On 22 July 2013 the alternative investment fund managers directive (AIFMD) was implemented into UK law. It is a key milestone in the history of the European funds industry creating a much tighter regulatory framework for the many fund managers that fall within its scope.
While it seems as though the AIFMD has been sprung upon the industry the draft directive was in fact first published more than four years ago in April 2009. There has been much debate and controversy surrounding many of the proposals, but firms now need to get to grips with what the AIFMD will mean for them.
Many firms are already in the midst of putting in place policies, procedures and structural changes in order to address the directive's requirements, whereas others are still trying to understand whether and how the AIFMD will affect them. To steer you through this major change Wragge & Co's funds experts have produced a series of short articles covering the main sections of the AIFMD and the UK regulations and FCA rules which implement it, including useful links to other valuable resources.
Are you caught? Thresholds and exemptions:
The directive covers the investment managers of hedge funds, private equity funds, retail investment funds, investment companies and real estate funds among others.
In order to determine whether your business falls within the scope of the directive it is important to understand:
- whether you are an alternative investment fund manager (AIFM) as defined by the directive; and
- whether there are any available exemptions that you can rely upon.
Meaning of AIF and AIFM
Article 4 of the directive defines AIFMs as legal persons whose regular business is managing one or more alternative investment funds (AIFs) it is important to understand what is and is not an AIF to know whether a manager is an AIFM.
An AIF is defined as a collective investment undertaking (including investment compartments) which:
- raise capital from a number of investors, with a view to investing it in accordance with a defined investment policy for the benefit of those investors; and
- is not an undertaking for collective investment in transferable securities (UCITS).
The definition of an AIF does not include, in general, pension funds, family offices, joint ventures, insurance contracts, employee participation schemes, employee savings schemes or holding companies. The precise scope of these carve-outs continues to be subject to consultation. The AIFMD does not apply generally to AIFMs in so far as they manage one or more AIFs whose only investors are the AIFM or members of the AIFM group.
Each AIF will have one single AIFM. This may in some cases be difficult to determine. It can be the AIF itself or a third party manager. The AIFM is responsible for portfolio and risk management services. In practice it is possible that some of these services will be delegated to a third party. If the delegation results in the manager being a mere 'letterbox entity' then it will not be the AIFM and it is likely that the delegate will become the AIFM.
Exemption for managers of small AIFs
Once the AIF and AIFM have been identified, it will be important to calculate the assets under management (AUM) of the AIFM. While there is no absolute exemption for AIFMs of small AIFs, article 3 of the directive confirms that a lighter touch regime applies to AIFMs managing AIFs with AUM which in total do not exceed one of the following limits:
- €500 million, provided the AIFs are unleveraged and have no redemption rights during the first five years; or
- €100 million (including assets acquired through the use of leverage).
AIFMs relying on the small fund exemption are still required to register and are subject to limited regulatory reporting requirements, although member states have discretion to impose a higher level of regulation. The UK Government has stated that it is not looking to effectively 'gold plate' the directive requirements.
The UK regulations contain provisions for 'small registered UK AIFMs' and 'small authorised UK AIFMs'. Small registered UK AIFMs are effectively internally managed AIFMs; certain small real estate fund managers and fund managers of qualifying social enterprise funds or qualifying venture capital funds. Small AIFMs which are not eligible to be small registered UK AIFMs will have to apply to become small authorised AIFMs.
A disadvantage for AIFMs relying upon this exemption is that they will not benefit from the directive's marketing passports. To benefit from the directive's marketing passport an AIFM of a small AIF must opt into the directive and comply with its requirements in full.
The EC delegated regulation issued on 19 December 2012 contains provisions on how AIFMs should calculate AUM and leverage.
Exemption for AIFs with a limited life & grandfather provisions
An AIFM that ceases to manage AIFs before 22 July 2014 does not need to apply to become authorised or registered.
The AIFM regulations contain some grandfathering provisions to AIFMs in so far as they manage AIFs that are closed-ended and either:
- make no additional investments after 22 July 2013; or
- will expire/terminate within three years from 22 July 2013 and have closed their subscription period before the directive came into force.
The AIFM in such cases do not need to be authorised under the directive and are exempt from the directive's requirements save those relating to annual reporting and a number of other provisions relating to the acquisition of non-listed companies and asset stripping.
Is authorisation required?
In determining whether authorisation is required under the directive, the following terms are important:
- an EU AIFM is an AIFM that has its registered office in the EU; and
- an EU AIF is an AIF which has its registered office or head office in the EU or is authorised or registered in the EU.
Assuming the exemptions above do not apply then the following will require authorisation:
- an EU AIFM managing an EU AIF;
- an EU AIFM managing a non-EU AIF; and
- a non-EU AIFM managing an EU AIF.
A non-EU AIFM managing a non-EU AIF will not require authorisation.
Transitional provisions
Part 9 of the AIFM Regulations addresses transitional provisions. It is worth noting that:
EEA AIFMs:
- AIFMs managing an AIF before 22 July 2013 will be able to continue managing those AIFs from 22 July 2013 without immediately needing to obtain the new permission of managing an AIF or becoming registered. Such firms will have a 12 month period to become authorised or registered. Applications for variation of permission, authorisation or registration must be received before 22 July 2014;
- the transitional period is only one year and, therefore, all AIFMs must fully comply by 21 July 2014, regardless of whether there has been sufficient time to approve their registration or authorisation;
- a UK firm which wishes to begin managing an AIF for the first time after the 22 July 2013 will not benefit from any transitional provision;
- AIFMs must comply with the requirements of the AIFM regulation, relevant to them, from the point that their application for registration or authorisation is approved.
Non-EEA AIFMs
There are also transitional arrangements for non-EEA AIFMs wishing to market in the UK using the national private placement regime. These AIFMs are not required to notify the FCA about the marketing of AIFs in the UK until 22 July 2014 if they manage an AIF immediately before 22 July 2013 and have marketed that AIF in an EEA State before 22 July 2013.
