FORUM: Gearing up for the AIFM directive
September 2013 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
FW moderates a discussion on preparations for the AIFM directive between Floortje Nagelkerke at Norton Rose, Mary Bruen at PwC, and Neil Robson at Schulte Roth & Zabel.
FW: In your opinion, what impact is the AIFMD likely to have on the European private equity market?
Nagelkerke: The impact of the AIFMD will differ per jurisdiction. In some jurisdictions private equity firms were already regulated. However, in other jurisdictions it will be the first time that private equity firms are confronted with rules, regulations and a regulator. The AIFMD introduces obligations on the manager of funds, not on the fund itself. Fund managers have to comply with higher capital requirements, the calculation of which is based on funds under management. In addition, they will be required to appoint a depository that is responsible for the safekeeping of the assets of the funds manager. This depositary will also have a degree of governance oversight. Fund managers also have to comply with transparency obligations towards investors in the fund and to the regulators. The AIFMD also introduces provisions on asset-stripping. These rules may be limiting for fund managers because there are for instance limits on distributions, capital reductions and redemptions.
Bruen: AIFMD opens the door to the regulation of private equity in Europe. The Directive has its roots in UCITS and MiFID and in many respects results in the application of a ‘retail wrapper’ to a professional product. The future of AIFMD and UCITS will be inextricably linked. The provisions of AIFMD are being rolled in to the next iteration of UCITS and those of UCITS will once again form the basis for AIFMD II in 2017. It is likely that the future of European investment will become ever more regulated and those that do not see this as beneficial to their investors, their investment strategy, their operations or their cost base are already looking at alternatives. The result will be something of a dichotomy. Managers that perceive benefit to the ‘AIFMD’ brand will create European structures and those that do not or who favour more entrepreneurial strategies or esoteric asset classes will remain or move outside of the EU.
Robson: Apart from the depositary rules for EU funds, additional disclosure requirements and the asset stripping rules, the main area of impact is probably the requirement for PE managers established in the EU, in common with other EU-based fund managers – including those in the hedge funds, real estate funds and other non-UCITS sectors – to get themselves authorised as AIFMs by their home EU country regulator. Although the process is still not clear in every country of the EU and EEA, in the UK the Financial Conduct Authority (FCA) has published details regarding the Variation of Permission (VoP) application process and the UK has finalised rules, so that we have a clear picture of what is expected. UK managers should get their VoP applications in to the FCA in good time; six months ahead of the 22 July 2014 deadline might be prudent.
FW: To what extent will the Directive lead to an increase in costs for fund managers?
Bruen: For non-EU managers with non-EU funds the increase in cost should not be that significant as it should only relate to compliance with the transparency requirements, and, potentially some strengthening of substance. For EU managers the costs could be significant. The most costly components of the Directive for EU private equity managers are expected to be the depositary, capital and risk management provisions. Compliance with the Directive will most likely require additional resources – in-house or outsourced, initial and ongoing costs to meet the conduct of business, and organisation rules and additional funding associated with capital requirements. Depositary fees will be new to most private equity managers and the Directive’s provisions require a ‘look through’ of the structure to the underlying operating companies, which, depending on the structure and location of the assets, will add cost.
Robson: The general view would seem to be that the key area of increased costs will be the fees payable to service providers. As mentioned above, EU AIFMs with EU funds will need an EU depositary, but even AIFMs of non-EU funds will still need to comply with the so-called ‘depositary lite’ requirements, for which there is almost certainly going to be a new and additional fee for the fund to bear. At the current time we still do not have a lot of clarity as to the specific requirements for these services, though there are indications that ‘depositary lite’ oversight service providers will soon be making their presence known in the market. For those EU AIFMs with non-EU funds that intend to maintain their current custody and administration arrangements, there is still some uncertainty as to whether or not these arrangements will need to be re-papered or if the currently bilateral arrangements – between the fund and the service provider – should be made tripartite agreements – between the fund, the service provider and the EU AIFM entity. It is hoped that clarification will be forthcoming shortly.
