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.
The final text, which represented the culmination of lengthy and difficult negotiations, was published in the Official Journal on 1st July 2011. It was implemented in the UK on 22 July 2013, the date by which all member states had implement the directive into law. The Directive is being fleshed out by level 2 delegated acts, such as the Commission's delegated Regulation, which was published on 19 December 2012. ESMA is also in the process of establishing guidelines on technical aspects of the directive, such as on reporting requirements, which further supplement the directive.
The Directive will apply to managers of all non-UCITS alternative investment funds (AIF) that are managed or marketed in the EU. The AIFMD will apply to all EU managers (AIFM) managing and marketing an AIF in the EU and all non-EU AIFMs who are either managing and marketing an EU AIF or marketing a non-EU AIF to EU investors.
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 and is wider than the "collective investment scheme" definition in the UK's Financial Services and Markets Act.
It does not include:
- holding companies;
- the management of pension funds;
- employee participation or savings schemes;
- joint ventures;
- governmental bodies which manage funds supporting social security and pension systems;
- supranational institutions;
- national central banks;
- securitisation special purpose entities (SPEs), although the Commission, in its answers to questions it received on the AIFMD (published on 25 March 2013), specified that SPE should be interpreted narrowly and that the European Securities Markets Authority (ESMA) will publish further guidance on the application of the AIFMD to SPEs, and
- entities managing AIFs whose only investors are companies within the same group (provided none of those investors are themselves an AIF).
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 €500m 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.
Where an AIF is leveraged and/or investors have redemption rights within the first five years, the AIFM can benefit from the exemption where the AIFs' assets (including assets acquired by leverage) do not exceed €100m.
An AIFM wishing to rely on this exemption must be satisfied that its aggregate assets under management across all AIFs for which it is the AIFM do not exceed the limits. AIFMs relying on the exemption will be subject to registration and limited regulatory reporting requirements, though member states will have discretion to require more.
AIFMs relying on an exemption will not benefit from the AIFMD's management or marketing passports unless they choose to opt into the entire AIFMD.
Smaller AIFMs, however, may choose to opt in to the full Directive regime in order to benefit from the rights granted by it.
An AIFM is any legal person whose regular business is to manage one or more AIF. The AIFMD specifies that 'manage' includes both the provision of "portfolio management services" and the provision of "risk management services". Neither of these terms is defined within the Directive and firms will need to make an assessment based on the factual circumstances of each entity.
An AIFM can be either an externally appointed manager appointed by or on behalf of the AIF, or a self-managed AIFM, where the AIF itself will be treated as the AIFM.
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 the Financial Conduct Authority (FCA).
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. This is known as 'passporting'. 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.
Two years after the main elements of the Directive come into force, ESMA will provide an opinion on extending the passporting regime to third country non-EU AIFMs.
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 most favoured nation (MFN) 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 and risk 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.
The AIFMD also includes extensive requirements relating to delegation of AIFM functions, valuation procedures and liquidity management policies.
The AIFMD contains remuneration rules which 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 payments (60% for very high earners) is to be deferred for at least three to five years and may 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.
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.
The AIFMD contains a maximum capital requirement of €10 million although this can be overridden by the overarching requirement that the amount of capital held by the AIFM 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.
Each fund must also have a credit institution (such as a bank) or an investment firm that is subject to the same capital requirements as credit institutions 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 AIFMD imposes strict liability on depositaries, with limited exemptions, for any loss of financial instrument.
In the event of a loss, the depositary will therefore be required to produce, without undue delay, an identical financial instrument or a cash equivalent to the instrument lost.
For funds that do not generally invest in assets held in custody and which do not have redemption rights exercisable for five years, Member States can authorise them to appoint a lawyer or other professional adviser to act 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 in the third country where the AIF is established, although this is subject to various conditions, such as the depositary being subject to effective regulation and supervision in the third country. Alternatively, for non-EU funds the depositary may be established in the member state where the AIFM has its registered office or a branch or the member state of reference for the AIFM.
