As many readers will be aware, the Alternative Investment Fund Managers Directive (the "AIFMD") is due to be implemented by Member States at a national level by 22 July 2013.
The AIFMD will govern many aspects of how most investment fund managers established in the EU (other than those that exclusively manage UCITS) ("AIFMs") run and structure their businesses and the services they provide. The AIFMD will also impact the ability of AIFMs established outside of the EU to market those of their funds that are non-UCITS funds ("AIFs") to investors in the EU.
For the last two months the industry has waited for the adoption of the European Commission's 'Level II' regulation ("Level II"). Level II is one of the key ingredients necessary for a manager who will be characterised as an AIFM (or its group) to plan effectively for implementation (as it will provide greater detail than the Level 1 Directive, and flesh out some of the high level provisions set out in Level 1). The second key ingredient, for those AIFMs in the UK, is FSA guidance and in particular its policy statement on how the Financial Conduct Authority (the "FCA"), once established, will effect implementation in the UK.
The wait for Level II has proved long, open ended and unpredictable and the FSA has helpfully recognised the need for its views to be heard as the shadow cast by 22 July 2013 looms ever larger. It has therefore published the precursor to its eventual policy statement, CP 12/32 (the "Consultation Paper").
Despite many of the positions revealed in the Consultation Paper being subject to Level II and despite it being only Part 1 of 2 intended parts, the Consultation Paper gives a useful sense of the direction in which the FSA is moving and of how the FCA will approach implementation. While not definitive, the Consultation Paper should prove a useful aid in planning for change.
This briefing simply seeks to pick out what we consider to be the key points that those responsible for implementing the AIFMD in their respective organisations may find most instructive. For a more comprehensive analysis of the AIFMD, and its implications for your business, please click here.
New managers to comply from establishment
- Firms that wish to begin managing an AIF for the first time after 22 July 2013 will not benefit from any transitional period. They will need to seek authorisation and should note that the FSA's projected turnaround time for processing applications is 3 months (further, the FSA does not expect to receive applications prior to 22 July 2013).
Grace period for existing managers
- EEA firms managing AIFs as at 22 July 2013 will be able to continue to manage their AIFs in accordance with the FCA Handbook applying to them immediately before that date, without needing an AIFMD authorisation.
- This transitional provision appears to apply also to the marketing of AIFs without an AIFMD authorisation (i.e. if an AIFM is managing or marketing AIFs prior to 22 July 2013, it may continue to do so).
Launching new AIFs during the grace period
- Although the language is somewhat ambiguous, we consider that the Consultation Paper would allow AIFMs that already market or manage AIFs to also launch (and manage and market) new AIFs in advance of receiving authorisation under the AIFMD in respect of each newly launched AIF. Responses to the FSA should seek confirmation of this view.
What existing managers must achieve prior to 22 July 2014
- Existing AIFMs must, however, by 22 July 2014 (i) have submitted an application for AIFMD authorisation and (ii) be compliant with the relevant laws and regulations flowing from the AIFMD. Effectively therefore, there appears to be a grace period of one year for existing managers.
2. Who is the AIFM?
- EEA-established managers of AIFs will need to seek authorisation in order to manage or market the AIFs they manage to professional investors.
The AIFMD has been criticised for its extremely wide definition of 'AIF'. It has proved difficult to distinguish an AIF from certain other forms of undertaking not typically considered 'funds' using the existing definition. The Consultation Paper makes efforts to remedy this by noting certain criteria that distinguish AIFs from non-fund like undertakings.
- It states that an AIF would not usually directly participate in a commercial activity such as manufacturing goods, constructing buildings or providing services to customers. An AIF may, however, own an entity that participates in such activities, but would not itself participate in that activity.
- Further, an AIF would not typically have a substantial number of employees carrying on commercial activities.
