FORUM: Complying with the AIFM Directive
September 2014 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
FW moderates a discussion on compliance with the AIFM Directive between Martin Brockhausen at King & Wood Mallesons, Martin Krause at Norton Rose Fulbright, Michelle Moran at Ropes & Gray, and John Adams at Shearman & Sterling.
FW: Could you provide a brief overview of the purpose and provisions of the AIFMD? Broadly, what has changed under the new regime?
Brockhausen: The Alternative Investment Fund Manager Directive (AIFMD) aims to provide a “harmonised and stringent regulatory and supervisory framework for the activities within the Union of all AIFMs”, including EEA AIFMs as well as non-EEA AIFMs. Accordingly, the directive contains regulatory requirements for AIFMs and the AIFs they manage if they operate – including with regard to marketing – within the EU, whereas the AIFMD allows for de minimis exceptions for AIFMs that are ‘sub-threshold’ in terms of the assets they manage. A positive side effect of the harmonisation is that fully compliant EEA AIFMs are ‘rewarded’ with a marketing passport allowing them to market to professional investors across all member states. A harmonised passport regime for non-EEA AIFMs was intended to be implemented after a transitional period of two years, although it is questionable whether the intended timeline will be kept.
Krause: Prior to the enactment of the AIFMD, only a certain type of fund was regulated on a European basis – the so-called Undertakings for the Collective Investment in Transferable Securities (UCITS). All funds other than these were unregulated or only subject to regulation in some jurisdictions. In particular, this held true for hedge funds and private equity funds. Since legislators and regulators believed that hedge funds and private equity funds caused significant damage during the financial crisis, they responded with the enactment of the AIFMD to abolish all risks from these fund types for the financial stability. However, when the AIFMD evolved, it finally now covers all funds which are not yet covered by the UCITS Directive. Probably the most eminent element of the AIFMD is the compulsory use of a depositary to ensure that fund managers can no longer pretend their funds would have a certain NAV whilst, in reality, there are no assets left. Another important element is the need for minimum equity of the fund manager or comparable insurance protection and, furthermore, the prohibition that the AIFM must not become a letterbox entity which significantly limits the potential for outsourcing. The AIFMD was heavily criticised by the US, which believed it would be a protective measure against non-EU asset managers prohibiting it access to the European markets. This criticism is probably correct as we see fewer and fewer non-EEA asset managers marketing their products into the EU. But also within the EEA, a number of asset managers have given up, since their assets under management are simply not high enough to achieve the necessary economies of scale to economically survive under the AIFMD. Conversely, large asset managers will benefit as many of their smaller competitors disappear from the scene. Equally, the European passport for marketing to professional investors is a milestone for licensed AIFMs, permitting them to market their funds all over Europe.
Moran: AIFMD aims to create a harmonised framework for the authorisation and regulation of managers of AIFs which manage or market AIFs in the EEA. Broadly, an AIF is any fund which is not a UCITS, meaning that AIFMD will apply to managers of hedge funds, private equity funds, certain retail investment funds, investment companies and real estate funds, among others. In an environment traditionally characterised by a lack of regulation, AIFMD represents something of a paradigm shift. EEA managers must now observe strict requirements on conduct of business – including conflicts of interest, remuneration, risk management, valuation and disclosure to investors and regulators – regulatory capital, the safekeeping of investments through the mandatory appointment of depositaries, delegation and the use of leverage. Non-EEA managers marketing in the EEA will also be subject to certain ‘baseline’ disclosure and reporting requirements, although individual member states can, and do, impose stricter rules.
Adams: Ostensibly, it is all about increasing investor protection and decreasing systemic risk. The provisions try and achieve that in two ways. First, by more tightly regulating fund managers and imposing transparency, conduct of business and other rules on fund managers – including how they pay their staff. Second, by requiring managers to give regulators access to vast amounts of information about the alternative funds that they manage. What has changed is that European fund managers are more tightly regulated than ever, and non-European managers are coming to terms with restrictions on their Europe-focused activities.
FW: What operational challenges have fund managers faced since the implementation of the AIFMD in July 2013? How have they responded?
