As part of the European Commission's efforts to reform the European financial regulatory environment in the wake of the financial crisis, on 11 November 2011, the European Parliament voted to adopt the Alternative Investment Fund Managers Directive ("AIFMD"). The AIFMD is due to be implemented across the EU by July 2013 and will have a significant effect on a large cross-section of alternative investment fund managers ("AIFMs") that manage and/or market alternative investment funds ("AIFs") within the EU, including managers of hedge and private equity, venture capital, commodity, infrastructure and real estate funds.1
In November 2011, the European Securities and Markets Authority ("ESMA") published its technical advice to the European Commission on possible implementing measures of the AIFMD ("Level II"). This marked a significant milestone in the four-stage legislative framework and added significant substance to the Level I measures represented by the AIFMD itself.2
Following adoption of the AIFMD, there has been significant discussion among industry participants as to whether it might be possible to comply with the provisions of the AIFMD by structuring the AIF as a self-managed investment company, in the same way that UCITS3 self-managed investment companies ("SMICs") are managed.4
Prior to the publishing of Level II, there was not much direction given about how a self-managed AIF (referred to in this article as a "SMAIF") might look in terms of AIFMD implementing measures. There were also concerns that, notwithstanding the very important UCITS precedent, the delegation that would be inherent in a SMAIF might be such that it would become a "letterbox" entity in contravention of AIFMD.
Level II provides helpful guidance on the complexion of a SMAIF and goes into detail in respect of the general operating conditions for AIFMs, including SMAIFs.
Why Are SMAIFs Important?
Quite simply, structuring an AIF as a SMAIF means that the fund is both an EU AIF and an EU AIFM, which, from July 2013, subject to compliance with the provisions of the AIFMD, will be able to take advantage of the passporting provisions of the AIFMD in a similar manner to a UCITS.
Earlier drafts of the AIFMD provided that AIFMs could delegate only to other AIFMs. This position was changed in subsequent drafts so that, as a general rule, delegation of portfolio management or risk management is permitted where: (i) the delegate is authorised or registered for the purpose of asset management and subject to regulatory supervision; and (ii) cooperation is ensured (see discussion below) between the competent authority of the home Member State ("EU Competent Authority") of the AIFM/SMAIF and the supervisory authority of the undertaking.
Accordingly, SMAIFs should be able to delegate to U.S. and other non-EU investment managers without the investment manager having to be an AIFM or having to comply with either the private placement or third-country provisions of the AIFMD.
In its Level II advice, ESMA removed an earlier suggestion that the regulatory regime applicable to a delegated entity should be equivalent to that which applies to an EU AIFM, on the basis that this position was not supported by the Level I text. However, in discussing how cooperation can be assured between the EU Competent Authority and the supervisory authority of the delegate, Level II has set out detailed requirements for the form of the cooperation agreements, which should be in the form of written arrangements. It will be necessary to ensure that these arrangements are entered into by ESMA or, failing that, by the national regulatory authorities, as soon as possible.
The Problem with Private Placement
For U.S. and other non-EU investment managers, the opportunity to sell funds in the EU using the AIFMD passport will not be available for at least two years after the implementation of the AIFMD and, accordingly, in the absence of the option of a SMAIF, such managers will be required to rely on the continuance of the private placement regime. The continuance of private placement under the AIFMD is subject to a number of fundamental uncertainties.
First, it is not compulsory for EU Member States to allow private placement or "marketing without a passport", which means that certain Member States may choose not to implement these provisions, or may remove or limit existing provisions. In addition, those Member States that do permit marketing without a passport may provide for stricter rules than those contained in the AIFMD. However, the concept of reverse solicitation or passive marketing5 has been retained. For example, the UK Treasury has provisionally indicated its intention to continue to permit the marketing of non-EU AIFs managed by EU AIFMs, and EU and non-EU AIFs managed by non-EU AIFMs, to UK professional investors, subject to compliance with the minimum requirements specified in the AIFMD. It will be interesting to see what actions other Member States take in this regard.
Second, Member States may only allow private placement where there is a cooperation agreement in place between the Member State of the AIFM or where the AIF is marketed, and the supervisory authority of the non-EU AIF or AIFM. There has been little to date in establishing cooperation agreements, and ESMA has also cautioned that when these arrangements are entered into, there will be a need to "ensure a regular flow of information for supervisory purposes, including for systemic risk oversight [and to ensure]...that enforcement can be performed if necessary". It is worth noting ESMA's comment that "in this context, it is crucial to avoid creating an unlevel playing field which unduly favours entities established in third countries".
Given the added burden that the AIFMD will undoubtedly place on EU AIFMs, there may be a lively debate as to what constitutes a level playing field. It is likely that the form of agreement will be a multilateral memorandum of understanding ("MMoU") centrally negotiated by ESMA. However, ESMA will be challenged in meeting its goal "to finalise such a MMoU in good time ahead of the deadline of July 2013 and in a manner that ensures fair treatment of all third country authorities".
