Background and timing of ESMA consultation process on the AIFM Directive
The new Directive on Alternative Investment Fund Managers
("AIFM Directive") entered into force on 21 July 2011,
following its publication in the "Official Journal" of
the European Union on 1st. of July. However, as the AIFM Directive
only sets out the high-level framework for future rules for the
management of alternative investment funds in the European Union,
implementing measures are needed to flesh out the specific legal,
technical and regulatory details of the new regime.
On 13 July 2011 the European Securities and Markets
Authority ("ESMA", formerly known as CESR) issued
draft advice on implementing measures for the AIFM Directive and
launched a consultation process. The draft advice, presented in the
form of a "Consultation Paper", responds to a request of
the European Commission for assistance addressed to CESR (i.e. the
predecessor organisation of ESMA) end of last year.
The substantial Consultation Paper (438 pages) addresses the
following three areas singled out by the European Commission as
substantial for the implementing of detailed technical aspects
under the AIFM Directive:
- General provisions including scope and exemptions, authorisation and operating conditions;
- Role of custodians;
- Transparency issues (such as annual reporting and disclosure to investors) and leverage (including methods for calculating the leverage and the exposure of the Alternative Investment Fund ("AIF").
The Consultation Paper does not address issues of scope in any
detail, beyond a consideration of how the threshold for the value
of assets should be calculated in order to exclude small AIFMs. In
particular, there is no reference to joint venture
arrangements.
A further area concerning supervisory aspects under the AIFM
directive, which was also raised by the European Commission, is not
covered by this Consultation Paper. ESMA launched a separate
consultation for these aspects on 23 August 2011 by issuing a new
consultation paper covering any topics dealing with third countries
in the AIFM Directive. These span from supervisory cooperation,
marketing of non-EU AIFs, the delegation of certain functions to
service providers outside the EU to the appointment of non-EU
depositaries.
Definition of "Assets under Management" for exemption under Article 3 of AIFM Directive
For the calculation of the "assets under management"
as mentioned in Article 3 of the AIFM Directive ESMA relates to the
"total value of assets"-approach. ESMA states that it
considers further methodologies, such as the calculation of
acquisition cost of assets held.
Moreover ESMA suggests that the calculation of the "total
value of assets" should include assets acquired via leverage,
that is using a gross method of calculating the exposure of the AIF
including any borrowing. ESMA seems to refer to the leverage which
exposes the AIF directly, any borrowing at the level of an
intermediate or holding vehicle would therefore not be included for
the purpose of calculating the "total value of
as-sets".
ESMA also proposes that the Alternative Investment Fund Manager
("AIFM") assesses all situations where the "total
value of assets" would exceed the thresholds on an ongoing and
lasting (not temporary) basis. In this respect ESMA specifies that
the situation may be considered as temporary when it is likely to
remain as such for a period longer than three months. ESMA suggests
that the value of the AIF is to be monitored quarterly.
General Operating Conditions
Capital Requirements regarding additional own funds and insurance coverage
Article 9 of the AIFM Directive sets out a minimum capital requirement consisting in a fixed amount (EUR 125,000 for external AIFM resp. EUR 300,000 for self-managed AIFM); for portfolios of AIFM exceeding EUR 250 million an additional 0.02% of the value must be added in own capital or – if higher - 25% of the fixed overhead costs. A maximum in underlying own monies of EUR 10 million is provided for by the AIFM Directive. All capital must to be held in cash. In addition to these amounts the AIFM Directive imposes the requirement to have a professional indemnity insurance in place or to have additional own funds which are also to be held in cash. ESMA was asked to provide its technical advice on such insurance and additional own funds and in the Consultation Paper ESMA proposes a method for calculating additional own funds providing qualitative and quantitative requirements.
Qualitative requirements
The qualitative requirements contains the implementation of
effective internal operational risk management policies and
procedures by the AIFM in order to identify, measure, manage and
monitor appropriately operational risk including liability risks to
which the AIFM is or could be reasonably exposed. This implies
inter alia:
- the record of any operational failures and loss experience and the set up of an historical loss database by the AIFM; within the risk management framework the usage of the historical internal loss data and of external data, scenario analysis and factors reflecting the business environment and internal control systems;
- the implementation of a regular internal reporting if operational risk exposures and loss experience;
- the implementation of procedures for taking appropriate corrective action;
- the documentation of the AIFM's operational risk management policies and procedures;
- regular reviews of the operational risk management policies and procedures and measurements systems;
- the maintenance of adequate financial resources covering liability risk arising from professional negligence by own funds or an insurance at all times.