Moran: The ‘one size fits all’ approach which characterises AIFMD has had a marked impact on an industry with significantly differing operating models. The requirement to appoint a depositary – and the issue of depositary liability – has caused concerns, as have constraints on leverage and liquidity management. Similarly, structural changes necessitated by the rules on valuation and risk management have proved problematic, particularly for smaller managers. Remuneration is especially contentious with many US managers struggling to reconcile their domestic and European obligations. Regulatory reporting will generate much new work and is currently among managers’ most pressing concerns. The lack of regulatory certainty increases the burden as the inconsistent approaches to implementation across the EEA have made a one-stop compliance solution impossible. Despite this, managers have proved to be remarkably resilient and have taken a pragmatic approach to the operational challenges. Indeed, some managers are beginning to see opportunities in the AIFMD model.
Adams: One big issue has been that the AIFMD is fundamentally a ‘one size fits all’ piece of legislation. It tries to ‘work’ for all different types of alternative funds – including hedge funds, private equity, infrastructure, real estate and listed funds. You can do that with something like UCITS, where there are basic rules about what a UCITS can be, where it can be, and what it can do. It is much harder to do it for every other type of fund in the world in one fell swoop. The end result is that the AIFMD imposes requirements on some managers that don’t – to put it mildly – fit comfortably with their businesses. So that in itself has been a challenge. Another operational challenge has been timing. Guidance is filtering through all the time from ESMA and from national regulators on really fundamental issues. And many managers have of course been under pressure to get systems, policies and procedures in place at a time when not all of these issues have been properly ironed out.
Brockhausen: The actual impact of the AIFMD and the national implementation laws differ significantly between EU member states and types of AIFMs. For AIFMs which were already subject to a high level of regulation prior to AIFMD implementation, for example AIFMs located in EU member states in which the alternative investment fund industry was already highly regulated, the AIFMD did not bring a lot of new challenges. For AIFMs which were potentially faced with full regulation for the first time, the challenges were more significant. The reaction of these previously more lightly or not regulated AIFMs was either to aim for the aforementioned ‘sub-threshold’ exception from full compliance or to adapt their internal corporate and governance structure as required. In the latter case, the resulting challenges were of course greater for smaller, owner-managed firms than they were for large institutional managers.
FW: What steps must fund managers take to ensure they are AIFMD compliant following the end of the transitional period on 22 July 2014?
Krause: Many asset managers used the grandfathering period following the enactment of the national transpositions of the AIFMD from 22 July 2013. They launched funds on 21 July 2013 and were managing and marketing them until 21 July 2014. Fund managers within the EEA had to file for a licence as an AIFM by 21 July 2014 and can only proceed upon issuance of such licence. Non-EEA fund managers must no longer market their funds without a notification to an EEA regulator. In a number of EEA jurisdictions, such a filing might not be possible prior to 22 July 2015 which effectively means a temporary ban for these fund managers. Managing funds in the EEA without the required AIFM-licence is an infringement of the AIFMD and in some jurisdictions, including Germany, might constitute a criminal offence. An offer of non-EEA funds to European investors without a completed notification procedure could result in an administrative fine and civil-law liability in the event of a loss. Practically, with effect from 22 July 2014, non-EEA AIFMs have disappeared from the scene and, in the absence of a notification, reverse solicitation is the only way left to sell to European investors.
Brockhausen: ‘Sub-threshold’ AIFMs were generally only required to register with their national regulators if the respective home member state of the AIFM implemented the exception offered by the AIFMD – which most member states did. AIFMs which are required to be fully compliant need to obtain a full licence from their regulator. The interpretation of the AIFMD varies significantly among EU member states as to whether it was sufficient for the application for a licence or registration to be submitted prior to 22 July 2014. In order to obtain a licence, the respective AIFMs needed to adapt their internal organisation to comply with AIFMD requirements – for example, separation of certain functions, minimum capital, and so on. Furthermore, AIFs managed by fully licensed AIFMs generally need to comply with certain requirements, to the extent grandfathering provisions are not available.
Moran: Managers looking to comply either became authorised by their home regulator – an EEA-manager – or registered in the European jurisdictions into which they intended to continue marketing beyond the transitional period. Much of the structuring done by managers was to mitigate the effects of – rather than to comply with – the AIFMD. Some managers decided not to use onshore fund vehicles, while others migrated their operations offshore to take advantage of a less onerous regime. The drawback is that the funds may not be passported around the EEA and so, for many large managers, it was preferable to submit to full AIFMD compliance. Indeed, some managers saw AIFMD compliance as a chance to consolidate their operations, move operations onshore, and utilise the marketing passport and the investor protections built into AIFMD compliance as selling points. Many non-EEA managers deliberately timed marketing campaigns to stop prior to the end of the transitional period.
