The AIFM Directive will add a new compliance burden that is primarily targeted at hedge funds and private equity fund managers in the EU. Despite rigorous debate concerning the overreaching supervision of managers and the fact that it will add to costs, the Directive is an attempt to provide better protection for investors.
On 19th October 2010 EU finance ministers met and agreed the text of the Directive. The following week, the EU Parliament Economic committee provided backing to the Directive, and on November 10th and 11th 2010 the EU Parliament will debate and vote on the Directive. Pursuant to this, the entry force of the AIFM Directive will be in early 2011, and at the beginning of 2013 EU member states will be required to have fully implemented the Directive. Non-EU funds, such as Cayman Funds, will only be able to apply for a “passport” to market funds in the EU in 2015. In the meantime, the implication is that non-EU funds will be able to market their funds in the EU as they do at present; however non-EU managers should expect to be asked to abide by the standards of the AIFM Directive.
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Authorisation of AIFM
The AIFM Directive introduces a key new provision on the authorisation of asset managers which will require a significant increase of the initial capital requirement from (previously) €50,000 to €125,000. For UK-based managers this nearly threefold increase raises the barriers to entry and places a greater burden on the managers; however, this is not necessarily punitively costly either.
It is not clear whether there will be any grandfathering provisions for existing management companies. In addition, a further authorisation requirement is that the head office and registered office of the AIFM should be in the same EU member state. Here, we should be aware of potential tax structuring issues, as well as what this means if the manager is acting as an advisor.
Operating conditions of AIFM
The AIFM Directive will address many aspects of operations and will require new policies and disclosures from managers. Some of these will prove onerous and potentially subject to other European directives.
The main policy will be concerned with remuneration and practices which must be in place for specified categories of staff. This is new for managers and it is still unclear how this will be applied. It may be confusing in particular for UK LLPs.
The Directive is very broad in its application to remuneration (e.g. it will extend beyond risk takers and control functions to any employee receiving a total remuneration that takes them into the same remuneration bracket as senior management and risk takers). The Directive also requires new processes requiring the establishment of remuneration committees made up of members of the management body, but excluding any member performing executive functions.
Managers will also be required to identify and take steps to prevent all conflicts of interest. The Directive does not however provide guidance on what constitutes a conflict of interest, so managers will have to invest time to determine the scope of any conflicts of interest and whether this will affect the fund’s internal operations.
In relation to risk management, the Directive requires that managers must set a maximum level of leverage (for each AIF) and state the extent of the right of re-use of collateral or guarantees. This is good news for the market as it attempts to reduce the risk of a financial crisis reoccurring.
However, specific risk management requirements are vague and will be a cause of much debate as to what the Directive expects for managers to comply. For example, managers will be required to separate risk management from the operating units and perform in-depth risk profile analysis. Here, the question arises as to how these requirements will be enforced. The Directive states that full risk management systems must be reviewed at least once per year but is no more specific.
Additionally, the AIFM Directive requires that, for each fund, the manager must appropriately monitor liquidity risks to ensure compliance with any policy or control systems.
Organisational requirements
The new Directive also requires that managers put in place new systems, notably with regard to valuation. Managers will have to establish how to put in place methods for independent valuation of assets for each fund. Managers will be required to calculate and publish annually the Net Asset Value (NAV) per share/unit of a fund, and they must ensure that valuation is performed either by an external valuer, or internally if no conflict of interest arises.
An interesting point under valuation is that the manager is still ultimately responsible for “proper valuation” of the fund, calculation and publication of NAV. This should help gain clarity on the pricing of existing assets but may increase the liability of the managers.
Delegation of AIFM functions
The Directive seeks to address matters of delegation and creates a degree of responsibility for managers to properly choose qualified and capable third parties. This requirement involves a new onerous task for managers, and managers will have to think at board level as to how they justify selecting providers and on the basis of what types of legal obligations.
With regard to the depositary, the AIFM Directive states the manager must ensure that a single depositary is appointed for each fund. The main role of the depositary is to ensure proper management of cash flows and safe-keep financial instruments and other assets for which it shall bear sole responsibility. An additional and new role required of the depositary is to ensure that any activity pertaining to the fund’s shares or units accords with national law. This may well add a new burden on depositaries although it would not seem to add anything beyond what are standard responsibilities.
