AIFMD - the end of the beginning

After almost two years of political wrangling and frequently heated discussion, it would appear that the European Union is now very close to agreeing a final text for the directive on Alternative Investment Fund Managers ( ‘the Directive’). Provisions are substantially different compared to previous drafts in several key aspects. In many respects a transition has been made from being largely motivated by political considerations to a more concessional and practical version. The ‘alternatives’ industry, which has lobbied hard in this regard, should take substantial credit for this.

Beyond compliance

AIFMD extends beyond being an exercise in implementing new regulatory rules - as was the case with 2007’s Markets in Financial Instruments Directive (‘MiFID’) which was the culmination of a long-term ambition to harmonise the European regulatory environment for investment firms. Prior to AIFMD’s implementation, affected firms will need to carefully consider how the Directive will impact upon its operations and overall strategy. For example, firms may have previously made institutional decisions based upon legal and tax considerations to which AIFMD implications must now be added.

It is likely that AIFMD will mean an additional cost burden for such firms – in the first instance in order to assess whether firms’ corporate and fund arrangements continue to be appropriate in light of AIFMD, and thereafter the cost of implementing the incremental regulatory requirements imposed by the Directive. It has been suggested that the costs – at least in part – will be passed onto investors. Considering one of the Directive’s objectives is investor protection, this is something of a quid pro quo and perhaps an unsolicited one.

Timings

Following some procedural formalities, not least translation into the 23 official and working languages of the EU, the Directive will most likely become legally binding during Q1 or Q2, 2011. Member states will then be required to transpose the Directive into national legislation within two years of this date.

Prior to this transposition, a period of secondary rule making will be conducted. This ‘level II’ process will interpret and expand the 200+ page Directive and much of the detail will be determined as a result. This process will be overseen by a new regulatory body, the European Securities and Markets Authority (ESMA). There will therefore be further lobbying opportunities as the incoming regulatory regime is fine tuned.

Key issues

In brief, the position with respect to certain key issues is as follows:

• Scope

Broadly, AIFMD is applicable in three situations: EU based alternative investment fund managers (‘AIFMs’) that manage one or more alternative investment funds (‘AIFs’); non-EU based AIFMs that manage one or more EU based AIFs, and non-EU based AIFMs that market one or more AIFs in the EU.

A majority of the Directive does not apply if the AIFM’s assets under management vis-à-vis- AIFs fall below certain thresholds¹; however such firms will not be able to benefit from the ‘passporting’ provisions described below.

• Marketing

This has been one of the more contentious items and one in which a compromise position has been attained by the European politicians. Non-EU AIFMs that wish to market AIFs in the EU will initially be able to do so under the existing ‘private placement’ arrangements, subject to transparency provisions detailed in the Directive.

From (most likely) 2015, a ‘passport’ regime will come into effect. This will require the non-EU AIFM to comply with the Directive in its entirety, and will need to select a ‘Member State of reference’ for the purposes of authorisation. Furthermore, the passporting regime is only permissible where the country in which the third country AIF satisfies certain conditions, including tax information sharing and not being on the Financial Action Task Force’s list of non-cooperative countries.

This is a less draconian regime compared to previous proposals. However, it is believed that the passporting regime will be costly to implement for non-EU AIFMs.

From (most likely) 2018, the private placement regime is likely to disappear, leaving the passporting regime as the sole option.

However, AIFMD does not cover ‘reverse solicitation’ i.e. where EU investors contact a non-EU AIFM and subsequently invest in AIFs managed by this AIFM.

• Disclosure and transparency requirements

Disclosure and transparency requirements will apply in areas including remuneration, leverage, liquidity and acquiring major holdings or controlling interests in non-listed companies.

• Depository liability

It was previously proposed that strict liability for loss of custody investments be imposed on depositaries for acts and omissions of sub-depositaries. However, it has now been agreed that depositories can discharge themselves of that liability provided certain conditions are met.

• Regulatory capital requirements

The ‘base’ regulatory capital requirement will be EUR 125,000 for AIFMs that manage third party AIFs, where the assets under management of the AIFs managed by the AIFM is less than EUR 250 million. Thereafter, an additional amount based on incremental assets under management applies, up to a maximum of EUR 10 million. This may have a significant impact on certain firms (see below).

• Private equity

It has been commented that the private equity industry will be more adversely affected than  the hedge fund and property fund sectors.

For instance, ‘asset stripping’ provisions mean, inter alia, that non-listed companies held by an AIF won’t be able to make distributions, capital reductions or share redemptions for a 2 year period (albeit 2 years this is an improvement on perpetually, which was previously mooted). There will be a requirement to use depositories, which is currently not the case.   Private equity firms that are currently ‘non-MiFID’ and with a regulatory capital requirement of £5,000 will be subject to increased requirements as detailed above.

It has also been argued that the Directive will create an unlevel playing field between private equity firms managing AIFs and other firms that fall outside the Directive, such as sovereign wealth funds.

• Short selling

Provisions relating to short selling have been removed, which reduces the potential for AIFMs to be subject to a different short selling regime compared to other firm types.

To conclude we are now 20 months into the process of agreeing and implementing AIFMD, but there is perhaps another 2 and a half years to go; we are less than half-way through.  A framework has been agreed, but there is a long way to go before there is greater clarity concerning how the Directive will operate in practice.

[1] EUR 100 million; or EUR 500 million if only unleveraged AIFs are managed, that do not grant investors redemption rights during a period of five years.

15th November 2010