- Alternative Investment Fund Managers Directive
- November 30, 2010 | Authors: Walter R. Henle; Allan G. Murray-Jones; Ezra Zahabi
- Law Firms: Skadden, Arps, Slate, Meagher & Flom LLP - Munich Office ; Skadden, Arps, Slate, Meagher & Flom LLP - London Office
The funds industry now has a final text of the European Alternative Investment Fund Managers Directive (“AIFMD” or the “Directive”). A number of the uncertainties which arose from previous drafts have been resolved. Taken in the round, some of the worst fears of the industry have not been realised (our earlier note was titled “Keep Calm and Carry On”).
Having said that, the Directive is a very odd, political piece of law making. Some of the concerns evidenced by the Directive seem to be misconceived, and there still remains remarkably little evidence that funds contributed (in a way which would be dealt with by this Directive) to the global financial crises of 2007 - 2009, the aftermath of which we currently live through (at least, we hope it is the aftermath). The nearest we have had to frank recognition of that has been a speech by Lord Turner, chairman of the UK’s Financial Services Authority, in relation to new rules on remuneration for the financial services sector. Lord Turner said that whilst there is little evidence that hedge funds contributed in a fundamental way to the downturn, hedge funds are a significant and growing influence and might cause disruption in the future.1 A preamble to the Directive states the opposite (that the activity of funds spreads or amplifies risk), although we are not aware of any of its advocates providing convincing evidence of this (and in some ways “spreading risk” is desirable). In short, this is not a logical basis for comprehensive legislation. There is a reasonably clear intention to demonstrate that, in this matter at least, the EU can lead the world so, in the eyes of some, acting might be more important than getting it right.
As set out below, the AIFMD covers a wide range of matters, some controversial, some not. In some areas it takes a very broad brush approach; in others it descends to considerable detail. Those who are familiar with the English language versions of European directives (the official EU languages for directives are English and French) will not be surprised to find some of the language to be close to impenetrable (although a final version tidied up by the EU jurist-linguists is expected to offer a slightly improved version). Whilst the actual laws which will bind fund managers will be those made by individual countries to implement the Directive there remains, as with all European directives, a scope for the European Court of Justice to turn its eye to the detail which tends to result in more expansive, rather than less expansive, domestic legislation. In addition, the EU Commission will be responsible for more detailed technical provisions in some areas covered by the Directive. So, in short, things could yet become more complicated.
This note is intended as an overview to highlight some areas we think will be of concern to clients. Although the note does not go into detail due to restrictions on the available space we will be delighted to assist clients seeking further detail.
As set out in our earlier note, an “Alternative Investment Fund” (“AIF”) is virtually any collective investment undertaking, whether corporation, partnership, trust or other, designed to give investors the benefit of access to investments. The Directive focuses on rules for managers of AIFs which also captures self-managed AIFs, e.g. those in corporate form (“AIFMs”). There is an exclusion for “holding companies” (i.e., normal conglomerates), but many forms of investment (e.g., listed property companies) which one might not normally think of as “funds” will be caught. This has led to the “one size fits all” approach that has been criticised by the funds industry, although in some aspects the final text is an improvement of previous drafts.
The role of the new European Securities and Markets Authority (“ESMA”), in the process of being created by the European Union, will be significant, as it will apply or disapply certain provisions of the Directive and make more detailed proposals for regulation. Notwithstanding that ESMA is to be headquartered in Paris, capital of one of the more interventionist states and one whose politicians have been extremely critical of the funds industry, it is likely to be made up largely of experienced staff from existing national regulators, and there is no reason to fear it. Getting debates to a technical level with experienced regulators can only be a good thing.
The Directive will take effect in individual EU member states as they adopt the necessary laws to implement the Directive, and is intended to be effective across the EU from early 2013 when all EU member states are required to have implemented it.
Some of the earlier drafts of the AIFMD were fiercely Eurocentric and discriminatory against non-EU fund managers, effectively blocking access by European investors to non-EU funds, leading to widespread complaints among the European institutional investor community and intervention by, amongst others, the US Secretary of the Treasury. The finalised regime is more helpful.