- It is unclear how the FSA's thoughts on this important matter are to be codified. It is also unclear how such principles are intended to apply to non-fund like undertakings that might operate principally through subsidiaries (notwithstanding the 'holding company exemption' which is so broadly drawn that it is difficult to determine exactly how it may be used). It is however encouraging that the FSA has sought to make such distinctions and one hopes that they will prove sufficient in time to extricate undertakings that have been, perhaps unintentionally, drawn into the broad AIF definitional net.
- The FSA has not clarified the position on REITS. It correctly observes that a REIT may or may not be an AIF, depending on the specific activities it may carry on, but fails to articulate what would distinguish a non-AIF REIT from an AIF REIT. Instead the FSA characterises REITS as property investment firms and states that some property investment firms have both fund and non-fund characteristics. The industry will therefore need further clarity on the FSA's position in relation to REITS (and, in particular, how to draw distinctions between AIF and non-AIF REITS).
- Joint ventures which give investors "substantial management control over strategic decisions" are unlikely to be AIFs. Each arrangement, however, notwithstanding that it might be characterised by the parties to it as a joint venture (and so prima facie excluded from the AIFMD), will need to be assessed on a case by case basis.
- The Consultation Paper states that asset managers structured as English limited partnerships will not be able to become AIFMs on the basis that they do not have separate legal personality. The Consultation Paper does not go into further detail but it should be confirmed whether or not the general partner of such asset managers would be considered the AIFM. Clarity will need to be sought from the FSA on this point.
- Investment trusts that had hoped or are hoping to re-characterise themselves as internally managed will need to review the policy statement the FSA ultimately publishes before taking actions that would alter their existing operating model. The Consultation Paper does not definitively close the book on the internally managed model (indeed it is required for AIFs that are already self-managed). There appears however to be a difficulty applying this concept to AIFs which currently have an external manager but which are considering become the AIFM themselves since the examples of entities which the FSA considers might be characterised as internally managed are expressed to include those investment companies whose board retains control of all investment management functions, where no external manager has been appointed, and where the investment company employs staff to assist with investment management decisions. Although this is not an exhaustive list, it appears that the FSA is trying to distinguish traditional self-managed AIFs from other AIFs that might seek to argue that they are internally managed simply on account of having an active non-executive board of directors in place.
3. Authorisations and the New Regulated Activities
- The Consultation Paper confirms that "a firm cannot be a manager of AIFs or UCITS and simultaneously perform the full range of activities possible under a MiFID authorisation". The AIFMD does however provide for an AIFMD authorised firm to provide some limited MiFID services. The FSA's initial view is that these services, even though effected under an AIFMD authorisation (rather than a MiFID derived one), would still be able to be passported through the EU. An AIFM will not however be able to perform wider MiFID activities, even if it had done so prior to its authorisation as an AIFM.
- A firm that wishes to manage an AIF will need to be authorised to undertake the new regulated activity of "managing an AIF". The permission for this new regulated activity will cover existing regulated activities such as managing, dealing, arranging and the like.
- The FSA is attempting to simplify the permissions a firm needs. A firm that obtains the authorisation for managing an AIF will not also need to be authorised for establishing, operating and winding up a collective investment scheme nor will it need to be authorised for acting as a sole director of an open ended investment company. Note, however, that firms that manage collective investment schemes that are neither AIFs (e.g. certain family office vehicles, which are not to be considered AIFs under the AIFMD) nor UCITS (in respect of which a non-AIFMD permission for "managing a UCITS" will be required) will need to also have a separate permission to establish and operate a collective investment scheme.
- A permission for managing an AIF will always cover portfolio management and risk management. The FSA, however, suggests that an AIF may appoint third party entities other than an authorised AIFM to perform the ancillary services of administration, marketing and activities related to the assets of the AIF (e.g. real estate administration). These third party entities may, depending on the activities undertaken, need to have the appropriate permissions for performing those functions (for example effecting the issuance and redemption of fund units). If, however, a third party entity is only performing activities that are not regulated activities, it may avoid needing a permission. If the AIFM chooses to undertake the ancilliary services itself, the activities will, however, be considered regulated activities (even if some of those activities would not be if performed by a third party non-AIFM entity). The FSA argues that this should provide 'certainty' to managers seeking to passport such functions throughout the EU.
