The EU’s Alternative Investment Fund Managers Directive (AIFMD) has gone through numerous rewrites and development phases since the acronym first entered the public domain way back in 2009.
AIFMD originally included a requirement that it must be reviewed by the European Commission by 22 July 2017. The Commission is now reportedly looking for experts to undertake an evidence-based study, to ascertain whether AIFMD’s initial objectives have been met, but also to qualify its impact on the alternatives industry and its institutional client base.
In essence, AIFMD’s key focus areas are investor protection and the application of sensible risk management. It was framed by policymakers less than one year after the Bernard Madoff fraud became public and the collapse of Lehman Brothers, but how much progress has AIFMD made in redressing such issues, and what could be improved?
Recognising the role of the depositary
AIFMD outlines the framework by which an impacted fund manager and alternative investment fund (AIF) should appoint a depositary to provide oversight of the fund. The depositary’s responsibilities include ensuring that financial instruments and assets are held appropriately throughout the custody chain, verifying ownership of assets, daily monitoring of cash flows and a broad range of oversight duties to ensure the fund is being managed in accordance with its prospectus.
The Madoff fraud, which some investigators believe occurred over a period of around 30 years, could perpetuate itself as there was limited – if any – external scrutiny over where assets were held or if they even existed in the first place. Meanwhile, Lehman Brothers’ bankruptcy revealed failings in asset safekeeping principles with non-existent segregation policies while managers found their assets trapped due to the bank’s re-hypothecation practices.
An engaged AIFMD depositary should flag these issues to the manager, fund boards, and if necessary the regulator. Unlike the annual fund audit, the depositary reviews fund activity daily and thus develops a solid understanding of the fund’s operations allowing the depositary to identify issues in a timely fashion. In this sense, the depositary requirements are positive for the industry as they provide valuable, objective oversight of operations thereby complementing the work at the manager and fund boards.
The requirement to appoint a depositary caused concern at managers at first as they assumed it would significantly increase costs, but service provider fees turned out to be modest relative to other fund costs. Institutional investors are recognising the value of the added protections, particularly relative to the costs.
In addition, depositaries will not work with managers if they feel there are poor operational processes and controls at the fund, given the risks they face taking on such business. An inability by a manager to find a willing depositary to work with them may prove to be an impetus to strengthen their internal governance since they will otherwise be unable to market their fund. Again, this is a positive development for the industry, and one which should be recognised by the European Commission in its AIFMD review.
Other suggested areas of focus in AIFMD 2
AIFMD may be much improved following multiple redrafts and amendments, but it is still shy of being a finished product. Any Directive or Regulation will have costs associated with it and AIFMD does not disappoint.
Uniform Annex IV reporting
Annex IV reporting for managers privately placing their products in EU markets is suffering from creeping regulatory arbitrage, and this is something the EU needs to monitor. For example, some EU regulators demand non-EU managers marketing feeder products include data points on the master fund in Annex IV filings even if the latter is not sold into the country, whereas others do not. Inconsistent approaches to Annex IV filings therefore need to be ironed out, and this should be raised in the study.
The third country marketing passport, continuation of private placement and review of gold plating
The process to extend the AIFMD marketing passport to “third country” managers and funds has stalled reportedly due to Brexit and the Commission not wishing to establish any precedent for third country access to the EU until Brexit negotiations are concluded. As a result, the existing national private placement regimes will continue for the foreseeable future and certainly beyond the original 2018 AIFMD phase out date.
However, different regulatory approaches and ‘gold plating’ continue to frustrate pan-EU AIFM distribution whether this be via the marketing passport which was introduced by AIFMD for EU funds, or private placement for non-EU funds. This is a complaint that urgently needs to be resolved, as different cross-border practices and processes add to managers’ costs and ultimately reduce choice for European investors.
A more meaningful measure of leverage
Equally, there is a strong case to reassess how leverage is calculated under AIFMD. ESMA’s methodology for leverage calculations requires any notional values of derivatives to be added to the overall balance sheet before being divided by the net asset value. This can inflate leverage reporting, and there are calls for an alternative risk-weighted exposure methodology to be permitted to present a more meaningful measurement. This is also something that should be considered by the Commission.
These recommendations should be adopted by the EU, as it will make life easier for managers looking to export their fund products to EU investors. The EU funds’ industry is going through a period of change and transitioning, which has been made much more difficult due to Brexit. Intelligent appraisal of AIFMD is required if the European funds industry is to remain strong and successful at this sensitive juncture of EU change.