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By Carne - “the AIFMD experts”
AIFMD Guide for Asset Managers
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Experience
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Contents Page
1 Preface 3
2 Overview of the AIFM Directive 4
3 What is an AIF / AIFM? 8
4 Why launch an AIF? 8
5 What Do Investors Want? 9
6 Product types and fund structures 10
7 Operating model and practical solutions to the AIFMD
(options for accessing EU markets under the Directive) 11
8 Choice of domicile 13
9 Considerations for non-EU AIFMs 17
10 AIFM authorisation process 18
11 Costs for set up 21
12 Delegation arrangements 21
13 Risk management requirements 23
14 Remuneration provisions 27
15 Transparency reporting 28
16 Role of the depositary 29
17 Distribution opportunities, issues and challenges 32
18 Converting existing structures to EU AIFs 34
19 How can Carne help? 36
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About Carne Carne is a leading provider of governance and oversight support for the global asset management industry. We are experts in AIFMD and UCITS funds and provide governance services for regulated and offshore funds in various jurisdictions both within and outside the EU.
Carne has offices currently in Ireland, Luxembourg, London, Cayman, Channel Islands, Chicago, New York and Switzerland. Our independent governance services include: • AIFMD Oversight• UCITS Oversight• Fund Directors• AIFM & UCITS Management Companies• Risk Management Services• MLRO Services• Company Secretarial Services• Compliance Officer Services
Carne Global Financial Services Limited. 2nd Floor, Block E, Iveagh Court, Harcourt Road, Dublin 2t: +353 1 489 6800
© Copyright Carne Group 2014. All rights reserved. No part of this guide may be reproduced in any form or by any means without written permission from Carne.
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1. Preface
The introduction of the Alternative Investment Fund Managers Directive (“AIFMD” or “Directive”) represents both a challenge and an opportunity for alternative fund managers. Many asset managers may initially regard the Directive as an obstacle to future distribution of their funds in the EU, but the Directive also clarifies both the future passporting regime for alternative funds and provides a regulatory framework that will encourage more investors in Europe to revisit alternative strategies outside the UCITS world.
At Carne we work with alternative managers of both UCITS and now AIFs in a variety of jurisdictions, helping them to meet the new regulatory requirements in an effective and professional manner. We have published this guide to help alternative fund managers to understand what the AIFMD means for them and some of the new choices it delivers.
With the right support, it is possible to build a governance and reporting framework that will reassure investors and demonstrate the seriousness of an organisation’s investment proposition. Our AIFMD and risk teams have pooled their collective experience within this guide to bring managers an informative primer on the Directive to aid them in launching or converting products they will be able to distribute with confidence within the EU.
Carne believes that the passport allowed under the Directive will be much more important than the industry presently recognises and will lead to a similar distribution model to the highly successful UCITS brand (which outside of the 40x Act regime is the world’s leading investment product). In the alternative investment space, we believe that the “passported AIF” will become the leading global alternative branded product with tremendous distribution potential. This comes at a time when liquid alternatives are growing at a phenomenal rate and long term income producing real assets are critical to institutional investors for meeting their future liabilities. As with the advent of the UCITS product directive Carne is again taking a market leading role in seizing the opportunities of this Directive by further developing our leading governance team with more risk management and investment professionals in order to deliver best in class AIFMD solutions.
Carne is the only third party AIFM to have licences in both Ireland and Luxembourg and was the third AIFM globally to receive its licence. Carne was involved in four out of the first five AIFM applications in Ireland. We are working with many new and existing large global asset manager clients in providing our innovative AIFMD solutions. This gives Carne a unique perspective and puts us in a market leading position as a provider of independent third party AIFMD solutions.
John Donohoe, CEO Carne Global Financial Services
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2. Overview of the AIFM Directive
The Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers (“AIFMD” or “Directive”) entered into force in the European Union in 2011, with implementation into national legislation by EU Member States required by 22 July 2013. The aim of the Directive is the monitoring and supervision of alternative investment funds, such as private equity and hedge funds, through the creation of an EU-wide harmonised regulatory framework.
Since its release, the original Directive has been supplemented by additional regulations and implementing measures issued by the European Commission, to provide further details on a number of areas set out by the Directive, as well as by detailed guidance from ESMA and national regulatory authorities.
