Six months have passed since the deadline for the implementation of the Alternative Investment Fund Managers Directive by EU Member States on 22 July 2013. Philip Lovegrove and Liam Collins of Matheson look at the issues.
With a further six months remaining until the much-welcomed transitional period expires, it is timely to consider certain of the issues which are giving rise to most discussion in the industry, as asset managers seek to obtain alternative investment fund manager (AIFM) authorisations and align their fund documents with the AIFMD’s requirements before the end of the transitional period.
Whether the AIFMD will develop into an international brand for alternative investments globally remains to be seen, but asset managers are increasingly looking at the opportunities that it can offer in terms of asset-raising through the “professional investor passport” to ensure that they are not left trailing behind their competitors by the end of this year. Notwithstanding the transitional period, a number of asset managers have already obtained their AIFM authorisations. The Central Bank of Ireland has confirmed a filing deadline of 21 February 2014 for Irish AIFMs that want to be authorised by 22 July 2014.
Among the many issues that the directive throws up, there are a number of “hot topics” which asset managers cannot ignore.
CONTRACTUAL DISCHARGE OF LIABILITY
The AIFMD states that the depositary is strictly liable (i.e. liable come what may) for the loss of financial instruments that can be held in custody but also that, subject to certain conditions, the depositary can discharge itself of that liability by transferring it to a delegate. AIFMs are understandably reluctant to release the depositary from the strict liability standard and the precise conditions of discharge, and how they may be met, often present a stumbling-block to negotiations over AIFMD depositary agreements.
“The AIFM is obliged at all times to act in the best interests of the fund and its investors”
The fundamental condition is that the discharge should be justified by an “objective reason” (an unexplained phrase) which must be detailed in the contract allowing the discharge (and disclosed to investors also). The establishment of “an objective reason” is not straightforward. For one thing, the AIFM is obliged at all times to act in the best interests of the fund and its investors and so it must be satisfied that it is doing so when it transfers liability from the depositary to its safe-keeping delegate (e.g., a prime broker). If the delegate is a greater credit risk than the depositary, this may be a difficult thing to do; objectively, a good reason would be needed to justify a transfer of liability to a less creditworthy entity. In addition, the AIFMD Level 2Regulation (a European Union legislative term) provides that the objective reason must be limited to precise and concrete circumstances that characterise a given activity. It would appear, therefore, that the fact that a depositary seeks to discharge liability as a matter of course or as its standard practice would not be sufficient on its own.
“In some cases, the depositary can transfer its liability to a third party”
The AIFMD Level 2 Regulation also provides that certain circumstances are automatically deemed to constitute objective reasons, namely circumstances in which the depositary can demonstrate that it had no other option but to delegate its custody duties to a third party. In such cases, the depositary can transfer its liability to that third party. Particular examples of this are where the law of a non-EU country requires that certain financial instruments should be held in custody by a local entity or where the AIFM insists on maintaining an investment in a particular jurisdiction despite the depositary warning that this will increased the amount of risk. The AIFMD itself also provides for a specific case where an objective reason is not required,namely where the law of a non-EU country requires certain financial instruments to be held in custody by a local entity and no local entity satisfies the AIFMD delegation requirements.
Regardless of the reason itself, the AIFM will have to satisfy itself that options other than the discharge of liability were considered, for example, the procurement of an indemnity from the delegate to the depositary, and that those options did not represent the best interests of the fund or its investors.
Where liability is discharged, the AIFM’s role with respect to custody can change also. As the delegate (e.g. the prime broker) is now the entity responsible for certain assets, the AIFM may be expected to conduct ‘due diligence’ to ensure that the delegate is capable of performing the custody functions delegated to it and may also be expected to monitor the performance of those functions continually.
This issue is certain to be the subject of some discussion over the coming months as asset managers and depositaries seek to accommodate the new liability landscape within their structures.
Prior to the AIFMD, responsibility for the valuation procedures of an Irish alternative investment fund (AIF) resided with the AIF’s board of directors. Whenever the board of directors of an AIF has elected to act as AIFM under the AIFMD (i.e. a self-managed AIF), the board will retain this responsibility. However, if an external entity is appointed as AIFM, that entity will assume responsibility for this function, representing a change from normal practice in the pre-AIFMD world. The key issues for consideration in relation to valuation provisions under the AIFMD are:
(i) which entities are permitted to carry out the valuation function;
(ii) the classification of an external valuation agent;
(iii) the valuation procedures under the AIFMD; and
(iv) the liability provisions in relation to the valuation function.
WHO CAN ACT AS VALUER?
The AIFM itself can perform this function on the proviso that the process is functionally separate from its portfolio management and remuneration duties, and that measures are taken to mitigate any potential conflicts of interest.
“The AIFM may appoint an external valuer who cannot sub-delegate this function to anyone else”
Alternatively, the AIFM may appoint an external valuer. Importantly, it is not permitted for this external valuer to sub-delegate this function to anyone else. Additionally, the AIFMD must ensure that the external valuer is professionally recognised, can furnish professional guarantees, and is appointed in compliance with the delegation provisions of the directive. It is worth noting that either one or several external valuation agents can perform the valuation of the AIF’s assets.
WHO IS AN EXTERNAL VALUATION AGENT?
