The Alternative Investment Fund Managers Directive (2011/61/EU) (the “Directive” or “AIFMD”) states in Recital 94 that its objective is:
...to ensure a high level of investor protection by laying down a common framework for the authorisation and supervision of AIFMs [alternative investment fund managers]...
and opines that the deficiencies in the Member States’ existing regimes demonstrate that such protection would be better provided at the European Union level.
The importance of investor disclosure (which is equated with investor protection) is emphasised throughout the Commission Delegated Regulation (EU) No 231/2013 (the “Delegated Regulation” also known as “Level 2”) adopted pursuant to the Directive. It notes, for example, at recital 124 that:
It is essential for investors to obtain the minimum information necessary with respect to particular AIFMs and AIFs [alternative investment funds] and their structure in order to be able to take the right investment decisions tailored to their needs and risk appetite. That information should be clear, reliable, readily understandable and clearly presented...
These are great ideals.
Member States were required to implement the Directive by 22 July 2013 and, following a one year grandfathering period in most Member States, all AIFMs (to the extent provided in the Directive) must now be compliant with AIFMD. For AIFMs of AIFs established in the European Economic Area (“EEA”)1 or AIFMs marketing into the EEA AIFs established outside of the EEA, this includes ensuring compliance with Articles 22 and 23 of AIFMD. These articles set out the Directive’s core requirements relating to investor transparency and are supplemented by Articles 103 through 109 of the Delegated Regulation.2
The Historic Position
Disclosure and transparency requirements were historically driven by the rules of the jurisdiction in which the relevant AIF was established, the requirements of any exchange on which the AIF's interests were listed and, on occasion, by the jurisdiction of an investor. These legal requirements, often limited, were buttressed by industry standards and voluntary codes of conduct.
Although there are many exceptions (particularly given the very broad definition of “AIF”, being generally any fund that is not a UCITS), the disclosure provided by an AIF was frequently dependent upon the professionalism of an AIF’s promoters, service providers and the AIF’s governing body.
Many would argue (at least in the Anglo Saxon world) that funds not generally available to the retail market do not need a high level of regulation. In particular innovation, beneficial risk taking, freedom of competition and a healthy market place for the benefit of professional investors, is fettered by extensive regulation.
Nonetheless the countries comprising the EEA have determined that restricting the types of investors who could invest in an AIF is not enough. Rather, the benefits of regulation (in the case of this article, specifically in relation to investor transparency) outweigh the disadvantages of added bureaucracy and cost together with, in all likelihood, a restricted supply of investment opportunities in Europe.
This Article considers the new rules and the extent to which they improve the position of investors.
Investor Disclosure and Transparency under AIFMD
AIFMD provides a minimum level of relatively uniform disclosure that must be provided to prospective and existing investors before and during the course of their investment in an EEA established or marketed AIF.
AIFMD mainly provides for investor transparency by requiring three types of disclosure: (1) point of sale or pre-investment disclosure (AIFMD Art. 23(1)); (2) periodic disclosure (AIFMD Art. 23(4)); and (3) regular disclosure (AIFMD Art. 23(5)).
The core requirements relating to pre-investment disclosure are set out in Article 23(1) which requires that certain information be “made available” to investors before they invest. This includes information relating to:
- the AIF’s investment objective, strategy, restrictions and risks (including the means by which the objective or strategy may be changed);
- use of leverage and collateral and asset reuse arrangements;
- service providers (with significant detail around prime brokerage arrangements) and fees;
- delegation arrangements;
- dealing terms and liquidity management;
- valuation procedure and net asset value calculation;
- fair treatment and preferential treatment of investors; and
- how periodic and regular disclosure will be made available.
Any material change to this information must also be made available prior to investment.
AIFMD provides that this information must be made available in accordance with the “...AIF rules or instruments of incorporation...” but gives no further guidance. Arguably, most of the required pre-investment disclosures should be (and indeed historically much of it has been) made in the offering document issued by the AIF, with material changes reflected either in an updated offering document or in a supplement to that document. However, certain information that needs to be made available may change too frequently or may otherwise be inappropriate or undesirable to include in the offering document. For example, the latest net asset value of the AIF will change as at each valuation day and information regarding preferential treatment (e.g. side letter terms) granted to any investor may change as investors invest and redeem. For information of this type, the rules of the AIF must state how the information may be obtained and this could be, for example, “upon request to the investment manager”, via a website or by a regularly updated investor information sheet. An alternative is for all AIFMD mandated but changeable pre-investment disclosure to be made by way of a supplement to the offering memorandum which is kept updated. This requirement for changing information results in the key benefit of having all applicable information in one readily accessible place being lost.
A further question arises as to whether additional AIFMD mandated disclosures should or could only be distributed when marketing to EEA investors. Consideration should be given to whether as a matter of fairness non-EEA investors should or indeed must receive the same disclosure as EEA investors. This will be an area of interest for litigators in years to come.