The Directive seeks to regulate the investment managers of alternative funds. It applies to entities managing Alternative Investment Funds (“AIFs”) who distribute or domicile their products within the European Union. The managers of these products (referred to as “Alternative Investment Fund Managers”, or “AIFMs”) must comply with a comprehensive set of compliance, risk, organizational and reporting requirements under the Directive.
The Directive makes a distinction on the basis of whether the AIFM is EU or non-EU domiciled. EU domiciled AIFMs (“EU AIFMs”) are required to register with their home state regulatory authority for approval or authorisation as an AIFM and must, as a result of such registration, comply with a number of provisions. The AIFs under the management of the AIFM are in this way also caught by the Directive and must by proxy comply with a series of requirements around reporting, oversight and disclosure.
Non-EU based AIFMs (“non-EU AIFMs”) are also caught if they advise a European-domiciled alternative investment fund (“EU AIF”) or a non-European alternative investment fund (“non-EU AIFs”) that is currently distributed in the EU. The obligations on non-EU AIFMs are lighter than those imposed on their EU counterparts, although the Directive provides for the possibility of full registration being made available to non-EU AIFMs from 2015 (subject to regulatory review and assessment of the Directive’s effectiveness until then), with associated requirements for full compliance with the Directive’s provisions.
Although the Directive became effective on 22 July 2013, a number of EU member states have introduced a transitionary period to allow EU AIFMs, currently managing existing alternative collective investment schemes, enough time to implement the necessary changes to their organisational structure and to prepare the necessary regulatory applications. As such, in practice EU AIFMs based in a number of jurisdictions (most notably the UK, Luxembourg and Ireland) have until 22 July 2014 to fully comply with the Directive. Such a transitionary period is however not applicable to newly established EU-domiciled alternative investment funds, whereby such schemes fall fully within the scope of the Directive and therefore must be compliant with the Directive’s provisions (including the requirement to appoint an EU AIFM) upon launch.
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Key Dates
22 July 2013 EU member states required to implement AIFMD into national law
22 July 2014 Deadline for those AIFMs that have been carrying out activities within scope of AIFMD prior to 22 July 2013 to submit application for authorisation as an AIFM (a number of jurisdictions have extended the deadline to 2015 for non-EU AIFMs of existing AIFs in their domicile)
2015 ESMA will report on functioning of passporting regime and will review whether to extend this to non-EU AIFs and non-EU AIFMs
2018 ESMA review of impact of AIFMD and whether to end existing private placement regimes of member states
The Directive allows for certain thresholds and exemptions, whereby managers of funds falling in the following categories are outside the scope of the Directive:
- Small AIFMs, i.e. managers of AIFs with total AUM of less than EUR 100 million or equivalent, and managers of AIFs with total AUM of less than EUR 500 million or equivalent, where the AIFs are unleveraged and with no redemption rights for five years following the date of initial investment in each AIF;- Securitisation special purpose vehicles;- Single investor funds as defined in the regulations;- AIFs whose sole investors are group companies of the manager (as long as none of these investors is in itself an AIF).
Nonetheless there are still certain notification requirements that the exempted AIFMs must comply with (such as confirmation of below threshold status to the regulatory authorities).
The key provisions of the Directive are as follows:
• Appointment of Depositary: For every AIF under its management, the EU AIFM is required to appoint a single independent depositary with responsibility for the safekeeping of assets, oversight of compliance by the AIF with applicable laws and regulations and monitoring of cash flows. In the case of EU AIFs, the depositary must be established in the home state of the AIF and must be a regulated EU credit institution, EU investment firm or another institution already approved to act as a UCITS depositary. In the case of non-EU AIFs, the depositary may be domiciled either in the country of the AIF, or the home state of the AIFM, or in a member state of reference
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and further requirements apply in addition to the prudential and supervisory equivalence. For non-EU AIFs, the depositary may be a non-EU institution equivalent to an EU credit institution or EU investment firm, provided that it is subject to EU-equivalent effective prudential regulation (including minimum capital requirements) and supervision. An exemption from the depositary requirement exists for private equity and real estate AIFs, whereby they can use professional advisers to act in this capacity. A lighter depositary regime (“depo-lite”) applies to EU AIFMs managing non-EU AIFs, if these schemes are marketed or distributed across the EU. The Directive introduces a number of obligations on the depositary, the most debated being in relation to the strict liability of the depositary with regards to sub-custody/delegation arrangements (subject to a negligence/intentional failure test). The Directive specifies that a written agreement must be in place with the depositary and prescribes specific requirements for inclusion in such agreement. The AIFM must be a party to the depositary agreement alongside the AIF and there needs to be an ongoing exchange of information and oversight between all parties (which would be formalised via a service level agreement).
