The EU Commission issued a draft Directive on 30 April 2009 to introduce the regulation and supervision of EU domiciled Alternative Investment Fund Managers (AIFM) who manage and administer or market alternative investment funds in the EU. An Alternative Investment Fund (AIF) is any fund which is not a UCITS fund.
A UCITS is an investment fund established in accordance with the UCITS Directive which can be marketed to retail investors throughout the EU. The UCITS brand has been very successful, as UCITS are seen to (and do) enjoy a high level of investor protection.
The proposed Directive is therefore likely to impact on managers of unregulated property, venture capital and private equity funds, as well as hedge funds and other non UCITS funds.
The draft AIFM Directive has been the subject of very intensive lobbying and debate. As a result of votes on May 17 and May 18, respectively, of the European Parliament’s Economic and Monetary Affairs Committee (ECON) and European finance ministers at the meeting of the Economic and Financial Affairs Council (ECOFIN), EU Parliament and EU Council texts of the draft AIFM Directive have been produced and these form the basis for negotiations at a series of “trilogue” meetings, which are taking place between representatives of the EU Parliament, EU Council and EU Commission. Once a compromise text is agreed and approved by ECOFIN, it will be sent for approval by a plenary session of the EU Parliament. At present, the target date for the plenary vote is Autumn of this year.
The provisions of the Directive when formally approved will be implemented by individual EU member states and will come into force in July 2012 or later. The AIFM Directive will be complemented by implementing rules known as delegated acts adopted by the EU Commission on the basis of advice provided by CESR (the Committee of European Securities Regulators), which will soon evolve into ESMA ( the European Securities and Markets Authority). Until the trilogue process is completed and the final text of the Directive has been published, it will not be possible to know the shape of the regulatory regime that will begin to apply at the earliest from 2012.
Among the areas on which there is substantial divergence between the ECON and ECOFIN texts are the terms under which funds and managers established outside the EU can market to EU investors. One of the stated objectives of the EU Parliament version of the draft Directive is to create incentives towards the relocation of off-shore funds to the EU in order to bring not only regulatory and investor protection advantages but also allowing for the proper taxation of revenues, at manager, fund, and investor level .The latest EU Council draft text ( dated 27 August, 2010) shows an increasing role for ESMA and excludes this contentious third country issue (relating to the access of non-EU funds/managers to EU investors).
Some of the issues arising in relation to the draft Directive;
- Authorisation and organisational requirements for AIFM. For authorisation, AIFM will be required to furnish information on the ownership of AIFM and will be required to provide detailed information on the planned activity of the AIFM, the characteristics of the AIF to be managed and delegation arrangements for keeping of assets. The AIFM will also be required to hold and retain a minimum level of capital. If an AIF is self –managed, it will have to satisfy the capital requirements itself.
- Exemptions. The EU Council version provides that the Member States may exempt AIFM managing portfolios of AIF with total assets below certain thresholds. These AIFM would have no rights under the Directive but would be permitted to ‘opt-in’ to the provisions of the Directive. The EU Parliament text proposes a different level of regulation for different types of fund, while holding companies, banks and pension funds which are only investing their own money will be outside the scope of the Directive.
- Passport. Authorised AIFM will be permitted to market AIF to professional investors (as defined in the Markets in Financial Instruments Directive) in other Member States, subject to some notification, and will have the right to manage AIF in other Member States, again subject to notification.
- Retail investors. Member States could allow for marketing of AIF to retail investors in their Member State and may impose additional requirements for this. There will be no passporting rights for marketing AIF to retail investors. Where a Member State allows for the marketing of AIF to retail investors in its territory, this possibility should be available regardless of the Member State where the AIFM is established (provided it is EU). Member States may not impose stricter criteria on AIF established in the EU and marketed on a cross border basis than an AIF marketed domestically.
- Third Country Issues. This encompasses non EU AIFM operating in the EU and also the marketing of non EU AIF in the EU. This topic has been much-debated and it is impossible to know what the final outcome may be. The EU Commission proposed a system based on equivalence whereby third country AIF and AIFM could market in the EU if their home legal system is deemed equivalent to that under the EU, but the latest draft has omitted these provisions pending the trilogue discussions. The EU Parliament proposed that non-EU AIFM would voluntarily comply with the AIFM Directive, and their regulators would act as agents of ESMA (the new European Securities and Markets Authority) in supervising the AIFM. A Non EU fund could be marketed in the EU if its home country:
- has sufficiently high standards to combat money laundering and terrorist financing
- grants reciprocal access for marketing EU funds,
- has agreements in place with the EU member status where the fund will be marketed regarding exchange of fax and monitoring issues, and
- recognises and enforces EU judgments on AIFMD related issues.