Third, the AIFMD requires the competent authority in the third country to meet the standards of data protection required by the Data Protection Directive6. This too will be a difficult hurdle.
What Can Be Learned from UCITS?
The template for SMAIFs comes from the UCITS world where the UCITS Management Company Directive made provision for the concept of self-managed investment companies.
The UCITS Directive and Central Bank of Ireland's ("Central Bank") Guidance Note 4/07 on the Organisation of Management Companies set out a series of operating conditions for SMICs, which are designed to ensure that the SMIC has, and maintains, sufficient substance and does not delegate the totality of its functions to one or more third parties, so as to become a letter-box entity. These requirements will form the template for the establishment of a SMAIF regime in Ireland.
Level II considers that an AIFM would become a letterbox entity when: (i) the AIFM is no longer able to effectively supervise the delegated tasks and manage the risks associated with the delegation; and (ii) the AIFM no longer has the power to take decisions in key areas that fall under the responsibility of the senior management or to perform senior management functions.
The substance requirement is achieved by putting in place management structures meeting common EU standards. For UCITS, the Central Bank has set out the key management functions that it considers to be the responsibility of the board of directors of the SMIC. The Central Bank regards the management functions as significant roles and requires a business plan to be prepared setting out, inter alia, the identities of the persons appointed to perform those functions and how they will be performed in practice (e.g., reports to be provided by delegates and escalation procedures). With the exception of requirements in relation to liquidity management, the management functions that are imposed on SMICs are broadly similar (and in some instances virtually identical) to the operating conditions under the AIFMD.
Alignment of Level II with the approach adopted in respect of UCITS highlights the likelihood that AIFMs and SMAIFs will be required to adopt a business plan or procedures manual to document their operating, administrative and accounting policies and procedures. While UCITS will provide a template, it will be important from an Irish perspective to ensure that the approval process for SMAIFs can be aligned as closely as possible with the existing fast track approval process for qualifying investor funds.
The initial capital requirements for SMAIFs are the same as those for SMICs – €300,000 (approximately US $400,000). In addition to the initial capital requirement, AIFMs are subject to an "own funds" requirement of 0.02% of the amount by which the value of the SMAIF's portfolio exceeds €250,000,000 ("Own Funds Requirement"). The Own Funds Requirement has been criticised as inappropriate in the context of SMAIFs, and it was hoped that Level II would clarify that the Own Funds Requirement did not apply. Unfortunately, the Level II advice did not provide this certainty and focused on the Own Funds Requirements in the context of cover for potential liability risks. Notwithstanding that ESMA did not address this issue, the UK Financial Services Authority, in its discussion paper on the implementation of the AIFMD, suggests that the Own Funds Requirement applies only to externally managed AIFMs. If SMAIFs are subject to the Own Funds Requirement, this would mark a significant divergence from the UCITS Directive.
The European Commission is now in the process of preparing implementing measures in light of the Level II advice. The alternative investment funds industry will be watching closely the implementing measures adopted by the Commission and further developments by EMSA relating to the form of cooperation agreements.
* This article is based on an article that appeared in the March 2012 issue of HFMWeek.
1 The AIFMD will require AIFMs to be authorised pursuant to a harmonised regime and will impact on capital requirements, remuneration, valuation of assets, safekeeping of assets, delegation, leverage and marketing of EU AIFs and non-EU AIFs, managed by an EU AIFM or a non-EU AIFM.
2 The AIFMD is a Lamfalussy directive. This means that the primary legislative act (Level I – the AIFMD itself) is only the first – framework – part of the four-stage process. Level II, which is presently underway, is the stage when the implementing measures are prepared by the European Commission to supplement Level I. The European Commission has mandated ESMA to advise it on the content of these measures. The European Commission will enter into public consultation before adopting Level II, which must be endorsed by a "qualified majority" of EU Member States (51%, and a minimum of 255 votes out of 345). Once Level II has been adopted, each Member State will then implement the Level I text and Level II regulations into the Member State's domestic legal system. Level III will comprise advice to the European Commission from ESMA on the development of Level I and II measures. Level IV will consist of the measures EU Member States enact to bring Levels I and II into force in their respective national laws.
3 Undertakings for collective investment in transferable securities (UCITS) are a retail fund structure established by Directive 85/611/EC, as replaced by Directive 2009/65/EC (the "UCITS Directive"). UCITS may take advantage of a marketing passport throughout the EU.
4 SMICs are managed by the board of directors of the investment company pursuant to a delegation model, whereby the board of directors delegates the investment management and administration of the UCITS to third parties.
5 These terms refer to instances where an investor, on its own initiative, contacts an AIFM and subsequently invests in the AIF managed by the AIFM.
6 The Data Protection Directive (the "DPA") regulates the processing of personal data and the free movement of such data. Subject to certain limited exemptions, the DPA only permits the transfer of personal data outside the European Economic Area to countries that have "adequate levels of data protection". The European Commission has prepared a list of countries that are deemed to provide an adequate level of data protection, which includes the United States, Canada and Australia.
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