- Firms already holding a Part IV permission might be able to seek a 'variation of permission' (rather than a full new application). The Consultation Paper speaks also of a 'grandfathering' process for managers with existing permissions to establish and operate a collective investment scheme or act as a sole director of an open ended investment company. Although unclear, it appears that this is a form of automatic rollover application. No detail, however, is given.
- Authorisation applications or applications for variations of permission will be processed within 3 months (although the FCA may take an additional 3 months if it notifies the relevant applicant).
- Existing UCITS management companies that intend also to manage AIFs will need to apply for authorisation or a variation of permission in the ordinary course and will receive no accelerated or favourable treatment.
- As stated above, applications for authorisation or variations of permission must be submitted by 22 July 2014. The FCA will not be processing applications prior to 22 July 2013.
4. The FCA Handbook
- National transposition of the AIFMD will be effected by updating SYSC (Senior Management Arrangements, Systems and Controls), and COBS (the Conduct of Business Sourcebook) and also by adding a new section of what will (likely) be the FCA Handbook: the Investment Funds sourcebook, "FUND".
- FUND will replace COLL and will cover both UCITS and the AIFMD.
- Level II provisions will be copied into, or referred to in, the relevant parts of the FCA Handbook.
- While the FSA is and will continue to consult on changes to the current FSA Handbook and national transposition of the AIFMD, the AIFMD will be implemented and enforced by the FCA after 1 April 2013 (the effective date of the split of the FSA into the FCA and PRA).
- Although the FSA Handbook will itself be split (even if notionally) into two handbooks, the PRA Handbook and the FCA Handbook, its form immediately prior to the split and its substantive provisions are expected to survive past 1 April 2013.
5. Transparency and Reporting
- The AIFMD requires certain information to be provided to investors prior to their investment and following their investment insofar as there are material changes to it. The Consultation Paper makes it clear that this information should be provided to investors upon request and if the constitution of the AIF does not already provide for information to be provided upon request, it will need to be amended.
- The drafting of these provisions appears to cater primarily for open ended AIFs. Our view is that the pre-sale disclosure requirements relate to investments in new shares or units. Accordingly, in the context of closed ended AIFs this applies to IPO or secondary issues only and would not apply to purchases in secondary markets. The FSA does not explicitly confirm this, but we consider that it is implied and will be seeking that confirmation.
- NURS and QIS will also be subject to the AIFMD pre-sale disclosure requirements but this will not relieve them of having to comply with the current disclosure rules for authorised funds (i.e. they will be subject to two sets of rules simultaneously, at least for the period immediately following national implementation).
- The AIFMD also requires information to be reported to the FCA. Level II should contain reporting templates and these will be incorporated into the FCA Handbook. The FSA argues that this should facilitate disclosure by AIFMs operating in multiple Member States (and who will therefore need to provide information to multiple competent authorities).
- The AIFMD states that Net Asset Value should be calculated in accordance with national law and instruments constituting the AIF. The FSA does not intend to provide further guidance on this.
7. Capital and Professional Indemnity Insurance
There will be three types of firm for the purposes of determining capital requirements.
- Collective Portfolio Management firms ("CPM firms"): This refers to firms that manage AIFs and/or UCITS but provide no MiFID services (as permitted under the AIFMD).
- Internally Managed AIFs: This refers to AIFs that have chosen not to appoint an external manager.
- Collective Portfolio Management Investment firms ("CPMI firms"): This refers to firms that manage AIFs and/or UCITS but also provide MiFID services (as permitted under the AIFMD and/or the UCITS Directive, as relevant).