- Earlier drafts proposed that member states would not allow the marketing of an AIF to retail investors in their territory, when such AIF invests more than 30% in other non EU AIFs. On a positive note, it appears that we may see the continuation of private placement regimes.
- Notifications to regulators. An AIFM would be required to report to its regulator on a regular basis on the principal markets and instruments in which it trades, its principal exposures and concentrations of risk. The AIFM would also be required to notify its regulator of the identity of the AIF it manages, the assets in which the AIFs invest, their liquidity profile and arrangements, risk management arrangements and the use of short selling by AIF. Additional disclosure obligations would apply to AIFM managing leveraged AIF and controlling stakes in companies.
- Transparency. AIFM would be required to disclose to AIF investors, details of the AIF’s investment strategy, leverage, risk and liquidity characteristics, details of the AIF's service providers (i.e. depositary, valuer, auditor), any delegation of management function, and the AIFM's risk management systems. For each AIF an AIFM manages, it would periodically disclose to investors the percentage of the AIF's assets which were subject to special arrangements, such as side pockets, arising from their illiquid nature. AIFM would be also required to disclose all fees and charges whether directly or indirectly borne by investors as well as preferential treatment provided to other investors (and the type of those other investors) by AIFM.
- Delegation. Both versions provide that the AIFM must inform its home regulator of delegation. The EU Parliament version provides that the regulator may reject delegation within one month. The AIFM liability will be unaffected by the delegation. The EU Council draft permits delegation of portfolio or risk management to authorised firms such as to non-EU managers provided, inter alia, that co-operation between regulators is ensured. Moreover, delegation and sub-delegation would be possible without a limit on the length of the chain of delegation so that it would be possible to delegate to third-country service providers. The EU Parliament version envisages delegation only to AIFM authorised to manage AIF of the same type.
- Remuneration. The revised drafts contain more detail on remuneration policies and practices. AIFM must have remuneration policies and practices which do not encourage risk taking which is inconsistent with the risk profiles of the AIF it manages. The EU Council draft introduces the principle of “proportionality” , while provisions relating to clawbacks and fixed minimum time limits on remuneration have been dropped.
- Depositaries. Issues around who may act as a depositary, the liability of depositaries, the ability of depositaries to delegate to sub-custodians and their liability in the event of such delegation are still unclear. The latest EU Council draft does recognise the concept of a prime broker. The question of whether the provisions on depositaries in the AIFM Directive should also apply to UCITS depositaries and whether the new UCITS IV Directive should be revised accordingly is also the subject of debate. The EU Commission is currently examining the role and liability of UCITS custodians throughout the EU as a result of fallout from the Madoff fraud and its conclusions are likely to impact on these provisions. It is likely that the depositary of a fund will have to be located in the fund’s home member state.
- Valuator and Valuation of Assets. A valuator will have to be appointed to value the assets of each AIF and the EU Commission will issue organisational and administrative provisions so as to avoid conflicts of interest. The process for valuation of assets and calculation of NAV (Net Asset Value) should be independent from the management functions of the AIFM (but it seems that it may be possible to achieve this by information barriers). Private equity funds may not require annual valuations.
- Leverage. AIFM will be required to set leverage limits for each AIF. Under the EU Parliament draft, fund leverage may be capped. Leverage limits must be notified to investors and the amount of leverage employed will be reported to regulators regularly.
- Short-Selling. In principle, short-selling should operate in a harmonised regulatory framework to reduce any potential destabilising effect, involving procedures, risk management and disclosure to competent authorities. The EU Parliament draft proposes to ban naked short-selling, to empower the new European Securities and Markets Authority to restrict short-selling and generally restrict short-selling.
- Further issues. The draft Directive contains detailed provisions on AIFM managing AIF in non EU countries, delegation, conduct of business, conflicts of interest, risk management and liquidity management provisions.
- Regulatory Co-operation. EU Regulators would be required to co-operate and share information whenever necessary so as to achieve the aims of the Directive.
The current drafts of the Directive contain many nuances, inconsistencies, and clear differences of approach so we can expect a significant amount of change before the wording becomes final. The EU Commission will also have a significant amount of work to do to furnish detailed implementing provisions. It appears that ESMA will take an increasingly important role. The provisions are in a state of flux and the text of the proposed Directive will change.