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.
There are also specific disclosure requirements on AIFMs that manage private equity funds where the fund acquires shareholdings in a non-listed company or issuer.
AIFMs must set their own leverage limits for each fund they manage following defined guidelines. AIFMs must also 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.
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.
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.
This is subject to certain carve outs for some distributions from distributable reserves.
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.
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 will only be able to market EU AIFs and/or non-EU AIFs to professional investors under each Member State's private placement regime, provided that the non-EU AIFM complies with disclosure rules and relevant co-operation arrangements are in place with the competent authorities of the member state where the AIF is marketed and the supervisory authorities of the third country where that AIF is established. For example, if a non-EU AIFM were to market a Guernsey Fund in France, a co–operation arrangement must be in place between Guernsey Financial Services Commission and the Autorité des Marchés Financiers.
The negotiations for co-operation arrangements are being conducted by ESMA and can be monitored on the ESMA website via press releases. ESMA has confirmed that co-operation arrangements are in place with all EU Member States and with the Brazilian Comissão de Valores Mobiliários (CVM) and the Swiss Financial Market Supervisory Authority (FINMA).
In 2015 ESMA will assess whether the passport regime should be extended to non-EU AIFs and non-EU AIFMs operating within the EU. Up until this time, Member States are able to impose their own restrictions to their existing private placement regimes. Whilst there is no clear indication of the intentions of each member state on whether or how to maintain their private placement regime, certain regulators such as BaFIN have made clear their wish to review existing private placement regime and to potentially tighten their rules, including extending this to real estate investment trusts (REITs).
Between 2015 and 2018 member states' national private placement regimes and the European passport could co-exist, provided ESMA recommends that the passport be extended to non-EU AIF and non-EU AIFM). However in 2018 ESMA is required to provide a recommendation as to the desirability of terminating the member state national private placement regimes. If it does so the Commission will have to pass secondary legislation phasing out these private placement regimes.
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.
Important AIFMD dates
22 July 2013 - member states required to implement the AIFMD into national law
22 July 2014 - deadline for AIFMs that performed activities before 22 July 2013 within the scope of AIFMD to submit an application for authorisation
2015 - ESMA to report on the functioning of the passporting regime for EU AIFs and EU AIFMs and to consider extension of the passporting regime to Non-EU AIFs and Non-EU AIFMs
2018 - ESMA to review the AIFMD's impact and to consider ending Member States' private placement regimes
How will the AIFMD be implemented into UK law?
The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 will be amended to include management of an AIF as a new regulated activity. HM Treasury is responsible for transposing the requirements of the AIFMD that require changes to primary and secondary legislation, the key piece of legislation being the Alternative Investment Fund Managers Regulations (AIFM Regulations).
On 1 May 2013, HM Treasury published a set of Questions and Answers on the transposition of the AIFMD, covering issues such as transitional arrangements, marketing and the definition of an AIFM. Furthermore, on 13 May 2013, HM Treasury published a further draft of the Alternative Investment Fund Managers Regulations which clarified certain issues arising from the first draft published in January 2013 (for example, the latest draft clarified that the obligation to make an application for permission or registration only applies to UK AIFMs that continue managing an AIF after 21 July 2014).
The FCA is responsible for transposing the AIFMD into the FCA Handbook. The main substance of the changes is likely to be found in a new investment funds sourcebook within the FCA Handbook, referred to as "FUND". This will replace the current rules and guidance contained in the Collective Investment Schemes sourcebook (COLL).
In March 2013 the FCA's predecessor (the Financial Services Authority) published a second consultation paper on the AIFMD. The FCA is expected to publish a third consultation paper on UK implementation of the AIFMD in May 2013.
For more on AIFMD contact:
Monica Gogna; Michael Lewis
Ian Warner; Daniel Greenaway