Q&A with Iain Cullen, Partner, Simmons & Simmons

Getting to Grips with the incoming AIFM Directive

Originally published in the December 2010 issue

In November, the European Parliament voted heavily in favour of the Alternative Investment Fund Managers Directive (AIFMD) to regulate hedge funds and private equity funds on a pan-European basis for the first time. MEPs adopted the rules by a vote 513 to 92. The formal vote on 11th November brought to a close nearly two years of debate between parliamentarians, European Union member states and the European Commission.

The new rules will introduce capital and disclosure requirements on managers of alternative investment funds but will also deliver pan-European marketing rights to approved fund managers within the EU. Later, funds outside the EU will have access to the pan-European market in exchange for meeting several conditions.

The legislation marks a substantial change from the proposals originally introduced. But it is certain to increase the costs to investors. British MEP Sharon Bowles, chair of the parliament’s economic and monetary affairs committee who was heavily involved in the negotiations, terms the legislation “a good result.”

Syed Kamall, a London MEP, and the lead member on the Directive for the European Conservatives and Reformists group, is greeting the new rules with a degree of caution. He believes they will be costly to Europe’s hedge fund and private equity industries, but notes that funds will also be able to sell across the EU without the individual scrutiny of every member state, thus strengthening the single market.

Hedge fund managers and investors are expressing cautious optimism that AIFMD can be made workable. This view reflects the fact that the initial proposals would have been disastrous for financial institutions, pension funds and fund managers. If the Directive is implemented skilfully it may help promote transparency without closing the market for alternative funds.

The new legislation will help bring some stability to London’s alternative funds sector. But it may also come to be seen as the thin edge of the wedge for Brussels to meddle in financial services industries that are already subject to national legislation. Critics of the Directive note that it emerged out of a spiteful effort from Socialist politicians to make hedge funds and private equity a scapegoat for the financial crisis. After two years of negotiations it is clear that the reform of the alternative fund sector has prevailed over the aims of a minority of politicians who wanted to squash the industry.

Observers note that hedge fund managers have had to put up with years of debate and delay around the Directive. The confusion has made it very difficult to undertake long term strategic planning. Thus there is some sense of relief at bringing an end to the uncertainty. Most managers, of course, are already used to operating in a regulated environment whether it involves the Financial Services Authority or the Securities and Exchange Commission, or other regulators. Thus there is little fear of regulation per se. Instead, managers generally take a pragmatic approach and in this respect the imposition of the Directive will be treated no differently.

There is evidence, however, that managers are only beginning to develop strategies to adapt to the Directive or exploit the opportunities that may be created by its passage. According to a recent poll by PwC, only 2% of private equity, real estate and hedge funds have a plan in place to respond to the AIFMD and its implementation over the next couple of years. Moreover, only 16% have set up a dedicated working group to consider the implications and formulate how they should respond. The poll also reveals that 41% of respondents expect the AIFMD to result in increased management fees and over half of asset managers expect their profitability to be hit by the cost implications of the Directive.

There is also an overall lack of appetite to bring funds onshore, as only 13% of the respondents with offshore funds said they were planning to bring them onshore as a result of the AIFMD. Hedge funds had the most appetite, with a quarter intending to come onshore. This compares with only 6% of the private equity industry and 8% of the real estate sector.

It is clear that the AIFMD is the just the beginning of a significant period of regulatory pressure for the asset management industry. It is thus important for managers to adopt solutions for it which will mesh with the UCITS regime, the Dodd-Frank Wall Street Reform and Consumer Protection Act and other regulatory changes.

In order to get a clearer appreciation of what the AIFMD means for managers, Editor Bill McIntosh spoke with Iain Cullen, Partner, at Simmons & Simmons. Cullen has devoted over two years to the AIFMD, including advising clients and various industry fora on its likely impact. The following is an edited transcript of their conversation.

Q: Hello Iain, and welcome. The European Parliament recently passed the Alternative Investment Fund Managers Directive. It is thus an opportune time to discuss some of the Directive’s implications. First off, Iain, there’s a transition period, with the Directive effectively coming into force over a period of time. Tell me a bit more about how that’s going to operate and how hedge fund managers should deal with it.

A: The Directive will finally be approved by the European Council in January 2011. It will then be translated and published in the Official Journal. Following that publication the two year transposition period will begin which means that it should be around the first or second quarter of 2013 when the Directive has to be implemented in the member states. There are then various provisions that we can discuss later, which will come into force at a future date, in particular, in relation to the marketing of third country funds.

Q: The issue regarding third countries was particularly contentious, I believe. Tell us a bit more about how that’s been resolved.

A: It’s been resolved by a compromise, as is usually the case with European legislation. One of the most recent texts had a provision which allowed non-EU funds to obtain a passport for marketing throughout the EU, immediately, on the Directive coming into force. That drew strenuous objections from the French in particular. And so the compromise that’s been reached is that EU funds will be able to obtain a marketing passport from the first day that the Directive comes into force. However, non-EU funds will have to wait for at least two years, because the provisions allowing them to obtain a marketing passport are suspended for that period of time. They will then only come into force when the European Securities and Markets Authority (ESMA), the new European regulatory authority, gives a positive recommendation, and the Commission then passes implementing legislation, which is not objected to either by the European Council or by the European Parliament.
Subsequently, three years after that, when ESMA, gives another positive recommendation, then the Commission will pass further implementing legislation, and the private placement regime will be switched off. Now, it is not necessarily the case that the passport for non-EU funds will actually come into force, and if it doesn’t, then the ability to switch off the private placement regimes will not exist. That’s an outline of how the timing will work in relation to the marketing issues.