Transitional depositary provisions
The AIFM regulations were amended as a result of the consultation process to assist AIFMs with regard to the appointment of authorised depositaries during the transitional period. During the transitional period the depositary of an authorised AIFM need not have received its new permissions and therefore it can continue to operate under its existing permissions until 22 July 2014.
Implementation and what will your permissions look like?
The directive was conceived following the financial crisis that began in 2008. Its purpose is to harmonise requirements for the management and administration of alternative investment funds (AIFs). While AIF managers (AIFMs) were not perceived by regulators to be the cause of the crisis, the view was that this was an area that would benefit from improved, more efficient regulation.
The directive came into force on 21 July 2011 and EU Member States had until 22 July 2013 to implement it although not all member states managed to meet this deadline.
How will the Directive be implemented in the UK?
It is expected that implementation will involve the following:
- the creation of a new investment funds sourcebook within the Financial Conduct Authority (FCA) handbook, referred to as FUND. This will replace COLL and will contain requirements for undertakings for the collective investment of transferable securities (UCITS) operators and AIFMs;
- amendments to the Regulated Activities Order to be effected by HM Treasury;
- a new set of regulations; the alternative investment fund manager regulations 2013; and
- direct application of the EC delegated regulation (231/2013).
New regulated activities and overlap with collective investment schemes
The category of an AIF is broader than the existing category of collective investment schemes (CIS) as it includes bodies corporate such as closed ended investment companies (which are excluded from being a CIS) although it excludes UCITS.
For the sake of practicality the Government proposes that:
- the definition of a CIS in the Financial Services and Markets Act 2000 stays the same;
- in the Regulated Activities Order there would be a new activity of managing an AIF. A firm which has permission to "manage an AIF" would not need the "establishing, operating etc a CIS" permission in relation to managing that AIF even if that AIF is a CIS;
- there would also be a new regulated activity of managing a UCITS. A firm which had this permission would not need permission to operate a CIS to manage that UCITS;
- the activity of sole director of an open ended investment company (OEIC)would be abolished because the activities of managing an AIF or a UCITS will replace it entirely;
- the UK would retain the regulated activity of establishing, operating etc. a CIS. This would be required by a firm which operated a CIS but did not have the "managing AIF" permission or "managing UCITS" permission; and
- the activities of acting as the trustee of an AUT and the depositary of an OEIC would be replaced by two new activities of acting as depositary of an AIF or acting as depositary of a UCITS.
Limits on AIFM activities
The new rules will impose significant limits on the activity undertaken by AIFMs which may force some firms to re-structure. Firms should therefore carry out a review of what they currently do and how it will be classified under the directive.
Internally managed AIFs may:
- manage their own assets;
- administer and market their own fund;
- carry on activities in relation to underlying assets; and
- not become authorised as an external AIFM of another AIF.
External AIFMs may:
- manage, administer and market the AIF for which they are AIFM; and
- carry on activities relating to the assets of the AIF. This might include fiduciary duties, facilities management, real estate administration, advice relating to corporate structure, industrial strategy, mergers and acquisitions and "other services connected to the management of the AIF and the companies and other assets in which it has invested".
Manage UCITS funds
Member states may also authorise an external AIFM to be a discretionary portfolio manager and provide investment advice, provide custodian services and receive and transmit orders as non-core services (see below).
Application of MiFID
In providing some of the additional services noted above the AIFM will be subject to certain MiFID provisions but will not be authorised under MiFID.
An AIFM will not be able to execute orders, underwrite or provide placing services.
The European Commission has published the following useful answers to three questions it has received in relation to the directive and MiFID:
Q. Can credit institutions and MiFID firms apply for authorisation as an AIFM?
A. The directive does not permit AIFMs to carry on banking or MiFID activities other than those listed in Article 6(4) of the directive (as above: discretionary portfolio management, provision of investment advice and custody and reception and transmission of orders). AIFM authorisation is incompatible with an authorisation as a credit institution or a MiFID firm.
Q. Can an AIFM provide the services listed in Article 6 (4) of the directive through a separate restricted MiFID licence?
A. This is not possible: AIFMs can provide these services only via the directive licence.
Q. Does the directive passport regime also apply to the activities listed in Article 6 (4)?
A. It does not. The directive passport applies only to management and marketing activities.
Before applying for authorisation or registration, time taken to consider current business models and permissions and whether changes are necessary in view of the new AIFMD regime will pay dividends.
Authorisation and registration
Once you have made the decision that your business model requires authorisation by the FCA under the AIFMD here are some headlines to assist in the application process.
Full scope firms
A full scope firm is an alternative investment fund manager (AIFM), managing alternative investment funds (AIFs) which meet the thresholds of assets under management (AUM). In short, this means for leveraged AIFs, AUM of more than €100 million, and for non-leveraged AIFs with no redemption rights for five years, AUM of more than €500 million.
Already authorised?
Full scope firms, already authorised by the FCA, will need to vary their permission to obtain the "managing an AIF" permission, as will a "sub-threshold" firm wishing to opt-in to the full scope of the directive and become a full-scope UK AIFM.
AIFs falling in this group will need to complete the variation of permission (VoP) form for full-scope AIFMs and a schedule of all AIFs for which the firm is AIFM. For firms wishing to outward passport, this should be included with the application.
The application fee will depend upon your current activities. The new "Managing an AIF" and "Managing a UCITS" activities will fall into both fee block A7 (portfolio managers) and A9 (managers and depositaries of investment funds and operators of CIS or pension schemes) except where a firm is classified as a venture capital firm. Any application that results in a firm moving into one or both of these fee blocks for the first time will be subject to a fee of £2,500. If your firm is already in both fee blocks, there will only be a £250 administration fee.
