This guide was last updated on 27th July 2011.
The Alternative Investment Fund Managers Directive (AIFMD) is one of a package of measures drawn up by the European Commission to regulate financial services in the wake of the global financial crisis.
Its aim is to establish a harmonised regulatory framework for monitoring and supervising the perceived risks posed by unregulated funds such as private equity and hedge funds. Rather than regulate the funds themselves, however, the Directive targets their fund managers.
Negotiations over its terms were difficult and protracted, but agreement was finally reached in October 2010 and the final text approved by the European Parliament on 11th November. The Directive was published in the Official Journal on 1st July 2011. Member states have until 22nd July 2013 to implement it into law.
The revised text includes provisions that will eventually allow non-EU managers and funds to obtain a passport to market into the EU. There are also measures on remuneration, strict liability for depositaries and safeguards against asset stripping.
More detail will be provided in extensive implementing measures, known as delegated acts, which will be adopted by the European Commission.
On 13th July 2011, the European Securities and Market Authority (ESMA) published a consultation paper on the delegated acts. The responses received will influence ESMA's advice to the Commission, due by 16th November 2011. The consultation closes on 13th September.
Application
The Directive will apply to anybody with a head office or registered office in the European Union who is an alternative investment funds manager (AIFM) of an alternative investment fund whether the fund is located in the EU or elsewhere.
It will also apply to non-EU managers managing European funds (whether they are marketed in the EU or not) and to non-EU managers marketing non-EU funds within the EU.
Alternative investment funds are defined as "all collective investment undertakings that are not regulated under the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive." This includes private equity funds, hedge funds, real estate funds, commodity funds, infrastructure funds and other types of institutional fund.
It does not include holding companies, the management of pension funds, employee participation or savings schemes, certain securitisation special purpose vehicles, insurance or joint ventures.
A lighter regime will apply to managers of alternative investment funds with a cumulative value of less than €100 million, and managers of funds with a cumulative value of less than €500 million in total where the fund portfolio consists of funds that are not leveraged and has a lock-in period for investors of at least five-years.
Smaller AIFMs, however, may choose to opt into the full Directive regime in order to benefit from the rights granted by it.
Authorisation
Under the Directive, an EU AIFM will not be able to provide management or administrative services to a fund unless it has been authorised by the competent authority in its home member state and it complies with the Directive on an ongoing basis. In the UK, the competent authority is currently the FSA.
Once authorised, an AIFM will be able to provide management services to a fund domiciled in any other member state, either directly or via the establishment of a branch. The AIFM will need to notify its home state regulator of its intentions and provide certain information, which the home state regulator will forward to the host state regulator.
The host state regulator will not be able to impose any additional requirements on an AIFM passported in this way.
Duty of care
Managers will be required to act honestly and with due care, skill and diligence in the best interests of the fund, the investors and the market. They must also ensure that all fund investors are treated fairly. Once the Directive is in force, managers should consider their MFN ("most favoured nation") terms and approach to side letters with this in mind.
More specifically, every AIFM will need to make sure it has appropriate procedures in place to deal with conflicts of interest, risk management and liquidity management. The Directive includes obligations to carry out regular stress tests and to ensure that risk management and portfolio management functions are independent from each other and subject to annual reviews.
Professional indemnity insurance to cover the manager's liabilities is not mandatory but the AIFM must either have it in place or set aside an appropriate amount of own funds.
More details will follow in delegated acts to be adopted by the European Commission.
Remuneration
The revised text contains remuneration rules which were not included in the original proposal. These are akin to the rules being introduced for the banking sector and are intended to curb risk-taking behaviour.
Member states must ensure managers have remuneration policies and practices in place for those categories of staff whose professional activities have a material impact on the risk profiles of funds they manage. These include senior management, risk takers, control functions and any employee whose total remuneration takes them into the same bracket as senior management and risk takers. Larger AIFMs will be required to set up a remuneration committee.
Guaranteed bonuses will be allowed in only limited circumstances. At least 40% of bonus payment is to be deferred for at least three to five years and must be "considerably contracted" if the fund underperforms. A "substantial proportion" (usually at least 50%) of the bonus should be in the form of units or shares in the fund concerned.
Guidelines on sound remuneration policies are to be published by ESMA.
