Ireland: A Guide to the AIFM Directive - Putting Fund Managers on the Right Path

INTRODUCTION

The European Union has finally succeeded in introducing a directive to establish a harmonised pan-EU framework for the regulation and supervision of the activities of alternative investment fund managers ("AIFM"). This will be implemented within the EU from January 2013.

The Alternative Investment Fund Managers Directive ("AIFM Directive") will automatically apply to AIFM located in the EU. Its scope will also cover AIFM located outside the EU who manage EU based alternative investment funds ("AIF") and also, to a certain extent, non-EU AIFM managing non-EU AIF that are marketed in the EU.

The initial draft of the AIFM Directive was produced in April 2009 as a reaction to the perceived role of hedge funds in the recent financial crisis. After a prolonged period of drafting and much political wrangling the AIFM Directive has been formally approved.

This paper presents an overview of the key provisions of the AIFM Directive and an analysis of how they will impact the operations of fund managers. While it does not propose to be a comprehensive study, it aims to address some of the most immediate questions that will be posed by fund managers now the AIFM Directive is finally a reality.

Some fund manager frequently asked questions:

• Does the AIFM Directive apply to our business?
• To what extent will the AIFM Directive affect our business?
• What does authorisation require?
• When does the AIFM Directive come into effect?
• What will we need to do in advance of the AIFM Directive's introduction?

DOES THE AIFM DIRECTIVE APPLY TO OUR BUSINESS?

The first question posed by fund managers will be whether the AIFM Directive impacts their business.

Is your firm located within the EU?

If the answer is no, the AIFM Directive will only apply if you manage EU funds or market non-EU funds within the EU and only to a limited extent.

Does your firm provide portfolio management services or risk management services to investment funds?

The AIFM Directive will not apply if the answer is no.

Is your firm engaged as the primary/ principle entity responsible for portfolio management/risk management services for one or more investment funds?

If the answer is no and if your firm acts as a delegate to a primary entity and that primary entity is ultimately responsible for the fund's portfolio management (and marketing within the EU) the AIFM Directive will not apply to your firm and such primary entity will be the fund's AIFM and subject to the AIFM Directive.

Is your firm's activity restricted to managing UCITS funds?

The AIFM Directive will not apply if the answer is yes.

Does your firm manage fund assets below €100 million in total?

If yes, the AIFM Directive will apply to your firm to a very limited extent only – your firm will be required to register under the AIFM Directive and provide certain confirmations to your home Member State competent authority.

Does your firm manage fund assets restricted to less than €500 million in unleveraged, closed-end funds?

If yes, the AIFM Directive will apply to a very limited extent only – requiring registration.

If your firm manages AIF, the AIFM Directive will apply to your firm and authorisation will be required, unless the application of the AIFM Directive is limited or excluded as described above.

SCOPE OF THE AIFM DIRECTIVE - KEY CONCEPTS/DEFINITIONS

Some of the key words/phrases that determine the scope of the AIFM Directive are summarised below.

FAQ – TO WHAT EXTENT WILL THE AIFM DIRECTIVE AFFECT OUR BUSINESS? - ROADMAP

Key elements on the level of application of the AIFM Directive will be:

• the location of the AIFM
• the location of the AIF
• whether marketing activity is carried out within the EU in respect of the AIF

TO WHAT EXTENT WILL THE AIFM DIRECTIVE AFFECT OUR BUSINESS? – CONDUCT OF BUSINESS RULES

Below is a summary of some of the key conduct of business requirements that will impact on any AIFM caught by the AIFM Directive.

• Remuneration Policy – AIFM must adopt appropriate remuneration policies with the purpose of ensuring staff are not incentivised for managing an AIF in a manner that is not consistent with the AIF's risk profile. (Article 13)
• Conflicts of Interest – procedures must be put in place to identify, prevent, manage and monitor conflicts of interest. (Article 14)
• Risk Management – a risk management function, separate from the portfolio management operations, must be implemented so as to identify, measure, manage and monitor risk. (Article 15)
• Investment Rules – maximum leverage limits must be set in respect of each AIF. (Article 15). Also, procedures must be applied to monitor liquidity risk and ensure the liquidity profile of each AIF managed meets the redemption policy. (Article 16)

TO WHAT EXTENT WILL THE AIFM DIRECTIVE AFFECT OUR BUSINESS? – OPERATIONAL REQUIREMENTS

• Independent Valuation – the assets of each AIF must be valued by a sufficiently qualified external valuer or by a unit of the AIFM that is functionally independent of the portfolio management unit and remuneration policy. Where an AIFM acts as valuer, measures must be in place to ensure conflicts of interest or undue influence on valuations staff are avoided. Also, Member State competent authorities may require that the AIFM's valuation procedures are verified independently by an external valuer or an auditor. (Article 19)
  
