What are the key provisions of the Alternative Investment Fund Managers Directive, approved by the European Parliament on 11 November 2010?
The original draft of the Directive was issued on 29 April 2009, with the aim of enhancing investor protection. The draft faced immediate criticism on a variety of grounds and intense lobbying followed by various interest groups. Some of the major concerns fired at the earlier drafts of the Directive have, as a result of the lobbying activities, been addressed. However, the Directive remains controversial.
In addition, the Directive only provides the framework proposal in relation to a large number of the provisions. The Commission or the European Securities and Markets Authority (ESMA; the recently appointed successor to the Council of European Securities Regulators) is charged with providing further guidance, detailed rules or technical standards which will clarify the requirements of the Directive. We should know more about these provisions in the coming months.
The Directive applies to managers of alternative investment funds (AIF). An AIF is defined in the Directive as any collective investment undertaking which is not an UCITS (undertaking for collective investment in transferable securities) and which raises capital from a number of investors with a view to investing such capital in accordance with a defined investment policy for the benefit of those investors. Each AIF must have only one manager (AIFM) which may be an external appointment or an AIF may be internally managed in which case the AIF itself must be authorised as an AIFM.
The headline terms
The Directive contains the following key provisions:
The Directive requires AIF managers to be authorised. This will involve an application to the relevant regulator containing information about:
- the manager (including information about the persons effectively conducting the business; the shareholders or members of the AIFM; and remuneration policy for certain employees of the AIFM and arrangements for delegation of functions); and
- the AIF that the manager intends to manage (including information on investment strategies; policy on leverage; risk profile of the assets and depositary details).
The regulator must be satisfied that the persons conducting the business of the AIFM are of good repute and are sufficiently experienced in relation to the investment strategies pursued.
Once authorised the AIFM's authorisation will be valid in all member states.
2. Ongoing operating conditions for the AIFM
The Directive sets out a number of ongoing obligations that fall upon the AIFM. These all promote the high duty of care owed by the AIFM to the AIF and its investors:
- AIFMs must act honestly, with due care and diligence and fairly in conducting its activities;
- AIFMs must act in the best interests of the AIF and the integrity of the market.
- AIFMs must take all reasonable steps to avoid conflicts of interest and when these cannot be avoided, to identify, prevent, manage, and, where applicable, disclose those conflicts of interest in order to prevent them from adversely affecting the interests of the AIF and its investors.
- AIFMs must treat all investors of the AIF fairly.
- No investor in an AIF may obtain a preferential treatment unless this is disclosed in the AIF constitutional documents.
3. Exemption for managers of small funds
It is worth being aware that an exemption for managers of smaller funds has been included in the final version of the Directive (Article 2a, paragraph 2), however it is not absolute. The exemption applies for funds with assets under management of less then €100 million; or €500 million if the fund is closed ended, does not use leverage and does not permit redemption for 5 years following the date of the initial investment.
AIFMs that satisfy the above criteria will nevertheless continue to be subject to registration requirements with the regulator and will also be required to provide information on investment strategies of the AIF, its principal exposures and most important concentrations. This is to enable the regulator to monitor systemic risk.
If an AIFM ceases to satisfy the criteria above, then it will have a period of 30 calendar days in which to seek authorisation. An AIFM that relies upon the "small fund" exemption will not be able to take advantage of the rights granted under the Directive to AIFMs (such as the passporting right enabling an AIF manager, once authorised, to operate in all member states). Member states will be free to impose stricter requirements in their implementing legislation.
4. Minimum capital requirements
An AIFM that is internally managed must have an initial capital of at least €300,000. AIFMs that are appointed by AIFs must maintain a minimum share capital of €125,000 plus 2% of the amount that its gross assets under management exceed €250 million; subject to a cap of €10 million.
AIFMs will need to have a remuneration policy in respect of certain key employees. This is driven in part by the recent controversies surrounding bankers' bonuses. The Directive sets out the categories of staff that should be included; it includes specifically those staff whose activities have a material impact on the risk profile of the AIF and risk takers. The remuneration policy must be consistent with the promotion of sound and effective risk management and should not encourage risk-taking which is inconsistent with the risk profiles and the fund rules of the AIF.