Delegation
The Directive provides that an AIFM will need to notify its home state regulator and fulfil certain conditions before it can delegate any of its functions to a third party, including being able to justify the delegation arrangements objectively.
Where an AIFM delegates portfolio management or risk management functions, the third party must be authorised and subject to supervision and (if it is a third country undertaking) there must be a cooperation agreement between the home state and third county regulators. Delegation of these functions to the fund's depository or a delegate of the depository is not permitted.
Sub-delegation is allowed, subject to the AIFM's prior consent, prior notification to the AIFM's home state regulator and the same conditions and restrictions as apply to delegation.
The AIFM will be required to review the delegated services provided on an ongoing basis. Delegation will not affect its duties to its investors or its primary liability for the management of the fund. Managers will not be allowed to delegate to such an extent that, in essence, they can not longer be regarded as managers.
Capital and assets
Where the fund is internally managed (i.e. where the legal form of the fund permits internal management), it must have initial capital of at least €300,000.
An AIFM of one or more externally managed funds will require initial capital of at least €125,000. Where the value of the portfolio exceeds €250 million, the AIFM must provide an additional amount of own funds equal to 0.02% of the amount by which the value of the portfolio exceeds €250 million.
But, whatever the figure, the amount must never be less than one quarter of the previous year's fixed overheads.
For each fund the AIFM manages, it must ensure that appropriate procedures are established for a proper and independent valuation of the fund's assets to be carried out at least once a year and more frequently where appropriate, such as where there is an increase or decrease in the fund's capital.
The Directive does not require an external valuer to be appointed, but it provides that the valuation process must be independent from the portfolio management and remuneration policy of the AIFM.
Depositaries
Each fund must also have a credit institution (such as a bank) or investment firm acting as a depositary in order to receive and safe-keep the payments made by investors and the financial instruments that belong to the fund, as well as to verify ownership of assets.
The final text, however, includes a concession that will benefit private equity funds, venture capital funds and real estate funds. Member states may allow funds which have no redemption rights exercisable during the period of five years and which generally do not invest in assets that must be held in custody to appoint a lawyer or other professional adviser as their depositary.
For EU funds, the depositary must be established in the home member state of the fund. For non-EU funds, the depositary can be based outside the EU subject to various conditions, such as the depositary being subject to effective regulation and supervision in the third country.
The depositary may delegate certain functions (again, on certain conditions) even to a non-EU sub-depositary. Delegation will not generally affect its liability, which is strict in the case of loss of financial instruments held in custody and otherwise requires evidence of intent or negligence.
There are, however, specific and limited circumstances when liability for loss of financial instruments may be contractually transferred to a sub-depositary to whom the depositary has delegated custodial functions.
Disclosure and reporting
The Directive imposes significant disclosure obligations on AIFMs managing EU funds or marketing funds in the EU.
Before they invest, investors must be given a description of the fund's investment policy, detailed information about how the fund is managed, what functions are delegated and any fees and expenses that will be charged. The required information also includes disclosure of any investment restrictions, the use of leverage and the fund's valuation and liquidity management procedures.
On top of this, the AIFM must disclose periodically to investors (and report to its home state regulator) the percentage of fund assets which are subject to special arrangements because of their illiquid nature, any new arrangements for managing liquidity, the fund's current risk profile and the risk management systems being employed.
Any material changes in the information disclosed to investors must be highlighted in the manager's annual report for each fund. The annual report must also disclose the total remuneration paid to the AIFM's staff and the aggregate amount paid to senior management and others who have a material impact on the fund's risk profile.
The manager will be required to report regularly to its home state regulator on the principal markets and instruments in which it trades and periodically on the main categories of assets in which it invested and, where relevant, the use of short selling within the period.
Leverage
AIFMs may set their own leverage limits for each fund they manage following defined guidelines, but they must be able to demonstrate that the limits are reasonable and that they are complying with them at all times.
For each EU fund managed and for each fund marketed in the EU, the AIFM must disclose to investors on a regular basis the total amount of leverage used and any changes to the maximum level.
Funds employing leverage "on a substantial basis" must provide their home state regulator with information about the overall level used and a detailed breakdown. Where necessary, home state regulators can ask for additional information and, in exceptional circumstances, ESMA may request regulators to impose additional reporting requirements.
