Alternative Investment Fund Managers Directive - an update

Introduction

The Alternative Investment Fund Managers Directive ("AIFMD" or the Directive) creates a European-wide framework for regulating managers  of 'Alternative Investment Funds' ("AIF") (referred to in the Directive as 'Alternative Investment Fund Managers' ("AIFM")) and imposes restrictions on "marketing" AIF to investors in the EU.

AIFMD came into force on 22 July 2011 and must be transposed in each Member State until 22 July 2013, while July 2014 is the deadline for full authorisation for pre-existing AIFMs (12 months from implementation date).

Where are we now?

At this stage in the implementation process, only the high-level rules of AIFMD have been finalised.  More detailed rules are expected in due course consequently there remains considerable uncertainty about how the rules will develop, what additional UK requirements might be imposed and their interpretation.

On November 2011, ESMA published advice to the European Commission on implementing measures following consultations.  On 23 February 2012 ESMA published a discussion paper on the key concepts of the AIFMD and is to publish a proposal on scope in the first half of 2012 and will be working on guidelines on a range of other issues during 2012, including: remuneration, leverage, and third countries.

The Commission produced its formal proposal for discussion in dialogue with the Council and Parliament in Q1 2012.  Formal dialogues are to take place in Q2 2012 and adoption of the proposal is expected in July 2012. 

On 23 January 2012, the FSA published DP12/1 Implementation of AIFMD (deadline for response was 23 March 2012).

Scope

Wide scope

The practical implications of the AIFMD are potentially wide, bringing within its scope fund arrangements which were not previously within the scope of UK regulation.  The AIFMD applies to any legal person appointed by or on behalf of the AIF whose regular business is managing one or more AIFs.  For these purposes, "managing" an AIF means providing risk management or portfolio management services to the AIF.

An AIF is defined as any "collective investment undertaking" whether open-ended or closed-ended, regardless of domicile:

• which raises capital from a number of investors;
• with a view to investing it in accordance with a defined investment policy;
• for the benefit of those investors; and
• which is not an undertaking for collective investment in transferable securities ("UCITS") fund.

In consequence, an AIF will comprise: hedge funds/funds of hedge funds, private equity funds, listed closed-end funds, real estate funds, infrastructure funds, commodity funds, long-only funds which are not UCITS funds and non-UCITS retail funds.

What is not caught?

The following fund structures will fall outside the scope of the AIFMD:

• single investor funds or arrangements where the asset is owned directly by the participants (as there will be no AIF);
• managed accounts that are not structured as collective investment undertakings;
• securitisation special purpose entities;
• holding companies: companies with shareholdings in one or more other companies, the commercial purpose of which is to carry out a business strategy or strategies through its subsidiaries, associated companies or participations in order to contribute to their long-term value, and which is either a company:
  • operating on its own account and whose shares are admitted to trading on a regulated market in the EU; or
  • not established for the main purpose of generating returns for its investors by means of divestment of its subsidiaries or associated companies, as evidenced in its annual report or other official documents.
• Joint ventures - the term is not yet defined.  A major industry concern is that AIFMD could unnecessarily regulate joint venture investment vehicles where the participants neither want nor need the protections which regulation under AIFMD seeks to provide. The FSA considered in its recent discussion paper (DP12/1) ways of distinguishing a joint venture from an AIF.  One of the possible criteria of a joint venture mentioned by the FSA was where all participants have some involvement in the day-to-day management of the vehicle which would make for an extremely restrictive test.  Another restrictive interpretation would be where a numerical limit was put on the number of investors who could constitute a joint venture.  A better test which was considered by the FSA is where a joint venture is distinguished from a AIF on the basis of whether there is a public capital raising and active marketing of units in the investment vehicle, as a public capital raise is not required when each of the participants are previously known to each other and are entering into commercial arrangements on the basis of that existing relationship.  
• Size exemptions apply where an AIFM assets under management fall below the following thresholds (note: where the de minimis exemption applies, the AIFM remains subject to a registration requirement):
  • EUR 500 million - ungeared AIF's that do not grant investor redemption rights during a period of 5 years
  • EUR 100 million - geared AIFs

Note: there is an opt-in procedure available to AIFs that fall below the thresholds.  This may be attractive to funds that want the benefit of an EU-wide market passport.

Which entity needs to be regulated?

AIFMD regulates the AIFM of an AIF.  Each AIF must have a single AIFM responsible for performing portfolio management and risk management, and for ensuring compliance with AIFMD.  AIFM is defined as a legal person whose regular business is managing one or more AIFs.

The obligations of the AIFMD fall on the AIFM, as manager of the in-scope AIF.  Firms currently with a MiFID licence may be prevented from managing AIF under this licence and may be required to restructure.

Although usually an externally appointed portfolio manager is the AIFM, this is not always the case and it may be appropriate for the AIF to be internally managed and thus itself be its own AIFM in which case responsibility for ensuring compliance with the AIFMD will fall directly on the governing body of the AIF (although an internally managed AIF cannot be authorised as the external manager of another AIF).