Be prepared to submit a considerable volume of information covering details of:
- Remuneration policies; compliance procedures and arrangements in relation to delegation, valuation and liquidity risk management;
- arrangements in place in relation to depositaries;
- fees, charges and expenses borne by investors; and
- any preferential treatment granted to investors (for example, in a side letter). NB the investor's identity does not need to be disclosed
and, in relation to the AIF:
- the AIF's rules or instruments of incorporation; and
- details of the risk profile, leverage policy and arrangements for collateral or the re-use of assets.
Any material change must be notified to the FCA in advance.
The FCA has three months to determine a complete application. This period may be extended by a period of a further three months if it considers an extension necessary and notifies the firm.
The AIFM can start managing AIFs as soon as its authorisation is granted.
In relation to approved person and senior persons, if you are already authorised there may be some changes required to existing approved persons and controlled persons and any such changes should be considered before submitting the application.
The approved persons regime is not applicable to UK AIFMs for internally managed AIFs which are not collective investment schemes. However, the FCA will require information relating to individuals who effectively conduct the business of the AIFM and, if this applies to your firm, you will need to complete a notification of senior person form for each relevant individual.
Not already authorised?
If you are not already authorised by the FCA, you will need to complete the wholesale investment firms application as well as the VoP form, schedule and passporting form mentioned above.
If the same information is requested in the wholesale investment firms application as the VoP form, the FCA state that you should provide this in the VoP form only.
You will need to supply signed hard copies where signatures are required and you should also email a completed form pack to AIFMDAuthorisations@fca.org.uk. You will only need to pay the authorisation fee in respect of the wholesale investment firms application.
The authorisation fee will be £5000.
Sub-threshold firms
If a sub-threshold firm has not opted to be a full-scope UK AIFM then it will be required to be authorised or registered with the FCA as either:
- an authorised sub-threshold AIFM, referred to as a small authorised UK AIFM; or
- a registered sub-threshold AIFM, referred to as a small registered UK AIFM.
Firms which are currently authorised persons and which want to become small authorised UK AIFM's will already be authorised by the FCA and, should complete the VoP form for small authorised UK AIFMs together with the schedule of AIFs it manages.
Application fees will be calculated on the same basis as for full scope firms varying their permission set out above.
A new entity requiring authorisation as a small authorised UK AIFM should complete the following forms:
- wholesale investment firms application;
- VoP form for small authorised UK AIFMs; and
- schedule of AIFs for small authorised UK AIFMs.
As above, if the same information is requested in the wholesale investment firms application as the VoP form, the FCA state that a firm should provide this in the VoP form only.
Firms falling within one of the following categories will be able to register as a small registered UK AIFM:
- it is an internal AIFM of an AIF which is a closed ended investment company e.g. it is not a collective investment scheme. It might be an investment trust for example.
- it is a collective investment scheme (but not an AUT, an authorised OEIC or a UCITS scheme) which holds the majority of its assets in land and certain conditions are met.
The application fee for registration is £750.
Note that an authorised operator with permission to establish, operate or wind up a collective investment scheme will be required for each AIF that is a collective investment scheme, if you are registering rather than applying for authorisation.
Capital requirements and additional own funds
An AIFM is required to maintain a minimum level of capital. For internally-managed AIFs it is €300,000. For an external AIF it is at least €125,000 plus 0.02% of the portfolio value which exceeds €250 million, subject to a cap of €10 million. In addition AIFMs will need to provide either additional own funds or obtain professional indemnity insurance to cover liability risks arising from professional negligence.
All forms referred to in this note are available on the FCA website.
Ongoing compliance requirements
Once an AIFM is authorised under the AIFMD it must adhere to a number of ongoing compliance requirements. There are rules that apply to the way the business is organised and controlled and others in relation to conduct of business matters. The compliance obligations introduce minimum standards of governance, conduct and risk management.
The key ongoing compliance requirements under AIFMD are as follows:
Separate compliance function
An AIFM must establish a "permanent and effective" compliance function as part of its organisational requirements. This requirement applies irrespective of the size and complexity of the AIFM's business. The compliance function is to have two key responsibilities:
- monitoring risks including the evaluation of measures, policies and procedures and actions taken to address any compliance deficiencies; and
- advising those who are responsible for carrying out the services/activities, and this should include advice to assist them in complying with the AIFMD's obligations.
A compliance function which is not independent will fail to meet the AIFMD's standards. A number of important criteria must be met in this respect, including the need to ensure that there is necessary resource for an appointed compliance officer who must report to senior management as to whether or not remedial action has been taken in any areas of deficiency.
In keeping with the flexible and "proportionate" approach adopted under AIFMD, the function should fit the nature, scale and complexity of the AIFM's business activities. Therefore, a separate compliance unit may not have to be established if this would be disproportionate in view of the particular AIFM's business provided it can demonstrate independence.
Conduct of business
An AIFM's conduct of business will be judged under general principles set out under article 12 of the AIFMD which, in summary, require it to act in the best interests of the AIF or investors of the AIF, and with honesty and due skill, care and diligence.
A key part of the ongoing compliance obligations is the fair treatment of all investors in an AIF.
Operating conditions
Some of the key requirements for AIFMs are in relation to the following matters:
- Remuneration policy - an AIFM must adopt a remuneration policy and procedures that govern staff "whose professional activities have a material impact" on the risk profiles of the AIFMs or AIFs they manage. In response to industry concerns over how to align the AIFMD remuneration regime with the Financial Services Authority's (FSA) remuneration code, the FCA's most recent position is that complying with the AIFMD regime will be deemed to be complying with the code.