It is clear from the recitals to the Directive that it is not the intention to prevent EU institutional investors from investing in non-EU funds which are not actively marketed in the EU.
Initially, non-EU funds may be marketed to professional investors in EU countries, in compliance with the laws of individual EU member states, subject to compliance with some broad provisions relating to regulatory cooperation agreements being in place with the regulators in the relevant EU member states, the jurisdiction of domicile of the non-EU AIF not being a FATF “blacklisted” country and compliance with certain rules (primarily those referred to under “Asset Stripping,” “Transparency” and “Control of Companies” below). This is what observers are calling the “private placement regime.” It is not compulsory for EU members to permit private placements.
From 2013, EU fund managers will be able to benefit from passport provisions, so once a manager is approved in one country, they will be able to market appropriate products into all other EU countries. Subject to the views of ESMA, the passport provisions may be available for non-EU fund managers after 2015, but if they are the private placement regime will eventually be lost (three years after the adoption of the passport regime for non-EU managers). In that case, non-EU funds marketed inside the EU, even to large institutions, will have to be fully compliant with the AIFMD, subject to minor exceptions.
In our first comments on drafts of the AIFMD, we noted that non-EU fund managers may, in the future, wish to consider splitting their funds into two parts, one for investors outside the EU and one for EU investors. That still seems to us to be a sensible precaution, particularly for funds which might still exist in or after 2018. That said, non-EU fund managers are likely to benefit from the fact that by the time they must be fully compliant with the Directive for funds marketed in the EU, many of the inevitable teething problems will have been ironed out.
It is worth stressing again that the AIFMD does not restrict non-EU funds entering into transactions in Europe, subject to existing laws which may require European affiliated managers (or sometimes advisers) to be appropriately authorised.
The remainder of this note addresses issues which are primarily relevant, initially, to EU funds managers.
One dramatic change, to which the Madoff scandal clearly contributed, is the need for funds to utilise depositaries. The depositaries themselves will be much more than mere custodians of assets. They will, for example, be responsible for verifying cash flows to and from fund investors.
This remains a difficult part of the Directive and the one most likely to cause major additional expense (and may verge on the impractical). Whilst the strict liability for depositaries in the earlier drafts of the Directive has been modified, a depositary will be liable for loss caused by assets held by an AIF being lost or non-existent or any failure to comply with its duties unless it can demonstrate that no reasonable depositary could have prevented the loss. This is quite a high standard, very near the original strict liability. The Directive permits the depositary to delegate some of its depositary functions to a suitable third party for proper reasons and under appropriate monitoring arrangements, and it is technically possible to transfer liability for breach of custodial duties (but not other items for which the depositary remains liable), provided that the AIF or AIFM have sufficient recourse to such sub-depositary and the sub-depositary has agreed to such transfer of liability. Depositaries will have many material responsibilities. Existing custodians have been very critical of the AIFMD, and how far they will feel able to accept these significant additional responsibilities is unclear, as is the level of additional costs. At a minimum, persuading a depositary to work with a new funds manager may be difficult enough to create a barrier to entry.
Particularly for private equity and real estate funds, an interesting issue will be which assets have to be held by the depositary. If, as many of them do, they invest in private equity investee companies or properties via a holding structure in Luxembourg, which assets will have to be held by the depositary? Will it be the shares in the Luxembourg company, or the assets which it in turn acquires, which need to be held by the depositary? On the face of the Directive, the assets belonging to the fund itself, being the shares in the Luxembourg holding company, will need to be held by the depositary. If this is the case, the role of the depositary might be less onerous than feared so it will be interesting to see how individual countries legislate in due course. One can imagine depositaries being extremely reluctant to become, for example, the registered owners of real estate assets.
Remuneration of Staff
All AIFMs caught by the Directive will have to apply appropriate remuneration principles, of which 17 (not all of which could conceivably be seen to be appropriate for most funds) are set out in the Directive. AIFMs need to comply with the principle in a way which is appropriate to their size, internal organisations and the nature, scope and complexity of their activities.
