ESMA July 2011 consultation on AIFMD Level 2 measures - Overview

There follows a high level overview of the key areas set-out in the ESMA consultation paper, covering first topics where new requirements are proposed which are additional to current regulatory requirements and as such may present the biggest challenge to firms. It then discusses areas in which increased formality is proposed in respect of matters to which most firms likely already attend to some degree, for example risk and liquidity management.  The overview concludes with an assessment of requirements that broadly match current FSA rules.

New Requirements

Authorisation Threshold

EU Alternative Investment Fund Managers (“AIFMs”, defined more fully in a previous note by IMS) with aggregate AUM of EUR 100m will not require regulation under AIFMD. A higher threshold of EUR 500m is available if the funds are unleveraged and have no redemption rights within 5 years. Such managers will remain regulated under MiFID unless they chose to opt into AIFMD, for example, to obtain the ability to raise funds across the EU under a passport.

The ESMA guidance establishes how AUM is to be calculated and what to do if a manager’s total AUM temporarily breaches the authorisation threshold. A breach of the limit for 3 months is tolerated before the manager is obliged to become regulated under the AIFMD.

Capital Requirements

An AIFM is required to have initial capital of (i) €125,000 plus (ii) 0.02 per cent. of the value of the portfolios of the AIFs it manages in excess of €250 million, subject to a cap of €10 million.

This adds to the minimum capital requirement under the current regime with an obligation on AIFMs to also cover the risk of professional liability by holding additional own funds or obtaining professional indemnity insurance. The amount of insurance cover required will also be governed by the total AUM of the manager.

Depositaries

A large portion of the consultation paper discusses depositaries which must safeguard the fund’s assets and ensure the manager’s compliance with the fund requirements as set out in the relevant fund documentation, as well as certain legal requirements in relevant jurisdictions.

In short managers caught by AIFMD will need to appoint a depositary but the risks to the deposit institution related to holding that position, which will be subject to “strict liability” in the eyes of the law, will potentially mean much higher costs for the manager in relation to functions currently held by Administrators, Prime Brokers and Custodians.

Leverage

Leverage will be relevant to the AUM for authorisation threshold purposes, for the purposes of providing to the manager’s regulator certain market data and also in relation to potential limitations set by the regulator from time to time, although limits on leverage will normally only be applied to prevent disorderly markets and the build-up of systemic risk.

The consultation paper discusses the specific details regarding calculation of leverage and pushes for the use of both the “Gross Method” and the “Commitment Method”. Use of the “Gross Method” means that netting and hedging arrangements are not taken into account although they are for the most part included under the “Commitment Method”. ESMA specifically rule out the use of VAR (Value at Risk) models to calculate leverage.

Codification of Existing Practice

Certain areas of the consultation papers deal with issues where firms may already aspire to such standards for reasons of commerciality.  We describe them here under the heading codification of existing practice. However some of these requirements may in reality go further than those implemented at some firms and may require additional documentation of processes.

Risk Management

Firms will be required to maintain an independent (where possible) permanent risk management function which maintains effective procedures and controls around investment risk, including qualitative and quantitative controls. This function will have to report to the senior management on a regular basis and will need to report any material changes to risk management procedures to the competent authority (currently FSA). Additionally back testing, scenario analysis and stress testing will be required to evidence compliance with risk management requirements on an ongoing basis.

Liquidity Management

In December 2009 the FSA implemented liquidity requirements for firms. These requirements had limited impact on investment management firms, as long as they had no proprietary trading positions on the balance sheet of the manager.  AIFMD will create requirements around ensuring the liquidity of the fund vehicles as well as the manager. Firms therefore will need to maintain liquidity procedures and monitor the liquidity of their funds in line with the interests of the investors, counterparties, creditors and any other counterparties. These procedures will include requirements to stress test the portfolio.

Compliance and Internal Audit

Where possible, ESMA’s advice envisages that firms will need to maintain an independent compliance function, as well as an internal audit function. This may at a minimum consist of an independent senior staff member who is not a member of the front office and does not have conflicts related to, for example, fund performance related remuneration. The guidance notes that a firm for which this would be disproportionate can choose to document why this is the case instead of applying the requirements.

Valuation

The thrust of the consultation in this area is to require written procedures related to valuation, including information relating to all of the parties involved with the process and established methodologies for valuation.  However, this is not likely to prove more demanding than many investors’ due diligence.

Existing MiFID and FSA requirements

The requirements below broadly match current FSA rules and is reflective of ESMA’s desire, where possible, to match the AIFMD requirements to the Markets in Financial Instruments Directive (MiFID) which has been in place since November 2007. As such the majority of managers should already be in compliance with these requirements. However the AIFMD rules may end up varying from MiFID to some extent, as ESMA is also benchmarking the proposed requirements against the Undertakings for Collective Investment in Transferable Securities Directives (UCITS).  The end result of such a process inevitably leads to a highest common denominator situation.

Conduct of Business

Conduct rules broadly echo the MiFID requirements and to some extent the UCITS requirements which managers already operate under. These requirements cover areas such as conflicts, inducements, best execution, order handling, and the duty to act in the best interest of investors. These rules may in some cases require additional levels of disclosures to investors than are currently in place and look to cover specific issues such as records regarding subscriptions and redemptions.

Systems and Controls

This area broadly mirrors the ‘common platform’ for corporate governance and senior management arrangements created by MiFID and the Capital Requirements Directive (CRD). These rules are currently set out in the Senior Management Systems Sourcebook (SYSC) in the FSA handbook. This includes general requirements around training and competence, data security, business continuity planning and reporting to senior management on a regular basis. In some cases these requirements, such as regular reporting to senior management, are more prescriptive than they are under the current rules.

Delegation

These requirements are equivalent to FSA requirements related to critical outsourcers, however, there might be scope for more entities to be classified as being critical or important. For example one-off compliance assistance is not considered critical by ESMA, meaning that accepting ongoing compliance support may be considered critical. Firms must ensure for relevant outsourcers that they are able to effectively undertake the outsourced tasks and also should ensure that investors are protected, thus requiring relatively high initial and ongoing due diligence to be undertaken. These requirements extend to any sub-delegation by delegates of the manager.

Transparency

There will be additional reporting requirements via an annual report, disclosures to investors and reporting to competent authorities.

The annual report is essentially a financial report on behalf of the fund vehicle and the data required for the report would normally be sourced from the funds audited accounts. The annual report should also feature a detailed breakdown of the remuneration paid to the manager including information on fixed and variable remuneration and information regarding the underlying remuneration procedures.

Additional proposed disclosures to investors include the percentage of assets subject to special arrangements (eg. ‘side pockets’), any changes to liquidity management arrangements and a detailed risk profile update with information on the risk management systems. Further disclosures may also be required when leverage limits are changed.

In addition new requirements around proposed quarterly reports to the competent authority (ie the FSA’s successors) will be put into place. These reports may include fund details regarding instruments traded, markets a firm is active on, portfolio concentrations, details on side pockets, description of risk management procedures, the current risk profile of the Fund and the results of stress tests.