Annex II of the Directive sets out a number of principles that must be complied with by AIFMs "in a way and to the extent that it is appropriate to their size, internal organisation and the nature, scope and complexity of their activities". These principles are designed to align rewards with the performance of the AIF and not to reward failure. They include a requirement that assessment of performance is set in a multi-year framework appropriate to the life-cycle of the AIF to ensure that the assessment is based upon longer-term performance and that actual payment of performance based components of remuneration is spread over a period which takes account of the redemption policy of the AIF and its investment risks.
The provisions on remuneration are likely to be relevant to carried interest provisions agreed by AIFMs. ESMA is charged with developing guidelines on sound remuneration policy and this will be of great interest to the industry.
6. Marketing and third country provisions
The provisions governing managers and funds based in third countries have possibly been the most controversial. A compromise has been reached, but the rules are complex; in short they provide:
An EU AIFM (authorised under the Directive) may market shares or units in an EU fund to professional investors in any member state (Article 31 of the Directive). This passport right will become available in 2013 (when the Directive becomes law) and has the advantage that compliance with the different national placement regimes of each member state would not be required in such cases.
The passport right does not apply to marketing targeted at retail investors. Here, member states are entitled to impose stricter requirements on the AIFM or the AIF.
The marketing passport above, will not apply (at least initially) to third country funds; these being
- non-EU AIFs managed by an EU AIFM,
- non EU AIFs managed by a non-EU AIFM and
- EU AIFs managed by an non-EU AIFM.
These funds will continue to be subject to the national placement regimes of each member state. Rules permitting the passporting of these funds are likely to be introduced in 2015 with the national placement regimes being run in parallel until they are phased out by 2018 (subject to approval of ESMA). Until then third country funds can continue to be marketed in accordance with national placement regimes without having to comply fully with the Directive.
An EU AIFM that is looking to market a non-EU AIF, which is not being marketed in the EU, will nevertheless need to comply with the Directive (with a few exceptions). In addition there must be a cooperation agreement in place between the AIFM's regulator and the appropriate authority of the country where the AIF is established.
An EU AIFM that is looking to market a non-EU AIF, which is being marketed in the EU, will need to comply fully with the Directive. In addition there must (as above) be a cooperation agreement in place between the AIFM's regulator and the appropriate authority of the country where the AIF is established. The third country should not be listed as a Non-Co-operative Country and Territory by the Financial Action Task Force on anti money laundering and terrorist financing.An agreement on the exchange of tax information must be in place between the third country and relevant member state.
It is worth noting that the Directive does not prohibit passive marketing. It is acceptable for investors to approach non-EU AIFMs in respect of non-EU AIFs.
The Directive permits delegation but prior notification must be given to the regulator and the AIFM will remain strictly liable for any delegates' performance. There are a number of conditions that must be satisfied before delegation can occur. These include:
- the delegate must be of good repute and have sufficient resources and experience;
- the AIFM must be able to objectively justify its delegation;
- the AIFM must be able to demonstrate that the delegate was selected with all due care and that it is in a position to monitor effectively the delegated activity;
- no delegation of portfolio or risk management can be given to the depositary and the mandate in such a case must be given to an entity that is authorised or registered for the purpose of asset management or the prior approval of the regulator is required.
AIFMs must ensure that a depositary is appointed for each AIF. The assets of the AIF must be entrusted to the depositary for safe-keeping. There are various duties placed upon the depositary regarding
- the verification of the AIF's ownership of assets and its cash flows;
- the appropriate valuation of shares or units of the AIF;
- an obligation to ensure that any sale, redemption or cancellation of shares or units in the AIF are carried out in accordance with applicable laws and the AIF's constitution
The Directive contains details of who may act as depositary and where such depositary may be located. These provisions have been relaxed considerably since the earlier drafts of the directive. To avoid conflicts of interest the AIFM is not allowed to act as depositary.
The depositary is subject to strict rules on liability. However, the Directive states that if "it can prove that the loss has arisen as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary" then it shall not be liable. It will also be liable for "all other losses suffered by [the AIF or its investors] as a result of the depositary's negligent or intentional failure to properly perform its obligations pursuant to the Directive".
