Background – What Has Happened?
During November and December, the UK Financial Services Authority (“FSA”), the European Commission and the European Securities and Markets Authority (“ESMA”) all published important documents as part of the implementation of the Alternative Investment Fund Managers Directive ("AIFMD"). The FSA published part one of its two part implementation consultation paper containing the UK’s new draft rules (the “FSA CP”), the Commission published its Level 2 implementing Regulation (the “Regulation”) that contains much of the detail for the directive, and ESMA published two consultation papers on the interpretation of key terms in the directive (the “CPs”).
Although we are still awaiting the publication of further material, not least from the FSA, the UK Treasury and ESMA (on remuneration), there is now sufficient published material available for firms to make substantial progress on their implementation programmes. This client alert is therefore intended to give general guidance to firms on how they may implement the requirements, rather than merely a discussion of the directive’s requirements.
The Definition of an AIF
Clearly, this is the starting point. The directive only applies to the extent that any firm is managing an AIF. Although it is usually obvious whether the arrangements constitute an AIF, there is some difficulty surrounding joint ventures and property investment firms. The Regulation does not address this issue, and, although various property firms and their representatives asked ESMA to do so, the current CPs do not do so either.
This leaves only the FSA CP and the distinction it appears to draw is between, on the one hand, commercial enterprises and arrangements where investors have some form of management control over strategic decisions (which will not be AIFs) and investment vehicles where investors have a passive role (which probably will). In the property world, where individual transactions and club deals are common, this point will be of considerable importance. Only if investors have some form of involvement in the joint venture partnership will firms be able to say that the investment vehicle is not an AIF.
Article 61 of the directive contains an important, but little commented on, transitional provision of one year for all firms that are currently managing AIFs. Although this provision is clear that firms will have one year from July 2013 to obtain the relevant authorisation from the relevant regulatory authorities, it is unclear whether the transitional provision was intended to exempt firms from the other provisions in the directive as well. The FSA CP appears to suggest that the transition provision gives a blanket exemption for a year, and both the Commission and ESMA have so far not commented on this point. It is possible that the FSA’s feedback statement will retreat somewhat on this, and firms should be prepared for this possibility and should continue on the assumption that the provisions will apply with effect from 2013, not least because firms without such an authorisation maybe restricted in their marketing rights in other European countries.
The FSA has also stated that it will not accept applications for variations of permission before July 2013. This is slightly odd since it means that firms will not be able to exercise their passport rights until the applications have been granted (at least three months says the FSA). We hope that the FSA will show more flexibility on this point.
Firms that manage AIFs that have assets, in total, of less than EUR100million (leveraged) or EUR500 million (unleveraged) do not need to comply with the full requirements of the directive. They will, though, still need to register with the FSA and, under the Regulation, constantly monitor the assets to ensure that the limit is not breached. If it is breached temporarily (less than three months), the exemption will continue to be available, but firms will need to explain this to the FSA. We are still waiting for the Treasury to decide whether it implement this optional exemption or will require managers of small funds to comply with all the provisions of the directive.
OBLIGATIONS ON MANAGERS
Firms need to calculate leverage for various reasons: (i) to use the size exemptions, above; (ii) each AIFM must set a maximum level of leverage for each fund it manages; (iii) actual leverage must be disclosed to investors and regulators; and (iv) AIFMs must have a leverage policy for each AIF they manage.
Leverage is defined as, broadly, any structure intended to increase the exposure of the AIF. This would include, for example, borrowing at the level of a propco in a real estate fund, although would not include general day-to-day commercial borrowing of a trading company in a private equity fund.
Leverage is calculated as the ratio between the exposure of the AIF and its net asset value on both the gross method and the commitment method. The former includes all exposures, without netting, except for cash and near-cash holdings. The latter allows for netting positions, although the conditions for netting are strict so firms should be careful to ensure that commercial hedges are actually allowable for these purposes.
ESMA has originally proposed a third method of calculation: the advance method. This has not been included in the Regulation.
Capital/Professional Indemnity Insurance
The directive requires AIFMs to hold a minimum capital of 0.02% of assets under management, subject to a minimum of EUR125,000. In addition, AIFMs will need to maintain either an additional 0.01% of assets under management to cover professional liability risks or take out a PII policy from an insurer that covers, for each claim, at least 0.7% of the portfolios managed.
The Regulation contains little that the industry is not familiar with as a result of MiFID as implemented in the UK. The Regulation will require AIFMs to maintain policies and procedures to deal with the following.
- The prevention of malpractice within the AIFM.
- Due diligence on investments to ensure that they are compliant with the AIF’s objectives.
- The payment or receipt of inducements.
- The handling of subscription and redemption orders.
- Conflicts of interest.