  NOTE: Article 19 paragraph 10 states that "the AIFM is responsible for the proper valuation of AIF assets, the calculation of net asset value and the publication of that net asset value. Therefore, in no case shall the AIFM's liability towards the AIF and its investors be affected by the fact that the AIFM has appointed an external valuer." There is also provision for external valuers to be liable to the AIFM for losses suffered by the AIFM as a result of the external valuer's negligence or intentional failure to perform its tasks. This is a significant departure from how most funds currently operate in relation to valuation of assets, parties responsible and legal liability.
• Delegation – an AIFM can delegate portfolio management activities to an entity outside the EU provided there is co-operation between the competent authority of the AIFM's home Member State and the delegate's regulator. Delegation of functions by an AIFM must be objectively justifiable. (Article 20)
  
  NOTE: Article 20 paragraph 1(d). Non-EU fund managers may wish to explore the possibility of establishing an EU AIFM (akin to a UCITS management company) and delegating portfolio management services from this EU AIFM to their main asset management centre outside the EU. An AIFM will need to carry out some functions or retain some substance in order to avoid becoming a "letter-box entity".
• Custodian Eligibility, Duties and Liability – each AIF must appoint a single depository or custodian. The AIFM Directive sets out criteria for eligibility of custodians (EU authorised credit institution; certain MiFID authorised firms with adequate capital authorised to provide the ancillary service of sakekeeping of financial instruments for clients; entities eligible to act as custodians of UCITS pursuant to UCITS IV requirements). For EU AIF, the custodian must be located in the AIF's home Member State. The AIFM Directive also outlines conditions applicable to custodians of non-EU AIF. (Article 21)
  
  NOTE: In terms of custodian liability, Article 21 paragraph 11 provides that a depositary shall be liable for loss to an AIF unless "it can prove that the loss has arisen as a result of an external event beyond its reasonable control, the consequences of which would have been unavoidable despite all reasonable efforts to the contrary." The European Commission will expand on this definition and outline its parameters in Level 3 implementing measures.
  
  NOTE: The AIFM Directive outlines general duties of the custodian and also conditions applicable to any delegation of functions to third parties. The AIFM Directive requires a subrogation power is in place so that where there is a delegation of functions, the sub-custodian will be required to enter a contract in writing assuming legal liability that in effect enables the AIF or the AIFM to claim against it directly.
• Regulator Leverage Limits – Member State competent authorities may impose limits on the level of leverage that an AIFM may employ or other restrictions on how they manage AIF when necessary in order to ensure the stability and integrity of the financial system. (Article 25)
• Asset Stripping – an AIF holding a controlling stake in a private company will be prohibited from facilitating or supporting any measure to reduce such company's capital or cause a purchase by such company of its own shares. This rule applies for two years from the date of acquisition of control of the company. (Article 30)

TO WHAT EXTENT WILL THE AIFM DIRECTIVE AFFECT OUR BUSINESS? – TRANSPARENCY

• Annual Report – AIFM must arrange for each AIF to produce an audited annual report within six months of each financial year end. Such report must be available to the competent authority in the Member State of the AIFM and each AIF and investors in each AIF on request. (Article 22)
  
  NOTE: While the annual report relates to the AIF, the AIFM Directive requires disclosure of remuneration by the AIFM to its staff, including breaking down the amount paid to staff between fixed remuneration and variable and more specific details on remuneration paid to senior management and key staff whose actions have a material impact on the risk profile of the AIF.
• Investor Disclosure (Initial) – AIFM will have to make specific disclosure to investors before they invest. The AIFM Directive is not specific on the format of the information to be provided. Such information could be built into to the AIF's offering document and indeed some (but not all) of the required information would ordinarily be captured in a standard fund offering document. However, some of the information (such as historical performance data and latest net asset value or market price of the AIF's shares) will need to be obtained from live/very recent sources. (Article 23)
• Investor Disclosure (Ongoing) – AIFM will have to make specific disclosure to investors periodically regarding liquidity, risk management and the level of leverage employed by the AIF. The details and regularity of such disclosure will be resolved by the Commission. (Article 23)
• Regulator Disclosure – AIFM will have to make disclosure to the competent authority of their home Member State regarding their operations and the AIF they manage. (Article 24)
• Leveraged AIF/Private Equity AIF Additional Disclosure – Chapter V of the AIFM Directive provides for additional reporting requirements for AIFM that manage leveraged AIF or private equity AIF. For example, if an AIF holds controlling stakes in private companies, the AIFM will need to report certain information to other shareholders and its regulator.

WHAT DOES AUTHORISATION REQUIRE?

AIFM must be authorised under an EU-wide regime. The following elements must be specifically addressed as part of an application for authorisation.