- Conflicts of interest - an increasingly important area for the financial services industry is that of conflicts of interest. Its treatment under AIFMD (which is consistent with MiFID) supports the wider AIFMD theme of acting honestly and with due care and treating investors fairly. The level 2 measures specify the types of conflict of interest that may arise and lay down a requirement for a conflicts of interest policy which includes procedures and arrangements that AIFMs are expected to implement and apply in order to identify, prevent, manage, monitor and disclose conflicts of interest. This is likely to be a key area of interest going forward and senior management should be diligent and proactive to ensure that the policies and procedures are operating in practice as required.
- Risk management - there must be functional and hierarchical separation of the risk management function from other business units. A documented risk management policy is necessary and detailed processes to identify, measure, manage and monitor risk. Independence of the risk management activities is also key.
- Liquidity management - requirements are imposed for each AIF managed and the AIFM must be able to demonstrate to its regulator that it has an appropriate liquidity management system that is aligned to each AIF's investment strategy, liquidity profile and redemption policy.
- Investment in securitisation positions - restrictions are imposed on AIFMs exposure to credit risk of a securitisation; they must be able to demonstrate to the regulator for each individual securitised position that they understand those positions and have policies/procedures which are appropriate to the risk profile for the relevant AIF's investment in securitised positions.
- Valuation - procedures must be put in place by an AIFM to ensure that a proper and independent valuation of the assets of the AIF can be performed. The valuation can be performed by an external valuer or by an the AIFM itself so long as the valuation task is functionally independent from the portfolio management and remuneration policy, and other issues such as conflicts avoided. Where the AIFM chooses to conduct the valuation internally, the regulator may request a verification of the procedures by an external valuer. Delegation of the task to an external valuer will not transfer responsibility for a proper valuation to the third party.
- Delegation - an AIFM is able to delegate functions to third parties under certain conditions, so long as the AIFM does not become the equivalent of a "letter-box entity". Additional requirements apply if risk or portfolio management are delegated. In certain circumstances, a delegate may then sub-delegate functions. Ongoing monitoring obligations will apply in relation to delegated functions.
- Leverage - where an AIFM manages an AIF that employs leverage on a substantial basis, AIFMD imposes reporting requirements. An AIFM must also set leverage limits for each AIF it manages and be able to demonstrate the reasonableness of the leverage limit.
- Disclosure obligations - transparency is a key theme throughout AIFMD. An AIFM must prepare an annual report for each EU AIF it manages and each AIF it markets in the EU. Detailed investor disclosure obligations are also set out in AIFMD which will apply prior to and after an investor's investment. Any "material change" to the information already provided to an investor must also be disclosed. An AIFM must also comply with a number of ongoing disclosure requirements to investors and the regulator.
In respect of the ongoing compliance requirements, a firm should undertake a gap analysis in order to identify the steps that may be needed to meet the AIFMD conduct of business principles. This might, for example, involve creating or amending your firm's policy and/or procedures governing conflicts of interest, risk management, liquidity management and valuation procedures; ensuring that your firm's systems comply with ongoing disclosure requirements to investors and/or regulators, or improving your due diligence procedures.
Remuneration
Article 13 of the alternative investment fund managers directive (AIFMD) directs all alternative investment fund managers (AIFMs) to have remuneration policies and practices for those categories of their staff whose professional activities have a material impact on the risk profile of their AIFM or of the alternative investment funds (AIFs) they manage. Annex II of AIFMD (Annex II) sets out the details which AIFMs must comply with when establishing remuneration policies and the detail is supplemented by the European securities and markets authority's (ESMA) guidelines on sound remuneration policies published 11 February 2013 (the guidelines).
This note highlights the key provisions relating to the Remuneration requirements of the AIFMD:
When do the remuneration provisions apply?
The remuneration provisions of AIFMD are applicable to AIFMs which are either external managers or, where an AIF does not appoint an external manager, the AIF itself.
AIFMs which fall below the financial threshold set out in AIFMD will not be subject to AIFMD's remuneration provisions.
Which staff are caught?
The guidelines define the categories of staff which will be subject to the remuneration policies and practices outlined in Annex II (identified staff). The following categories of staff should be included as identified staff unless they have no material impact on the AIFM's risk profile or the AIFs it manages:
- executive and non-executive members of the AIFM's governing body;
- senior management;
- staff (other than senior management) responsible for risk management, compliance, internal audit and similar control functions;
- staff responsible for heading the portfolio management, administration, marketing and human resources divisions of the AIFM;
- other risk takers such as staff capable of entering into contracts and positions and taking decisions that materially affect the risk positions of the AIFM or the AIFs it manages; and
- other staff members whose total remuneration takes them into the same remuneration bracket as senior managers and risk takers (if they also have a material impact on the risk profile of the AIFM or the AIFs it manages).
AIFMs should be able to demonstrate how they have assessed and selected their identified staff.
Do the provisions apply to delegates?
AIFMs should also ensure that entities to which the AIFM delegates portfolio or risk management activities are either subject to regulatory requirements on remuneration which are as effective as those set out in AIFMD and the guidelines, or that appropriate contractual arrangements are put in place to ensure there is no circumvention of the remuneration rules in relation to the delegates' identified staff.
What does proportional implementation require?
ESMA notes that the different risk profiles and characteristics of AIFMs justify a proportionate implementation of the remuneration policies and practices laid down by the AIFMD. The effect of this proportionality principle is that not all AIFMs will have to implement AIFMD's remuneration requirements in the same way and to the same extent. Proportionality will work both ways: some AIFMs will have to apply more sophisticated remuneration policies and practices; and some can meet the requirements in a simpler or less burdensome way.
The following are relevant criteria when considering implementing a proportional approach to the directive's remuneration principles:
- the size of the AIFM and the AIFs it manages;
- the AIFM's internal organization; and
- the scope, nature and complexity of the AIFM's activities.
The proportionality principle applies to types of AIFMs and should also operate within the AIFM with respect to different categories of identified staff.
The only remuneration requirements set out in AIFMD that may be disapplied altogether (and then only if it is proportionate to do so) are those relating to the pay-out process and the need to have a remuneration committee.