• Delegation Arrangements: One of the key provisions of the Directive is that the AIFM cannot delegate functions to the extent that it becomes a letterbox entity and while there has so far been limited regulatory guidance to assess what exactly would constitute this, the understanding is that the AIFM must be able to retain a certain level of substance, activity and expertise, particularly in the area of risk management and/or portfolio management, even if certain roles are in practice delegated to third parties. An important area of focus is the need to have appropriate due diligence prior to engaging with the third party and what processes need to be put in place for the ongoing monitoring of the delegate.
• Governance and Oversight: The Directive has a substantial impact on the governance framework of AIFs and AIFMs as it imposes additional responsibilities on the AIFM itself. Emphasis is placed on having a robust governance and effective risk management culture, in particular in light of the AIFM’s accountability for delegation arrangements, responsibility for valuation, necessary flow of information and ownership of key decisions.
• Risk Management: The risk management activity needs to be functionally and hierarchically segregated from the portfolio management function and must operate independently and with sufficient expertise, authority and resources to ensure all risks in the AIFM and AIFs are appropriately quantified, monitored and managed on an ongoing basis.
• Policies and Procedures: The AIFM is required to have in place a number of documented policies and procedures to cover areas including but not limited to delegation arrangements, risk management, conflicts of interest, due diligence processes, conduct of business, valuation and remuneration practices, setting out escalation arrangements, responsibilities of senior management and oversight of the board. These policies need to be reviewed on a regular basis and should be aligned with the operational complexity and characteristics of the AIFM/AIFs.
• Valuation: Under the Directive, ultimate responsibility for the valuation of the AIFs under management falls to the AIFM, unless this is delegated to an approved third party acting as external valuer. Whilst in practice the pricing activity may continue to be undertaken by the administrator, the AIFM is required to have procedures in place to document the valuation process and for escalation and review of any issues, with ultimate responsibility resting with the AIFM’s board.
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• Remuneration: AIFMs are required to have in place a written remuneration policy designed to prevent conflicts arising from the compensation arrangements of staff at the AIFM, who, through their role within the AIFM or the delegates’ activities, could materially impact the risk profile of the AIFs. While the Directive’s provisions in this regard are aligned to other regulatory initiatives that are currently being implemented in the EU (e.g. CRD IV, MIFID II), the provisions represent completely new territory for non-EU investment managers who are now within the scope of these requirements when acting as delegates to the AIFs for the provision of portfolio management services.
• Transparency Reporting: AIFMs and AIFs are required to provide substantial reporting to the regulatory authorities on a quarterly or semi-annual basis, (depending on AUM) as well as to investors on a regular basis. While a number of the requirements set out in the Directive relating to investor disclosures would already typically be covered in a prospectus/offering memorandum, there are some new items that must now be disclosed to investors pre-investment (e.g. latest NAV, historical performance) and on an ongoing basis (e.g. total leverage employed).
• Leverage: there is no limit for leverage that may be employed but limits must be disclosed on a regular basis to investors and to the regulatory authorities (both total leverage employed and maximum allowed) and the limits must be monitored on an ongoing basis through the AIFM’s risk management framework. For AIFs where the leverage calculated under the Commitment method is 3X or greater, the fund is deemed to be employing leverage on a substantial basis and additional reporting requirements will apply to the AIF. The amount of leverage in the fund will have an effect on the amount of capital required by the AIFM (see below).
• Capital Requirements: The Directive imposes capital requirements on both AIFs and AIFMs. AIFs are required to hold minimum capital of EUR 300,000, while AIFMs are required to hold minimum capital of EUR 125,000 plus 2 basis points of assets under management (NAV) greater than EUR 250 million. The Directive provides detailed guidance as to the basis for the calculation of the figure for assets under management. In addition AIFMs must ensure that they have in place sufficient funds to cover risks arising from professional liability risks, either in the form of professional indemnity insurance provided by a third party, or through additional own funds (equal to 1 basis point of gross assets).
