Whatís the Alternative? An Overview of the Alternative Investment Fund Managers Directive from a Guernsey Perspective
Sam Shires, Group Partner and Stephen Ozanne, Associate
AO HALL Advocates
The Alternative Investment Fund Managers Directive (Directive 2011/61/EU) (AIFM Directive) sets out new rules that are being introduced in the European Union (EU) in respect of the authorisation, operation, and ongoing reporting for managers of alternative investment funds (AIFMs) which manage and/or market alternative investment funds (AIFs) in the various member-state countries of the EU.
After approximately 18 months of negotiations and considerable debate between the European Commission, European Parliament and the Council of the European Union, the European Parliament voted through the AIFM Directive on 11 November 2010. The text of the AIFM Directive was later published in the Official Journal of the EU on 1 July 2011 and commenced to be enforced on 21 July 2011. However, from an offshore perspective, the way in which the AIFM Directive will actually be implemented is yet to be seen. EU directives, unlike EU regulations, set out certain results that must be achieved by each EU member-state. It is then for each member-state to implement their own legislation to give effect to the directive. This gives member-states a degree of leeway as to how the directive can be implemented in their respective jurisdictions, which can result in different member-states having slightly different rules.
Importantly, EU AIFMs wishing to market non-EU AIFs in the EU will be required to fulfil all of the requirements under the AIFM Directive, whilst non-EU AIFMs wishing to market non-EU AIFs in the EU should fall under a separate regime that, in particular circumstances, may be a lighter-touch regime in comparison to the regime for EU AIFMs.
This guide is therefore intended only to give a general overview of the key elements of the AIFM Directive as it may apply to offshore (non-EU) AIFMs (particularly AIFMs who are domiciled in Guernsey) who wish to market AIFs in the EU.
What is the timing for implementation?
While EU member-states are required to implement legislation to comply with the AIFM Directive within two years from the date of its approval (i.e. before 22 July 2013), non-EU AIFMs who wish to manage and/or market AIFs in the EU should only be required to be authorised pursuant to the new regime at the earliest by late 2015, when the European Commission is expected to implement the new passport regime for non-EU AIFMs (Passport Regime). Pursuant to the Passport Regime, non-EU AIFMs who are authorised under the AIFM Directive will be able to market AIFs across the EU.
However, until the Passport Regime has been implemented and the European Commission has determined to withdraw EU member-states’ national private placement regimes (NPP Regimes), non-EU AIFMs will still be permitted to continue to market non-EU AIFs in the EU pursuant to the NPP Regimes (it is expected that the NPP regimes will remain in place until at least 2018), subject to additional reporting requirements in respect of annual reports, investor disclosure and regulatory reporting in respect of AIFs acquiring substantial stakes in EU companies.
Further, there are transitional provisions that will apply that exempt AIFMs from the AIFM Directive if the AIFs they manage are closed-ended and make no further investments after the transposition date of the AIFM Directive of 22 July 2013. Also, if the life of a closed-ended AIF terminates within three years from the transposition date (i.e. before 22 July 2016) and the AIF’s final closing for subscriptions was before the AIFM Directive was in force (i.e. 21 July 2011) again the AIFM will also be exempt.
Who will the AIFM Directive apply to?
For the purposes of the AIFM Directive, an AIFM means any legal person whose regular business is managing one or more AIFs.
Subject to certain limited exemptions, the AIFM Directive will apply to AIFMs who are:
established in the EU and manage one or more AIFs irrespective of whether the AIFs are EU AIFs and/or Non-EU AIFs; or
established outside of the EU, and:
manage one or more EU AIFs; and/or
market one or more AIFs in the EU irrespective of whether the AIF is an EU AIF or non-EU AIF.
Importantly, for the purposes of the AIFM Directive ‘managing AIFs’ means performing investment management functions in respect of portfolio management and/or risk management of an AIF, which is not a usual definition of ‘management’ in respect of collective investment schemes. Therefore, it is possible that the definition of managing AIFs under the AIFM Directive may cover more entities than would usually be classed as a manager of a collective investment scheme.
The AIFM Directive also contains some specific provisions in respect of depositories, sub-custodians, prime-brokers and valuers but it is not intended to directly regulate those types of entities.