The key principles require that remuneration policies are consistent with and promote sound effective risk management and do not encourage risk-taking inconsistent with the risk profiles, fund rules or instruments of incorporation of the funds the AIFM manages. They must be in line with the business strategy, objective, value and integrity of the AIFM and its funds (or their investors) and include measures to avoid conflicts of interest. More detailed technical requirements set out in the other principles broadly mirror the regulatory parameters on remuneration practices of certain regulated firms set out in the Third Capital Requirements Directive which came out in 2010.
Broadly, one would expect that private equity houses will be able to work within the remuneration rules without too much difficulty. Many hedge fund managers will find them onerous, and much will depend on material legislation implementing the Directive. In the UK at least, some hedge fund managers seem confident they can operate within similar rules applicable more generally to firms within the financial services sector.
When the European Parliament announced the legislation, it noted with apparent pride that it had acted to prevent asset stripping. Asset stripping is defined as a situation where if a fund (or funds) has or have control of a company and, within 24 months after gaining control, it allows distributions which reduce the net assets of the company to less than one half of subscribed capital or exceed, in effect, accumulated profits. It is unlikely that many funds are involved in asset stripping in this sense, and equally unlikely that the provisions in the Directive would effectively prevent the activities of those funds that are. An AIFM could transfer the assets of an investee company to cash, which would not breach the Directive, and then sell the company concerned as a cash box to a non-AIFM purchaser who could, if necessary, wind the company up. That said, these provisions (which were added at the last minute and never exposed to public scrutiny) could be a trap for the unwary. If a group is acquired do the restrictions apply to distributions by one group company to other group companies? If they do, otherwise non-controversial internal reorganisations may be caught. Could a consortium trip over the rule if it divides up a group into separate companies to be transferred to separate consortium members? There may be other unintended consequences so the details of the implementation legislation will be critical.
There is no space in this note for the detail of all the AIFMD provisions. However, in passing we would mention the following:
Leverage - AIFMs will have to establish reasonable maximum levels of leverage which their AIFs are allowed to utilise in advance. Care will be needed in drafting these limits (for example, one would need to avoid a fall in asset values triggering a need to deleverage when no funds are available to do it and asset prices depressed). There are no external leverage restrictions, although these can be imposed by national authorities, and ESMA may advise on this.
Conflicts - AIFMs are required to structure themselves to avoid conflict, and those conflicts that are “unavoidable” have to be disclosed and structures devised to deal with them. The legislation contemplates, for example, a conflict between two separate funds managed by the same manager.
Honesty - AIFMs have to behave honestly and with integrity and treat investors fairly. There is also a requirement to respect the “integrity of the market.” Some of this may be clearer when the European Commission develop rules to assess whether AIFMs are compliant.
Delegation - AIFMs may delegate some of their functions to suitable third parties for proper purposes, provided the relevant regulator has been notified and the delegation arrangements permit effective monitoring. Sub-AIMFs and their delegates must be properly authorised in the EU or in an equivalent jurisdiction or approved by the relevant regulator. Sub-delegation with the consent of the AIFM is permitted, subject to the same conditions. The AIMF’s liability to the AIF or investors will not be affected by the delegation or sub-delegation of any of its functions.
“Control” of Companies - as funds acquire more shares in private companies there will be requirements to disclose those acquisitions to regulators (more stringent controls already exist for disclosure of stakes in listed entities). In addition, once 50 percent control is reached, there will be a need to disclose intentions for the future business of the company, including consequences for employees, of which employees will have to be informed, and there will be annual reporting requirements. Such information will be required to be provided to the regulators, the company and shareholders, and to the employee representative/ the employees.
Transparency - there are detailed provisions for reporting, to both investors and national authorities. The information returns are clearly an additional burden (indeed, the Directive contemplates that they may produce too much information for regulators to deal with and makes provision to reduce the burden), but AIFMs ought to be capable of compliance in this area without too much stress. There are also provisions for the minimum contents of information memoranda for fund marketing.
Valuation - AIFMs are required to arrange the valuation of fund assets at least once per year and provide information to investors on valuation per unit which, in practice, is not straightforward for funds employing a limited partnership structure with carried interest based on performance. Valuations can be done internally, so most European funds, which already have to produce annual audited accounts, will not have to change practice very much. Ultimately, AIFMs will be responsible for the valuations.