed, the cooperation agreement will then need to be circulated to Member States for execution by the relevant Member State regulator and the third country regulator.
Third Country AIFMD/PPR Rules
Each of the financial centres in Guernsey and Jersey are considering the adoption of Directive compliant rules in time for July 2013 so that AIFs domiciled in these jurisdictions can be marketed into the EU in Member States either: (i) under national private placement regimes of relevant Member States as adapted by Article 42; and/or (ii) where private placement may be or become more restricted, on the basis that they have equivalent regimes almost identical to that prescribed by the Directive. A parallel, non-Directive regime will be maintained by these jurisdictions for those AIFMs marketing AIFs to non-EU investors and unaffected by the regulatory impact of the Directive.
The delay in the release of the Level 2 Regulation leaves little time for AIFMs to prepare for the July 2013 introduction of the new regime. Considerable planning will need to go in to establishing the scope of the Directive to existing non-EU AIFs and the effect of the Directive on compliance procedures and management and other service provider agreements in place for current structures. Structural changes may need to be made, not least to ensure that investors outside the EU are not impacted adversely by these changes. For some AIFMs outside the EU there may be nothing to do in relation to existing AIFs, where no further fund raising is planned. As passive marketing is not caught by the Directive’s marketing restrictions, there will also be third country AIFMs with an EU investor base which may raise funds, without any active direct fund raising in the EU. For managers with a non-EU investor base it is unlikely that the Directive will be an appealing prospect given its cost implications and the complex regulatory burden associated with some of its provisions. Since there are many complications associated with compliance with the Directive, it is also anticipated that new managers will structure their operations to minimise any adverse impact on their non-EU business wherever possible, which may result in the establishment of more fund structures outside the EU.