What will remuneration include?
For the purpose of AIFMD and the guidelines, remuneration consists of all forms of payments or benefits paid by the AIFM; any amount paid by the AIF itself (including carried interest); and any transfer of units or shares of the AIF, in exchange for professional services rendered by the AIFM's identified staff.
Remuneration can be either fixed or variable. Remuneration may include monetary payments or benefits. Ancillary payments and benefits which are part of a general, AIFM-wide, non-discretionary policy are excluded from the remuneration provisions of AIFMD provided that they have no incentive effect in terms of risk assumption. Returns on genuine investments in the AIF made by identified staff will not be subject to AIFMD's remuneration provisions. However, such investment must not originate from a loan given by the AIF to the member of staff for the purposes of co-investment if it is to be exempt from AIFMD's remuneration provisions.
What should be included in the remuneration policies?
Annex II of the directive sets out the general principle that the remuneration policies of AIFMs must promote and be consistent with sound and effective risk management. Remuneration policies should not encourage risk taking which is inconsistent with the risk profiles of the AIFs that the AIFMs manage. The remuneration policies of AIFMs also have to be in line with the business strategy, objectives, values and interests of the AIFM and the AIFs they manage and should include measures to avoid conflicts of interest. Such remuneration policies and the implementation of them must be periodically reviewed.
When should any remuneration be deferred?
AIFMD stipulates that at least 40% of an AIFM's variable remuneration must be deferred over a period which is aligned with the AIF's life cycle and redemption policy. AIFMD suggests that an appropriate period for deferral is at least three to five years, unless the AIF's life cycle is shorter. Furthermore, an AIFM's variable remuneration, including the deferred portion, must only be paid or vested if it is sustainable according to the financial situation of the AIFM as a whole and justified according to the performance of the business unit, the AIF and the individual concerned.
Remuneration committees
AIFMD provides that AIFMs such as those that are significant in terms of their size or the size of the AIFs they manage must establish remuneration committees.
Disclosure/transparency
The annual reports of an AIFM must include disclosure of the total remuneration for the financial year (split into fixed and variable remuneration) paid by the AIFM to its staff; the number of beneficiaries of that remuneration; where relevant, carried interest paid by the AIF and the aggregate amount of remuneration broken down by senior management and members of staff of the AIFM whose actions have a material impact on the risk profile of the AIF.
AIFMs are also required to disclose detailed information regarding their remuneration policies and practices for their identified staff. In accordance with the guidelines, AIFMs should further provide general information about the basic characteristics of their AIFM-wide remuneration policies and practices. Such disclosure should be published at least annually as soon as practicable after the information becomes available. Furthermore, each AIFM should let their remuneration policies be accessible to all of the staff members to whom they apply.
The situation in the UK
In its policy statement PS13/5, the Financial Conduct Authority (FCA) said that they would "proceed with [their] guidance that complying with the AIFMD remuneration regime will be deemed to be complying with the Code";. The FCA said that they believed that "this should be less burdensome to AIFMs than having to comply with overlapping regimes";. The FCA added that they "have not yet proposed guidance on an AIFMD proportionality framework, but...will consult on such a framework in due course".
Depositaries - basic questions answered
The concept of appointing a depositary will be new for many alternative investment fund managers (AIFM). An AIFM is responsible for ensuring a depositary is appointed, under contract, in accordance with the requirements of article 21 of the directive for each alternative investment fund (AIF) that it manages.
The provisions regarding depositaries were originally proposed in order to safeguard an AIF's assets against Madoff style scandals. As a result of lobbying, numerous changes have been made to the scope of the provisions, but they will nevertheless still be an unwelcome requirement for many AIFMs.
What is a depositary?
A depositary is an independent third party responsible for the safekeeping and administration of the AIF's assets.
Who can be a depositary?
For an EU AIF, one of the following:
- an EU credit institution;
- an authorised MiFID investment firm; or
- a prudentially regulated and supervised institution of a type that is eligible to be a UCITS depositary under the UCITS IV Directive.
An AIFM cannot act as the depositary.
A prime broker may be a depositary if (a) its functions as depositary are functionally and hierarchically separated from its functions as a prime broker and (b) potential conflicts of interests are disclosed to investors and appropriately managed.
A depositary must be established in the same EU member states as the EU AIF.
What will the depositary do?
The main responsibilities of the depositary are:
- safekeeping of assets (by for example ensuring that financial instruments are registered and accounts segregated);
- verification of ownership of the AIF's assets;
- monitoring cash and cash flows;
- reconcile subscription and redemption orders, ensure appropriate controls are applied on income distribution; and
- verify that appropriate procedures are applied for valuation of shares/units.
Can the depositary delegate to third parties?
The depositary may delegate its safe-keeping functions subject to satisfying a number of conditions such as exercising all due skill, care and diligence in the selection and the appointment. The delegate must segregate the depositary's client assets from its own and those of the depositary and may not re-use (rehypothecate) the AIF's assets without the prior consent of the AIF or the AIFM on its behalf.
What liability will the depositary face?
The area of a depositary's liability was one of the most controversial and fiercely debated.
Article 30 of the AIFM regulations states that where financial instruments held in custody are lost, the depositary is obliged to return identical financial instruments or the corresponding amount to the AIF/AIFM unless the loss resulted from an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary. The depositary is also not required to comply with the obligation if the lost financial instrument was held in custody by a third party and the transfer of liability has duly taken place by way of contract. In the event that the AIF or the investors suffer other losses the depositary is liable to the AIF or the investors if the losses are a result of the depositary's negligent or intentional failure to comply with a provision that applies to it.
The depositary liability provisions apply notwithstanding any contractual provisions that state otherwise and the depositary may not restrict or cap the value of their liability under the AIFMD.
What will be the cost implication?