Quantitative requirements
ESMA proposes two alternatives to calculate the quantitative
requirements of the additional own funds for liability risk:
The first option is based on the variable assets under management
and suggests one basis point (0.01 %) of the value of the
portfolios of AIF managed by the AIFM as capital basis whereas the
second proposal takes into account the variable income as well, in
addition to the assets under management, proposing an amount of
0.0015 % of the value of the portfolios of AIF managed by the AIFM
with an additional 2 % of the relevant income in own funds. The
relevant income is defined as the sum of all income received in
relation to the collective portfolio management activities of the
AIFM minus the sum of commission and fees payable in relation to
collective portfolio management activities, based on a calculation
of the average income ./. costs) over three years.
In certain circumstances the competent authority of the home Member
State of the AIFM may authorise the AIFM to lower the percentage
with regard to the additional own funds requirement (first option:
from 0.01% to 0.008% of the value of the portfolios; second option:
from 2% to 1% of the relevant income).
With respect to the alternative professional insurance ESMA
proposes that the insurance should cover specific risks listed and
relating to fraud by "relevant persons", risks in
relation to investor products and business practices and risks in
relation to business disruption, system failure and process
management. ESMA also proposes minimum coverage in numbers (i.e.
per claim a minimum of the higher of
- EUR 2 million; and
- 0.75% of the value of the portfolios exceeding EUR 250 million and in the aggregate the higher of:
-
- EUR 2.5 million; and
- 1% of the value of the portfolios exceeding EUR 250 million; and
- the required additional own funds (see above).
General Principles
ESMA proposes general principles for due diligence which an AIFM has to comply with. More specifically an AIFM is supposed to:
- ensure a high level of diligence in the selection and ongoing surveillance of its investments, and this in the best interests of the AIF, the underlying investors and of the market integrity;
- ensure that the AIFM has adequate knowledge and understanding of the assets in which the AIF are invested;
- establish written policies and procedures on due diligence and implement effective arrangements in order to ensure that investment decisions on behalf of the AIF are carried out in compliance with its objectives, investment strategy and risk limitation (if any) of the AIF. The due diligence processes and procedures must be regularly reviewed and updated, as need may be.
In addition to these general principles, ESMA suggests more specific due diligence requirements for AIFM who invest in (more) illiquid assets of a long duration:
- AIFM managing AIFs which invest in long duration, less liquid assets such as real estate or "partnership interests" (e.g. private equity investments), typically carry out the investments upon a comprehensive and detailed due diligence process and an extensive negotiation of the agreement. ESMA considers that the due diligence requirements apply also during the negotiation phase itself;
- AIFM who invest on behalf of AIFs in such specific assets should set out a business plan consistent with the duration of the AIF and market conditions. They should update such a plan whenever substantial changes occur with regard to the investment strategy of the AIF or to market conditions;
- AIFM should deliver to its senior management the proposal to invest in a certain target company or real estate highlighting the advantages/disadvantages and the exit strategy as well as any further proposal related to such an investment during the AIF's duration.
Risk Management
Moreover ESMA also proposes detailed implementing measures on risk management adapted to the nature, scale and complexity of their business and of the AIF it manages.
Custodians
With respect to the custodian function of cash monitoring as set out in the AIFM Directive it was highly controversial if the cash monitoring would require an ex ante control. ESMA in its Consultation Paper does not recommend an ex ante control for the cash monitoring, but rather strongly supports that the AIFM ensure that the custodian be granted access to all information related to any cash account of the AIF. ESMA suggests two alternative approaches regarding the custodian's cash monitoring obligations:
- The custodian may be installed as a central hub where all information related to the AIF's cash flow is centralised to ensure effective cash monitoring; or
- the custodian ensures there are procedures in place to appropriately monitor and review periodically the AIF's cash flow.
The custodian must mirror every transaction in a record-keeping
system. To ensure the verification of ownership, ESMA recommends
imposing an obligation that the assets are either registered in the
name of the custodian, or in case they are registered in the name
of the AIF or in the name of the AIFM, that the custodian must be
able to ensure that it can any ant time provide a comprehensive and
up-to-date inventory of the AIF's assets.
ESMA recommends general principles on the custodian's oversight
function. In particular, the custodian should monitor compliance of
the AIF with investment restrictions and leverage limits defined
the offering materials.