- The AIFMD requires an AIFM to meet an initial capital requirement and an own funds requirement. The FSA clarifies that the initial capital amount can be met out of own funds on an ongoing basis (which is consistent with the approach for MiFID investment firms).
- The AIFMD's requirement for ongoing capital (excluding capital to cover professional negligence risks) comprises a fixed amount (€125,000 or, if an Internally Managed AIF, €300,000) plus a variable amount (being 0.02 per cent. of assets under management above €250 million or, if higher, a quarter of the firm's fixed expenditure). The FSA has taken the view that the variable amount will not apply to Internally Managed AIFs, notwithstanding that the AIFMD itself is not definitive on this point.
- CPMI firms will need to comply, not only with the capital requirements derived from the AIFMD, but also with the capital provisions applicable to BIPRU limited license firms. Effectively, it will need to maintain whichever the higher own funds amount is.
- Even though the AIFMD allows for it, the FCA will not permit the variable amount to be satisfied, even in part, by guarantee.
- The AIFMD requires that own funds be invested in liquid assets or assets readily convertible to cash in the short term. The FSA suggests that the assets readily convertible to cash in the short term are those assets that could be realised for cash within one month. Examples cited include cash, readily realisable investments that are not held for short-term resale and debtors. Other assets could be included but the AIFM would need to demonstrate that it could realise such assets within one month.
- Not much in the way of additional information or insight is provided by the Consultation Paper save to confirm that the various restrictions on and conditions attaching to delegations by an AIFM will apply even where such delegation is intra-group.
- The AIFMD requires that where portfolio management is delegated to an entity in a non-EEA jurisdiction, that "co-operation is ensured". The FSA confirms that this will need to be evidenced by a signed co-operation arrangement as between the FCA and the supervisory authority in the relevant non-EEA jurisdiction. The existence of such co-operation arrangements will be published on a website.
Determining whether or not a delegation by an AIFM would render it a "letter box entity" (which will not be permitted) will be decided on a case by case basis in a "robust and flexible way". The FSA envisages the FCA taking into account, among other things, the following:
- The AIFM and AIF operating models and the types of assets under management: It is unclear what this means but might indicate that the FSA would see the legitimacy of delegation increasing in proportion to how 'exotic' a pool of assets within the portfolio might be.
- The activities being carried on by the entities concerned, whether intra group or with third party delegates: This seems to be saying nothing more than the FCA will consider what has been delegated and what has been retained. It is difficult to determine the significance of the reference to 'intra group' and whether the FCA will be accommodating where a delegation is intra-group (which we would hope to be the case).
- The judgements being made and the nature of decision making: It is clearly important to the FCA that "judgements made by an AIFM on the core activities of portfolio and risk management are genuine rather than a show of compliance". The elements of the core activities retained by an AIFM must clearly amount to more than a box-ticking exercise and we would hope that being able to demonstrate effective risk management oversight, clear reporting processes and the ability to take control whenever required will satisfy the FCA, in particular in the context of intra-group arrangements.
- Part 2 of the Consultation Paper is expected to provide greater detail.
9. Risk Management and Leverage
- It is old news that the AIFMD requires an AIFM's risk management function to be functionally and hierarchically separated from its portfolio management function. We have previously argued that this may be unworkable in many private equity and real estate AIFMs. The FSA has acknowledged this (at least in respect of private equity AIFMs). The Consultation Paper appears to concede the point and, in relation to private equity, states that it "will take account of each firm's structure in supervising the requirements". No explicit mention is made of real estate fund managers. This should be clarified.
- The Consultation Paper anticipates Level II requiring quantitative and/or qualitative risk limits to be set for each AIF that an AIFM manages. If only qualitative limits are set, such an approach will need to be justified to the FCA. Increased flexibility will not be considered a sufficient reason.