A further requirement is that custodian activities can be delegated to a third party, although there must be a written contract in place giving the fund a direct right of action against the third party.
Transparency requirements
In addition to the above, managers will be required to produce an annual report for each fund that the manager manages and/or markets in the EU, as well as regularly report to authorities of the home member state. The new transparency requirement involves disclosure to investors before investing in a fund, and notification of material changes. This is a welcome requirement and likely done by many managers already, although not always a legal requirement.
AIFM managing specific types of AIF
The AIFM Directive includes a new disclosure requirement for managers managing a leveraged fund. Managers must provide home member state authorities with information which will be used to assess the systematic risks of use of leverage which may ultimately be used to impose limits on leverage or other restrictions. This will probably not prove popular with managers, but should be easily available as part of standard risk management monitoring.
Specific rules in relation to third countries
Since non-EU managers only have to apply for a passport in 2015, there is some ambiguity regarding what to do until 2015. Presumably, non-EU managers will be able to continue to market in the EU as they have done to date, under private placement rules.
(i) EU AIFM with a Non-EU AIF
• When managed but not marketed in the EU, the manager must comply with all the Directive’s requirements, except provisions related to the depositary and filing of an annual report. The Directive broadly states that the manager must also ensure that “appropriate cooperation arrangements” are in place. The issue here is that the Directive does not specify the meaning of such arrangements, and therefore managers are left with no guidance regarding this ambiguity.
• When managed and marketed to professional investors in the EU with a passport, the manager must comply with all requirements (except those specific to EU Manager with an EU fund), and ensure that appropriate cooperation arrangements, multilateral tax agreements and anti-money laundering are in place and notifications are submitted to competent authorities.
• When managed and marketed to professional investors in EU Member State without a passport, it is important to note that EU member states may impose stricter rules on the manager in respect of the marketing of non-EU fund investors on their territory. Also, the manager must comply with all requirements, except those provisions related to the depositary, and provide for appropriate cooperation arrangements and anti-money laundering.
(ii) Non-EU AIFM with a Non-EU AIF
Non-EU managers will need to meet a number of requirements, including appointing an EU legal representative to be a point of contact within the EU for regulators and others.
• When marketed to professional investors in the EU with a passport, authorised non-EU managers must comply with all the AIFM Directive requirements, and also ensure that appropriate cooperation arrangements, multilateral tax agreements and anti-money laundering are in place.
• When marketed in EU Member States without passport, member states may impose stricter rules on the manager in respect of marketing of the fund to investors in their territory. Non-EU managers must comply with transparency requirements and ensure that appropriate cooperation arrangements, multilateral tax agreements and anti-money laundering are in place.
Marketing to retail investors
The manager will be allowed to market funds to retail investors, regardless of whether funds are marketed on a domestic or cross-border basis, or whether they are EU or non-EU funds. Accordingly, EU member states may impose stricter requirements in their territory. In addition, the manager must inform the Commission and the EU Securities and Markets Authority (“ESMA”) of the types of retail investors and other information. Here, we do not know whether disclosure of such information should be prior to the marketing or on an ongoing basis.
Implications of the AIFM Directive
The full impact of the Directive will not be clear for many years. Much of the Directive though complete in concept will need to be distilled through European and local country legislation as well as practical application. One immediate implication of the Directive is that it will be more difficult to establish new managers and funds due to the increased upfront and ongoing costs of policies, procedures and disclosures. Though many managers will bear some of those costs, much of the increase will be passed on to investors.
However, while there will be higher costs, investors will benefit from some increased degree of protection and disclosure. The real question is whether this degree of increased protection will be worth the cost to investors and impact on the European industry.
Robert Mirsky is a Partner and Managing Director at Laven Partners with over 13 years’ experience in advising financial services companies, investors and hedge funds. He joined Laven from Ernst & Young where he was a leader in the European hedge funds practice. Prior to that, he established and led Deloitte’s hedge fund practice in the UK.
Jérôme de Lavenère Lussan is the founder and CEO of Laven Partners and has 15 years’ experience within the financial and legal services industry. His background includes acting as a COO of a hedge fund and a financial lawyer at Jones Day.