Q: With regard to depositaries, there’s obviously been an introduction of new rules.How is that going to function?

A: The Directive requires that every EU fund have a single depository, and when the passport comes into force, that every non-EU fund have a single depositary. But, until then, to the extent that non-EU funds are marketed by private placement, the one provision of the Directive that they will not have to comply with is that requiring a depositary, although they will have to appoint one or more entities to fulfil certain functions that the depositary would otherwise have to fulfil.

Q: That’s quite a big change, obviously, from how these types of things operate now.

A: It is a partial change in practice. In the current structure used by hedge funds the prime broker or prime brokers effectively act as the depositary. Technically, when the Directive comes into force, prime brokers will still be able to act as the depositary. But they will need to be able to distinguish between their role as depositary and their role as prime broker, to ensure that the conflicts of interest that would otherwise exist can either be prevented or at least managed. That will be a particularly tricky thing for the prime brokers to arrange. My view is that it’s quite unlikely that prime brokers will want to act as depositary, simply because the conflicts of interest are there, and almost impossible, I suspect, to manage.

Q: The Directive also proposes some new provisions on valuations. Could you give us a couple of examples of the most important points concerning this?

A: Currently almost all hedge funds appoint an administrator to value their assets and that appointment is a direct appointment by the fund. The hedge fund manager is not a party to that agreement and is not involved with it, in a contractual sense. The Directive completely transforms this particular structure, despite a considerable amount of lobbying intended to try and prevent that from happening. The Directive now requires the manager itself to take responsibility for valuation. It’s entitled to value itself or it can appoint an external valuer, which must be independent of the manager. But it is the manager that retains responsibility for the valuation. So, in terms of the relationship between the fund, its investors and the manager, it is the manager that’s responsible for valuation. In turn, it is the manager who appoints the valuer, and the valuer is then responsible to the manager in the event of losses.

Q: There’s been a great deal of debate about the use of leverage: what is the AIFMD proposing on this?

A: Those who recall the early days of the Directive will remember that the first draft included provisions which gave the Commission power to set leverage limits for funds. That was not a particularly popular provision and, indeed, it has disappeared in the final version of the Directive. Alternative investment fund managers will now have to set their own leverage limits, which are required to be reasonable, and they need to be able to demonstrate to their own regulator that they can keep to those limits. The only circumstance in which limits can be imposed on a fund, or on the alternative investment fund manager, is in order to avoid disorderly markets or to prevent the build-up of systemic risk, when the regulator can impose limits to remove what it sees as that particular problem. The new EESMA is entitled to give advice to the regulators in any particular member state, when they consider that the regulator should impose limits, but they can’t compel them to. I think the other important point to note is that leverage is not required to be defined by the Commission any longer, although the methods of leverage are. The question of how leverage is calculated is also to be defined by the Commission, but in so-called Level 2 legislation –that’s the implementing legislation – that will be developed over the next two years.

Q: It seems obvious that the Level 2 legislation is going to determine how a lot of the provisions actually work out in practise, and I guess that was always the case, but as you’ve noted there have been great changes from when the legislation was proposed in 2008 to what is now being proposed.

A: That’s true, but the one thing we do have is even more Level 2 measures in the Directive than there were in the first draft. Somebody counted them up recently and I think they came to 72 in total. The devil, in this case, will be in the detail, although the Commission is obliged to consult with the financial services industry in drafting the Level 2 measures, and will involve ESMA, to a considerable extent. And the period over which these measures can be discussed is technically longer than the period over which the first draft of the Directive itself has been discussed, which has taken about 18 months. In theory there are, at least, two years for the Commission to pass what are technically called ‘delegated acts.’

Q: Are you optimistic that when the final provisions are sorted out at Level 2, that we’ll have a piece of legislation that will be broadly workable for the hedge fund industry, both in the UK and elsewhere in Europe?

A: I think it will probably be broadly workable. Arguably, one doesn’t need it, but it is a fact of life. The Directive itself, and hence, if you like, the implementing measures, are going to be considerably better than would have been the case, say, 18 months ago, when the Directive was first published. We will have to work with them, and each hedge fund manager will also have to work with the way in which its own regulator interprets the Level 2 measures. So, it will be just as important to see how the FSA implements the Level 2 measures, as the content of the Level 2 measures themselves.

Q: How difficult, in practical terms, do you think it will be for hedge fund firms in the UK to implement the changes they need to make in their practises to conform with the AIFMD?

A: I think it’s quite difficult to say at the moment. We need to wait and see the ‘delegated acts’ because much of the Level 2 legislation will determine exactly how the Directive has to be implemented and, hence, how existing managers have to restructure their funds. The area that is most likely to be of difficulty is in relation to the depositary provisions. But those managers who decide that they will continue to rely on the private placement rules and thus not have to comply with the depositary provisions will find it easier to implement the Directive, in many respects, than if they manage EU funds and are obliged to implement it and to restructure the funds to comply with the depositary provisions.

Q: Thanks, Iain. It’s clear that the AIFMD is going to have quite big implications for the next few years. I’m sure you’ll be busy helping hedge fund managers steer their way through it, and I really appreciate your explaining to us what is going to be to be required and some of the things that we will have to continue to monitor in the months and years ahead.