The AIFMD requires that limits to leverage are set. Regulators such as the FCA shall also be able to place limits on the use of leverage where systemic risk has been identified. The FCA is likely to take into account the following (non-exhaustive and broadly drawn) criteria in making such determinations:
- where the exposure of an AIF or several AIFs could constitute a material source of market, liquidity or counterparty risk to a financial institution;
- where the activities of an AIFM or its interaction with a group of AIFMs or other financial institutions contribute to a downward spiral in the prices of financial instruments which threatens the viability of such financial institutions;
- the type of investment strategy of the AIF, the market conditions and any likely pro-cyclical effects that may result from the imposition by the competent authorities of limits to the use of leverage; and
- the size of an AIF or AIFs, the concentration of risks in particular markets, any contagion risk, liquidity issues and the scale of asset/liability mismatch in a particular AIF investment strategy or irregular evolution of prices of assets.
- As noted above, many AIFMs will likely have until 22 July 2014 to comply with the AIFMD, including the provisions relating to remuneration. AIFMs should, however, be mindful of the time required to review and amend remuneration structures.
The Consultation Paper usefully clarifies the following:
- The remuneration provisions of the AIFMD will be implemented in the UK in a specific AIFM Remuneration Code (the "AIFM Code"), separate from the existing FSA Remuneration Code which implemented the remuneration provisions of CRDIII (the "CRDIII Code").
- In some cases, AIFMs will be subject to both the AIFM Code and the CRDIII Code, but the FSA has taken the helpful position that compliance with the AIFM Code will satisfy the requirements of the FSA Remuneration Code. In most, if not all, circumstances, therefore, AIFMs subject to both the CRDIII Code and the AIFM Code should only have to focus on compliance with the AIFM Code.
- The Consultation Paper also confirms that the FSA intends to implement the proportionality principle in the AIFM Code (which should, therefore, allow smaller or less complex AIFMs to disapply the more onerous provisions of the AIFM Code). In implementing proportionality, the FSA will establish a separate proportionality framework for AIFMs, "taking account of" the equivalent principle under the CRDIII Code, although the FSA does state that the AIFM and CRDIII proportionality frameworks are likely to differ in structure. An important detail that is not addressed is what quantitative measure, or measures, will be used to assess an AIFM's proportionality level.
The Consultation Paper is, however, lacking in detail and of concern in some regards.
- Apart from the general principles outlined above, the Consultation Paper sets out a skeleton text of the AIFM Code, but this largely just transposes the text of the Level 1 Directive itself. The FSA has not yet provided any guidance or interpretation because it is waiting for the European Securities and Markets Association to publish its guidance on the remuneration provisions (expected in Q1 2013) before conducting a more detailed consultation on the AIFM Code. The Consultation Paper, therefore, provides little additional insight as to how the AIFM Code will apply in practice.
- Unhelpfully, the skeleton text of the AIFM Code differs from the CRDIII Code by including a reference to "claw-back". This principle is also mentioned in passing in the Consultation Paper itself. Claw-back is mentioned in identical terms in both of the underlying Directives (the AIFMD and CRDIII), but the FSA did not include it in the CRDIII Code (which instead requires only malus (pre-vesting) adjustments). Including this principle in the AIFM Code would result in more stringent requirements on staff of AIFMs than on even the most senior staff of the largest investment banks. It is to be hoped that these differences arise from the fact that the FSA is awaiting the ESMA guidance before consulting on the detail of the AIFM Code, rather than from a positive policy decision.
- The FSA intends to publish a second consultation paper in February 2013, which should include more detail on the remuneration provisions. Further, provided that it has been published on time, the ESMA guidance should be taken into account. Firms wanting to respond to this next consultation should be aware that the consultation will only be open for an 8-week period, given the need for the FSA to publish final guidance before 22 July 2013.
Managers in the UK are now readying themselves for the road to implementation. The Consultation Paper should prove useful to those organising compliance within their respective firms. As we continue to advise clients on the AIFMD, the Consultation Paper serves as a helpful indicator of how the FSA sees the AIFMD playing out on a national level. We now await Level II, Part 2 of the Consultation Paper and further guidance on remuneration.