The AIFM Directive specifically exempts the following entities from the requirements of the directive: supranational institutions (such as the World Bank); national central banks; national, regional and local governments and bodies or institutions which manage funds supporting social security and pension systems; securitisation special purpose entities; and insurance contracts or joint ventures.
A partial exemption is also available for AIFMs managing AIFs with assets under management which in total do not exceed one of the following limits:
EUR 500 million, provided that all the managed AIFs are not leveraged and, in the case of AIFs providing for redemptions, provide for a five year lock-up period; or
EUR 100 million (including assets acquired through leverage).
AIFMs that fit within one of the above categories will still be required to register in their EU member-state of reference and provide information to the authority that they are registered with in respect of the main instruments they are trading, their principal exposures and the most important concentrations of the AIFs they manage in order for the authority to monitor systemic risk.
The AIFM Directive will apply to the management of AIFs which satisfy the following key elements:
the AIF is a collective investment scheme and is not regulated under the EU Directive on Undertakings for Collective Investment In Transferable Securities (UCITS);
the AIF raises capital from a number of investors (likely to be two or more);
the AIF invests in accordance with a defined investment policy for the benefit of its investors; and
the AIF is domiciled in the EU (an EU AIF); or
the AIF is not domiciled in the EU (a non-EU AIF), but it is marketed in the EU.
For the purposes of the AIFM Directive, marketing means the 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 investors domiciled or with a registered office in the EU.
The AIF can be in any form or structure and can be open or closed-ended.
The lighter touch regime
The AIFM Directive also provides a lighter touch regime for AIFs that have no redemption rights exercisable during a period of five years from the date of the initial investments of the AIF and that, in accordance with the AIF’s investment policies, generally do not invest in assets that must be held by a depository in accordance with the AIFM Directive, or generally invest in issuers or non-listed companies in order to potentially take control of EU companies. This lighter touch regime is targeted at private equity, venture capital and real estate funds. Under the lighter touch regime EU member-states will be expected to allow notaries, lawyers, registrars or other entities to be appointed to carry out custody functions for the AIF. This regime may fit very well into Guernsey’s existing closed-ended funds regime, where a formal custodian of the AIF is not normally required. Therefore, Guernsey funds that fit within the lighter touch regime should be able to benefit from the costs and operational advantages of not requiring a formal custodian. However, ultimately how the lighter touch regime will work in practice may depend on each member-state’s implementation of the AIFM Directive.
What is the Passport Regime?
The AIFM Directive provides the framework to establish the Passport Regime, which will enable non-EU AIFMs to manage EU AIFs and market non-EU AIFs across the EU. Non-EU AIFMs that wish to benefit from the Passport Regime once it has been implemented (subject to the European Securities and Markets Authority (ESMA) making a recommendation to implement the Passport Regime for it to be used by non-EU AIFMs) will be required to be authorised under the AIFM Directive.
What are the requirements for authorisation?
Once the Passport Regime has been implemented, non-EU AIFMs who wish to take advantage of the Passport Regime will need to be authorised in an EU member-state of reference and appoint a legal representative in that member-state (who will be one of the principal contacts for the AIFM for the purposes of the AIFM Directive).
In order for a non-EU AIFM to be authorised under the AIFM Directive it must first be established in a country that meets the following requirements:
The country has cooperation agreements in place between its supervisory authority (in Guernsey’s case, the Guernsey Financial Services Commission (GFSC)) and the authorities of the member-state of reference of the AIFM (to demonstrate that the GFSC already adheres to international cooperation, it has signed Memorandum of Understandings with regulatory and supervisory bodies in Belgium, Cyprus, France, Germany, Italy, Malta, Netherlands and the UK as well as with the International Organisation of Securities Commissions and a number of non-EU countries such as the US);
It is not listed as a Non-Cooperative Country and Territory by FATF (Guernsey is not listed);
It has signed an agreement with the member-state of reference that complies with the standards laid down in Article 26 of the OECD Model Tax Convention on Income and on Capital regarding effective exchange of information in tax matters (Guernsey has signed tax information exchange agreements with Denmark, Finland, France, Germany, Greece, Ireland, Malta, Netherlands, Poland, Portugal, Slovenia, Sweden and the UK as well as with a number of non-EU countries); and
Its laws, regulations or administrative provisions do not prevent the exercise of member-states’ authorities’ supervisory functions under the AIFM Directive (Guernsey’s financial services regulation should not prevent the exercise of the member-states’ authorities’ functions in this regard).
