This INDOS Financial article was first published in HFM Week and can be read here (subscription required).

A year has passed since the final implementation date of the Alternative Investment Fund Managers Directive (AIFMD). The general consensus among managers is that the Directive has been challenging but it has not proved as disastrous as some predicted.

Smaller alternative investment fund managers (AIFMs) have been able to avoid the bulk of AIFMD by registering as Small Authorised UK AIFMs. The majority of the remaining UK managers have become full scope AIFMs. Managers found registration to be a long and sometimes frustrating process as the UK Financial Conduct Authority (FCA) coped with the volume of applications. They breathed a sigh of relief upon submission and authorisation of their variation of permission (VOP) applications and then again following completion of their first Annex IV filing in January 2015. There has been some respite since but, feeling a sense of ‘regulatory fatigue’, many managers have been keen to get back to business as usual.

There is a general view that more work could be done to ensure ongoing compliance with AIFMD. While the past year has been difficult for managers, the authorisation and implementation effort to date may prove easier than fully adapting operations to meet regulatory expectations and broader fiduciary obligations.

For a number of managers the AIFMD ‘project’ has continued beyond authorisation. They can demonstrate how their day-to-day operations are continually adapting to comply with the new requirements. Some are revisiting decisions made on the grounds of expediency at the time of application such as the appointment of the depositary. Some managers are looking beyond the typical appointment of an affiliate of the administrator as they feel this has added little value to their overall business. For others, more work is required to tailor and effectively implement template AIFMD policies that compliance and legal firms provided as part of the authorisation process. There is a sense that there has been an increase in a ‘tick the box’ approach to compliance rather than a fundamental change to the way in which businesses are managed.

AIFMD is a complex piece of legislation and, despite being one year old, there are still a number of grey areas  such as interpretations around marketing, leverage calculation rules, and some aspects of valuation. One area where more work could be done is around risk management. AIFMD requires managers to implement a clearly defined risk framework, including policies and procedures for managing and monitoring a broad range of risks within an organisation and a requirement that risk management and oversight be functionally and hierarchically separate from the front office which can be a challenge for smaller managers. Questions remain whether the new risk management requirements have been effectively implemented, and any perceived shortcomings could expose managers to regulatory scrutiny.

There has been very little, if any, additional regulatory focus on managers post AIFMD authorisation and managers have noted that many investors have shown little interest in AIFMD. This has undoubtedly contributed to the reduced ongoing focus on AIFMD post-authorisation.
The FCA confirmed under a freedom of information request earlier in 2015 that it was investigating 67 firms subject to the AIFMD for a range of alleged regulatory breaches which did not include AIFMD related transgressions. Some predict the level of regulatory focus will pick up later in 2015 and 2016 citing the FCA’s 2015/16 business plan which indicates there could be more scrutiny of the asset management sector as a whole, particularly through thematic reviews. The announcement to extend the UK Senior Managers regime to the asset management sector could be another warning sign.

We have seen other European regulators flex their muscles and issue fines to hedge fund managers for failing to comply with transaction reporting rules and this could be a sign of things to come in areas such as non-compliance with the AIFMD marketing rules.

Regulatory non-compliance is one of the biggest risks faced by managers. For now, the industry has some breathing space before further regulations such as the Markets in Financial Instruments Directive II (MiFID II) come into force. It may just be a matter of time before managers face more regulatory pressure around AIFMD compliance and managers would be wise to use this period to keep focussed on AIFMD and ensure they fully meet their ongoing obligations.

This INDOS Financial article, which reviews the impact of the AIFMD one year on from its introduction in July 2014, was first published in The Hedge Fund Journal and can also be read here.

Almost a year has passed since the implementation of the Alternative Investment Fund Managers Directive (AIFMD). The general consensus among managers is that the Directive has been challenging but has not proved as disastrous as some predicted. But what have been AIFMD’s biggest challenges, or indeed opportunities?

EU transposition status
EU member states had to implement AIFMD into national law by 22 July 2013. Many countries failed to meet the deadline. Some countries, even now, have yet to implement AIFMD. Member states are liable to pay damages for any losses sustained by firms by failing to implement a Directive by the appropriate deadline but so far there does not appear to have been action taken against countries which transposed late.

