By now managers should have determined which of their funds are in scope, whether the firm can take advantage of the sub-threshold regime and how AIFMD applies to their firm. If you have not done so already, then this is the most urgent determination to make. The directive covers all non-UCITS funds, which includes managers of hedge funds, private equity funds, investment trusts, real estate funds and non-UCITS retail funds and allows exemptions from registration as a Full-Scope Alternative Investment Fund Manager (AIFM) for sub-threshold managers (The AIFMD permits a sub-threshold regime where an Alternative Investment Fund Manager has less than €100 million assets under management (including assets acquired through leverage) or €500 million unleveraged with a five-year lock-in. Firms that are likely to fall under the threshold will need to calculate their AUM, determining an annual AUM calculation and review date and monitor the level of AUM on a daily basis). Even where a firm is sub-threshold, marketing restrictions apply and firms will need to prepare to register the funds they market with the FCA.
We consider that it is of fundamental importance that managers establish a project governance framework, accountable to the senior management of the organisation. Cordium has identified a number of work-streams, some of which we can support directly, but a number of which will require control and input from across the organisation – operations, IT, finance, risk and the front office. If they have not done so already, managers should undertake an analysis of the detailed AIFMD requirements, identify where they do not currently comply and identify the actions and tasks that follow. At this stage, it is important that any such status analysis is sufficiently structured and comprehensive that the firm can develop a delivery plan and can identify the delivery work-streams and leaders it requires. Above this structure, the firm should put in place a project manager for control and reporting purposes.
The structure and location of the alternative investment fund (AIF) could be an issue depending on where and how the firm intends to continue to market the fund. This may impact the choice of location of the AIF and the AIFM.
AIFMD offers the opportunity of a passport for fund-raising across the EU under a single regulatory licence; so the central question for investment managers based in London and currently managing offshore funds is whether moving both the fund structure and the fund manager onshore will help raise funds until 2015 (when a passport for non-EU funds has been proposed) rather than relying on the national private placement regimes.
Managers should pay close attention to the changes that may take place to national private placement regimes and the EU’s determination of which non-EU jurisdictions are deemed co-operative – 42 have now been agreed. The UK’s national private placement regime will remain largely unchanged but there is speculation about the continued existence of national private placement in other EU countries and these should be kept under review. Under AIFMD, non-EU-based managers marketing under national private placement will need to prepare to meet disclosure and reporting requirements covering systemic reporting, private equity investment disclosures, as well as investor disclosures and regulatory reporting requirements. A firm marketing an AIF in a European state under national private placement rules will still need to notify the regulator in that country that the fund is being marketed there.
Delegation appears to have receded as one of the more challenging aspects of the Directive, owing to the seemingly liberal interpretation in some EU jurisdictions of the letter-box restrictions. Legal form appears to be trumping day-to-day substance, with the capacity to provide the services of portfolio and risk management more important than whether the nominated AIFM actually undertakes these tasks. The approach seems to be to “pick your poison”; an AIFM is likely to need to be registered somewhere and, in the case of non-EU structures, this is most likely to be the place where the investment manager is located. The FCA has said that it will look at the circumstances of each case when evaluating whether an offshore manager is a letter-box entity, but not until 2014. So, those advisers that stay out of the new regime may have the merits of their case evaluated by the regulator next year.
The FCA is now receiving applications for firms to be authorised as AIFMs. The much vaunted transitional provisions applied in the UK seemed to permit applications to be possible up to the implementation deadline of 22 July next year but recent FCA guidance has clarified that the FCA expects firms to be in compliance (that is authorised) ahead of that date. Allowing for the six months maximum the FCA is permitted under legislation to authorise, it has communicated that firms should submit applications by 22 January 2014. This is consistent with our own advice to managers that they should prepare for Q1 2014 application and with many managers’ own intentions.
This clarification should generate even more urgency amongst managers to proceed with preparations for AIFM authorisation.