EU AIFM

• Programme of Activity – AIFM must prepare a document outlining how it proposes to operate its business in compliance with the relevant obligations of the AIFM Directive. (Article 7)
• AIF Disclosure – AIFM must make detailed disclosure to their Member State competent authority regarding funds managed or proposed to be managed. (Article 7)
• Key Individuals – AIFM's principals must be of sufficient good repute and sufficiently experienced. (Article 8)
• Shareholders – Entities holding 10% or more of the AIFM's equity must meet suitability tests. (Article 8)
• Minimum Capital – Minimum capital requirements will apply. (Article 9)
  
  NOTE: the minimum capital requirements are broadly consistent with the requirements applicable to management companies of UCITS under Directive 2009/65/EC (€125,000 plus 0.02% of amount of assets managed in excess of €250 million up to a maximum of €10 million). Importantly, there is an additional requirement relating to cover for potential professional liability. Article 9 paragraph 7 requires the AIFM to maintain additional own funds "appropriate to cover potential liability risks arising from professional negligence" or hold appropriate professional indemnity insurance.

Non-EU AIFM Managing or Marketing EU AIF

From 2015, non-EU AIFM managing EU AIF or marketing non-EU AIF within the EU under a passport will need to obtain prior authorisation under Article 37 from the competent authority of the Member State where the EU AIF is established or where the non-EU AIF is marketed (the Member State of reference). In the latter case, where there are multiple AIF or where the AIF is marketed in multiple Member States, the relevant Member State will be determined in accordance with criteria specified in the AIFM Directive. There is a provision in the case of a conflict on the choice of Member State for the relevant competent authorities to "jointly decide" within one month on the Member State of reference.

The AIFM must establish a legal representative in the Member State of reference, responsible for compliance with the management and marketing activities performed by the AIFM under the AIFM Directive.

WHEN DOES THE AIFM DIRECTIVE COME INTO EFFECT?

AIFM Directive Implementation

The AIFM Directive was finally approved by the European Commission and European Parliament on 11 November, 2010. Its provisions must be transposed into national law in all EU Member States within two years of its entry in the Official Journal, so it is likely to come into force in the early part of 2013.

AIFM will then have one year to obtain authorisation under the new regime.

During the transposition period, the European Commission will, together with the European Securities Markets Authority (ESMA), develop implementing measures to support the AIFM Directive and supplement national legislation.

Phased Entry of Passport Regime

The passporting regime allowing AIFM (whether based in or outside the EU) to market funds to professional investors in the EU will come in to force at a future date, likely to be in 2015. Existing national private placement rules in relation to non-EU AIF can continue until at least 2018 but will be subject to additional conditions.

WHAT WILL WE NEED TO DO IN ADVANCE OF THE AIFM DIRECTIVE'S INTRODUCTION?

Determine if Authorisation is Required

As a first step it will be necessary for each firm to consider the scope of its fund management activity and whether this is captured by the AIFM Directive. This exercise should include an analysis of whether any exemptions may be availed of.

Consider the Authorisation Requirements

Each fund manager will need to consider the authorisation requirements and ensure they can be satisfied. Firms should be aware of the disclosure requirements relating to key individuals and shareholders. Compliance with new minimum capital requirements may also present issues in some cases.

AIFM – Gap Analysis

A critical exercise will be for each firm to undertake a detailed gap analysis to examine their existing business in the context of the new requirements, specifically in relation to conduct of business rules, organisational requirements, operational requirements and transparency/disclosure requirements. This would include, for example, putting in place a remuneration code, a risk management policy and conflict of interest procedures.

In respect of each of these areas, it is likely that measures will need to be put in place to bring the firm's business into line with the new requirements. Initial and ongoing compliance is likely to place demands on existing resources, so firms may need to contemplate hiring additional personnel or consider outsourcing solutions. AIF – gap analysis The AIFM Directive directly impacts on any AIF managed by an AIFM. Compliance with the AIFM Directive may require some structural changes for existing funds captured by the AIFM Directive and will also need to be factored into initial structuring for new funds. Matters to consider include:

• Single Custodian – Each AIF will need to appoint a single custodian based in the same jurisdiction as the AIF. Such custodian will need to meet the relevant eligibility criteria (depending on whether the AIF is in the EU or outside the EU). Existing funds that have appointed a single custodian will need to ensure the custodian agreement reflects the appropriate minimum standard of liability.
• Disclosure – Offering documents for funds may need to be adapted to ensure compliance with initial investor disclosure requirements. Alternatively, a supplemental investor disclosure document may need to be devised. Ongoing investor disclosure and regulator disclosure obligations will also need to be addressed.
• Audited Accounts – AIF that do not currently produce annual audited financial statements will need to start doing so.
• Independent Valuer – Each AIF will need to appoint an independent valuer. Fund administrators may offer this as a supplemental service to their existing fund accounting, registrar and transfer agency services or a new party may need to be engaged. Alternatively an independent unit of the AIFM may carry out this function. Contractually it will need to be clarified whether the independent valuer is appointed by the AIFM. The AIFM's investment management agreement may need to reflect the ultimate responsibility of the AIFM for valuations.
• Liquidity Management/Leverage Limits – AIF may need to adapt operationally to meet liquidity management obligations and leverage limits.