Size matters
Smaller alternative investment fund managers (AIFMs) have been able to avoid the bulk of AIFMD. AIFMs with less than €100m of gross assets, or €500m in the case of some closed ended funds, can avoid registering as full-scope AIFMs. Many managers found registration to be a lengthy and frustrating process as regulators struggled with the volume of applications. Some managers have sought to re-structure their operations outside of the EU to circumvent AIFMD although the majority of managers have become AIFMs.

Marketing: Passporting, private placement and reverse solicitation
The pan-EU passport is one of the main selling points of attaining AIFMD compliance as it enables an EU AIFM to freely market an EU AIF to institutional investors in Europe. However, the passport has not been as straightforward as expected with some member states ‘gold-plating’ AIFMD and imposing additional registration processes and fees.

EU AIFMs marketing non-EU AIFs are still subject to varying national private placement regimes – country by country rules for the marketing of AIFs to professional investors. AIFMD has prompted a number of countries to tighten up their private placement rules making it harder to market. Many managers have simply registered for marketing in their home country or favoured countries with the more straightforward notification requirements, rather than countries with full local registration and approval.

The increased compliance obligations have prompted a number of non-EU managers to stay away from Europe or rely on ‘reverse solicitation’, a concept whereby investors seek out managers at their own free will rather than the other way round. Regulators have interpreted the marketing rules in different ways and what constitutes reverse solicitation remains a grey area.

ESMA is required under AIFMD to give advice to the European Commission (EC) about the extension of the passport to non EU AIFMs and AIFs by 22 July 2015. ESMA has said it will not treat all non-EU countries as a single block, indicating that the passport will only be extended to AIFs or AIFMs operating in non-EU countries that are deemed to have regulatory equivalence. Almost 50 organisations provided ESMA feedback following its November 2014 ‘call for evidence’. There are divisions between those who advocate an extension of the passport, and those who feel ESMA has not had enough time to digest the impact of AIFMD to provide meaningful analysis to the EC.

Depositary
AIFMD introduced the role of the depositary – a service provider that has a fiduciary role to act in the best interests of investors and is responsible for providing safekeeping of assets, cash-flow monitoring and a series of oversight duties. The appointment of the depositary has been less stressful and costly than many expected. New entrants, generally affiliated to fund administrators, have launched ‘depositary-lites’ for non-EU AIFs and started providing services for certain kinds of private equity or real asset funds. A number of organisations had predicted a depositary bank, which for EU funds is subject to strict liability for any loss or misappropriation of assets held in custody, would refuse to work with managers trading in some markets and strategies. Generally this did not materialise.

Some managers are already revisiting their choice of depositary (typically an affiliate of the fund administrator that was generally appointed at the time of AIFMD authorisation because it was the path of least resistance) because they feel the depositary has not added any value to the business.

ESMA is also reviewing how assets held in custody should be segregated under AIFMD. It is common for assets to be held by sub-custodians pooled ‘omnibus’ accounts although custodians maintain records distinguishing which assets belong to whom. ESMA is considering various options which would require custodians to make changes to the omnibus model. The final outcome could have a significant impact on all market participants.

The rise of ‘Mancos’
Other service providers have sought to capitalise on the new regulations including AIFMD management companies, or ‘mancos’. Mancos allow managers to outsource the responsibility for AIFMD compliance to a third-party that possesses an AIFMD regulatory authorisation. Mancos generally undertake the AIFMD risk management function and delegate the portfolio management activity back to the investment manager. Mancos have proven popular with some non-EU managers since it has enabled those managing EU AIFs to take advantage of the pan-EU passport without actually having a presence in the EU. Different manco models have emerged and there are differing views as to the veracity and substance of some models. This is an area that is expected to receive increased regulatory scrutiny.

AIFMD regulatory reporting, so-called ‘Annex IV’
Annex IV has proven to be a challenge for many managers. Prior to AIFMD the majority of managers were not subject to any detailed regulatory reporting requirements over the funds they manage. Post AIFMD, EU managers are required to submit detailed reports to their local regulator on either a quarterly, semi-annual or annual basis. The UK Financial Conduct Authority’s (FCA) online reporting portal, known as GABRIEL, suffered bandwidth issues during the first significant Annex IV filing resulting in a number of managers being unable to file on time. The next major reporting period will be the end of July and the FCA will be under the spotlight to have resolved these issues.

