Luxembourg implements AIFMD and updates limited partnership regime
September 2013 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
Luxembourg implemented the provisions of directive 2011/61/EU on alternative investment fund managers (the ‘AIFMD’ or ‘Directive’) by means of the law of 12 July 2013 on Alternative Investment Fund Managers (the ‘Law’). The Law also introduces a number of changes to existing legislation, including ‘product laws’ applying to alternative investment funds and pension schemes in Luxembourg, i.e., the UCI Law, SIF Law, SICAR Law, ASSEP and SEPCAV Law (the ‘Product Laws’). It also updates and introduces significant improvements to the limited partnership regime and introduces a new Anglo-Saxon style limited partnership, which is already proving to be popular.
As a direct consequence of the legislative changes, the Luxembourg supervisory commission for the financial sector (Commission de Surveillance du Secteur Financier or CSSF) has created a new department dedicated to the supervision and approval of alternative investment fund managers (AIFMs) and alternative investment funds (AIFs). By issuing a series of questions and answers in relation to AIFMD on 18 June 2013 (the ‘CSSF Q&A’), the CSSF has sought to provide some much needed guidance on a number of topical and practical considerations.
The Law, the Directive and ESMA’s Level II text provide for a number of rules on delegation, some of which are general, while others are specific to the delegation of core functions (portfolio management and risk management).
General Rules on delegation
The reasons for delegation. AIFMs must be able to justify the entire delegation structure on objective reasons and provide a detailed description, explanation and evidence thereof. This can include (but is not limited to): optimising business functions and processes, cost saving, expertise of the delegate in administration or specific markets or investments or access of the delegate to global trading facilities.
The delegate.The delegate must have sufficient resources to perform the delegated tasks and the persons who effectively conduct the business of the delegate must be of sufficiently good repute and sufficiently experienced.
The delegation.The delegation must not prevent effective supervision by the AIFM and must not prevent the AIFM from acting in the best interests of investors. The AIFM must also be able to demonstrate that the delegate is qualified and capable of undertaking the functions in question, was selected with due care and that the AIFM is in a position to monitor effectively at any time the delegated activity and to withdraw the delegation with immediate effect when in the interests of investors.
The delegation arrangement should take the form of an agreement, which includes (at least) provisions relating to the following: a right of information, inspection, admittance and access of the AIFM; a right of instruction and termination of the delegation; recognition that sub-delegation can only take place with the consent of the AIFM; and the exclusion of any limitation of liability of the AIFM.
The AIFM should also ensure: that the delegate acts in compliance with applicable law and regulatory requirements; that it has established methods to review delegated activities on an ongoing basis; and that the continuity and quality of the delegated functions are ensured, also in the event of termination. The delegate must disclose to the AIFM anything impacting its ability to carry out the delegated tasks, protect confidential information and have a contingency plan for disaster recovery.
Delegation of core functions (portfolio management and risk management)
General rules.The delegation of core functions may be conferred only on undertakings which are authorised or registered for the purpose of asset management and subject to supervision or, where this condition cannot be met, subject to prior approval by the CSSF. When conferred on a third-country undertaking, cooperation between the CSSF and the supervisory authority of the undertaking must be ensured (a written cooperation arrangement allowing the CSSF to obtain requested information, access relevant documents, carry out on-site inspections on the premises of the undertaking, etc., must be in place). The CSSF has made significant strides in this respect and a number of cooperation agreements have been concluded.
No delegation to conflicted entities.The delegation of core functions may not be conferred on an entity whose interests may conflict with those of the AIFM or the investors in the AIF, unless such entity has functionally and hierarchically separated the performance of the portfolio management or risk management tasks from its other potentially conflicting tasks and the potential conflicts of interest are properly identified, managed, monitored and disclosed to the investors in the AIF.
Potential conflicts include, among others, scenarios: where the parties are members of the same group; where the delegate stands to make a financial gain or avoid a financial loss at the expense of the AIF; or where the delegate has an incentive to favour the interests of another client over the interests of the AIF.
The core functions are considered to be functionally and hierarchically separated from other conflicting tasks if different persons are engaged in the performance of the tasks and different persons are engaged in supervision for portfolio management/control tasks and risk management/operating tasks.
Letter-box entity considerations
The AIFM may not delegate its functions to the extent that, in essence, it can no longer be considered to be the manager of the AIF.
This is considered to be the case where, for example, the AIFM no longer retains the necessary expertise and resources to supervise the delegated tasks effectively and to manage the risks associated with the delegation or no longer has the power to take decisions in key areas which fall under the responsibility of senior management or to perform such functions.
The CSSF Q&A permits an AIFM to delegate parts of the core functions (i.e., portfolio management and/or risk management), but not both functions in their entirety at the same time and specifies that the principles laid down in section 7 of CSSF Circular 12/546 apply by analogy to Luxembourg AIFMs delegating investment management functions. This Circular stipulates that each delegation to an external service provider should be subject to prior written due diligence on the provider, which exercise should include the identification of operational risks flowing from the delegation.
CSSF Circular 12/546 also lists certain functions that cannot be delegated: (i) the determination of the general investment policy of each AIF; (ii) the determination of the risk profile of each AIF; (iii) the interpretation of the risk management analysis, including correcting measures, as the case may be; (iv) the implementation of a conflict of interest policy; (v) the implementation of a best execution policy; (vi) the selection of service providers; and (vii) the monitoring and control of delegated functions.