The requirements relating to periodic disclosure are set out in Article 23(4) of AIFMD and Article 108 of the Delegated Regulation. AIFMs are required periodically to disclose to investors:
- the percentage of assets that are subject to special arrangements arising from their illiquid nature (e.g. side pockets);
- any new liquidity management arrangements;
- the current risk management profile of the AIF (including, according to Article 108 of the Delegated Regulations, measures to assess the AIF’s sensitivity to the most relevant risks, any risk limits likely to be/that have been exceeded, a description of the circumstances and any remedial steps taken); and
- the corresponding risk management systems of the AIFM.
The Delegated Regulation provides at Article 108 that this information generally must be provided “...as required by the AIF’s rules or instruments of incorporation, or at the same time as the [offering memorandum] and - as a minimum - at the same time as the annual report is made available...” However, in the case of a material change being made to the liquidity management systems, disclosure must be made when the change is made and notice must be given “immediately” upon a liquidity management tool, such as a gate, being applied. “Periodic” disclosure has, therefore, a rather wide meaning.
As the requirements of Article 108 set out above are expressed in the alternative and specific methods of disclosure are not otherwise provided for under AIFMD, it is up to the AIFM and AIF to determine the appropriate means of communicating the relevant information. If a means of communication is provided for in the AIF’s rules or instruments of incorporation, this method must be used, provided the time frame is in line with AIFMD requirements.
Periodic disclosure relating to material changes to liquidity management systems or application of liquidity management tools could be communicated by investor letter, by email or by notice to investors that there has been an update on an appropriate website. Periodic reporting regarding assets subject to special arrangements and the AIF’s risk profile and AIFM’s risk management systems could be provided for in any periodic reporting provided by the AIF or the AIFM, such as a monthly newsletter or, at a minimum, in or with the AIF's annual report. In the case of the latter alternative, consideration should be given to whether the information will become stale given the time lag in the production of the annual accounts.
However, if the change would be considered material in terms of the pre-investment disclosure, then a supplement to the offering memorandum may well be appropriate.
AIFMs should carefully consider whether all investors are on their monthly newsletter distribution list and, as a commercial, regulatory and potentially a legal issue, how circulation will meet the needs of legal and (where different) beneficial owners.
Regular disclosure is required under Article 23(5)(a) of AIFMD in relation to any changes to:
- the maximum level of leverage (calculated in accordance with the gross and commitment methods provided for under AIFMD) which the AIFM may employ on behalf of the AIF;
- any right to the reuse of collateral; or
- any guarantee granted under a leveraging arrangement.
Article 109 of the Delegated Regulations provides that information related to these changes should be provided “without undue delay”.
There are no other requirements in AIFMD or the Delegated Regulation as to how regular disclosure under Article 23(5)(a) should be made. It could be made by way of an investor letter or in a regular newsletter (subject to our comments above) provided that this is to be issued promptly following the change. However, given that the change of leverage may be a material change to a pre-investment disclosure requirement, this would probably be better dealt with by way of an offering document supplement provided to prospective and existing investors.
Article 23(5)(b) also requires the regular disclosure to investors of the total amount of leverage employed by the AIF. Pursuant to Article 109 of the Delegated Regulation this information must be provided “...as required by the AIF’s rules or instruments of incorporation, or at the same time as the [offering memorandum] and at least at the same time as the annual report is made available...”
Other than the requirements of Article 109 set out above which are, in any event, expressed in the alternative, there is also no guidance under AIFMD or the Delegated Regulation as to how regular disclosure under Article 23(5)(b) should be made. It could be provided for in any periodic reporting provided by the AIF or the AIFM, such as a monthly newsletter or, at a minimum in or with the AIF's annual report (subject to the same concerns relating to the information becoming stale as noted above).
In terms of frequency and methods of disclosure there does not appear to be any distinguishing factor between “periodic” and “regular” disclosure. Some of the periodic and regular disclosure is to be made available “as required by the AIF’s rules or instruments of incorporation”, or at the same time as the offering memorandum and at a minimum at the same time as the annual report is made available and certain periodic disclosure is to be made available “immediately” while certain regular reporting is to be made available “without undue delay”.
In addition to the pre-investment, periodic and regular disclosure required under Article 23, an AIFM for each EU AIF it manages and each AIF it markets into the EEA is required to make an annual reportavailable to existing (and prospective) investors within 6 months of the end of the financial year. Article 24 of AIFMD (and Article 29 where the AIF takes control of a non-listed company) supplemented by Articles 103 through 107 of the Delegated Regulation sets out required content for the annual report and the method of preparation.
The accounts must be audited and prepared in accordance with the accounting standards of the home Member State of the AIF or the country where the AIF is established and in accordance with the rules set out in the AIF’s rules or instruments of incorporation.
The annual report must include, in addition to the normal requirements of a statement of assets and liabilities and income and expenditure:
- a report on the activities of the financial year;
- any material changes to the information disclosed pursuant to Article 23;
- information regarding the remuneration paid by the AIFM to its staff during the relevant period; and
- where the AIF acquires individually or jointly control over a non-listed company, information regarding the target company’s business development.
Detailed requirements in terms of contents are included in the Delegated Regulation at Articles 104 and 105.
