Commission publishes draft Directive The European Commission published a draft Directive on 30 April 2009 which proposes a new regulatory and supervisory framework for Alternative Investment Fund Managers (AIFMs) across Europe.
What is an AIFM?
The draft Directive defines an AIFM as any legal or natural person whose regular business is to manage one or several Alternative Investment Funds (AIFs). An AIF is basically any collective investment undertaking that is not a UCITS. The Directive is not confined to hedge funds and private equity funds, but also includes real estate funds and other property funds. Both open-ended and closed-ended funds are covered.
Why regulate AIFMs?
The Commission believes that regulation of AIFMs at national level (which is the case in some countries, like the UK, but not all EU Member States) does not adequately reflect the cross-border nature of their risk. But is this the right way to address the risks? The Alternative Investment Management Association (AIMA) has condemned the draft Directive as “not a proportionate regulatory response to any of the identified causes of the current crisis”. Could the Directive create more problems than it will solve?
Which AIFMs will need a licence?
EU-domiciled AIFMs with assets under management above the threshold of €100 million (less than the €250 million originally envisaged) will need authorisation in their home Member State and will be subject to ongoing requirements. An unauthorised AIFM cannot provide management services to AIFs or market AIFs within the EU. The only significant concession is for managers of AIFs with no leverage and a lock-in period of five years or more.
These will need authorisation only if they have over €500 million assets under management. This significantly higher threshold is because the Commission believes AIFMs of unleveraged funds are unlikely to cause systemic risks.
The Commission thinks the Directive will cover around 30 per cent of AIFMs, managing almost 90 per cent of assets of EU-domiciled AIFs. The draft focuses on regulating the activities of AIFMs, rather than AIFs. This is in line with the current UK regulatory approach. Nor will the Directive regulate investment policies of the funds. This would be impractical given the professional nature of the investor base and the diversity of business strategies of funds.
The AIFM will have to hold and keep a minimum level of capital. The minimum capital for AIFMs is €125,000. Additional capital of 20 basis points of the value of the assets under management over €250 million will be required with no upper limit. But, in any case, the own funds of the AIFM must never be less than the amount already required under Article 21 of the Capital Adequacy Directive that applies to investment firms. This is currently equivalent to one quarter of an investment firm’s preceding year’s fixed overheads. Given that the Directive does not impose capital requirements for the fund itself, it is difficult to see what the capital proposals are seeking to achieve.
All AIFMs operating in the EU will be required to show that they are suitably qualified to provide AIF management services. AIFMs will have to provide detailed information on their planned activity, the identity and characteristics of the AIF(s) managed, and their internal arrangements for governance (including arrangements for delegation), risk management, valuation and safe-keeping of assets, audit arrangements, and the systems of regulatory reporting, where required.
Some of the authorisation requirements seem too detailed. For example, authorisation applications must include all the constitutional documents of each AIF the AIFM manages. Also, AIFs will need to get permission to delegate services to third parties. This seems unduly demanding, as MiFID firms do not have to get such permission - instead they just have to comply with certain rules when doing so. This should give enough regulatory control over the services delegated.
An AIFM will also have to report regularly on the principal markets and instruments in which it trades for its AIFs, the AIFs’ principal exposures, performance data and concentrations of risk. It must also notify the regulator of the identity of the AIF managed, the markets and assets in which the AIF will invest and the organisational and risk management arrangements established in relation to that AIF. Extra disclosure obligations will apply to AIFMs managing leveraged AIFs and controlling stakes in companies.
An AIFM must ensure that a depositary is appointed for each AIF it manages to receive all payments from subscribers and to ensure effective ownership of any assets the AIF invests in. The depositary must be an EU credit institution independent of the AIFM and act solely in the interests of AIF investors. The Directive allows delegation to a sub-depositary in a third country where the AIF is located if the Commission considers that sub-depositaries in that jurisdiction are regulated to a standard equivalent with EU law.
Independent valuation agent
An AIFM must also ensure that a valuation agent independent of the AIFM is appointed for each AIF it manages to establish the value of shares or units in the AIF and any assets the AIF invests in. Appointment of a valuation agent in a third country is only allowed if the valuation standards and rules used by valuators in that jurisdiction are equivalent to those applicable in the EU.
Acquiring a controlling interest in companies
Provisions specifically aimed at the private equity industry provide that an AIFM managing one or more AIF which either individually or in aggregate acquires 30 per cent or more of the voting rights of an issuer or of a non-listed company domiciled in the EU must notify the company, other shareholders and employee representatives of voting rights acquired. The notice must include the AIFM’s policy for preventing and managing conflicts of interests, in particular between the AIFM and the issuer or nonlisted company, and certain employee matters. Note this requirement will not apply where the issuer or non-listed company concerned is a small and medium enterprise that employ fewer than 250 persons, has an annual turnover not exceeding €50 million and/or an annual balance sheet not exceeding €43 million.