FW: What actions should non-EEA private fund managers take now to ensure compliance?
Adams: A non-EEA manager should be looking urgently at its current and planned marketing activities in the EEA. That means any marketing by it and also any third parties such as placement agents. The manager needs to focus on what marketing is taking place, where and to whom, and – crucially – what form the marketing actually takes. Once the manager knows which EEA countries are relevant, and what marketing activities – whether meetings, calls, sending fund documents, ‘teasers’ or performance data – the manager wants to take place in those countries, it is possible to work out what steps need to be taken and whether the AIFMD is even relevant. But it is, unfortunately, a country-by-country analysis. It may be perfectly possible to send a factsheet to a UK institutional investor, yet sending the same factsheet to a Swedish investor may be illegal. So it’s absolutely essential to nail down the activities in each EEA country. If AIFMD marketing is to take place, then the fund manager will – at the very least – need to conduct a ‘healthcheck’ of its fund documents to ensure that the required pre-investment disclosures are properly being made. There will be many other hoops to jump through in many countries. Managers should also not underestimate the work involved in the periodic reporting to EEA regulators that is triggered by marketing.
Brockhausen: The AIFMD does not directly regulate non-EEA AIFMs but nevertheless has a massive impact on non-EEA AIFMs if they want to market their AIFs to European investors. Since the marketing passport for non-EEA AIFMs has not yet been introduced, the AIFMD provides the individual member states with broad discretion on how to allow marketing by non-EEA AIFMs. As a result, non-EEA AIFMs must currently comply with the national rules of each member state they wish to market in. Many member states used the implementation of the AIFMD as a reason to either modify or completely abandon their private placement regimes under which marketing was possible in most member states prior to AIFMD implementation. Depending on the member state in question, the consequences vary from minimal changes to significant new requirements for non-EEA AIFMs, including, for example, the requirement to appoint a depositary.
Moran: Non-EEA managers marketing in the EEA must comply with notification or registration requirements in the jurisdictions in which they propose to market and with the AIFMD’s ‘baseline’ disclosure, reporting and asset stripping provisions – where relevant. They should also consider the implications of additional requirements which member states might impose, such as the requirement in Denmark and Germany to appoint a depositary. Where ‘reverse solicitation’ or ‘passive’ marketing has previously been relied upon, consider whether this remains a viable strategy and, if so, whether enhanced compliance procedures are necessary. Reporting obligations require the implementation of systems for the preparation of annual reports – including a remuneration disclosure – and managers should begin familiarising themselves with the rules. US managers will notice some parallels with Dodd-Frank’s Form PF, but there are key differences. Specifically, managers should determine the first date for filing regulatory reports and ensure that relevant data can be generated.
Krause: As a matter of experience, non-EEA AIFMs have often established fund platforms in Ireland or Luxembourg but also on Malta and in certain other jurisdictions. These platforms mirror their US or Asian product strategies but, since the AIFs are European funds, they may be marketed under the European passport. This is a kind of industry answer to the challenges presented to it by the AIFMD. The notification route is much less popular and, depending on the jurisdiction, not an option prior to 22 July 2015 anyway. Nevertheless, the additional costs incurred by such shadow platforms are only acceptable if sufficient economies of scale can be achieved, which only holds true for larger asset managers.
FW: In your opinion, how well are fund managers coping with the complexity of AIFMD compliance? What more needs to be done?
Brockhausen: AIFMs which were already subject to significant regulation, or which are part of large organisations, adapted relatively easily to the requirements and enjoy the additional benefit of the marketing passport. In such firms most of the regulatory requirements – such as separation of certain functions, dedicated officers for risk control, and so on – were already implemented as they were already necessitated by existing regulation or the mere size of the organisation. For smaller, often management-owned AIFMs with a very lean internal organisation, it has been much harder to adapt. Many of these AIFMs have been required to employ additional personnel or at least to undergo a significant internal restructuring. However, the main burden of AIFMD compliance lies in the initial adaptation to the new AIFMD requirements. Once this transition has been properly completed, AIFMs generally cope well with the ongoing compliance requirements, even if interactions with the national regulators remain challenging at times.