Preparing to become an AIFM
The authorisation process involves the regulator establishing the readiness of the manager to act as an AIFM. The process requires significant attestations as to the state of compliance at applicant firms. The FCA has been placing considerable emphasis on the importance of senior management attestation and the soundness of firms’ business models. It is important therefore that managers have significantly addressed the main areas of compliance with the Directive before the application is submitted. This will avoid delay and embarrassment in the event the FCA requests details of the firm’s policies and procedures. One challenge for managers is that AIFMD is not just a compliance project. Cordium has identified around 12 work-streams or themes around which the project implementation will need to be based. The owners of these work-streams may well be external to compliance and require specialist support interpreting and understanding the compliance requirements. Below we identify some of the main work-streams that need addressing.
Need for a depositary
AIFMs must appoint a single depositary for each EU AIF managed. This is expected to be an EU bank, investment firm or UCITS depositary. The depositary of a non-EU AIF may be established in the third country where the AIF is established, or any chosen Member State. An AIFM cannot be the depositary and a prime broker acting for an AIF cannot act as depositary for that AIF unless it separates its brokerage and depositary activities.
The depositary is responsible for the verification of the AIF’s ownership of assets, cash flows, payments, and the safekeeping of assets. It will be liable to the AIF (or its investors) for losses in its custody and so will need to make its own assessment and appointment of sub-custodians. This could limit the number and types of prime broker a fund uses. The depositary appointment is made by the AIFM, so managers should now be in discussion with depositaries around their capabilities and the functional and contractual arrangements these will entail.
Whilst private placement of non-EU AIFs is permitted, EU AIFMs will need to ensure that one or more entities are appointed to monitor cash flows, the safekeeping of assets and valuation and subscription and redemptions of units and shares in lieu of a depositary. Managers should be in dialogue with their administrators, prime brokers or third parties as to who can and will perform this role. If both the manager and the fund are based outside of the EU there is no requirement for a depositary to be appointed while the national private placement rules remain.
Another important consideration is that private equity depositaries will be allowed. This is important for managers that currently hold assets for their private equity funds; nothing in AIFMD prohibits the private equity depositary being a company in the same group as the AIFM, as long as it can provide the sufficient guarantees needed to enable it to perform the depositary functions and commitments effectively.
Understanding the depositary’s requirements on the manager and the administrator regarding record-keeping, exchange of information and on-site reviews and visits, as well as establishing and building the various information flows, is likely to be one of the most challenging aspects of AIFMD implementation, requiring detailed consideration, evaluation and an AIFMD-compliant contractual footing.
AIFMD-compliant policies and procedures
Of course, implementation of a major EU directive will result in the re-papering of compliance manuals, policies and procedures. Cordium has updated its compliance infrastructure used extensively across the alternatives sector in two important respects:
Compliance policies and procedures
These have been updated to reflect the change in regulatory status and the FCA’s new FUND sourcebook. Our compliance infrastructure manual, policies and compliance monitoring programme have been updated for, or at least benchmarked to, the AIFMD directive for;
For the first time under EU rules, proxy-voting policies are mandatory for investment managers and such a policy is now included in our materials.
Cordium has benchmarked, updated and amended over 80% of the materials that comprise our compliance infrastructure for alternative managers as a result of AIFMD. Firms using their own compliance infrastructure need to plan to do the same.
Portfolio risk and liquidity management
AIFMD introduces regulatory standards for portfolio risk and liquidity management. Firms that manage or operate UCITS schemes will be familiar with the types of standards AIFMD introduces but, if not, investment managers will need to consider how far they need to formalise their risk and liquidity management arrangements to meet AIFMD standards.
At a minimum, Cordium considers that fund managers will need to establish, upgrade or benchmark existing portfolio risk and liquidity management arrangements, including risk policies, risk guidelines and operational risk arrangements to the requirements of the AIFMD (Article 15-18, Level 2 Articles 6 to 8, 11, 38-45). Such policies and procedures will include documentation covering:
Further benchmarking of investment procedures to the AIFMD will be required where funds invest in illiquid assets, particularly around investment due diligence.
New capital requirements
Firms will need to assess what their capital requirements will be and whether further capital may need to be introduced. Externally appointed AIFMs will have to hold an “initial capital” of at least €125,000. If assets under management are greater than €250 million, additional “own funds” of 0.02% of the aggregate portfolio value are required on the excess (of €250 million) but the required total of the “initial capital” and the additional “own funds” shall not exceed €10 million. Own funds shall not be lower than the amount that is required under the Capital Requirements Directive (CRD), i.e., the Fixed Overhead Requirement.