Nagelkerke: We anticipate that the costs for fund managers will increase. Not only because of the higher capital requirements, but because they will need to pay additional costs in order to comply with the AIFMD. Fund managers will need to pay for the services of the depositary, that they now have to appoint. In addition, they will need to employ the services of an external valuer and enter into professional indemnity insurance.In order to ensure compliance with AIFMD, fund managers must pay regulatory fees, not only at the start for the application for the licence, but, most likely, on a yearly basis.
FW: What can managers do to ensure they establish AIFMD-efficient fund structures?
Robson: The answer is the same as it has been for the last few years while the AIFMD has been in development: PE managers would be best advised to seek the advice of local counsel in the EU – whether they are an EU AIFM or a non-EU AIFM that intends to invest in EU companies and or market their funds in the EU – to ensure that they have as full an understanding of the AIFMD rules as they can before launching a new fund with a European focus.
Nagelkerke: In the early stages when fund managers consider setting up a specific fund structure, they need to consider whether they want to attract the monies from investors in or outside the European Union. This will have an impact and is decisive whether an AIFMD licence is necessary, or that a passport will be available to market throughout the whole of the European Union. Most fund managers will also have to consider the different tax treatments for setting up a specific fund structure. Non-EU fund managers may want to rely on ‘reverse solicitation’ or ‘passive marketing’, as no licence is necessary if the fund manager is contacted by an investor. Investors in the EU can therefore seek out and contact non-EU managers about investing in non-EU funds, although the scope of what is permitted is not precisely defined and may be different for each member state.
Bruen: The response to AIFMD is, in the first instance, a strategic one. Managers need to determine whether they want or need an AIFMD compliant structure or whether they should remain or move outside of the EU. Future investment and product focus will be an important part of the decision process in this respect and may lead to restructuring decisions depending on whether managers elect or are required to be fully AIFMD compliantor determine that private placement remains their preferred access to Europe. As such the Directive provides an opportunity for managers to reassess their existing structures and streamline their operations to provide the most efficient structure going forward from both a tax and operational perspective. The solutions will be different for different managers – for example, EU, Non-EU, or Parallel structures – as will the related benefits and costs. We have been working with our clients to help them through this process.
FW: Are you seeing PE funds exploring new investment strategies in response to the imminent arrival of AIFMD? What approaches are they taking?
Nagelkerke: The AIFMD regulates the fund manager and not the fund itself. This means that the AIFMD does not seek to impose any restrictions on the investment strategies that a fund can pursue. We do not foresee that fund managers will explore completely new investment strategies, although the fund manager does consider the type of investments that it will undertake. Often, private equity fund managers have specific investment strategies, and ideas for certain sectors and companies which they may not want to publicly disclose for fear that competitors will interfere and the investment opportunities will alter. Therefore, they may explore the possibilities for not investing in companies established in the EU. In that case the transparency rules will not be applicable to fund managers.
Bruen: To date I have not seen significant changes to investment strategies on the private equity side. Co-investment products and ‘club’ deals are becoming a popular way to extend the life of existing funds without generating the need to go back to the market and in many cases without triggering the Directives application. AIFMD has increased the attractiveness of service providers in the alternatives space to private equity firms and deals in this sector are on the increase. Private equity firms are reconsidering investment structuring to respond to the ‘asset stripping’ provisions of AIFMD. Distributions, capital reductions, share redemptions and acquisitions of own shares by some portfolio companies will be restricted for 24 months, subject to limited carve-outs. As a result AIFMs will need to consider the potential impact of this restricted flexibility carefully when considering portfolio investments.
Robson: So far there has been some suggestion that some PE managers might avoid investing in certain EU companies so as to avoid the asset stripping rules, or that they will only invest in the debt of EU companies rather than in the equity – which should otherwise avoid the asset stripping rules – but at this stage it seems too soon to tell if there will be any significant changes in strategy. We can expect the market to balance once the full effect of the AIFMD is felt.