Non-EU managers marketing across multiple EU member states are required to submit multiple Annex IVs to different regulators. EU regulators have interpreted the requirements in different ways meaning non-EU managers face additional challenges where they market in more than one country.

Valuation
AIFMD places responsibility for valuation of the AIF squarely in the court of the AIFM. Given the independent administration model has worked well for many years and ensured independence between the investment manager and the valuation of the fund, few in the industry saw the logic with this. There has been little regulatory guidance as to how the valuation rules should be implemented but in practice the day-to-day role of the administrator, manager and board of directors of the AIF has not changed.

Risk Management
AIFMD requires managers to implement a clearly defined risk framework, including policies and procedures for managing and monitoring risk within an organisation. This covers all aspects of risk from traditional front office areas such as market and credit risk, to liquidity, counterparty and operational risk. The risk management function should be functionally and hierarchically separate from the front office which can be a challenge for smaller managers. Questions remain whether the new risk management requirements have been effectively implemented and firms will stand up to regulatory scrutiny in this area.

AIFMD requires AIFMs to set a maximum level of leverage for each AIF they manage under two prescribed methods (gross and commitment). These measures have caused a lot of confusion and debate. Critics argue the results are misleading and unhelpful to investors and regulators trying to understand and assess risk. There are calls for an alternative measure to be introduced.

Remuneration
Initial concerns about the impact of the AIFMD remuneration rules have, for many managers, not materialised either. In the UK, only the largest managers are now impacted to a full extent. The FCA took the view that firms under a £1bn AUM threshold (£5bn for closed end unleveraged AIFs) could effectively dis-apply the remuneration deferral and bonus claw back aspects of AIFMD although managers will still have to provide some disclosure to investors around remuneration.

Post AIFMD regulatory focus
There appears to have been little additional regulatory focus on managers since they became authorised as AIFMs. The FCA confirmed under a freedom of information request that they were currently investigating 67 firms subject to the AIFMD for a range of alleged regulatory breaches but a notable exclusion were specific AIFMD related infringements. Some predict the level of regulatory focus will pick up later in 2015 and 2016 citing the FCA’s 2015/16 business plan which indicates there will be an increased focus on the asset management sector as a whole. As such, asset managers may need to brace themselves for additional scrutiny.

Investors
Many end investors were slow to show interest in AIFMD and many remain disinterested. The longer term impact on European investors is unclear. Whilst some EU investors have been reluctant or actively prohibited from allocating into non-EU products the non-EU fund market remains strong for now. There is no doubt the costs for managers and investors have increased as have the barriers to entry for new managers.

The future
For now, the industry has some breathing space. Many are keeping a watchful eye on future developments such as the potential extension of the AIFMD passport to non EU managers and funds. It is still too early to predict the long-term impact of AIFMD and whether an AIFMD brand, similar to UCITS, will emerge.

This INDOS Financial article was first published in the July 2015 edition of Hedge Fund Intelligence’s InvestHedge and can also be read here.

Following the final introduction of the European Alternative Investment Fund Managers Directive (AIFMD) in July 2014, both non-EU managers and EU managers running non-EU domiciled alternative investment funds (AIFs) have been restricted to marketing their investment vehicles into the EU via national private placement regimes (NPPR). By contrast, EU managers of EU funds, or full-scope alternative investment fund managers (AIFMs) are now able to market their funds via a pan-European marketing passport. That is the theory anyway, but what is happening in reality, and how are EU policymakers going to shape the marketing rules going forward?

Current state of play
A number of EU managers have sought to restrict marketing of their non EU funds to within their home country or countries with the simplest and most flexible NPPR requirements, such as the UK and the Netherlands. The increased compliance obligations – namely regulatory registration and/or authorisation, increased investor disclosures, filing the the detailed Annex IV regulatory report and, in some cases, the appointment of a depositary service provider – has prompted a number of non-EU managers to stay away from Europe or to rely on ‘reverse solicitation’, a presently undefined concept whereby investors seek out managers at their own free will rather than the other way round. Other managers are simply waiting for the European Commission (EC) to announce whether the AIFMD marketing passport will be extended to non-EU AIFMs and non-EU AIFs.