Own funds must also be held in liquid form which is a narrower requirement than under current prudential rules. Firms should therefore consider how they currently apply capital in their balance sheet and whether they have sufficient capital, particularly if the firm currently operates under the CAD or MiFID Exempt regimes.
One potential spanner the FCA has thrown into the mix is contained in its consultation on implementing the CRD IV; specifically, the proposal to include Collective Portfolio Management Investment Firms (CPMI) – that is, firms authorised to manage alternative funds and provide discretionary investment management services, under its new CRD IV-based prudential regime – “IFPRU”. We hope that this point will be addressed in the FCA’s consultation process.
The AIFMD requires firms to hold “adequate capital” for the risks they take in their business and an AIFM should have, as part of its risk management policy, adequate policies and procedures for operational risk management. These should enable an internal loss database to be built up to serve for the purpose of assessing the operational risk profile of the manager. Existing ICAAP documentation and operational risk management arrangements are likely to need to be extended and enhanced. Professional indemnity insurance (PII) or additional own funds may also be required to cover liabilities arising from professional negligence.
Draft FCA remuneration consultation considers the criteria by which AIFMs would need to comply in full with the remuneration restrictions in the directive, including the ‘Pay-out Process Rules’, covering the more demanding elements of the remuneration code, namely: (i) retained units/shares; (ii) deferral; and (iii) performance adjustment.
Firms will need to determine whether they must comply with the Pay-out Process Rules in full or not at all. Assets under management are considered to be a principal driver, with suggested thresholds of:
However, the FCA considers that AUM is a crude measure of risk, so firms will need to assess the significance of ‘other proportionality factors’ that may bring the firm under the Pay-out Process Rules even though a threshold is not met. These include;
A number of these factors may be used to calibrate a firm’s determination of the application (or perhaps more importantly disapplication) of the Pay-out Process Rules. In view of the significance of these rules, firms should ensure appropriate senior management approval of the adopted policy.
Private equity disclosure requirements
Managers will need to consider how to amend their investment and communication arrangements when a fund invests in non-listed companies, so that they meet the Directive’s requirements for formal disclosures to external shareholders, fund investors, employees, trade unions and the regulator. The rules do not apply for acquisition of small and medium enterprises (essentially those that have fewer than 250 employees and less than €43 million balance sheet) as well as real estate SPVs.
Systemic reporting requirements
In order to fulfil systemic reporting requirements, AIFMs will be required to file with the regulator within one month of the relevant reporting periods information on:
(a) the main instruments in which it is trading, investment strategies and their geographical and sectorial investment focus;
(b) the markets of which it is a member or where it actively trades;
(c) the diversification of the AIF’s portfolio, including, but not limited to, its principal exposures and most important concentrations.
It is likely that managers will look to administrators or other service providers to prepare the information required for the regulator, but the manager remains responsible for its submission.
We do not yet know how the information will be submitted to the regulator, but one important task managers can do now is to start identifying what data is required, how it will be sourced and how managers will validate its accuracy. This task must not be underestimated. Managers’ experience of preparing and submitting Form PF to the Securities and Exchange Commission (SEC) provides some insight to the task in hand. Although the complexity will vary according to each firm’s strategy, for some firms:
It may be that firms need to consider establishing regulatory reporting teams independent of compliance just to deal with the volume of information regulators are now requesting.
These are some of the work-streams that Cordium considers a firm implementing AIFMD authorisation should be addressing now. All firms are different and managers will need to identify and prioritise the work-stream most relevant to them. With just a few months to go, there is no time to wait and action is needed if firms want to submit their applications to the FCA to become AIFMs in January next year.
Jon Wilson has over 20 years’ financial services experience. He qualified with Coopers and Lybrand before moving on to lead an asset management supervision team at the UK regulator. Wilson gained further experience at UBS, Deutsche and Merrill Lynch Investment Managers before joining Cordium in 2006.