FW: How will AIFMD impact non-EU private equity managers? What requirements and obligations will they face?
Bruen: Where continued access to Europe is to be secured through private placement Non-EU managers’ immediate focus will need to be on the transparency demands of the Directive and on the substance requirements of the AIFMs to avoid them being deemed a ‘letter box entity’. This is a much lower compliance burden than that faced by EU managers who will have to comply with all the Directive’s provisions. As a result, we are seeing a number of private equity managers strengthen or create substance in the Channel Islands to ensure that they do not fall subject to some of the more costly provisions of the Directive. Some managers are creating parallel structures; a new AIFMD compliant structure for certain EU investors and a non-AIFMD compliant structure for the remainder of their investors. Notably, one such structure set up by one of our clients, failed to attract more than one investor to the AIFMD compliant structure.
Robson: The key area of concern for non-EU PE managers is likely to be the ‘private equity’ rules on disclosures of holdings and asset stripping – which become relevant where one or more funds managed by the AIFM are marketed into the EU and acquire a ‘control’ position in an EU listed or an EU unlisted private company. The AIFMD requires that when one or more such funds acquires, disposes of or holds shares of a private EU company, the AIFM managing the funds must notify the regulator of the relevant company’s EU country of the proportion of voting rights of the private company held whenever that proportion reaches, exceeds or falls below the thresholds of 10, 20, 30, 50 and 75 percent. Any holdings conferring control – that is, in excess of 50 percent voting rights – also require notifications to the company’s board of directors as well as to any shareholders whose details are available to the AIFM or can be made available by the private EU company. Disclosure must also be given in the fund’s annual report or in the annual report of the private EU company – or both – of a fair review of the development of the company’s business over the period covered by the annual report, and an indication of important events since the end of the financial year; the company’s likely future development; and any acquisitions of own shares. Also significant is the AIFMD requirement that when one or more of the AIFM’s funds acquires control of a listed or non-listed EU company, for 24 months following the acquisition of control, the AIFM managing the fund must use its best efforts to prevent certain distributions, capital reductions, share redemptions or acquisitions of own shares.
Nagelkerke: The AIFMD will only affect non-EU private equitymanagers if they wish to market one or more of their non-EU funds in the EU. Under the AIFMD there is a transitional period of three years for non-EU fund managers. The AIFMD imposes a series of minimum obligations in respect of such fund managers but, for the foreseeable future, the rules in each member state will be different as they each implement – or choose not to implement – their own national private placement regimes. And there are some significant differences in the approach of key member states. What is clear is that non-EU managers with significant levels of EU investors will need to navigate a number of different regimes in order to continue to market their products to those investors. There will not be a passport available for such fund managers, even if it is authorised in an EU jurisdiction. The AIFMD can also have an indirect effect on non-EU investment managers or advisers if they are delegates of authorised EU AIFMs.
FW: What issues and challenges are associated with ‘Level 2’ requirements which aim to incorporate the regime into each country’s legislative landscape? What domestic legal and regulatory preparations have you seen in various European countries?
Robson: One of the greatest areas of uncertainty at this time is the fact that not all EU countries have implemented the AIFM Directive into national law yet and, of those that have, several have not yet issued guidance, so the picture remains somewhat unclear in many countries. It is therefore a challenge for PE managers to know exactly what rules they have to comply with in which jurisdictions of the EU. For those with a strategy of investing in EU companies this will therefore be a critical issue and many will have to seek their own legal advice from local counsel to be able to know whether an acquisition is inside or outside the scope of the AIFM Directive.