• AIF/AIFM Passport: Under the Directive it is now possible for an AIF to obtain a “passport” from the AIF’s home state, which allows its cross-border marketing and distribution in other member states across the EU to qualified (i.e. non-retail) investors. The authorisation process for the passport is straightforward and based on an exchange of information between regulators. Approval can be obtained within a month of the filing being made in the AIF’s home state. It is also possible for the AIFM itself to obtain a “passport” from its home state regulator, allowing it to provide AIFM services cross-border (i.e., to act as AIFM for AIFs domiciled in another EU jurisdiction). The passport is currently only available to AIFs and AIFMs that are EU-domiciled, but there is the intention for the
passport provisions to be extended to non-EU AIFs/AIFMs from 22 July 2015 (subject to ESMA review).
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3. What is an AIF / AIFM?
The definitions of what should be considered an AIF and what is an AIFM are set out in the Directive under Article 4 (1) and a number of terms contained in the Directive for these definitions were further clarified in a guidance paper from ESMA1.
Under the definition in the Directive, an AIF is a collective investment undertaking, which (i) raises capital from a number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors; and (ii) does not require authorisation as a UCITS scheme.
In its definition of an AIF, the Directive therefore aims to capture all collective investment schemes that are not UCITS regardless of their legal structure, investment strategy or open-ended/closed-ended characteristics.
The definition of an AIFM is a legal person whose regular business is managing one or more AIFs.
There are a number of exemptions set out in the Directive whereby the following entities are not to be considered as AIFMs:
- holding companies; - occupational retirement schemes and the managers thereof (in so far as they do not manage AIFs); - supranational institutions (such as the European Central Bank, the World Bank, the International Monetary Fund, and other supranational institutions and similar international organisations), in the event that such institutions or organisations manage AIFs and in so far as those AIFs act in the public interest; - national central banks;- employee participation schemes or employee savings schemes; - securitisation special purpose entities.
4. Why launch an AIF?
One of the primary reasons to launch an AIF is their increasing popularity with investors. A number of investors that do allocate to alternative investment funds want to continue having such exposure but are reluctant to invest in offshore vehicles.
A number of continental European countries have campaigned actively against offshore jurisdictions and in some instances it has become difficult to invest in vehicles domiciled in offshore centres with a low level of regulation which the EU has no control over.
The fact that AIFs are regulated by onshore EU jurisdictions delivers a certain level of comfort to a number of institutional investors such as pension funds, and financial institutions such as banks and insurance companies. Another element which comforts European clients is the AIF’s obligation to have a European financial institution acting as depositary and therefore responsible for the safe keeping of the assets.
1 ESMA - Final Report: Guidelines on key concepts of the AIFMD (24 May 2013)
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From a fund manager’s perspective, the AIFMD will enable active marketing, a key advantage for raising capital. Cayman Islands funds and other offshore domiciled funds are becoming more difficult to market proactively in continental Europe. Most EU countries are tightening their private placement regimes that have been used traditionally, thereby restricting active marketing.
Allocators to alternative funds are heavily solicited. Not being able to actively market, to have the visibility expected by investors, is a serious impediment to the success of an AIF. With an AIFMD-compliant structure the investment manager can register the fund in the various EU jurisdictions for active marketing purposes, allowing it to actively solicit business using one-on-one meetings and investor promotion events.
5. What do investors want?
Within Europe, if investors are sophisticated and have no internal restrictions regarding investment in offshore funds, they will typically continue to favour those offshore funds, as they are cheaper to run and offer scope for the investment manager to manage assets with no restrictions. However investors that fall into this category are shrinking in number, which would restrict European marketing considerably. The new European regulatory framework is already giving most investors a higher level of comfort and the depositary aspect of AIFMD and UCITS will also provide additional confidence regarding the safekeeping of their assets.
Liquidity is also often an important consideration and while the approach of investors will vary, the UCITS framework has already shown how successful a regulated European structure can be in this regard.
For private clients and family offices tax reporting will also be a key element. Some European countries will have a lower capital gains tax rate than the income tax rate. Private clients in these jurisdictions will want to report capital gains, and compliant funds will have to allow such reporting, already provided for in UCITS funds and a fairly easy process for AIFs. Offshore funds may find it difficult to report such data in a properly tax compliant manner.