Moran: AIFMD represents a paradigm shift in terms of how managers do business. Ambiguous legislation and the absence of clear regulatory guidance presented challenges and created unintended consequences. In our experience, most managers are committed to complying with the directive, but it is felt that it will take some time for issues to be resolved and for market norms to develop. Nevertheless, they are taking a pragmatic approach to compliance where possible and hope that regulators will too. Early indications are that some regulators are prepared to be more pragmatic than others. However, the penalties for non-compliance have yet to be tested. Until recently, AIFMD was something of an academic consideration for many non-EEA managers as, by taking advantage of transitional provisions, they were able to delay compliance. It is only now that we are beginning to see how the real complexities of the AIFMD are affecting these managers.
Adams: It is a mixed bag, as you might expect. In part that is because, for some managers, a lot of what the AIFMD is about is not really relevant to their business. Working around the provisions of the AIFMD dealing with depositaries, valuation and stress testing, for example, can be complex and even surreal for some managers of closed-ended funds. And smaller managers that have not historically had bright lines between, for example, valuation and portfolio management, are particularly hard hit. I think most UK managers are in good shape. The policies and procedures are in place, and now it is going to be about how things operate in practice. The periodic reporting, which for many managers will be done quarterly, will be a real test of how well managers are coping. That would be something to focus on now that we’re safely past AIFMD implementation.
FW: In what areas are you seeing additional costs arising for fund managers as a result of AIFMD compliance? How can these costs be managed, or reduced where possible?
Krause: The main cost components are the substance for the AIFM to avoid an unlawful letterbox entity and the costs for the depositaries. This incurs the question whether there is any potential left for both non-EEA and EEA asset managers who cannot cope with the AIFMD. First, AIFMs with assets under management not in excess of €500m or, in the event of leveraging, not in excess of €100m, may register themselves as small AIFMs. But this is not necessarily an attractive option because institutional investors might be prohibited from investing in their products and if they wish to market to retail investors, they, again, will have to comply with certain rules including the appointment of a depositary. There is another option that is becoming increasingly popular. The AIFMD exempts securitisations from its scope. In turn, the AIFMD defines securitisations by reference to the Regulation (EC) No 24/2009 of the European Central Bank of 19 December 2008, concerning statistics on the assets and liabilities of financial vehicle corporations engaged in securitisation transactions. This regulation has an extremely wide scope of application not requiring credit risk and not requiring tranching which, effectively, means there is a significant and large exemption from the scope of the AIFMD. Basically, non-EEA asset managers may avail themselves of the benefits of this exemption by using asset backed securities and have for them a prospectus approved under the Prospectus Directive. This is an easy and cheap exercise. On the basis of such prospectus, marketing on a European basis will be permissible. However, non-EEA asset managers should consult the regulation exactingly and strictly follow its requirements. Otherwise, they might be prosecuted and subject to liability in the event investors lose money.
Brockhausen: In our experience, there are two main cost drivers for fully licensed AIFMs that are unavoidable under the current regulatory framework. These are the necessity of appointing a depositary for the assets of the managed AIFs and the need for previously small AIFMs to maintain larger organisations to comply with new requirements – for example, the requirement to functionally and hierarchically separate the functions of risk management from the operating units, including from the functions of portfolio management, and the requirement to have not only personnel dedicated to investments but also to compliance. Other additional costs such as obtaining advice to make the internal structure AIFMD compliant or to outsource certain functions to professional service providers are either one-time expenses or can be reduced in the future once AIFMs have become more acquainted with the new rules.
FW: In your opinion, have fund managers come to terms with what AIFMD will mean for their operations going forward?
Adams: I think that most UK managers are in good shape. They have wisely spent a long time trying to ready themselves for this year, and understanding what the impact of the AIFMD will be for them. Non-EEA managers are generally less familiar with how the AIFMD will impact their operations – assuming that they choose to market under the AIFMD. Most of those managers are familiar with the pre-investment disclosures and the filing processes in various EEA countries. But the periodic reporting and the annual remuneration disclosure are still difficult pills to swallow for many managers. And the lead-in time before marketing can take place is, in some countries, a big issue. It can be a shock for a manager to find out that, however much they need to market a fund to a German investor, they have to wait several months. Other non-EEA managers have decided simply not to market into some or all of the EEA. So in that sense they have come to terms with what AIFMD means – it means they will no longer target certain investors.