Nagelkerke: As the Level 2 requirements are all laid down in European legislation, these have direct effect in all European jurisdictions. In principle, no implementation measures are necessary on the national level to ensure that parties have to comply with the rules. Some jurisdictions only need to amend the national rules and regulations to refer to the European Regulations in order for the regulators to be able to impose measures upon parties that are not compliant with the rules and obligations – for instance in the Netherlands. In other jurisdictions, these European regulations have been brought into the national legislation by copying them, such as in the UK.
Bruen: I was involved first hand in drafting and negotiating ESMA’s Level 2 advice during a one year secondment to the UK regulator. Mypractical understanding of the Directive, and appreciation of how complex and challenging it is to interpret, is gained from experiencing hours of discussions at both UK and EU level. The Level 2 advice reflects the difficulties in gaining consensus across member states and as a result it represents a compromise. It is written in shades of grey and, despite being implemented as a regulation, will have different interpretations across member states to fit in with their national regimes. Member states continue to implement the Directive post 22 July – the implementation deadline – and the overall picture of what it means at an EU level is still unfolding. Even for those 12 member states that met the 22 July deadline there are still numerous unanswered questions as to practical implications as they continue to grapple with a very complex piece of legislation and attempt to provide guidance. Many member states have provided a one year transitional period which will give them and managers some breathing space.
FW: In general, what steps should fund managers take now to prepare for compliance with the AIFMD regime, and what are the key implementation dates they need to consider?
Nagelkerke: Fund managers need to start preparing their application. They can start by assessing whether their business operations conform to the AIFMD requirements, if necessary. In addition, fund managers need to enter into negotiations with depositaries. We understand that fewer fund managers than anticipated have applied for a licence so far. Therefore, although the transitional year ends on 21 July 2014, it is expected that regulators will receive many applications in the months before July 2014 and will need time to process the application. Therefore, regulators have informed fund managers that they should aim to have their application with the regulators by January 2014.
Bruen: The first step is to identify if and how you are caught by the Directive. Managers should review their existing structures to identify AIFs and determine which entity or entities may be considered subject to the AIFM and, as a result the likely routes to marketing in Europe post 2013. Future investment focus will be an important part of the decision process in this respect and may lead to restructuring decisions depending on whether managers elect or are required to be fully AIFMD compliant or determine that private placement remains their preferred access to Europe. Where continued access to Europe is to be secured through private placement, managers’ immediate focus will need to be on the transparency provisions of the Directive and on the substance requirements of the AIFMs to avoid it, or them, being deemed a ‘letter box entity’. Alternatively, where managers are required, or, if relevant, elect to be fully AIFMD compliant they will need to achieve compliance, in a relatively short timeframe, against all key requirements of the AIFMD. As a result, managers may need to amend existing fund structures and their managers, create or strengthen offshore arrangements, raise capital and insurance, restructure the management group, engage depositories, change remuneration arrangements, or deal with marketing and reporting differently.
Robson: All fund managers should be looking at themselves, their funds and their marketing and investment strategies and assessing how much focus they have on Europe. EU AIFMs will need to become authorised by their national regulator as an AIFM – unless they are below the AIFMD’s de minimis threshold, in which case they will merely need to register with their regulator, as opposed to becoming authorised. Managers of EU-domiciled funds will need to assess what specific requirements they need to comply with for those EU funds, and those marketing in the EU will need to look into the rules for marketing as EU AIFMs with EU funds will have the benefit of a marketing passport as soon as the AIFMD is fully implemented in EU countries, and non-EU AIFMs or those EU AIFMs with non-EU funds will need to assess what the local private placement rules are and the AIFMD compliance overlay, which may involve registrations in the EU. The private equity disclosure and asset stripping rules will also have to be complied with, where appropriate. Effective from 22 July 2013 the AIFMD is supposed to be in effect in the EU, however some countries have not yet implemented the AIFMD into local rules and other countries – including the UK – have a transitional period in place to defer the AIFMD’s start date for some managers. It will be necessary to confirm whether the AIFMD is in effect for each manager and its specific EU activities.
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