Ten months ago on 22 July 2013, the Alternative Investment Fund Managers Directive (AIFMD) became EU law. The impact on most existing alternative investment fund managers (AIFM) was deferred by a one year transitional period which ends in two months time, on 22 July 2014. In this update we review developments over the past ten months and what to expect over the next two months and beyond.
EU transposition status
Despite the 22 July 2013 deadline for transposition of the AIFMD into national law, many EU countries did not achieve this deadline. Ten months on, approximately one-third of the EU has yet to transpose and implement AIFMD although several of those countries have legislation pending.
Regulatory authorisation status
For existing managers managing an alternative investment fund (AIF) as of 22 July 2013, AIFMD provides a one year transitional period until 22 July 2014, by which time AIFMs must be in compliance with the Directive. AIFMs must submit a complete application to their home state regulator for authorisation as an AIFM by this date. The UK initially took an alternative view that required managers to be authorised by 22 July 2014, but subsequently revised its position and now also only requires a complete application to be submitted by this date.
Across Europe there are expected to be well in excess of 1,200 firms caught by the Directive, with the largest number of firms based in the UK where the FCA is expecting to receive around 800 applications. The actual number of AIFMD approvals across Europe has been low by comparison – a recent report highlighted around 320 firms had been authorised in the UK, Ireland, Luxembourg, France, Germany and a handful of other locations, although many of these are “Small AIFMs” – firms that manage AIFs with less than €100m of gross assets and therefore are not subject to the full gambit of AIFMD. Despite less than two months to go until 22 July, a large number of firms are believed to have not yet submitted an application to their regulator. It now seems inevitable a large number of managers will not be authorised by 22 July and, whilst not required by the Directive, it remains to be seen whether there are unintended consequences for managers that are no authorised.
Remuneration and Capital
Ten months ago, many firms were concerned about the impact the Directive would have on remuneration (in terms of the ‘Pay Out Process Rules’ i.e. the amount and length of deferral) and capital (in terms of the potential increase in regulatory capital required to be held by managers). For UK managers at least, the FCA introduced a £1bn AUM threshold (£5bn for closed end unleveraged AIFs) below which the Pay Out Process Rules will not apply. The FCA also plans to consult on the treatment of derivatives when determining funds under management which drives additional ‘own funds’. For now at least, managers will be allowed to value derivatives at their market value rather than requiring them to be converted to their equivalent underlying positions.
Determining the AIFM
Because of the breadth and impact of the changes introduced by AIFMD, there had been predictions of firms restructuring their businesses to take themselves out of scope of as much of AIFMD as possible. In practice, most managers appear to be seeking AIFM authorisation for their existing UK management entities. A number of AIFMD Management Companies (ManCo) have been authorised, largely in Ireland and Luxembourg, where the ManCo is appointed as AIFM to an AIF, undertakes the AIFMD risk management function and delegates portfolio management to the existing investment manager. There are some advantages to this model, particularly for non-EU managers seeking to market EU AIFs through the AIFMD passport, as opposed to establishing a local EU presence themselves.
EU AIFMs managing EU AIFs are, once authorised, able to market their AIFs via a pan-European marketing passport introduced by AIFMD. All other managers, including those based outside of the EU (so-called ‘non-EU AIFM’), managing AIFs domiciled outside of the EU, can only market through national private placement regimes. Approximately two-thirds of the EU is continuing to allow the marketing of non-EU funds via private placement. An alternative to marketing is to seek to rely on so-called ‘reverse solicitation’ where investors approach managers at their own initiative. There is still very little regulatory guidance as to what constitutes marketing vs. reverse solicitation but there is a growing recognition that the risk (both regulatory, and what some refer to as the investor ‘put option’) of non-compliance with marketing rules has increased as a result of AIFMD. Others question whether reverse solicitation is a viable business strategy for managers looking to attract investors and grow their business.
Whether the AIFMD passport will be extended to non-EU AIFs remains an open question and subject to ESMA review in 2015. Given very few firms are understood to have begun marketing through the passport, some question whether ESMA will have sufficient information on which to base their review, and may simply seek an extension to the date by which they are required to report on the matter to the European Commission.
Valuation and the role of the Administrator
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, not least investors, see the logic or agree with this. Whilst the legal responsibility for valuation has changed and there is still much debate about the relationship between the different parties in the post-AIFMD world, in practice the day-to-day role of the administrator, manager and board of directors of the AIF should not change as a result of AIFMD. Managers should expect to receive questions from investors about these changes (more on this later). Very few administrators or other firms are willing to act as External Valuer (EV) largely because of the liability an EV is required to take on and therefore, in many instances, an EV is simply not being appointed by an AIFM.
