This article considers the options for investment managers who wish to avoid authorisation under the Alternative Investment Managers Directive (AIFMD or Directive) as an AIFM and yet access EU investors. When used in this article, AIFM (alternative investment fund manager) has the meaning given in the Directive, namely a legal person whose regular business is managing one or more alternative investment funds (AIFs), and ‘managing’ means providing at least risk and portfolio management services for an AIF.
To distinguish between AIFMs and AIF investment managers generally, the latter are referred to here, generically, as ‘managers’, whether or not they are technically an AIFM. A manager to which portfolio management has been delegated by an AIFM and which is not itself an AIFM is referred to as a ‘portfolio manager’.
Why avoid the AIFMD?
It might seem to be an inescapable conclusion that a manager based in the EU has no choice but to be an AIFM authorised under the Directive, or that a non-EU AIFM cannot benefit from the AIFMD passport. There are, however, alternatives available whereby an EU manager can avoid the requirements of the Directive applicable to an AIFM and remain as an AIF’s portfolio manager, and there are solutions for a non-EU manager. An EU manager able to take advantage of these alternatives will avoid the AIFMD’s higher capital requirements, remuneration rules, depositary requirements, transparency rules, requirements on delegation, and valuation and liquidity management rules, among other things.
Solutions for EU managers
To avoid those requirements, an EU manager needs to be appointed as portfolio manager by an AIFM based either within or without the EU. The AIFM must not delegate to the portfolio manager to such an extent that the AIFM is a ‘letter box entity’. This is usually achieved by the AIFM retaining the risk management function so that all portfolio management can continue to be carried out by the portfolio manager, subject to overall supervision of the AIFM.
If the AIFM is based in an EU state, then any EU AIF whose assets are managed by the portfolio manager, such as an Irish or Luxembourg fund, is able to use the AIFMD passport. If the AIFM is outside the EU, for example in the Cayman Islands, then the passport will not be available, as is the case for an EU AIFM with only non-EU AIFs. Non-EU AIFs may only be marketed using a member state’s national private placement rules (NPPRs), whether managed by an EU or non-EU AIFM.
Although many managers have offshore holding companies— which, in the case of hedge funds, may be the entity which contracts with the fund as manager and delegates to the EU manager — the offshore entity rarely has the substance required to be the AIFM, and by default the EU manager would be the AIFM. Consequently, by using a third-party AIFM host that has the resources and expertise to perform risk management, an EU portfolio manager can be satisfied that the host AIFM has sufficient substance to meet the AIFMD substance requirements and, therefore, the EU portfolio manager can continue to do what it does best – portfolio management – subject to continuing MiFID equivalent regulation.
Solutions for non-EU AIFMs
Non-EU AIFMs may only access EU investors via the NPPRs, as mentioned above. In doing so, they are required to submit to the regulator of each country where the AIF is marketed detailed reports on the AIF being marketed on a periodic basis, make certain disclosures to investors and prepare an annual report compliant with the AIFMD, and disclose in that report the total amount of remuneration for the financial year paid by the AIFM to its staff. The total remuneration amount is to be split into fixed and variable remuneration and specify the number of beneficiaries, as well as any carried interest paid by the AIF.
This disclosure can be by reference to the remuneration of the AIFM’s relevant staff who are fully or partly involved in the activities of the AIF, but does not require disclosure of the remuneration of specific individuals, named or otherwise. The remuneration disclosure requirement has been cited as a barrier to marketing of AIFs in the EU by non-EU AIFMs, particularly by US managers. (Note also that the relevant staff of a portfolio manager (EU or non-EU) appointed by an EU AIFM will be subject to the AIFMD’s remuneration rules, under AIFMD delegation rules. The exception is for portfolio manager delegates of a Malta AIFM, as the Malta regulator does not apply these requirements).
If a non-EU AIFM, therefore, wishes to access the EU market, it can do so by: establishing its own EU-based AIFM and seeking authorisation for it; marketing via the NPPRs; relying on reverse solicitation; or using a third party’s AIFMD hosting solution.
AIFMD hosting is a growing business, building on existing regulatory hosting services, and includes services provided to managers who want to use the AIFMD passport. The key service offered to managers is to provide an AIFM run by the service provider, which will retain risk management and delegate portfolio management to the manager as a portfolio manager. The portfolio manager may then establish an EU AIF to be managed by the AIFM. However, as the AIFM is not under the control of the portfolio manager, there are risks to this arrangement, as considered below. Some hosting providers offer a ‘plug and play’ AIFMD solution offering not just the hosted AIFM but also an EU AIF to go with it. A variation on that theme is the self-managed AIF, which is authorised in its own right as its own AIFM.
Pros and cons
Some pros and cons of AIFM hosting have been discussed above. Overall, the choice is generally one of speed of implementation and convenience, against the cost of buying into an existing infrastructure and fronting an AIF with a third-party AIFM. As a rule of thumb, the third-party AIFM will always itself perform the risk management function for the manager client, and, as AIFM, must supervise the portfolio manager. That requires a level of trust between the client and the provider, and for the client to be comfortable that the AIFM really does have the expertise and resources to perform its services, as although the Directive separates them out, risk and portfolio management are inextricably linked.
Some non-EU managers may determine that it is worth setting up their own independently run EU AIFM if the economics of a long term business plan merit it, rather than setting up an AIFM run by someone else with the attendant risks, including reputational risk. In any case the AIFM hosting model anticipates that a number of clients will fly the nest when they have reached a size which justifies independence.
When signing up to a hosting arrangement, portfolio managers should carefully scrutinise the contractual terms, especially where an initial discounted fee is offered as a quid pro quo for locking the client in for a long term before being able to terminate.
Conversely, a third-party AIFM has the power to terminate the portfolio manager. Absent the AIFM in pre-AIFMD days, that prerogative would have been the fund’s alone. There is also the risk of premature termination in the event that the host ceases business unexpectedly, e.g., if it is closed down by a regulator or it becomes insolvent.
The AIFMD regime is still relatively new and the proliferation of AIFMD ‘solutions’ now on the market may attract regulatory scrutiny sooner rather than later. For example, a possible area of regulatory focus will be to ensure that the AIFM has sufficient substance and is not in reality a letter box. Where a host fails that test, the consequences could be severe for the manager who has relied on it, either to use the passport (non-EU managers) or to avoid being an AIFM itself (onshore managers), as well as for the host.
Simon Firth is a partner at Kaye Scholer LLP. He can be contacted on +44(0)20 7105 0583 or by email: firstname.lastname@example.org.
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