The AIFMD clearly distinguishes between the valuation of assets and the calculation of their net asset value (NAV). The European Securities and Markets Authority’s (ESMA’s) guidance on this topic clarifies things by saying that an administrator who carries out the calculation of the NAV is not considered to be an external valuer as long as he (or it) is merely incorporating values which are obtained from other sources (as opposed to providing the values himself). As such, the administrator does not automatically assume the role of external valuer and the AIFM may retain the valuation function and determine the AIF’s pricing policy while also delegating the calculation of the NAV to the administrator.
The AIFM must ensure that “appropriate procedures” are in place for the proper and independent valuation of assets. Valuation must take place at least annually (although open-ended funds may be required to undergo valuation more frequently, whereas closed-ended funds must carry out a valuation each time the capital of the fund increases or decreases). Additionally, the AIFM will be required to determine the valuation methodologies that will be used for each of the types of asset in which the AIF may invest.
It is important to note that valuation policies and procedures should be reviewed by the AIFM at least annually.
LIABILITY OF THE AIFM
The AIFM’s liability towards the AIF and its investors is not affected by the delegation of the valuation function. The external valuer is, however, liable to the AIFM for any losses suffered by the AIFM as a result of its negligence or intentional failure to perform its tasks. This liability standard cannot be waived or amended by contract.
In the six months since July 2013, a clearer picture has begun to emerge in respect of two important issues regarding remuneration under AIFMD: (i) whether or not remuneration requirements are applicable to an AIFM’s delegates and (ii) the options available to AIFMs and their delegates when they are assessing the extent to which these requirements apply to them and their staff.
“ESMA believes that the remuneration requirements should apply to delegates”
ESMA’s guidelines for remuneration, which it published in July 2013, indicate that the authority believes that the remuneration requirements should apply to delegates, as its definition of “Identified Staff” (i.e. those to whom the remuneration rules apply) includes staff at entities to which portfolio or risk management has been delegated. Before ESMA released these guidelines, EU member-states were allowed to opt out of them. It appears that only one country has taken this option.
In terms of assessing the extent to which the remuneration requirements apply, some aspects of the AIFMD rules may be of assistance to AIFMs and their delegates.
Firstly, ESMA’s guidelines make it clear that the rules will only apply to staff who have “a material impact on the risk profile of the AIFM or the risk profiles of the AIF they manage”, so that wherever the parameters of a delegation of portfolio or risk management by an AIFM are sufficiently restrictive that a delegate or its staff cannot have such an effect, the remuneration rules will not apply.
Secondly, the “proportionality principle” may enable AIFMs and delegates to decide not to apply the so-called “pay out process” rules, which may require variable remuneration to be paid in units of funds under management, to be deferred for three to five years and to be subject to ‘clawback’ provisions where warranted by subsequent performance. For example, the UK’s Financial Conduct Authority (FCA) and the Irish Funds Industry Association, among others, have suggested that anyone who has the job of determining whether it is “proportionate” to apply the remuneration rules should consider assets-under-management thresholds, with AIFMs with assets under management below de minimis levels being presumed exempt. Equally, others think that wherever the management of AIFs represents a small proportion of a delegate’s overall business, it may not be proportionate to require the delegate to set up systems and other infrastructure to comply with the remuneration rules.
“ESMA might be thinking of publishing a Q&A document, which could confirm some commonly-held views”
The FCA is due to publish guidance about this shortly and its points are expected to be broadly in line with proposals outlined in its previous consultation. ESMA is also understood to be thinking of publishing a question-and-answer document, which could provide welcome ‘certainty’ by confirming some commonly-held views. These include those outlined above and others on subjects such as the timing of the application of the rules; other remuneration regimes (e.g. CRD and MiFID) which may be deemed to be equivalent to AIFMD; and the possibility that variable remuneration might be paid in units of entities other than the funds under management themselves, wherever that is not possible or practical.
THE EFFECT OF THE AIFMD ON PRIVATE EQUITY MANAGERS
Because the AIFMD defines the phrase ‘alternative investment fund’ so broadly, previously unregulated private equity fund managers may now find themselves falling into its regulatory clutches, with all the resultant problems and benefits that that may bring. We have seen a marked increase in the number of private equity fund managers who are considering Ireland as a domicile because the directive contains a ‘marketing passport’. In this regard, the Irish AIF vehicle offers the characteristics and flexibility of the typical private equity fund product, while being authorised and regulated by the Central Bank and offering the AIFMD-compliant standard which investors are increasingly likely to seek. The financial services industry is also collaborating with the Irish government to make amendments to the existing investment limited partnership legislation. The idea is to make this structure more attractive as an option for private equity managers.
The next six months will certainly be an interesting time as far as the asset management industry is concerned, as a host of regulatory developments follow in the wake of the directive. In addition, it is expected that the next months will also see the introduction in Ireland of the Irish Collective Asset-management Vehicle (the “ICAV”), a new corporate fund vehicle tailored for the needs of asset managers, which should prove to be a popular alternative to the existing Irish fund vehicle range for both UCITS and AIFs. Since 2008, assets under management in Irish AIFs have experienced 120% growth. Ireland is certainly well-placed to build on its existing position as the domicile of choice for the establishment of AIFs.
This article originally appeared in Compliance Matters in January 2014.