The appointment of a depositary will necessarily increase an AIF's operating costs. The extent of these costs will become apparent as AIFMs, depositaries and insurance companies get to grips with the compliance requirements of the directive.
Are there circumstances in which a depositary is not required?
A depositary is not required for AIFMs that qualify as small AIFMs and in relation to a non-EU AIF that is either managed by a non-EU AIFM and marketed in the EU via national private placement regimes or managed by an EU AIFM but not marketed in the EU.
Is there a model depositary agreement?
No, there is no model depositary agreement; however the commission's delegated regulations contain some guidance on the key terms that should be covered in the agreement. The contract must be in writing.
Authorisation
Firms can apply to the FCA for authorisation. It is worth noting that transitional provisions apply to firms that were authorised persons prior to 22 July 2013 which enable them to act as an AIFM depositary before they have the specific depositary authorisation. They have until 22 July 2014 in which to become authorised with the new specified activity of acting as a trustee or depositary of an AIF.
Marketing and third country provisions
The alternative investment fund managers directive (AIFMD) contains complex regulations governing the marketing by AIFMs of interests in alternative investment funds (AIFs). In the UK these regulations will operate alongside and sometimes overlap with the FCA's existing financial promotions regimes. However, one of the main advantages that the AIFMD offers to AIFMs is the marketing passport which is explained below.
The marketing passport
The marketing passport is a right for AIFMs to market an AIF to professional investors in all member states. With a passport, there is no need for an AIFM to seek approval in each separate member state for marketing the AIF. This should result in significant time and cost savings for AIFMs.
The AIFMD also contains provisions concerning the marketing of non-EU funds and marketing by non-EU managers - these are often referred to as the third country provisions. These provisions were subject to great debate and political lobbying. The final position is complex and involves a delayed application of the AIFMD marketing passport in certain cases. In short, if an EU AIFM's wishes to market a third country AIF, or if a non-EU AIFM wishes to market an EU AIF then the passport regime will not be available until 2015. By 2018/2019 the commission may decide to abolish all member states private placement regimes.
The following table presents a useful high level summary
Even when the passport is extended to non-EU AIFs additional conditions will apply such as; (i) the AIFM complies with certain provisions of the AIFMD; (ii) there is an appropriate co-operation arrangement with the third country in place; and (iii) the third country where the manager is established is not listed as a non-cooperative country of territory by the financial action task force.
It is worth noting that non-EU AIFs and EU AIFs managed by a non-EU AIFM can continue to be marketed to professional investors in member states pursuant to national private placement rules possibly until mid-2018, although additional conditions may apply. In particular there needs to be an appropriate co-operation arrangement between the UK and the relevant third country of a non-EU AIFM.
What is 'marketing' under the AIFMD?
AIFMD defines "marketing" as "a direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM of units or shares of an AIF it manages to or with investors domiciled or with a registered office in the Union".
No guidance has been issued by the commission or ESMA on the meaning of marketing. However, some useful guidance can be found in the FCA's final policy statement and perimeter guidance. The FCA has confirmed the following:
- Passive marketing
The AIFMD does not restrict professional investors who wish to invest in AIFs on their own initiative. If the offer or placement is made at the initiative of the investor, namely if there is "reverse solicitation" or passive marketing then this activity is not marketing. Confirmation from the investor that the offering or placement was made at its initiative should normally be sufficient to demonstrate this provided that the confirmation is obtained before the offer or placement takes place.
- Draft documents
Whilst the FCA was of the view that sending draft documents (including promotional presentations or pathfinder version of a private placement memorandum) is not marketing, it has reserved position on this until the EU provide guidance.
- Listing
The listing of an AIFs is not in itself considered marketing however the activity undertaken leading to a listing may be caught.
- Invitation to offer
An invitation to an investor to make an offer to subscribe for the investment will be treated as an offer.
- Indirect offering
This includes situations in which the AIFM distributes units or shares of an AIF through an intermediary.
Professional investors
The marketing passport only applies to professional investors. Marketing to retail investors, therefore, remains subject to each member states current private placement provisions.
Professional investors will include the majority of institutional investors such as pension funds, banks, insurance companies and sovereign wealth funds will fall within the definition. It will have the same meaning as used in MiFID.
Transitional provisions
The AIFMD came into force 22 July 2013 but transitional provisions allow certain AIFMs up to a year in which to seek the necessary variation of permission, authorisation or registration in their home member state. Applications must be received before 22 July 2014. An AIFM wanting to take advantage of the marketing passport can only do so once it is authorised. As such it should submit its application promptly. The transitional provisions contained in the UK implementing regulations are designed to help AIFMs continue to market funds in the UK after July without interruption. It allows marketing in the UK by certain UK AIFMs or EU AIFMs to continue for up to 12 months.
A UK firm that wishes to begin managing and marketing an AIF for the first time after 22 July 2013 will not benefit from any transitional provision. It will first have to apply to the FCA for authorisation and be fully compliant with the AIFMD before it can begin to manage and market the AIF.
Overlap with financial promotions
An overlap exists in the UK between the concepts of "marketing" under AIFMD and a "promotion" under the relevant Financial Services and Markets Act (FSMA) subordinate legislation dealing with promotions.
Marketing to retail investors can only be done if a financial promotion can be made to that investor in compliance with the financial promotion regime. The FCA has decided to implement industry suggestions for a public register of privately placed funds.
Key issues for private equity funds
The AIFMD introduces a raft of new regulatory requirements which AIFMs will need to understand and comply with. A number of these regulations are targeted specifically towards private equity AIFMs. This note summarises the key issues faced by private equity fund managers with regard to the AIFMD.
Small AIFMs
Private equity AIFMs that are sub-threshold and wish to take advantage of the lighter regulatory regime that is available to smaller AIFMs, will need to register as a small registered UK AIFM pursuant to regulation 10 of the UK regulations, or apply for part 4A permission to carry on the activity of managing an AIF as a small authorised UK AIFM. Most sub-threshold private equity AIFMs are likely to become small authorised UK AIFMs as opposed to small registered AIFMs due to the restrictive conditions that apply to small registered UK AIFMs.