The AIFM Directive in the Context of Other Regulation

For EU based fund managers already authorised under the MiFID regime, the requirements of the AIFM Directive may not be quite as daunting as initially envisaged. Similarly, fund managers with US clients may be gearing up for registration under the US Dodd Frank regime, so may already be in the process of bolstering their operations to meet those requirements.

The overlap of these other regulatory areas means that while it is certainly likely the AIFM Directive will require changes to be implemented, both to the fund manager's own business and indeed the funds they manage, many of the requirements may be substantially addressed already. In such cases, the steps required to bring their business and funds into line may be more a case of "gold-plating" rather than a radical overhaul.

Sidestepping the AIFM Directive

Fund managers may wish to contemplate measures to ensure their business falls outside the scope of the AIFM Directive. This may include the use of structures outside the AIFM Directive's scope such as UCITS, managed accounts and structured products. For non-EU managers, an extreme solution to sidestep the AIFM Directive is to withdraw from the EU market completely, both in terms of management operations and fund marketing. While implementing measures may provide more clarity, it appears that non-EU AIFM with non-EU AIF contemplating this exit strategy can retain legacy EU investors. In addition, it seems possible that such non-EU AIF will not be prevented from accepting subscriptions from EU investors that propose to subscribe for the AIF without solicitation by the AIFM and without the AIFM facilitating the subscription in any way, subject to compliance with any Member State specific rules.

However, exiting the EU is a most radical measure and highly unlikely in most cases given the capital available in the EU market.

Who Ultimately Carries the Cost?

It is expected that most fund managers will still wish to maintain a place in the EU. Increased compliance requirements and regulatory oversight may simply be the price that must be paid. One fear is that the costs of compliance with the AIFM Directive are built into fees charged to funds – effectively meaning investors are the ones ultimately carrying the extra costs.

New Opportunities – The Irish QIF

Specifically on the fund product side, the potential positive implications of the AIFM Directive should not be underestimated. The passport regime (once successfully introduced and implemented) is likely to open up new distribution opportunities to alternative investment funds not previously available through private placement channels. This has already been recognised in an Irish context, for example, by an initiative to bring the investor eligibility criteria/minimum subscription requirements for the Qualifying Investor Fund (QIF) into line with the MiFID professional investor criteria and the AIFM Directive passport regime.

The QIF, which is already subject to a single custodian requirement, is now primed to take up the role of EU regulated alternative investment fund that can be openly sold pan-EU to professional investors.

The case for the Irish QIF is supported further for existing funds by the presence of the Irish re-domiciliation regime. This relates to a range of measures recently introduced to enable non-Irish funds to migrate to Ireland under a streamlined process. The three key elements of the new regime being:

• track record can be maintained
• investor consent will generally not be required and
• no tax crystallisation - the relocation should not carry any adverse tax implications for the fund or its investors

For further information on re-domiciliation, please refer to our guidance paper entitled "Re-domiciling funds to Ireland – key elements to consider".

Other EU fund domiciles will no doubt look to compete in this space. Particularly for fund managers caught by the AIFM Directive regime due to the location of their own operations, it will be compelling to consider the QIF and similar EU-based products for their enhanced distribution capability.

CONCLUSION

The AIFM Directive is a regulatory development of major significance for fund managers based in the EU or raising capital in the EU. As the dust settles on this landmark piece of EU legislation, fund managers will begin to digest its finer details and consider how they can position their business going forward to effectively operate in this new and invasive post- AIFM Directive world.

Only time will tell how the AIFM Directive will play out in practice. Like any other situation, the winners are likely to be those that move quickly, adapt and innovate. The challenge will be how to navigate through the AIFM Directive (and all EU, US and other regulatory initiatives) while operating a successful business that continues to thrive.

Disclaimer

This information is for guidance purposes only. It does not constitute legal or professional advice. Professional or legal advice should be obtained before taking or refraining from any action as a result of the contents of this publication. No liability is accepted by Eversheds O'Donnell Sweeney for any action taken in reliance on the information contained herein. Any and all information is subject to change. Eversheds O'Donnell Sweeney is not responsible for the contents of any other website or third party material which can be accessed through this website.

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