Two new points are worth noting, however:
- AIFMs will need a best execution policy where “relevant.” The Regulation goes no further than that, but the original ESMA advice to the Commission on this point should still be applicable. It says that best execution is not relevant where the AIF invests in “real estate or partnership interests and the investment is made after extensive negotiation on the terms of the agreement.” The AIFM should still be able to demonstrate to the regulatory authorities, however, that there is no choice of different execution venue.
- The Regulation contains a new provision in relation to investments of limited liquidity (Art 19): AIFMs will need to prepare a “business plan” in relation to those investments, updated for minutes of relevant meetings and the preparation of documentation as well as economic and financial analysis conducted for assessing the feasibility of the project. This will be important for PE and RE funds in particular.
Risk management procedures are at the core of the directive’s requirements. Firms will need to:
- Implement a risk management function that is functionally and hierarchically separate from the business units. This means, in practice, that the members of the unit must not be engaged in, or supervised by anybody engaged in, the manager’s “operating units” (i.e., the investment managers).
- Consider carefully what exactly risk management constitutes in these circumstances since managers would normally say that investment management includes risk management.
- Draft a risk management policy identifying risks faced by each AIF and how they will be managed and setting various risk limits. This policy will be reviewed by the FSA.
Managers will be required to operate adequate liquidity management systems and to demonstrate their adequacy to the FSA. Managers also will be required to assess the risks posed to the liquidity arrangements for each substantial new investment and to impose specific liquidity limits for each AIF that it manages.
This requirement does not apply in relation to AIFs that are unleveraged (see above) closed ended funds. It is worth noting that the ESMA’s CP proposes that an open-ended AIF must have redemption rights at least once per year.
The organisational requirements under the directive and the Regulation will be familiar to firms authorised by the FSA: the establishment of proper management charts, personal account dealing restrictions and the recording of portfolio transactions. The Regulation, however, does permit firms not to establish internal audit functions or separate compliance functions where the nature, scale and complexity of the business do not warrant it. This will be useful for small managers, but such managers must expect close questioning from the FSA in such a case.
Managers currently value funds they manage, so this requirement will be largely familiar. Some specific points:
- The manager will be responsible to the AIF for valuation and cannot disclaim liability for its errors.
- Third-party valuers may be appointed, but the restrictions imposed on them and the liability that they must undertake suggest that few third parties have so far indicated any desire to undertake this role.
- Valuers within the manager must be independent from those carrying out the investment management function.
Managers frequently delegate activities to third parties that have relevant experience, and this will continue to be permitted under the directive. However:
- The manager must supervise the delegation effectively. This means the structure that some UK firms have adopted of using an FSA-authorised operator to carry out just administrative activities will not be permitted post July, since such an “operator for hire” is unlikely to be able to monitor the portfolio manager properly.
- Prior FSA approval will be required for the delegation, and specific regulatory approval will be needed if the investment manager delegate is not authorised. This may be relevant in the RE funds context where an investment manager may well not be authorised as property is not an investment.
- Delegation is not permitted where it is so extensive that the manager is merely a “letter box entity.” The Regulation gives guidance on this and includes, as an example of a letter box entity, where the delegation of investment management functions is “to an extent that exceeds by a substantial margin the investment management functions performed by the AIFM itself.” This means that offshore managers that use onshore advisers/managers will need to consider this carefully to ensure that the manager for the purposes of the directive doesn’t become the UK entity.
From July, managers will need to ensure that a single depositary is appointed for each AIF it manages. The only practical exception to this requirement is non-EU funds managed by non-EU managers that are promoted via the private placement exemption (i.e., not the passport when that becomes applicable). Some general points about the depositary:
- The depositary must be a credit institution or MiFID investment firm (or similar third country entity). An important exception is for AIFs with no redemption rights in the first five years and that invest in either assets not held in custody or, broadly, private companies. For these funds, managers may appoint other entities specifically authorised for the purpose. It remains to be seen, though, whether many such firms will exist.
- The depositary (or relevant branch of the depositary) must be in the same country as the AIF.
- The obligations of the depositary are extensive, including cash flow monitoring, asset safekeeping and other oversight duties. These responsibilities will mean that the depositary will need to undertake significant due diligence into the manager and its activities.
- The depositary may not exclude liability for loss of investments except in extreme cases. Whilst this does not directly affect the manager, it will presumably have cost implications and mean that a depositary is likely to monitor the manager’s activities closely.
All of the above suggest that the process of appointing a depositary could be a time consuming one. Managers who have not started this process should do so soon.
The Regulation has nothing of substance to add to the provisions of the directive on marketing. This leaves the position, broadly, as follows:
- EU AIFMs may market EU funds to professional investors in any member state under a Europe-wide passport. It seems, though, that this passport will not be available for managers in the UK until the autumn unless the FSA relaxes its refusal to take applications before July.
- EU managers may market non-EU funds under local private placement regimes provided that they comply with the directive’s requirements other than certain depositary requirements.
- Non-EU managers may market non-EU funds under the private placement regime subject to the information disclosure requirements.