AIFMs performing activities before 22 July 2013 are expected to take all necessary measures (i.e., expend their best efforts) to comply with the requirements of the Law and are required to submit an application for authorisation by 22 July 2014.
The ESMA Q&A confirmed that existing AIFs are expected to start reporting as of 22 July 2013 in accordance with the reporting frequencies anticipated by the Directive and the Level II text, as confirmed by CSSF press release 13/32. The requirement to comply with reporting and other obligations does not depend on having obtained an authorisation from the competent authorities.
The CSSF Q&A confirms that all collective investment undertakings or investment vehicles established under one of the Product Laws prior to 22 July 2013, and between 22 July 2013 and 22 July 2014, which qualify as an AIF under the Law, can appoint an (existing) AIFM which benefits from the transitional provisions applicable to AIFMs explained above if they qualify as an externally managed AIF. Once an AIF has appointed an AIFM authorised by the CSSF, that AIF has to take all necessary measures to comply with the product aspects introduced by the relevant Product Law (i.e., annual report, valuation rules, disclosure to investors, depositary rules).
An investment vehicle qualifying as an AIF established under one of the Product Laws and which benefits from the transitional provisions, should also submit to the CSSF, by 1 April 2014 at the latest, a file containing information regarding its compliance with the AIFMD by 22 July 2014.
The CSSF Q&A further confirms that the transitional provisions under the Law also apply to any new sub-fund created under a multiple compartment AIF that was established under one of the Product Laws prior to 22 July 2013.
AIFMs that are out of scope
AIFMs, in so far as they manage closed-ended AIFs which do not make any additional investments after 22 July 2013, may continue to manage such AIFs without authorisation under the Directive.
The ESMA Q&A provides a wide interpretation of ‘additional investment’ and specifies that it has to take place in the context of the specific investment strategy and in the context of the legal provisions which aim to exempt AIFMs that manage end-of-life AIFs from the application of provisions of the Directive. It would generally imply a new contract, involving investment of capital for the purpose of obtaining a gain. However, management for the sole purpose of maintaining the value of the portfolio should be possible without falling foul of the provisions of the Directive. Hence limited amounts of financial injection should be possible provided they arise out of existing commitments, represent a negligible percentage of the AIF’s portfolio and aim only to maintain the value of the portfolio.
AIFMs, in so far as they manage closed-ended AIFs whose subscription period for investors closed prior to 22 July 2013 and are constituted for a term which expires at the latest on 22 July 2016, may, however, continue to manage such AIFs without needing to comply with the majority of the provisions of the Directive and without having to submit an application for authorisation under the Law.
The ESMA Q&A highlighted that AIFMs benefitting from one of the above grandfathering provisions and which are exempt from authorisation and from compliance with the Law (except for certain limited provisions) are also exempt from registration.
The ESMA Q&A pointed out that the portfolios of the funds that fall within one of the grandfathering provisions should not be counted for the purpose of calculating assets under management of an AIFM which also manages other types of AIFs, an important consideration for calculating the threshold for potential application of the de minimis exemption.
The new Special Limited Partnership
In addition to proposing a number of beneficial changes to existing partnerships (société en commandite simple), the Law introduces a new type of partnership – the Special Limited Partnership or société en commanditespéciale(the ‘SLP’). The SLP is substantially similar to an Anglo-Saxon limited partnership and may be used for both regulated and non-regulated vehicles, whether they qualify as alternative investment funds under the AIFMD or not. The SLP is subject to very few mandatory rules and offers great flexibility in terms of governance, type and means of contributions for partnership interests, distributions, exclusions, claw-back arrangements, voting and other rights, redemption and reduction of partners’ interests, all of which can be freely determined by means of the limited partnership agreement. It also offers confidentiality as to the identity of limited partners, total flexibility in relation to the management of the partnership and delegation to third parties, as well as clarifying those acts which may be performed by limited partners without jeopardising the limit on their liability.
The SLP is tax transparent and not subject to Luxembourg income, net wealth or trade tax (provided that the general partner is not a Luxembourg limited liability company holding 5 percent or more of the partnership interests). In addition, management services rendered to a regulated SLP are exempt from Luxembourg VAT.
Taking all of the above into account, it is no wonder that the SLP has been received with great enthusiasm both inside and outside of Luxembourg.
It is expected that from next year onwards, investors in alternative investment funds will have essentially two options in terms of investing either in funds which are subject to harmonised pan-European regulation or in funds which are not. Luxembourg is set to offer managers three options: regulated management entities which comply with pan-European requirements and will entitle them to market under the European passport; other entities which are regulated and subject to prudential regulation in Luxembourg and which comply with best practice standards; and non-regulated entities.
Managers and investors will continue to benefit from the wide variety of legal and regulatory regimes, an expanded menu of legal forms and the potential to appoint, where necessary and appropriate, specialised custodians. It is not surprising that the content of the Law has been warmly received, both in Luxembourg and abroad.
Johan Terblanche is a partner at Loyens & Loeff. He can be contacted on +352 (466) 230 245 or by email: email@example.com.
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