Increasingly European institutional allocators are coming under pressure from the political environment and their shareholders to steer away from offshore centres, which have become fiscally less tolerable for governments. Large investors in alternative assets will be under pressure to custody their assets in Europe in a European fund structure.
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6. Product types and fund structures
An AIF that comes under the scope of the directive is broadly defined as being a Collective Investment Scheme (“CIS”) that is not a UCITS. Therefore AIFs are going to take many shapes and forms in the context of domicile, fund structure and product type. The below table illustrates some common jurisdictions where managers may choose to domicile their AIF in order to market the fund to European investors. It must be highlighted that an AIF can be domiciled anywhere and take many different forms and can comply with the Directive (although Non-EU AIFs will not be able to avail of the passport until earliest 22 July 2015).
Table 1: Product structures and passporting under the AIFMD
As Ireland and Luxembourg are well developed alternative fund jurisdictions, we are beginning to see asset managers set up new AIF products in these jurisdictions to avail themselves of the AIFMD passport. European Institutional investors are very familiar with Irish QIF structures (now QIAIF) and Luxembourg SIFs as hedge fund / alternative investment vehicles.
With the advent of the ICAV structure for funds, in Ireland, both Luxembourg and Ireland have AIF products with corporate legal structure (which don’t require a management company) that would allow US investors to tick the box. This enables asset managers to develop one single product that can be marketed and sold to global and US investors, without the necessity for needing a tax transparent feeder.In addition, the CCF in Ireland is gaining in popularity among asset managers looking to attract large pension investors where minimum income tax leakage is a large consideration.
Jurisdiction Product Types Passport PassportFund Structure (any product type)
EU AIFM Non-EU AIFM
Ireland QIAIFRIAIF - Retail AIF
Yes Yes - for institutional investors only
Earliest July 2015*Earliest July 2015*
VCCICAVUnit TrustCCF
Luxembourg SIFPart II Fund
YesYes
Earliest July 2015*Earliest July 2015*
FCPSICAVSICAR
Cayman Licenced FundAdministered FundRegistered Fund
Earliest July 2015* Earliest July 2015* LPSPC
Jersey/Guernsey
Jersey/Guernsey AIF**
Earliest July 2015* Earliest July 2015* LPPCCUnit Trust
* ESMA review of passporting** these are various fund structures which have been designated under Jersey/Guernsey law as AIFs
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Some European institutional investors are comfortable with investing in a less regulated non-EU jurisdiction, e.g. Cayman Islands. This will remain the case and these funds (as non-EU AIFs) will adapt to become compliant with the Directive as and when required. They will be sold on a private placement basis (where eligible) and eventually may look to access the passport from 22 July 2015 (subject to the passporting regime undergoing ESMA review).
Jersey and Guernsey, given their nature as significant private equity fund and property fund domiciles, are likely to be key jurisdictions within the AIFMD regime. Private equity and property fund managers in many cases will be subject to a financial regulatory regime for the first time as a consequence of the Directive. Many existing private equity and property funds in these jurisdictions will become AIFs under the new regime and will have to comply with the Directive.
7. Operating model and practical solutions to the AIFMD (options for accessing EU markets under the Directive)
EU AIFMs
All EU-based fund managers that currently manage AIFs (whether EU or non-EU AIFs) are required to be authorised (or approved, if below the authorisation thresholds) by their home state regulator from 22 July 2013. As mentioned above, a number of regulators have introduced transitionary periods of one year to allow managers to put in place the necessary organisational infrastructure and documentation, whereby authorisation in practice is required as of 22 July 2014, although any new AIF launched post-22 July 2013 (e.g. QIAIF, SIF) needs to fully comply with the Directive and therefore appoint an AIFM.
Implementation of the Directive across the EU has been varied, with jurisdictions such as Ireland and Luxembourg being among the early adopters of the Directive. There seems to be four distinct models that are being adopted by alternative investment funds as they restructure as AIFs:
1. The fund’s EU-based investment manager is appointed as an AIFM - this requires the investment manager to file an application for authorisation as an AIFM with its home state authority. As most investment managers across the EU are already regulated under the MiFID framework, a number of procedures, organisational and compliance frameworks would already be in place (the Directive is aligned to MiFID) although certain provisions will be new concepts for traditional fund management houses (e.g. remuneration or AIFM oversight and board governance) and smaller investment managers may find some of the Directive’s requirements particularly onerous (e.g. segregation of risk management and portfolio management function, etc).