Additional obligations will apply to an AIFM which manages one or more AIF employing “high levels of leverage on a systematic basis” – in effect where the combined leverage from all sources exceeds the value of the equity capital of the AIF in two out of the past four quarters. The AIFM must disclose to investors the maximum level of leverage which the AIFM may employ on behalf of the AIF as well as any right of re-use of collateral or any guarantee granted under the leveraging arrangement. In addition, the AIFM must also disclose to investors on a quarterly basis the total amount of leverage employed by each AIF in the preceding quarter.
The plus side: Selling funds cross-border
An AIFM authorised in its home Member State will be entitled to market its funds to professional investors (following the MiFID definition) in any Member State. The cross-border marketing of AIF will be subject to a notification procedure, under which relevant information is provided to the home Member State and passed on to the host. AIFMs will also be able to passport management services into other Member States, subject to a notification procedure.
The Directive also allows for EU-wide marketing of third country funds which comply with stringent requirements on regulation, supervision and cooperation, including OECD tax matters. These requirements could be impractical for popular offshore centres and low-tax jurisdictions to meet. Also, the rules allowing the marketing of third country funds will come into force three years after the rest of the Directive. So the passport is some way away even for funds from compliant jurisdictions.
The Commission anticipates that offshore financial centres will have a strong incentive to deliver the necessary improvements during this time and that this approach is consistent with the objectives of the G20 to enhance the transparency of such jurisdictions. However, the AIMA is concerned that this may “disadvantage European hedge fund managers against those outside of Europe, which could prove an incentive for them to move business elsewhere”.
Also, Member States may allow AIFMs to market third country AIFs domestically – AIFMs only need to comply with the stringent passporting requirements for marketing crossborder. In addition, AIFMs may market AIFs domestically to a wider audience than professional investors. In principle, it seems the UK will not need to change its current rules for marketing unregulated collective investment schemes.
Failure to comply with the rules
Breach of the rules will be a potentially serious matter. The Directive proposes that home state regulators may:
- prohibit an AIFM from carrying on business;
- take appropriate measures to ensure that the AIFM continue to comply with the relevant legislation; or
- refer matters for criminal prosecution to the competent jurisdictions.
Does the Directive cover short-selling?
The Directive does not address issues of short-selling or remuneration as the Commission recognises that many categories of financial market participants carry out these activities. Any measures would need to address all types of institutions that engage in such activities and of course are subject to separate Commission initiatives.
Is the Directive fair?
AIMA argues that major reports which analysed the crisis, including the de Larosiere report and the Turner review, concluded that hedge funds did not play a significant role in the crisis. The Directive targets AIFMs unfairly. The Commission believes that, while AIFMs did not cause the crisis, they may have exacerbated market turbulence sometimes by contributing to asset price inflation and the rapid growth of structured credit markets. On the other hand, the systemic risk posed by hedge funds’ use of leverage is significantly lower than that of investment banks. The main criticisms of the draft Directive are that it has not taken account of the views of the industry and has arguably gone further than G20, de Larosiere or Turner think necessary. The other major concerns are the capital requirements and the reporting burdens.
The recitals to the Directive make it clear that important details are to be delegated to the Commission under the “regulatory procedure with scrutiny”. In particular, the Commission will determine the procedures specifying, amongst other things:
- the minimum liquidity requirements for AIF;
- the requirements that AIFM will have to comply with when investing in securitisation instruments;
- the content and format of the annual report that AIFM have to make available for each AIF they manage;
- the disclosure obligations of AIFM to investors; and
- the reporting requirements to competent authorities as well as their frequency.
The alternative fund industry should keep a watchful eye on the measures the Commission adopts as the devil is in the detail.
What happens next?
The Directive is now up for debate with European Parliament and Council. However, the Commission hopes the Directive can be adopted by the end of the year. If this happens, Member States must implement it by the end of 2011, which means it will be 2014 before any third country funds could benefit from the new passporting regime.
Regulation is not new to UK-based AIFMs. On the positive side, it could open up professional markets in other EU Member States and will provide a passport for management services. But, given the nature of many domestic fund managers, fund passporting may be of little use until non-EU funds are covered. It remains to be seen whether offshore financial centres will be able (and indeed willing) to comply with tougher requirements on supervision, cooperation with European supervisors and compliance with the OECD tax code.
On the negative side, EU capital requirements will apply to all AIFMs covered by the Directive, and for some managers the financial impact of this will be significant. There is no choice of “opting out” of the Directive for AIFMs that do not want to provide cross-border marketing or services.
At least the draft Directive covers managers, rather than hedge funds and private equity funds themselves. This is eminently sensible – and consistent with the current UK approach. Excluding hedge fund strategies and investment policies is also welcome. Overall, some aspects of the draft Directive are undesirable, but it could have been far worse for AIFMs.
This article originally appeared in Compliance Monitor (www.i-law.com)