Requirements of AIFMD

EU AIFM must be authorised under and comply with AIFMD rules in order to manage or market AIF in the EU (the authorisation requirement also applies to EU AIFMs managing non-EU AIFs even if such AIFs are not marketed within the EU).  An authorised AIFM must do the following:

• retain initial capital of:
  • €125,000
  • 0.02% of the value of the AIF's portfolio value in excess of €250 million, capped at €10 million.
• have professional indemnity insurance in case of successful claims against the AIFM for professional negligence.
• appoint a depositary[1] to carry out functions such as booking payments made by and for investors, safeguarding of the AIF's financial instruments, verifying that the AIF has ownership rights to those assets it invests in and valuing the shares and assets of the AIF in accordance with the applicable national law.  The depositary is strictly liable for any losses to the AIF on assets that it holds, with only minor exceptions in the instance where it has delegated responsibility;
• perform the valuation function itself or appoint an independent external valuer
• comply with rules on conduct of business, transparency, delegation of functions,  leverage (gearing), outsourcing (delegation), conflicts of interest, risk management, capital requirements under the Capital Adequacy Directive, liquidity management, valuation, remuneration and marketing shares within the EU; and
• make disclosures to both shareholders and the home regulator.  This occurs in the application phase and on an on-going basis.  When applying to be an authorised AIFM, it will be necessary to disclose, amongst other information, shareholders over a certain threshold, remuneration policies, delegation agreements, investment strategies for the fund and depositary arrangements.  The home regulator is permitted to refuse the application for authorisation.

The rules on remuneration have proven particularly contentious.  Measures include limiting guaranteed bonuses and requiring substantial proportions of pay are allocated on a deferred basis.  Payment of carried interest to employees remains a complex area, although the directive appears to exclude from the rules on remuneration any share in profits of the AIF that the AIFM should receive due to investment into the AIF. 

The requirement on an AIFM to disclose interests in an EU registered company's shares will largely impact private equity fund managers.  For unlisted companies, there are a series of percentage thresholds for shareholdings that once reached will require the AIFM to inform its regulator.  If the AIFM gains control of a listed or unlisted company, then all other shareholders and the regulator must be notified, and the AIFM should request the directors inform the company's staff. 

'Asset stripping' restrictions provide that an AIFM cannot vote in support of a controlled company issuing a distribution (including dividends), or undertaking capital reduction, share redemption or purchase of own shares within two years of the takeover.  Dividends paid out of distributable profits are allowed so long as certain balance sheet requirements are met.

An AIFM is permitted to delegate management functions.  However there is a prohibition on delegating so much of the AIFM's function that the regulated AIFM would be deemed a 'letter box' entity, whilst crucial decision making was made by an unregulated entity.  This may require additional restructuring measures for existing fund/ fund manager structures to ensure compliance with the Directive.

Non-EU AIFMs

AIFMD distinguishes between EU AIFMs and non-EU AIFMs:

• EU AIFM - AIFM which has its registered office in a Member State of the EU; and
• Non-EU AIFM - any AIFM which is not an EU AIFM.

Non-EU AIFMs cannot obtain authorisation unless and until the European marketing passport is granted to Non-EU AIFMs in 2015.  Until such time a non-EU AIFM will only be caught by minimal parts of the AIFMD (annual report, disclosure to investors and reporting to regulators) if funds are marketed in the EU pursuant to existing private placement regimes.

Marketing

Marketing is defined as a 'direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM'in relation to an AIF under management.  Reverse inquiry/passive marketing are not currently caught by the AIFMD.  One way of testing whether the distribution of an AIF is within the scope of the Directive is by determining who initiates the marketing.  The AIFMD does not, however, provide any specific details or a test to determine who has initiated an investment transaction.

An EU AIFM can apply to become authorised to obtain the EU AIF marketing passport from 22 July 2013 (and must be so regulated by 22 July 2014).  This passport permits an EU-AIF to market the AIF to professional investors throughout the EU.  'Professional investor' takes its definition from MiFID's 'professional client'.

National private placement regimes will remain in place for non-EU AIFs (but not for marketing of EU AIFs managed by an EU AIFM to professional investors) at least until 22 July 2018. A non-EU AIFM will be able to benefit from such provisions provided that:

• the provisions of the AIFM Directive dealing with transparency (articles 22-24) and, where applicable, control of unlisted companies (articles 26-26) are complied with;
• appropriate co-operation arrangements are in place between regulators;
• the third country where the AIF or the AIFM is domiciled is not listed as Non-Cooperative for AML purposes; and
• any other national conditions are met.

Although EU AIFMs will also have an option to rely on national private placement regimes when marketing non-EU AIFs in the EU they will still need to comply with all the requirements of the AIFMD except the need for a depositary so such reliance is unlikely to be commercially attractive.

However, from 22 July 2015 certain non-EU AIFMs may also be able to market non-EU AIFs within the EU pursuant to a marketing passport provided that:

• the non-EU fund manager is "authorised" by an EU "member state of reference";
• the non-AIFM complies with all the provisions of the AIFM Directive;
• there are appropriate co-operation arrangements in place between the regulators;
• the third country is not listed as Non-Co-operative for AML purposes; and
• the third country has signed the OECD Model Tax Convention Agreements. 

During 2015-2018, the national private placement regimes will, subject to individual Member State discretion, continue in parallel to the EU passport.

Marketing: what could happen in 2018?

There is a possibility that the national private placement regimes will be switched off for non-EU funds from 2018 (can only occur if the EU passport is granted in 2015).

If the passport is granted for non-EU funds in 2015 and the national private placement regimes are switched off in 2018, then EU managers will only be able to market non-EU funds to EU investors with the passport and in full compliance with the AIFMD.

EU funds and EU AIFM will have a competitive advantage in 8 markets for at least two years (2013-2015) because some EU markets are opened up by the passport to active marketing for the first time (e.g. Denmark, France, Greece, Ireland, Italy, Poland, Slovenia and Spain). However, the national private placement regimes are the current status quo and might continue indefinitely so re-domiciling into the EU may be unnecessary.  Further, passive marketing/reverse solicitation, for now at least, continues to be allowed in those 8 markets.