ESMA review of the extension of the passport
The European Securities and Markets Authority (ESMA) is required under AIFMD to give advice to the EC about the extension of the pan-EU marketing passport to non EU mangers and funds by 22 July 2015. The EC is required to act on the advice of ESMA within three months. ESMA is considering whether a passport extension would result in any issues with respect to investor protection, market disruption, competition and the monitoring of systemic risk. ESMA has said it will not treat all non-EU countries as a single block, indicating that the passport will only be extended to AIFs or AIFMs operating in non-EU countries that are deemed to have regulatory equivalence. Almost 50 industry participants provided ESMA feedback following its November 2014 “call for evidence”. There are divisions between those who advocate an extension of the passport, and those who feel ESMA has not had enough time to digest the impact of AIFMD to provide meaningful analysis to the EC. Others have urged ESMA to review gold-plating of the passport by EU member states, such as the levying of fees and the introduction of additional regulatory requirements.

What have non-EU countries been doing?
All of the main non-EU fund markets have already signed co-operation agreements with EU member states laying the foundation for regulatory information exchange. Being able to demonstrate AIFMD equivalence will be a pre-requisite for the passport extension. A number of non-EU countries, most notably Guernsey, Jersey and Switzerland have been quick to implement what they regard as AIFMD equivalent regimes. Other major fund domiciles such as the Cayman Islands are yet to confirm details of their AIFMD ‘opt-in’ fund regimes although CIMA has recently issued a public statement seeking to provide re-assurance that work is on-going “to ensure Cayman funds can continue to be marketed within the EU and elsewhere in the foreseeable future”.

Potential outcomes
There are several possible outcomes. ESMA could issue negative advice, which would result in the continuation of the status quo, at least until the inevitable AIFMD II is introduced. Given the limited timeframe ESMA has had to undertake analysis of AIFMD implementation, ESMA might delay any determination about the extension of the passport to third country AIFs and AIFMs. Another outcome could be that ESMA will consider an extension on a country-by-country basis. There are rumours that a list of initial non-EU AIFM and non-EU AIF countries is currently being considered. The chairman of the ESMA committee reviewing the potential extension of the passport said in a speech recently that his preference was for “ESMA to prioritise quality over haste”.

While extending the passport to third country managers and funds would enhance competition in the EU asset management market and provide greater investment choice for European investors, the decision whether to extend the passport is politically sensitive and it is possible the EC could reject ESMA’s advice or introduce additional hurdles for third countries seeking equivalence so as to avoid granting them passports for pan-EU distribution.

If the EC does extend the AIFMD passport, ESMA will be required to issue advice to the EC on the termination of NPPR by 2018. Until this point, there will be a dual regime for funds to market – NPPR and the pan-EU passport.

Is the passport something that managers of non-EU funds and non-EU managers want or will utilise?
There has been a relatively low take up of the passport by EU managers of EU funds. Whether or not EU managers of non-EU funds or non-EU managers will embrace the passport is an interesting question.

For EU managers of non-EU funds, the extension of the passport should be attractive. These managers are already subject to the majority of AIFMD and will no longer need to comply with the myriad of NPPRs. The incremental AIFMD obligations to access the passport would not be significant.

Conversely, the extension of the passport to non-EU AIFMs is likely to present more challenges. Broadly speaking managers will need to become fully compliant with the AIFMD (which means they need to get authorised as an AIFM by the competent authorities of the EU member state that is its “Member State of Reference”) to use the passport. This is a significantly greater compliance burden than the investor disclosure and regulatory reporting obligations today for those marketing via NPPR. The AIFMD equivalence rules are also such that it may not be possible for some non-EU AIFMs subject to different or conflicting regulatory regimes to meet the equivalence test.

Conclusion
Some of the responses to the ESMA call for evidence suggest non-EU managers are not enthusiastic about subjecting themselves to AIFMD. Some might argue this is short-sighted as these managers are shutting themselves out from a $15 trillion investor market. Nonetheless, it could take some time for non-EU AIFMs to avail of the pan-EU passport through compliance with the directive. In the meantime, we could see an increasing number non-EU managers marketing into a handful of EU member states through NPPR.