Alternative Investment Fund Managers Directive

Alternative includes mainstream, right?

Originally published in the May/June 2009 issue

The European Commission’s draft Alternative Investment Fund Managers Directive (Directive), published on 30 April 2009, has been greeted with criticism from many including the hedge fund industry, the private equity industry and the quoted investment company industry. It has been described as “disappointing”, “protectionism” and “not a proportionate response to any of the identified causes of the current crises” which is not surprising given the rushed nature of its publication, the lack of consultation and the overt political pressure. The Directive seems to conflict with the comments made in the de Larosière Report and the UK’s Turner review. This Directive has been hastily prepared and if implemented in its current form it is quite feasible that the outcome may prove to be unworkable regulations that stifle investment and market access at a time when they are needed most.

Who and what does it cover?

Any legal or natural person whose regular business is to manage one or several Alternative Investment Funds, or AIFs, that is any collective investment undertaking that is not a UCITS), is defined as an Alternative Investment Fund Manager (AIFM). Any AIFM providing management services in the EU with assets under management (this definition is yet to be fully explained) in excess of €100 million will need authorisation from their home member state and will be subject to ongoing requirements. This will include hedge funds, fund of hedge funds, private equity funds, real estate funds, infrastructure funds, quoted funds, long-only funds that are not UCITS funds and even UK non-UCITS retail funds (NURS), notwithstanding that NURS are FSA authorised.

So unless their business is confined solely to managing UCITS funds or funds which are based outside the EU and not marketed in the EU, for whom there is an exemption, every UK fund manager will be affected. The only other major exceptions are divisions of banks, insurance companies or pension funds, and it is unclear whether their exclusion is only for their own account investments.

The reality for asset managers is that this relatively low threshold, despite the Commission’s suggestion that this will cover approximately 30% of hedge fund managers for example, would mean that a very large number may be caught, especially as the threshold covers AIF assets under the management of EUmanagers in both EU and non-EU domiciled funds and applies across a corporate group. Whilst on the face of it, private equity has managed to swing a concession, as if an AIFM is not using leverage and has a five year lock-in period for its investors, a higher threshold of €500 million will apply, the exclusion of leverage, aggregation and the marketing restrictions may make this concession of limited value.

More startling than perhaps the effect for hedge funds is the impact for quoted investment companies. This again is evidence of the hurried nature of the Directive. For example, it would require AIFs to have a liquidity policy and an independent valuator calculating values of shares or units even though there is no real benefit in having these if a fund is closed-ended and in any event the shares are exchange traded. It requires self-managed investment trusts to have an authorised AIFM thereby failing to recognise the position of their Board and the transparency that arises through the listed company structure.

Also there will be extensive additional disclosure obligations applying to fund managers with voting rights of 30% plus in any company but a small or medium sized enterprise, which appears unfair when these rules do not apply to any other type of owner, including sovereign wealth funds and institutional owners such as insurance companies and banks

Also of note are pre-clearance requirements for delegation by an AIFM, including a requirement that any delegated portfolio manager should be an AIFM itself, which would be a problem for multi-managers and global funds.

How will it work?
All AIFMs operating in the EU will be required to demonstrate that they are suitably qualified to provide AIF management services. “Management services” is defined as “managing and administering”. Both terms are unclear but it suggests overall responsibility for the fund. They will have to disclose to regulators detailed information on the planned activity of the AIFM, the identity and characteristics of any AIF managed, the constitutional documents and governance of the AIFM (including arrangements for the delegation of management services), the internal arrangements with respect to risk management, the arrangements for the valuation and safe keeping of assets, the audit arrangements and the systems of regulatory reporting. Changes to key information, particularly on the AIF managed and their constitutions, will be subject to a one month prior notification and clearance process by the AIFM’s regulator.

An authorised AIFM must report to its competent authority on a regular basis on the principal markets and instruments in which it trades, principal exposures, performance data and concentrations of risk. In addition, it must notify the competent authority of the identity of any AIF managed, the markets and assets in which the AIF will invest and the organisational and risk management arrangements established in relation to an AIF.