9. Notification of major holdings and asset stripping
These provisions were introduced relatively late in the process and affect in particular private equity funds. These provisions require:
- the AIFM to notify the regulator if its voting rights in a non listed company held by the AIF (alone or jointly) reaches, exceeds or falls below the thresholds 10%, 20%, 30%, 50% and 75%; and
- the AIFM to notify the target company and its shareholders and the regulator if the AIF acquires control, and ask the target company to inform employee representatives of the acquisition.
These notifications must be made within 10 working days. Small and medium sized enterprises are excluded from these provisions as are real estate special purpose vehicles.
In addition, if an AIF (alone or jointly) acquires control of an entity then the AIFM shall use its best efforts to procure that in the following 24 months the AIF does not permit any distribution, share redemption, buy back of own shares. This rule is aimed at preventing asset stripping (Article 29a of the Directive).
10. Risk management and portfolio management
The AIF manager must separate and ring fence its risk management function from the portfolio management function.
11. Leverage limits
Whilst there are no immediate limits imposed on an AIF's leverage, the AIFM must set a limit and be able to demonstrate that the limit is reasonable and that it complies with the limit set. The regulator is required to assess the risks that such leverage entails and when it deems it necessary, in order to ensure the stability and integrity of the financial system, it may impose limits.
The Directive contains a number of exemptions (for example holding companies, certain pension funds and certain central banks and government bodies). The exemptions are limited and will need to be considered carefully by firms looking to rely upon them.
The AIFM must ensure that appropriate and consistent procedures are established for each AIF it manages so that a proper and independent valuation of the assets can be performed. A valuation of the assets and the net asset value per share must be calculated at least once a year and if the AIF is an open ended fund then at a frequency that is appropriate to the assets and redemption frequencies. If an AIF is closed ended, then valuations shall also be carried out on any increase or decrease in the capital of the AIF.
The Directive sets out rules governing who can act as the valuer.
14. Transitional provisions
There are transitional provisions that will apply to existing AIFs once the Directive becomes law. However these are limited and apply only to closed ended funds where the fund has stopped investing by 2013 or the fund has held its final close before 2013 and terminates by 2016.
There are a number of common misconceptions about the Directive; the chief areas being as follows:
"The Directive only applies to hedge funds" - incorrect
Whilst the Directive was initially presented as a proposal to regulate hedge funds it has since been extended and now applies to all managers of alternative investment funds including private equity funds, real estate funds, commodity funds, debt funds, infrastructure funds and retail funds, that are not UCITs and listed investment companies. It applies to managers in the EU and outside the EU. Retail and institutional funds are also caught.
"Managers of small funds will not be affected by the Directive" – incorrect
As explained above, while there is an exemption for managers of smaller funds, those managers will nevertheless be required to register with their national regulator and regularly provide it with information to enable the regulator to monitor systemic risk.
"The Directive only affects EU managers and EU funds" – not quite correct
In addition to the above the Directive potentially affects EU funds managed by a non-EU manager; EU managers managing non-EU funds, and non-EU funds that are managed by a non-EU manager but which are marketed to EU investors.
"The Directive is agreed; there is nothing that can now be done to influence its terms" – correct in part
While the final form of the Directive itself has now been agreed; it leaves the detail relating to a large number of important issues to be clarified in further guidance, detailed rules or technical standards which have yet to be published by the Commission or ESMA. In addition there is the opportunity during the two years to influence the implementing legislation. The lobbying activities are as important now as they were before the Directive was issued to ensure that a sensible interpretation is reflected on all key issues.
The European Parliament has approved the Alternative Investment Fund Managers Directive, so what next?
The Directive is currently in the process of being translated into the various EU languages, after which it will enter into force. Each member state will then have a period of two years in order to pass domestic legislation implementing the Directive.
Firms should take advantage of the two year period before the Directive comes into force in order to:
- prepare. Identify the implications for the firm, assess the impact of the various provisions and consider the options for compliance, and
- continue, or begin, to lobby. The FSA is already in discussion with relevant industry bodies. Your views may affect the final outcome of the legislation. Contribution to the consultation process is important.
Please contact us if you would like any further information in relation to the Directive, or if you have comments on the Directive that you would like us to feed into the consultation process. We will continue to issue alertswith further updates over the coming months.
The above analysis is only a summary of the Directive. To see the final form of the Directive visit the European Parliament website.