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.
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.
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.
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.
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.
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.
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.
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.