Therefore, AIFMs in Guernsey should be very well placed to take advantage of the Passport Regime once it has been introduced.
AIFMs will be required to satisfy additional capital requirements, whereby AIFMs that manage external AIFs (i.e. the AIF has a separate AIFM appointed) will be required to maintain an initial capital of EUR 125,000 and maintain ‘own funds’ equal to or greater than:
One quarter of the AIFMs preceding year’s fixed overheads; and
If the value of the portfolios of the AIFs managed by the AIFM exceed EUR 250 million, the AIFM must provide an additional amount of own funds equal to 0.02% of the amount by which the total values of assets under management of the AIFM exceeds EUR 250 million, subject to a cap of EUR10 million.
Conduct of business
The AIFM Directive sets out the general conduct of business principles that AIFMs subject to the directive will be required to follow. These include:
Acting honestly, with due skill, care and diligence and acting fairly in conducting their activities;
Acting in the best interests of the AIFs, or the investors of the AIFs, and the integrity of the market;
Having and employing effectively the resources and procedures that are necessary for the proper performance of their business activities;
Taking reasonable steps to avoid conflicts of interest and identifying, managing and (where appropriate) disclosing any conflicts of interest that cannot be avoided;
Complying with all regulatory requirements applicable to the conduct of the AIFM’s business; and
Treating all AIF investors fairly.
AIFMs will be required to have remuneration policies and practices in place for categories staff, including senior management, risk takers, function controllers and any employees receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers, whose professional activities have a material impact on the risk profiles of the AIFMs or of the AIFs they manage.
ESMA is expected to provide guidelines on remuneration policies that will comply with the AIFM Directive.
Conflicts of interest
AIFMs will be required to take all reasonable steps to identify conflicts of interests that arise in the course of managing AIFs between:
The AIFM, its managers, employees and any person directly or indirectly linked to the AIFM by control (such as subsidiaries) and the AIF or the AIF’s investors;
The AIF, or its investors, and another AIF, or its investors;
The AIF, or its investors, and another client of the AIFM;
The AIF, or its investors, and a UCITS fund managed by the AIFM, or the investors in that UCITS fund; and
Two clients of the AIFM.
AIFMs will be required to have risk management procedures in place to:
Separate the functions of risk management from portfolio management;
Implement adequate risk management systems to identify, measure, manage and monitor all the risks relevant to the AIF’s investment strategy and to which the AIF may be exposed;
Implement a documented and regularly updated due diligence process when investing on behalf of AIFs;
Ensure that the risks with each investment of the AIF and their overall effect on the portfolio of the AIF can be properly identified, measured, managed and monitored, including through the use of stress testing procedures; and
Ensure that the risk profile of the AIF corresponds with the size, portfolio structure and investment strategies and objectives of the AIF.
AIFMs will need to have an effective liquidity management system in place to enable them to monitor the liquidity risk of the AIFs they manage and to ensure that the liquidity profiles of those AIFs comply with their underlying obligations and are consistent with their investment strategies and redemption profiles. It is expected that the European Commission will issue measures specifying the liquidity management systems and procedures that AIFMs should have in place.
Operating requirements: general principles
AIFMs that are licensed to act as fund managers in Guernsey should already be familiar with most of the operating requirements under the AIFM Directive since many of those requirements are similar to the requirements that must be met in order to obtain an investment business licence in Guernsey.
The AIFM Directive will require authorised AIFMs to have adequate and appropriate human and technical resources that are necessary for the proper management of AIFs. In particular, AIFMs will require sound administrative and accounting procedures, control and safeguard arrangements for electronic data processing and adequate internal control mechanisms, including rules for:
Personal transactions by employees;
Holding or managing investments to invest on its own account;
Enabling each transaction involving AIFs to be reconstructed according to its origin, the parties to it, its nature and the time and place it was effected; and
Ensuring that the assets of the AIFs are invested in accordance with the AIFs’ rules or instruments of incorporation and the relevant legal provisions in force.