AIFMs operating under the small AIFM regime will not be able to take advantage of the EU marketing passport.
Acquisition of major holdings and control
These regulations only apply to full-scope AIFMs and require additional disclosures to be made by an AIFM managing an AIF which acquires certain holdings or control of portfolio companies.
In particular the AIFM must:
- notify the regulator if the voting rights of an AIF in a non listed company held by the AIF reaches, exceeds or falls below the thresholds 10%, 20%, 30%, 50% and 75%; and
- if the AIF acquires control the AIFM must notify the target company and its shareholders and the regulator and (unless the information is sensitive - see below) it must ask the target company's board to notify employee representatives of the acquisition.
Such notifications must be done as soon as possible and in any event no later than ten working days after the date on which the AIF reaches, exceeds or falls below the relevant threshold.
If the AIF acquires control of a non-listed company or an issuer then the AIF must disclose additional information such as its policy for managing conflicts and the safeguards it has in place to ensure that agreements between the AIFM and the AIF or target company or issuer are on arms-length terms.
In addition, if the AIF acquires control of a non-listed company then within 20 working days the AIFM is required to disclose to the target company and its shareholders and (unless the information is sensitive - see below) ask the target company's board to notify employee representatives of its intentions as to the target company's future business and the likely repercussions on employment, including any material change in the conditions of employment. The AIFM must also provide the FCA and the AIF investors with information on how the acquisition has been financed
Sensitive information: if the communication of certain information would seriously harm the functioning of the target company or would be seriously prejudicial to it then the board of the target company will not be obliged to comply with the notification request.
The AIFMD recognised that the additional disclosure requirements could place private equity AIFMs at a significant competitive disadvantage compared to other companies that have a different ownership structure. The commission may look at this going forward in order to extend the principle on a more general basis.
The rules do not apply to special purpose vehicles established to buy, hold or administer real estate or small or medium sized enterprises.
Asset stripping
The asset stripping provisions only apply to full-scope AIFMs.
If an AIF acquires control of a non-listed company or issuer then in the following 24 months the AIFM must not facilitate, support or instruct any distribution, capital reduction, share redemption or buy back of own shares by the target company or issuer and must use its best efforts to procure the same.
The FCA has stated that it will consider issuing guidance at a later stage if required in relation to the scope and interpretation of this provision.
The European venture capital fund and European social entrepreneurship fund regulations
On 22 July 2013 the regulation on European venture capital funds ((EU) No 345/2013) (the EuVECA Regs) and regulation on European social entrepreneurship funds ((EU) No 346/2013) (the EuSEF Regs) are directly applicable in all EU member states. These regulations grant the AIFM of AIFs meeting certain conditions with the right, subject to registration and compliance with certain investment and organisational requirements, to a European marketing passport. The requirements imposed under the EuVECA Regs and EuSEF Regs are considerably lighter than the requirements of full-scope AIFMD, but go further than the small fund manager regime.
The EuVECA Regs and EuSEF Regs apply on a voluntary basis to small AIFMs who register as a small registered UK AIFM under regulation 10 of the UK AIFM regulations.
Carried interest and co-investment vehicles
Carried interest vehicles will often be established with managers or employees taking an equity stake. The FCA has confirmed that in general these vehicles should not be treated as AIFs which is useful but the individual circumstances of each project should clearly be assessed.
The FCA has also issued some guidance that states co-investment vehicles which involve managers or employees investing in a co-investment vehicle alongside other investors will not generally be viewed as an AIF. This is particularly if the investment into such vehicles is only of a nominal amount. The AIFMD is designed to protect investors from whom capital is raised rather than co-investment by the managers.
Depositary
In order to ensure that as proportionate a depositary requirement is put in place as possible for managers of relevant funds the FCA has introduced a new private equity AIF depositary model. This concession applies where a AIFM is not likely to hold significant financial instruments. Firms wishing to act as a private equity depositary will need to apply for funds for permission to act as a depositary of an AIF, but will have a limitation imposed on their permission to only act as a private equity AIF depositary. They will also be subject to a minimum capital requirement of €125,000.
This concession only applies to AIFs which have no redemption rights exercisable during the first five years and which generally do not invest in assets which must be held in custody or generally invest in issuers or non-listed companies in order to potentially acquire control over such companies. More information about depositaries can be found in our separate note on this topic.
EIS Funds
In order to determine whether an EIS fund is an AIF an assessment of the individual circumstances of the fund will be required. Typically an investor will appoint a manager to invest his subscriptions on a discretionary basis in qualifying companies. The structure typically avoids being a collective investment scheme for UK FSMA purposes but they are usually collective investment undertakings and are exempted from MiFID. On this basis, an EIS Fund may be an AIF but this will depend on the circumstances and whether all the conditions of the AIF definition apply.
Key issues for real estate funds
The publication of the AIFMD on 29 April 2009 caused shock waves to rumble through the real estate funds industry. Up until that point no one had really expected the AIFMD to extend to and regulate real estate funds; the AIFMD was only expected to cover hedge funds and private equity funds. While it has not been possible to extract real estate funds from the scope of the AIFMD, some significant concessions have been secured through the lobbying efforts of the last few years.
This note highlights the key issues in the AIFMD that are relevant to real estate funds.
Can a UK real estate fund manager avoid the AIFMD applying to its fund?
No; not if the fund manager falls within the definition of an 'AIFM' under the AIFMD and no exemptions apply. Further guidance on this can be found in our note 'Are you caught? Thresholds and exemptions'.
REITs - are they affected by the directive? And what about PAIFs?