2. The fund’s existing EU-based management company is appointed as an AIFM - where the fund already operates under a management company structure (either a UCITS or non-UCITS management company), it is possible for the management company to apply for authorisation
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as an AIFM. The UCITS management company in particular is already aligned in a number of aspects to the requirements of the Directive (e.g. oversight and board governance) although the requirements around certain procedures and carrying out risk management activities may not have been previously addressed. Where substance on the ground is an issue it is also possible for the management company to act as AIFM but delegate the day-to-day activities in respect of oversight and risk management to secondees from a local third party provider (provided the management company can demonstrate that it has sufficient local substance).
3. An EU-based third party provider is appointed as an AIFM - a number of existing UCITS management companies (in particular in Luxembourg and Ireland) have sought additional authorisation for approval as AIFMs and would offer to act as AIFM for third party funds. For the EU fund manager who may not wish to undertake this function in house, the solution can be convenient from a risk and timing perspective as the regulatory responsibility rests with the third party for AIFM activities (in terms of oversight, risk management, reporting, etc). The fund manager, appointed as a delegate to the AIFM/AIF to provide portfolio management services, can concentrate on providing the discretionary portfolio management activity.
4. The Fund itself becomes an AIFM as an “internally managed AIF” - it is possible for AIFs to be authorised themselves as “internally managed AIFs”, whereby the AIFM requirements are internalised within the fund. This means that the AIF legal entity must demonstrate local substance (for example through employees or secondees) to design and implement the required frameworks of oversight, governance, compliance and risk as per the Directive. Similarly to the set up described in point #2 above, whereby substance on the ground may be an issue, it would be possible for the AIF to delegate the day-to-day activities in respect of its AIFM tasks and responsibilities to secondees from a local third party provider.
Non-EU AIFMs
Under the provisions of the Directive, non-EU AIFMs are not required to seek authorisation until July 2015, however until then their marketing and distribution activities across the EU will be impacted by the AIFMD regimes that have been implemented by the different countries in Europe in relation to private placement, whereby even if the funds are distributed under the private placement regimes certain initial and ongoing disclosures to investors need to be complied with. In addition, the private placement regime in different countries is changing and some jurisdictions have either repealed existing private placement regimes or have ‘gold plated’ the requirements, so that it is becoming increasingly difficult for non-EU AIFMs to distribute their funds in Europe if they are not authorised under the Directive.
The possibility for non-EU AIFMs to be authorised under the Directive should become available in 2015. Until then, non-EU based fund managers will need to navigate the evolving requirements of the private placement frameworks across the different EU jurisdictions, or rely on reverse solicitation methods.
For EU AIFs the possibility of taking advantage of an EU-wide passport already exists under the Directive (the provisions of the Directive in this regard mirror those already in place for UCITS funds) and there seems to be a growing preference among institutional investors for funds that have obtained the passport (as perceived to operate under a greater EU regulatory scrutiny), rather than for funds that are not passported. However, the passport can only be obtained if the fund has appointed an AIFM.
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Additionally, all new European alternative funds launched from July 2013 are obliged to operate under the new framework, i.e. they are required to operate as AIFs and appoint an AIFM.
For the non-EU based fund manager, at the moment there are a few options available:
1. Wait until 2015 when the AIFMD regime may be extended to non-EU managers and apply for authorisation as a non-EU AIFM (via member state of reference). This solution would require the non-EU manager to have in place a substantial organisational, risk and compliance framework required by the Directive, including new policies and procedures (e.g. for remuneration, transparency reporting, delegation, etc), and most importantly to fall under the regulatory scrutiny of the EU regulators;
2. Leverage off its existing presence in an EU jurisdiction (e.g. a subsidiary or branch) with a view to upgrading the local EU entity to AIFM status – again, depending on the existing set up the entity will need to comply with the full suite of AIFMD organisational, risk and compliance requirements;
3. Establish a new AIF (or convert an existing alternative investment fund) as an internally managed AIF, whereby the AIFM requirements are undertaken not by a separate entity but met by the fund itself. This means that the AIF would need to demonstrate the necessary substance, infrastructure and organisational framework as required by the Directive (one solution may be for the fund to appoint employees, or have staff seconded from a local entity to provide substance);
4. Establish a presence in an EU jurisdiction for authorisation as an AIFM (for example a management company) - this solution requires substantial investment in terms of substance, personnel, systems, etc, as the entity will need to establish a brand new entity to be approved as an AIFM;
5. Leverage off established third party AIFM providers (e.g. management companies) to launch / operate an AIF under the management company set up of the existing approved third party AIFM.