Brockhausen: In general, fund managers have come to terms with the AIFMD, at least in terms of acceptance of the inevitable. Nevertheless, among many AIFMs there is still a degree of frustration about certain AIFMD requirements. For example, the benefit of needing a depositary in the context of a private equity or real estate fund is not really evident, even for many of the investors the requirement is intended to protect. Likewise, it is frustrating for AIFMs and their advisers when national regulators at times appear to be overburdened by their new responsibilities and the inherent complexities of this field. This can result in impractical regulatory guidelines, inconsistent application of the rules within a single country, and the inability or unwillingness to give clear and consistent guidance. Even though there is a general willingness to comply, challenges still remain.
Moran: Early indications are that EEA-based managers are coming to terms with AIFMD – however reluctantly – and a suggestion of a mass exodus from Europe seems to have been premature. For ‘third country’ managers, the experience is more mixed. For example, the larger US managers seem to see AIFMD compliance as a cost of doing business and will continue to market into Europe, provided there is sufficient interest in their funds from European investors. Many of these with significant infrastructure and a retail bent see AIFMD as a helpful carrier to entry. They are aware that smaller and mid-market houses are currently more reluctant to comply with AIFMD given that they do not have the same compliance and regulatory infrastructure as their institutional counterparts. However, as the boundaries between traditional and alternative funds continue to soften and the AIFMD brand strengthens, supported by growing investor preference, such reluctance may wane.
FW: What long-term impact do you believe the AIFMD will have on the European market?
Moran: Presently the AIFMD exemption for smaller managers is of fairly limited application and several EEA jurisdictions have yet to grant this. However, we would not be surprised to see the development of a more calibrated application of the AIFMD rules to managers of different sizes in the future. Despite the complexities and uncertainties, we think that there is cause for optimism. As the boundaries between traditional and alternative funds continue to soften and investors become more comfortable with alternative strategies, the case for transparent, well regulated vehicles becomes compelling. Arguably, investors have already been demanding aspects of this ‘AIFMD comfort blanket’ and it is to be hoped that AIFMD will do for alternatives what UCITS has done for mutual funds. The AIFMD passport will provide some managers with the opportunity to explore previously untapped markets but whether investors regard the change in product availability as positive and the cost of compliance as good value for money, remains to be seen.
Brockhausen: The AIFMD has certainly not been the ‘suicide of Europe’s fund industry’ as some pessimists predicted. As with most regulation, the AIFMD requirements will, after a relatively painful transitional period, be adopted by the industry and become part of ‘normal’ business. However, the concern remains that, due to the additional financial and other burdens imposed by the AIFMD, alternative investment funds have become less attractive for investors due to increased costs, although the increase in costs has been moderate to date and appears generally not to be a deal breaker for investors. There are also fears that non-EEA AIFMs are less interested in the European investor market due to a perceived increase in compliance requirements, notwithstanding the fact that, even in more restrictive jurisdictions like Germany, the actual additional burden for non-EEA marketing can be kept to a minimum with the right approach. These concerns are supported by a growing body of evidence.
Dr Martin Brockhausen focuses primarily on the formation of private equity and venture capital funds, as well as fund of funds, with a particular focus on the private equity real estate funds sector. His experience comprises advising both fund managers, including advice on carried-interest arrangements and co-investment schemes, and investors. He advises German clients as well as international clients on all kinds of German and non-German structures.
Dr Martin Krause is an asset management and debt capital markets lawyer. He specialises in open- and closed-end funds as well as in structured debt instruments looking at all relevant asset classes including real estate, renewables, credit exposures and other alternative investments. He structures and implements investment projects for asset managers, institutional investors and distribution channels considering all relevant regulatory, legal, balance sheet and, where appropriate, fiscal aspects.
Michelle Moran is an investment management partner in Ropes & Gray’s London office. She focuses on advising European and US clients on the establishment, authorisation and management of all types of retail and institutional investment funds domiciled in the UK, Ireland, Luxembourg and Jersey. Ms Moran has experience advising on a wide variety of transactions relating to investment managers, brokers, custodians, fund service providers and operating platforms.
John Adams is head of the UK investment funds practice at Shearman & Sterling (London) LLP. He advises on the establishment, promotion and ongoing operation of all types of investment funds. As well as advising fund managers, Mr Adams also has a very active investor-side practice, representing significant institutional and sovereign wealth investors in connection with their investments in funds.
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