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 profile needs to be formalised for each AIF and communicated to investors and prospective investors, including the maximum level of leverage (under two prescribed methodologies known as the gross and commitment method) that may be employed. The risk management function should be functionally and hierarchically separate from the front office. The FCA issued some guidance on the matter and has stated it will take a proportionate approach based on factors such as the size and complexity of a firm. Many managers will be used to risk management principles for their core market risks, but may find it more challenging to implement a limit framework across all aspects of risk required by AIFMD.
AIFMD’s Annex IV reporting is the European equivalent of Dodd Frank’s Form PF. All AIFM, regardless of size, will need to report to their regulator at least once a year but in most cases half-yearly, and for larger AIFMs and AIFs, quarterly. Given the first reporting date for most managers will not be until January 2015, it is probably not surprising few managers have reviewed and put in place arrangements to comply with the new reporting. Given the volume and complexity of the reporting requirements and the amount of data required to be aggregated and enriched, there is no room for complacency and managers ought to be starting to develop and implement a regulatory enterprise risk management infrastructure to comply.
One of the great ironies of AIFMD is that, for legislation designed to provide additional protection to investors, the end investors generally appear to have shown very little interest in AIFMD to date. This will change once managers start to distribute AIFMD compliant offering and other disclosure documents to investors. These documents will shine a spotlight on changes such as the changing roles in the valuation function and may well generate questions for managers.
Whilst not entirely new for EU funds, the AIFMD introduced new depositary requirements. The core duties of the depositary are to perform safekeeping of financial instruments, record keeping and ownership verification of ‘other assets’, cash-flow monitoring and a number of oversight duties. The depositary regime which applies depends on a combination of the domicile of the AIFM and the AIF:
- EU AIFM managing EU AIFs are required to appoint a single depositary. The depositary is generally required to be domiciled in the domicile of the AIF.
- EU AIFM managing non-EU AIFs are caught by the depositary requirements only if they market those funds to EU investors through private placement. The AIFM must ensure one or more entities are appointed to perform the depositary duties in what has become known as the ‘depositary-lite’ regime.
- Non-EU AIFM managing EU or non-EU AIFs are not subject to any depositary requirements, except if the AIFs are marketed through private placement in France, Germany, Denmark or Austria.
The main focus of the industry has been on the depositary model for EU AIFs since the depositary is required to take on the strict liability for loss of assets held in custody. In reality the majority of the industry is making use of a provision in the AIFMD which allows a depositary to discharge its liability to the entity performing the custody function on ‘objective reason’ grounds. This discharge, and other related matters, continues to be the subject of much debate. For a large number of non-EU AIFs, the depositary-lite requirements are entirely new and managers have been seeking to identify and on-board providers. This continues to be a challenge for some, particularly given many firms intending to provide these services have themselves yet to receive regulatory authorisation. Those managers that have yet to identify and commence the on-boarding process with depositaries should do so in the near future or run a very real risk that they will not be able to market their funds from 22 July.
It is probably fair to say that until more recently, AIFMD has not received as much attention as might be expected from managers outside of the EU, notably in the US and Asia. These managers are generally only caught by AIFMD if they market their funds to EU investors and would then be subject largely only to additional investor disclosure, regulatory reporting and registration obligations. A number of the EU countries which allow private placement extended the transitional provisions to non-EU managers. Now the transitional period is coming to an end, more US managers in particular are focussing on AIFMD to avoid a marketing blackout from 22 July. In some cases these managers are conducting a cost/ benefit analysis to assess whether the potential business opportunities outweigh the costs of AIFMD compliance.
AIFMD Compliance in general
As noted AIFMs need to be in full compliance with the Directive by 22 July 2014. Most managers have had to juggle AIFMD alongside other regulatory changes such as EMIR and FATCA and the general day-to-day running of their business. It is therefore perhaps not surprising so many managers have yet to submit their Variation of Permission (VoP) applications. For many managers, getting to the point of submitting a well documented VoP to their regulator has proven to be a time-consuming and costly exercise in its own right. In many respects, the VoP is just the start and the biggest challenge lies ahead – ensuring full AIFMD compliance from 22 July 2014. With only two months to go, many firms are taking a pragmatic approach in the hope regulators will take a similar view, at least initially. It is clear the regulators will remain under a lot of resource pressure for a while to come. We expect the review and authorisation of AIFMD applications will continue well past 22 July and managers may have some breathing space to bed down new processes pending further clarification and guidance on best practices.
For some, the world may not feel like it has changed dramatically on 23 July 2014 but managers should be under no illusion – AIFMD will change the way alternative investment management businesses will need to be run and the rules and regulatory expectations with which they will need to comply.
This article was first published by COO Connect.