The rules applicable to the valuation of assets and the net asset value per unit or share in an AIF will be those rules that are in place in the country where the AIF is established and in accordance with the AIF’s own rules and/or instruments of incorporation (e.g. for a Guernsey domiciled AIF, the relevant Guernsey rules in respect of valuations and the applicable provisions of the AIF’s constitutional and offering documents should apply). However, the AIFM Directive may impose additional requirements in respect of the timing and frequency that valuations are calculated and the European Commission has the power to introduce additional requirements in respect of the procedures for conducting valuations.
Unless the lighter touch regime applies (see above), a non- EU AIFM will be required to appoint a depository for the safekeeping of the assets of the AIF, the day-to-day administration of the AIF’s assets and to control the AIF’s investment policies and receipt and payment of funds to and from investors. It is expected that there will be a great deal of overlap between the depository’s functions and the AIFM’s functions. The depository does not need to be an EU entity and should include credit institutions and investment banks in the country where the AIF is established (e.g. those types of institutions that are normally regulated as banks and custodians in Guernsey).
AIFMs will be required to prepare annual reports in respect of each non-EU AIF it markets in the EU, which must be provided to investors on request and to the authorities of the member-state of reference of the AIFM and the home member-state of the AIF (if applicable), being the member-state where the AIF may be authorised or registered or has its registered or head office.
The AIFM Directive will also impose additional requirements on an AIFM if the AIF acquires a substantial stake (10% of voting rights) in a non-listed EU company, or if the AIF acquires control of an EU company, regardless of whether or not it is listed.
AIFMs will be required to set a maximum level of leverage that they may employ for each AIF they manage as well as set a limit on the extent that any right to reuse collateral (hypothecation rights) or guarantees that may be granted under the leverage arrangement. In setting these limits, the AIFM should take into account:
The type of the AIF, its investment strategy and any relationships with other financial services institutions, which could pose systemic risk;
The sources of leverage, the extent to which the leverage is collateralised and the need to limit the exposure to any single counterparty;
The scale, nature and extent of the activity of the AIFM in the markets concerned; and
The asset to liability ratio.
AIFMs will also be required to demonstrate that the leverage limits in place for each of their AIFs are reasonable and that those limits are complied with at all times. Member-states’ authorities will also have the power to impose additional limits on the level of leverage that an AIFM can employ in order to limit the systemic risk in the financial system contributed to by the use of leverage.
Whilst the AIFM Directive may impose additional regulatory requirements on non-EU AIFMs wishing to market non-EU AIFs in the EU, these requirements should be no more onerous than for EU AIFMs. Further, there are clear benefits for the AIFM to be domiciled offshore prior to the AIFM Directive becoming effective and particularly whilst the NPP Regimes continue to be in place.
Once the Passport Regime has been introduced (subject to ESMA making a recommendation to implement the Passport Regime for it to be used by non-EU AIFMs), offshore AIFMs, particularly those in Guernsey, should be ideally placed to take advantage of the new benefits of being able to market AIFs across the EU with a single authorisation and also to take advantage of the exceptions and the lighter touch regime that the AIFM Directive may offer.
Sam advises a wide range of clients on all aspects of corporate law in Guernsey. He has acted on a large number of fund establishments, including the establishment of the Mansion Student Accommodation Fund (GBP) (a cell of The International Mutual Fund PCC Limited), which now has a NAV that exceeds £170m.
Stephen also specialises in advising clients on all aspects of corporate law in Guernsey. He recently advised on the first Guernsey court-sanctioned scheme of arrangement for the transfer of cells between protected cell companies regulated as collective investment schemes. The transferred cells had a total NAV of approximately $150m. Stephen also advised on the establishment of the first Guernsey PCC investment umbrella fund specialising in film production, marketing and distribution.
AO Hall is a specialist law firm in Guernsey, Channel Islands, which focuses on key areas of Dispute Resolution, Corporate, Employment and Fiduciary. AO Hallís Corporate Team advises a wide range of clients on all aspects of Guernsey corporate and commercial matters, including investment funds and its experience in this area includes advising promoters, managers, administrators and custodians in relation to the establishment, operation, regulation and management of open and closed-ended investment funds in a wide range of asset classes, such as real estate, equities and esoteric assets. For more information, please visit www.aohall.com.