The FCA noted in its initial consultation paper that property investment firms (such as real estate investments trusts or REITs ) can have the characteristics of an investment fund (they may pool investment, have a defined investment policy, etc), but they may also have characteristics of a commercial company (such as having employees and performing service activities such as property construction and development). The FCA as a result considers that they may or may not be AIFs depending on the specific activities they carry on.
Property authorised investment funds (PAIFs) may also be subject to the AIFMD notwithstanding that they are already subject to certain regulation and the existing FCA COLL rules.
To what extent are UK real estate joint ventures excluded?
The AIFMD contains a recital which states that the AIFMD should not apply to joint ventures. Until recently there had been very little guidance on what distinguishes a fund from a joint venture.
The FCA stated in its first consultation paper joint ventures may have fund-like characteristics such as capital-raising, passive participants, defined investment policies, etc. However, where investors in a given joint venture structure have substantial management control over strategic decisions, there is likely to be a contrast with the governance of typical AIFs. The perimeter guidance issued by the FCA also usefully confirms:
- that the definition of an AIF as set out in the AIFMD requires capital to be invested on behalf of investors rather than the parties investing capital for themselves;
- that if the joint venture vehicle is managed by the members jointly then it will not be considered an AIF; and
- that an undertaking that does not raise external capital is not an AIF.
The perimeter guidance also identifies a number of factors that are relevant in determining whether an entity is a joint venture or a fund. It notes that joint ventures are often a marriage of equity and expertise, with one partner being responsible for day to day management and the other financial partner more concerned with the strategic decisions. A joint venture is also able to appoint a third party to manage operations without necessarily becoming an AIF. In fact the limited partnership model is specifically considered in which the limited partners are necessarily restricted from getting involved in day-to-day management; in such a case it is noted that a joint venture arrangement can still exist.
It is noted that joint ventures are more likely to have a policy focussed on the achievement of the parties commercial goals as opposed to a defined investment policy and an existing relationship.
How are UK real estate funds that already have an authorised operator affected?
Collective investment scheme regulations will continue to apply alongside the AIFMD as explained in the note on implementation of the AIFMD.
Are managers of small real estate funds excluded?
A lighter regulatory regime will apply to AIFMs of small funds as explained in our note on thresholds and exemptions. Certain real estate small fund managers may be able to qualify as a small registered UK AIFM, but the real estate qualifying condition is quite limited. In other cases the manager should consider applying for permission to manage an AIF as a small authorised UK AIFM.
In a real estate fund that is established as a limited partnership will the general partner be the AIFM?
It is likely that the general partner of an AIF established as a limited partnership will be considered the AIFM, however this will ultimately be determined by the particular circumstances of the AIF.
What if the general partner has delegated most of its responsibility?
If the general partner lacks substance and has delegated such of its responsibility to third parties that it becomes a letter box entity then it is likely that the delegate will become the AIFM.
What if the general partner is based in Jersey?
If the general partner is based in Jersey then it will be a non-EU AIFM. More guidance on this can be found in the analysis on third country rules.
How are real estate offshore trusts affected?
If the offshore trust and or its manager is not located in the EEA then the application of the AIFMD is subject to the third country rules.
What is a depositary and will one be required?
If the AIFMD applies to an AIFM (and none of the exclusions apply as set out in our note on Thresholds and Exclusions) then yes a depositary will be required. A depositary is an independent third party responsible for the safekeeping and administration of the AIF's assets. It would, amongst other things, be required to verify title to the real estate assets. The requirement to appoint a depositary is likely to be a culture shock to many real estate fund managers. Further guidance can be found in our note on depositaries.
How often will the real estate assets in an AIF need to be valued?
The UK implementing regulations state that AIFMs shall ensure that the assets of the AIF shall be valued and the net asset value per unit or share of the AIFs shall be calculated at least once a year. If the AIF is open ended then the frequency of the valuation shall be changed to one which is appropriate to the issuance and redemption frequency. If the AIF is closed ended then such valuation should also be carried out when there is an increase or decrease in the AIF's capital.
How long do I have before I need to comply with the AIFMD?
The directive is already in force however there are transitional arrangement that apply to some AIFMs - further detail is provided in our note on the transitional provisions.
Key dates and useful resources links
Key dates in the history of the directive are:
29 April 2009 - first draft of the directive was issued
8 June 2011 - directive adopted by the European Parliament and Council (to be transposed into national law and implemented by all member states)
19 December 2012 - delegated regulations issued by the European Commission (directly applicable)
22 July 2013 - UK AIFM regulation becomes effective
22 July 2014 - end of the AIFMD transitional period
2015 - possible extension of the passport system to non-EU AIFs and AIFMs
2018 - possible end of national private placement regimes
Key Documents/Links
- Eur-lex website, directive 2011/61/EU dated 8 June 2011 on Alternative Investment Fund Managers
or http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2011:174:0001:0073:EN:PDF]
- Eur-lex website, commission delegated regulation (EU) No 231/2013 dated 19 December 2012
- ESMA website, final report - guidelines on sound remuneration policies under AIFMD
- HM Government website, transposition of the AIFMD: response to consultation issued by HM Treasury 13 May 2013 and [https://www.gov.uk/government/consultations/transposition-of-the-alternative-investment-fund-managers-directive]
- HM Government website, transposition of AIFMD: Question and Answers issued by HM Treasury issued May 2013
- ESMA website, final report - guidelines on key concepts of the AIFMD dated 24 May 2013
- FCA website, policy statement PS13/5 on implementation of the AIFMD issued June 2013
- HM Government legislation website, the alternative investment fund managers regulations 2013 issued 22 July 2013
- FCA Website (AIFMD page)
- EC Website, questions regarding AIFMD
- FSA website, consultation paper CP12/32 on the rules and guidance to transpose the requirements of the AIFMD into UK law (Part 1) issued November 2012
- FSA website, consultation paper CP13/9 on the implementation of AIFM (Part 2) issued March 2013