The information regarding remuneration to be disclosed is set out at Article 22(2)(e) and (f) of AIFMD and supplemented by Article 107 of the Delegated Regulation and includes:
- the total amount of remuneration for the AIFM for the financial year split into fixed and variable remuneration (including carried interest), including the number of beneficiaries;
- remuneration paid to senior management and to AIFM staff whose “actions have a material impact on the risk profile of the AIF”;
- remuneration paid to staff who are fully or partially involved in the activities of the AIF, including the number of beneficiaries;
- the amount of the remuneration paid which is attributable to the relevant AIF and number of beneficiaries; and
- the AIFM’s remuneration policies and practices, including in relation to management of conflicts of interest.
The requirement to include information regarding AIFM remuneration in the AIF accounts is the most controversial investor disclosure requirement introduced by the Directive. It can pose security risks for the individuals involved and would be viewed by many as intrusive with limited benefit for investors. In this regard, the Directive and its supporting rules fail to recognise the clear differences in risk and operation between the banking and investment management industries.
Investor Protection – What have we gained?
Where then does all of this leave us in terms of investor transparency and the goal of improved investor protection post AIFMD?
Investors into AIFs have historically been high net worth individuals and professional investors. These kinds of investor are, from a global perspective, generally considered to have the knowledge and/or resources to evaluate the risks associated with an investment and the financial wherewithal to withstand losses should their assessment prove incorrect. They are also well placed to identify what information they need regarding the proposed investment in light of their particular circumstances and to request it from the investment manager. A uniform set of specific disclosures designed to apply across a wide variety of fund strategies and structures, while providing a base line, will not necessarily meet these investors’ needs.
Moreover, as a result of the increased regulatory burdens (from a transparency perspective this is particularly true of the remuneration disclosure requirements which are particularly distasteful to non-European based AIFMs) and the limitations on marketing, professional investors in the EEA are likely to have access to fewer investment opportunities in the future. In the view of various European continental institutional investors, the obligations imposed by AIFMD are likely to lead to a reduction in their investment returns, an increase in costs and greater volatility of returns as it will become harder to access a variety of non correlated investment portfolios.
The push for greater transparency in the alternative investment space arose following the financial crisis, driven in part by the increased allocation to alternative investment managers by institutional investors, but even more by the ideal that the state could control risk for its citizens. The industry as a whole also sought to meet concerns regarding transparency, with industry associations publishing guidelines on corporate governance, investor relations and disclosure. This emphasis on greater transparency has for some time been espoused by many European managers who sought to attract investors with more detailed disclosure in offering documents, responses to due diligence questionnaires and periodic investor reporting in the form of monthly newsletters and investor conference calls.
By the time AIFMD came into play a strong body of industry best practice had been developed, including the comprehensive Hedge Fund Standards issued by the Hedge Funds Standards Board and work undertaken by other trade bodies such as the Alternative Investment Management Association.
In certain respects, these guidelines are more comprehensive in terms of transparency than AIFMD. Certain types of disclosure required by AIFMD are of limited value - for example, the requirement to disclose whether the AIFM has chosen to obtain liability insurance or retain capital in order to meet potential negligence claims. Certain methods of disclosure are also unduly restrictive – for example the requirement that annual accounts be prepared in accordance with the standards of the AIF’s home member state or jurisdiction of establishment. This requirement limits the flexibility of an AIF to make use of another more appropriate set of accounting standards, for example, US GAAP where a European AIF targets US investors.
The minimum standard provided by AIFMD has also come with a cost, not only for the AIFM in complying with AIFMD, but also costs to the AIFs themselves and, accordingly, to investors. Fund documentation has had to be updated for AIFMD; the offering document must have been amended to ensure all the required disclosures are included and the investment management agreements must be revised due to the change of applicable regulation and allocation of responsibility between an AIF’s governing body and the AIFM. There are also costs associated with the periodic and regular disclosure and the increased requirements of the annual report, including the fees and costs of service providers engaged in the preparation and distribution of those documents. Some or all of these costs will be borne by the AIFs and so, indirectly, the end investors.
AIFMD does provide a legally mandated minimum and, to a degree, a uniform level of investor disclosure for EEA established or marketed funds. These requirements generally are in line with the disclosure previously provided by managers complying with best practice prior to the implementation of AIFMD. They do not provide prospective investors with all the information they will require given their individual circumstances and are therefore not a substitute for the due diligence that will continue to be undertaken by investors in the space. They also come with a cost to the investor as the costs of required amendments to the AIF documents and periodic and regular disclosure are likely to be borne by the AIF.
There are clearly benefits from sharks and charlatans being discouraged from the industry. The question that remains is, will the costs justify the benefit (both in terms of investor transparency requirements in AIFMD and also the totality of AIFMD)? Those who have watched the brand of UCITS emerge and the confidence and trust they have inspired across the (non-U.S.) world will hope for a similar result for European AIFMs. Meanwhile the teams of lawyers, accountants, compliance consultants and regulators will swell with little doubt that this will be at the partial or total expense of investors.