When deemed necessary "in order to ensure the stability and integrity of the financial system", the home state regulator may impose a leverage limit on the fund. The regulator must notify its intention to ESMA in advance and ESMA may provide advice to the regulator and specify remedial measures where the leverage used by one or more AIFMs poses substantial risks to financial stability.
Controlling influence
Additional notification and disclosure obligations arise where a fund acquires, disposes of or holds shares of a non-listed EU company over a certain size.
The AIFM must notify its home state regulator when the proportion of voting rights held by the fund at any time in a non-listed company "reaches, exceed or falls below" thresholds of 10%, 20%, 30%, 50%, and 75%".
Where a fund acquires control (50% or more of the voting rights) of a non-listed company, the AIFM must notify the unlisted company, the other shareholders and the AIFM's home state regulator of the date on which control was obtained and how this affects voting rights.
These notifications must be made no later than ten working days after the relevant threshold was achieved or control obtained.
Additional disclosure requirements apply when the fund obtains control over a non-listed company or an issuer (a company whose shares are admitted to trading on a regulated market). The control threshold for an issuer is, however, lower than for a company (in the UK it is currently 30% of voting rights).
The requirements include making available to the company, the shareholders and the home state regulator information about the fund's policies for managing conflicts of interest and communicating with employees about its intentions with regard the future business of the company.
The AIFM must request the board of directors to pass the notification of control and other information on to the employees or their representatives and use its best efforts to make sure this is done. The AIFM is not, however, required to ensure the board passes on information that would seriously harm or be prejudicial to the company. Employee representatives will not be permitted to disclose confidential information to employees unless they, too, are bound to maintain confidentiality.
The notification and disclosure obligations will not apply if the controlling influence is acquired in a small or medium sized company (i.e. one that employs fewer than 250 people, has an annual turnover of less than €50 million and/or an annual balance sheet not exceeding €43 million) or in a special purpose vehicle set up to purchase, hold or administer real estate.
Asset stripping
The Directive seeks to inhibit asset stripping by not allowing AIFMs to facilitate certain distributions to shareholders, capital reductions, share redemptions or acquisitions of own shares by the company for the first two years.
Insofar as the AIFM is authorised to vote on behalf of the fund, it must not vote in favour of such measures during this period and, in any event, must use its "best efforts" to prevent them taking place.
These provisions do not apply where control is acquired over small to medium sized companies or special purpose vehicles set up to purchase, hold or administer real estate.
Marketing
One of the main aims of the Directive is to set up a "passporting" system so that a fund and fund manager would be able to register in one EU state and be free to market in all other EU member states. At present, each member state may impose different requirements for the marketing of alternative investment funds in their territories.
Under the revised text, EU AIFMs will be able to market EU funds to professional investors in the manager's home member state or in other member states, provided they notify their home state regulator in advance and supply prescribed information about the fund.
Within 20 working days, the home state regulator will inform the AIFM if it may begin marketing in its home member state and what conditions and restrictions apply.
If the application is to market in other member states, the regulator will, within 20 working days, transmit the file to the regulators of the host member states and notify the AIFM of this. The manager will have a passport to market in those member states when it receives this notification.
In either case, any planned changes to the information supplied must be notified at least a month before being implemented or immediately after an unplanned change takes effect.
An EU AIFM will be able to obtain this passport in 2013 when member states have transposed the Directive into national law.
Non-EU AIFMs and funds will have to wait longer. Two years after member states have transposed the Directive into national law, ESMA will report on the passport regime for EU funds and managers and on a possible extension of the system to non EU funds and managers.
If ESMA recommends an extension, the European Commission will within three months adopt delegated acts specifying the date when the extended passport regime will come into effect.
Until then, non EU funds and managers will continue to be governed by the national private placement regimes of each member state where they want to market.
From 2013, however, additional requirements will be imposed by the Directive, such as the need to submit an audited annual report to the regulator in the member state where the fund is to be marketed. There must also be appropriate co-operation arrangements in place between the member state and the third country.
Even after extended passporting comes into effect, there will be a "dual system period" of about three years when national regimes will continue to apply. A second ESMA report will consider ending national private placement regimes. If termination is recommended, the Commission will adopt the necessary delegated acts within three months.
Member states may exercise an option to allow certain types of fund to be marketed to retail investors in their territory and may impose stricter requirements on such marketing. There is, however, no equivalent passport regime for marketing to retail investors.
Contacts:
See: The AIFMD (73-page / 1.01MB PDF)