Leverage
The AIFM Directive foresees certain special requirements applicable to AIFM managing AIFs employing leverage. In this context a further highly controversial issue was the question whether financing is used by a holding company under an AIF would be considered as an AIF using leverage. Pursuant to the definition of leverage in the AIFM Directive as "any method by which the AIFM increases the exposure of an AIF" an AIF should not be considered leveraged as borrowing at the level of the holding entity is not exposing the AIF in any way. ESMA confirmed this view in its Consultation Paper by clarifying that when calculating exposure it should be looked through corporate structures only to the extent that those structures have recourse to the AIF via cross-collateralisation or guarantees. It seems therefore that where the AIF itself does not provide guarantees or collateral for any borrowing at the holding vehicle level, such financing would not be considered as leverage in the meaning of the AIFM Directive.
Third country topics
The ESMA consultation paper on third country issues covers the following topics:
- cooperation arrangements for third country AIF and AIFM;
- delegation of portfolio/risk management functions to third country undertakings;
- assessment of third country depositaries; and
- identifying the "Member State of reference".
Cooperation arrangements for third country AIFs and AIFMs
Admission of third-country AIFs and AIFMs to EU markets through
national private placement regimes or (later than 2015) a passport
regime will involve a framework of supervisory cooperation and
exchange of information between EU regulatory authorities and their
counterparts in third countries. ESMA proposes that the relevant
cooperation agreements allow for the exchange of information for
both supervisory and enforcement purposes. The agreement should
ensure cooperation by the third country regulator in assisting the
relevant EU Member State regulator in enforcing EU or national
legislation. ESMA has recommended documents prepared by the
International Organisation of Securities Commissions
(IOSCO) as benchmark for the cooperation agreements. ESMA is
willing to propose an own sample cooperation agreement, a positive
approach as a standardised agreement would have the benefit of
consistency vis-ŕ-vis separate uncoordinated
bilateral agreements.
Finally ESMA stated that third country passport rules would be
addressed at a later stage, since these rules would not enter into
force before 2015. Therefore the consultation paper on third
country topic does not cover any passporting issues.
Delegation of portfolio/risk management functions to third
country undertakings
The AIFM Directive provides that, where an AIFM as authorised under
the AIFM Directive delegates portfolio management or risk
management activities to third parties, the delegation may only be
to "undertakings which are authorised or registered for the
purpose of asset management and subject to supervision". ESMA
proposes that a third-country undertaking should be deemed to
satisfy the above requirement "when it is authorised or
registered for the purpose of asset management based on local
criteria which are equivalent to those established under EU
legislation (...)"
The AIFM Directive further requires cooperation arrangements to be
in place between the AIFM's home Member State regulator and the
regulator of the delegate. The cooperation arrangements proposed by
ESMA in this regard are similar to those mentioned above.
Assessment of third-country custodians
Under the AIFM Directive a non-EU AIF's custodian can be
located either in the jurisdiction of non-EU AIF (i.e. third
country), in the home Member State of the AIFM (in the case of an
EU AIFM) or in the EU "Member State of reference" of the
AIFM (in the case of a non-EU AIFM). In order for a custodian to be
located in a third country, that third country custodian must be
"subject to effective prudential regulation, including minimum
capital requirements, and supervision which have the same
effect" as EU law and are effectively enforced.
ESMA has set out its proposals for the criteria to be taken into
account when determining whether a third country custodian is
subject to such equivalent standards. ESMA notes that the European
Commission may issue decisions declaring a given third country as
equivalent if it determines that the criteria have been fulfilled.
To the extent third country AIF jurisdictions wish to take
advantage of the possibility that AIF custodians may be located in
those jurisdictions, those third countries will need to consider
whether the equivalence requirement can be met.
Identifying the "Member State of reference"
The AIFM Directive provides that, where a non-EU AIFM intends to
market several AIFs in the EU, that non-EU AIFM's "Member
State of reference" is "the Member State in which that
AIFM intends to develop effective marketing for most of those
AIFs...". ESMA proposes that that phrase be interpreted to
mean the Member State where the non-EU AIFM intends to target
investors by promoting and offering most of the AIFs.
Timeline and Outlook
The consultation process for the Consultation Paper closes on 13
September, whereas the deadline for responses to the second
consultation paper is 23 September 2011.
In light of the feedback ESMA will have received it will finalise
and submit its advice to the European Commission by 16 November of
this year. The definite implementing measures will then be adopted
by the European Commission in the course of next year.
However technical the propositions of ESMA may appear, the AIFM
Directive is beginning to take shape. It is now to the professional
associations and any concerned stakeholders to duly screen and
evaluate the proposed measures and revert to ESMA with their
comments and practical input on behalf of the European fund
industry which will be subject to the new regulatory regime for any
investments beyond the UCITS mainstream for the years to come.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
