On 30 April 2009, the European Commission published its draft Directive on Alternative Investment Fund Managers (AIFM), which provides a regulatory framework for managers of hedge funds, private equity firms and other alternative investment vehicles. The draft Directive stems from concerns about the adequacy of the regulatory and supervisory frameworks of EU financial markets in the wake of the financial crisis and, in particular, the perceived lack of supervision of investment activities.
The Draft Directive
The draft Directive is an attempted “compromise” between the hard-line positions of France and Germany (who erroneously still blame hedge funds for proliferating the financial meltdown), and countries led by the UK which argue that stricter regulation could drive financial firms out of Europe.
Key provisions of the draft Directive are set out below. Note that these requirements are the minimum necessary for Member States. France and Germany, for example, can be expected to pass harsher requirements in 2011/12.
The draft covers managers of hedge funds and other funds such as real estate/infrastructure funds located in the EU with portfolios exceeding EUR100 million. PE managers (or non-leveraged AIFs without redemption rights within five years) of portfolios over EUR500 million are also covered.
AIFM will need authorisations from the relevant financial regulator in the Member State in which they are based (for many funds this will be the UK Financial Services Authority). The relevant regulator can restrict the scope of the authorisation, such as to the type of funds which can be managed. AIFM must provide the regulator with comprehensive information on the planned activity, identity and characteristics of the funds (including the identities of fund members and the instruments of incorporation/fund rules), governance mechanisms, arrangements for the valuation and safe-keeping of assets, audit arrangements and regulatory reporting systems.
Once authorised, AIFM get a ‘passport’ to market their products to professional investors in all 27 EU Member States. Cross-border marketing is subject to the filing of information/data with the host Member State authority.
In order to become and to continue to be authorised, AIFM must demonstrate that they are suitably qualified and satisfy the relevant regulator as to the risk management arrangements in respect of liquidity, operational and counterparty risk, the management and disclosure of conflicts of interest, the fair valuation of assets and the security of depository and custodial arrangements.
Conflicts of Interest
AIFMs will need to take all reasonable steps to identify conflicts of interest between their managers, employees or otherwise linked persons and their investors, and between investors. AIFMs may therefore need to alter their operations/responsibilities divisions and will need to disclose any conflicts to investors.
AIFMs must separate the functions of risk management and portfolio management, and implement systems to measure and monitor all risks associated with each Alternative Investment Fund (AIF) investment strategy. In particular, AIFM must ensure that the liquidity profile of their investments complies with their underlying obligations, and conduct regular stress tests. Each AIF must have a redemption policy appropriate to the liquidity profile of its investments which must be stated in the AIF rules/instruments of incorporation. Further, the Commission will be passing implementing measures controlling AIFM investment in securitisation positions and repackaged loans.
There are currently no restrictions on naked short selling. AIFM just need to make sure they have access to the securities and instruments when committed to deliver them. AIFM must also adequately manage the risks associated with the delivery of short sold securities and instruments.
Minimum Capital Requirements
AIFM are required to hold and retain a minimum level of capital of at least EUR125,000, plus 0.02% of the amount by which the value of the portfolios exceeds EUR250 million.
Disclosure to Investors
Investors must be provided with a description of the Fund’s objectives and investment strategy, including assets in which the Fund may invest, the investment techniques that may be employed, details of the circumstances in which leverage may be used, the types of sources of leverage permitted and any associated risks. In particular, AIFM must disclose periodically the percentage of its assets subject to special arrangements arising from their illiquid nature. AIFM must also provide an annual report to investors and relevant regulators, containing statements of assets and liabilities, income and expenditure, and a report on activities for the financial year. AIFM must also disclose any preferential treatment it gives one investor to another.
Reporting Obligations to Relevant Regulators
AIFM must regularly report on the principal trading markets, plus supply aggregated information on the main trading instruments and principal exposures. Further, they must report the percentage of assets subject to special arrangements arising from their illiquid nature, the actual risk profile of the AIF and its risk management tools and any use of short selling.
Additional Disclosure for AIFM Engaging in High Levels of Leverage
AIFM must disclose to regulators and investors the maximum level of leverage that will usually be employed and, on a regular basis, must disclose the total amount of leverage actually employed. Further, rules will be introduced to limit leverage depending on the nature of the underlying fund. High levels of leverage is defined as where the amount of leverage employed exceeds the value of the Fund’s equity capital.
Additional Disclosure for AIFM Holding a Controlling Influence in Non-listed Companies
AIFM in a position to exercise 30% or more of the voting rights of an issuer or non-listed company must notify the company and its shareholders of that control. They must identify the resulting situation in terms of voting rights, the conditions under which the 30% threshold has been reached the date on which it was reached. This is so except where the issuer or non-listed company employs fewer than 250 persons, has an annual turnover not exceeding EUR50 million and/or an annual balance sheet total not exceeding EUR43 million.
Off-shore, US and Other “Third Country” Funds
The draft only allows AIFMs to market in the European Union AIF domiciled in a "third country" from 2014 (or three years after the Directive becomes law in Europe). Third country funds are treated differently because the Commission needs more time to check whether the regulatory framework and supervisory arrangements in those countries are equivalent to the Directive, that the third country has entered into an agreement based on the OECD Model Tax Convention, and that European Union AIFs enjoy comparable access to that third country market.In the meantime Member States may allow or continue to allow AIFM to market AIF domiciled in third countries to professional investors on their territory subject to national law.
The draft Directive has been produced in record time. The consultations were ‘lite’ with politicians and officials keen to be seen to move quickly amidst the continued financial turmoil and in the run up to the European elections in early June. Many in the AIF industry attest the draft significantly increases funds’ operating costs, forces the dissemination of proprietary information and will ultimately drive AIFMs out of Europe. The socialist parties in particular in the European Parliament will push to toughen the Directive’s requirements in the coming months. The industry’s next challenge will be to prevent the draft from becoming more burdensome thereby further raising funds’ costs.
The draft Directive needs to be approved by the European Parliament and the Council, pursuant to the EU Co-Decision procedure. This could happen this year, with entry into force in 2011. However, due to the European elections in early June and widespread controversy/polarisation of views, adoption may not happen until 2010, meaning an entry into force in 2012 (by which time the Directive should be ‘transposed’ into the 27 Member States’ national laws).
There are opportunities to amend the draft Directive during the course of the Co-Decision procedure. McDermott has broad experience in the adoption of EU legislation and has advised numerous clients in this area, as well as providing monitoring of key developments and milestones. Once the Directive is adopted (late 2009/2010) the focus shifts to the FSA and the other financial regulators to implement the requirements into national law. The draft Directive gives discretion to regulators (as long as they implement the minimum requirements) and McDermott is well-placed to navigate AIFMand other interested parties through the Member State implementation processes.