One thing of note here is that an AIFM will be obliged to ensure that each AIF that it manages appoints an EU credit institution as a depositary of its cash and other assets. The depositary may delegate its tasks to other depositaries which, on the face of the draft, must also be an EU credit institution. It seems rather ironic that the one entity the Commission requires AIFs to lodge their money and assets with, the bank, is the entity at the root of the current economic crisis and also appears to be excluded from the requirement for authorisation under this Directive. It is questionable why an authorised custodian who has not demonstrated any of the ‘systemic’ concerns surrounding those performing a ‘maturity transformation’ function is no longer deemed to be an appropriate safe place. Extended obligations are imposed on depositaries, some of which they will not be allowed to exclude.

A non-EU domiciled AIF may delegate to a depositary in the same domicile (subject to certain conditions). The depositary provisions seem to ignore not only the current market practice of a hedge fund maintaining a relationship with a prime broker, as the majority of the principal prime brokers are not established in offshore centres such as Cayman and many are not EU incorporated credit institutions either, but possibly also normal global custody arrangements involving a range of sub-custodians around the world.

Some AIFMs may find that they have to increase their regulatory capital significantly. The Directive imposes a minimum capital for AIFMs of the higher of €125,000 and a quarter of their annual fixed expenditure. Additional capital is required if the assets under management exceed €250 million, namely an amount equal to 0.02% of the amount by which the value of the portfolios of the AIFM exceeds €250 million. No indication has been given as to how to calculate the value of portfolios for this purpose and the threshold now appears to be at odds with the other de minimis levels.

The interaction between this Directive and the Markets in Financial Instruments Directive (MiFID) is most unclear. All funds, however simple and even if they meet all the “non-complex criteria”, will be classified as “complex” instruments which cannot be sold on an execution only basis. In addition, there is a statement in Recital 5 of the Directive, that MiFID firms will only be able to provide investment services “in respect of” AIFs which are approved for marketing under this Directive, which, depending on its interpretation and implementation, could cut the client base of other European investment firms very significantly, prevent placing services and restrict those structures where there is only an adviser or discretionary manager in Europe.

So what is in it for you?
‘Authorisation’ as an AIFM will entitle the manager to market an AIF (domiciled in Europe) to professional investors only (as defined by MiFID) in the EU by way of an EU Passport. In some countries this would be a significant extension. In most it is little more, or even less than, existing private placement exemptions. Marketing to the retail sector, including HNWIs who cannot meet the MiFID “opt up” tests, is left to national regulation, subject only to a non-discrimination obligation.

Three years after the rest of the Directive comes into force an EU Passport will be provided for marketing non-EU AIFs and also authorising for that purpose non-EU based AIFMs, but only if they are determined by the EU Commission to comply with stringent requirements on equivalent regulation, supervision and cooperation which importantly and politically includes tax matters! This appears to deal with the offshore tax disclosure issues via the back door. This delay (even assuming its conditions will ever be met) does seem to place those outside the EU at a competitive disadvantage; for the intervening three years national laws will apply and some jurisdictions do not currently allow AIFs other than listed investment companies to be marketed at all.

What should you do now?
The Directive has been presented on the basis that it involves regulation of fund managers, not of funds. This is doubtful. In fact not only does it require extensive information to be provided in advance to regulators about each fund at authorisation, before any subsequent changes and prior to marketing (all of which will be a problem for those who create genuinely negotiated structures for professional investors who are not inclined to wait a month for a regulator to consider it), but also there are a number of provisions which point to product regulation either in the Directive itself (naked short selling and overall leverage level) or in implementing provisions, notably through powers to make more detailed rules on risk management and liquidity and limits the types of securitisation instruments that funds could invest in.

The Directive has now to be sent to the European Parliament and the European Council, where it is expected that it will be the subject of “intense political discussion and negotiation”. Now is the time for you to influence these discussions by expressing your views and lobbying where possible. In addition, you should be encouraging your professional investors to lobby too as all of the requirements described above will impose costs which will inevitably be charged to funds and reduce returns and they may also find more difficulty in accessing non-EU funds.

If the Directive receives political approval by the end of 2009, which the Commission says it is seeking, it could come into force in 2011. In practice it is likely to take longer, though the political pressure behind it should not be underestimated.