8. Choice of domicile
EU vs non-EU
For an asset manager interested in establishing an AIF, the choice of domicile will be dictated by a number of factors, the principal considerations being: tax, investor demand / requirements, the quality of the domicile (in terms of product, servicing capability and regulatory regime), and cost. Another factor that will determine the domicile is whether or not the asset manager wants to avail itself of the passporting provisions under the Directive (prior to 22 July 2015). If so, then the asset manager must domicile the AIF in the EU. In addition, to access the passport the AIF must have an EU domiciled AIFM (as mentioned below the AIF could be its own AIFM if structured as an “internally managed AIF”). Therefore an Irish/Luxembourg AIF set up as an internally-managed fund can access the passport.
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Other options include: an Irish/Luxembourg AIF appointing a third party AIFM (i.e. not the asset manager or related entity) in Ireland / Luxembourg or in any other EU country; or an Irish / Luxembourg AIF appointing the Investment Manager as AIFM (or related entity), as long as the entity acting as AIFM is regulated as an AIFM with its home state regulatory authority. The key point is that any AIFM regulated in an EU jurisdiction can passport its services to act as AIFM for an AIF domiciled in any other EU country for the purposes of complying with the Directive and accessing the passport.
Ireland versus Luxembourg
For asset managers setting up new structures who want to market the fund globally and avail themselves of the passport immediately (prior to 22 July 2015), the most obvious choice is to set up the AIF in either Ireland or Luxembourg. These two fund domiciles have the necessary infrastructure to service AIFMD-compliant AIFs for international investors with a wide choice of administrators, custodians, law firms and consultants.
It is important to note also that for AIFs established in Luxembourg and Ireland there is no taxation on the income or capital gains of the fund. In addition each jurisdiction has extensive and beneficial double taxation treaty networks. Luxembourg and Ireland are materially similar as domiciles for AIFs. There are however, some subtle differences between these two domiciles. Some of these are outlined below:
i) Legal SystemLuxembourg has a continental civil law European legal system whereas Ireland has a common law legal system. Despite the different legal systems, the nature of the legal agreements and fund documentation are similar. Both jurisdictions have excellent law firms, both locally based and subsidiaries of the international law firms.
ii) Language / CultureBusiness in Luxembourg is usually conducted in French although German and English are widely spoken and legal documentation can be drafted and submitted to the CSSF in English, French or German. All business in Ireland is conducted in English.
iii) Service ProvidersBoth Luxembourg and Ireland are very well served by administrators / custodians. Most of the international service providers have substantial operations in both locations. Ireland, however, is more widely recognised for the servicing of hedge funds and is the predominant jurisdiction globally for servicing European managed hedge funds.
iv) Independent Directors / Conducting OfficersWhere an AIF is structured in corporate form in Luxembourg (e.g. SICAV-SIF), there is no formal requirement to have Luxembourg-resident Directors. However the market practice is that there is usually at least one Luxembourg-resident Director. In addition, the CSSF’s requirements for internally-managed AIFs are very much in line with the existing substance requirements imposed on UCITS funds and management companies, with a requirement for the AIF to have an administrative centre in
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Luxembourg and to be able to demonstrate proper local infrastructure, organisation and substance. The Board of the AIF is ultimately responsible for the oversight function in relation to the various provisions of the Directive (e.g. compliance, risk management, supervision of delegates, etc) and these activities can be discharged by the Board itself, or by dedicated senior management (which in Luxembourg is understood to correspond to the role of “conducting officer/dirigeant” already implemented under the UCITS framework). In this regard, members of the board can act as conducting officers, or separately appointed individuals can be employed/seconded to undertake such role. Because of the potential for conflicts arising from the oversight of certain activities being undertaken by the same person (e.g. risk management and portfolio management) and to cater for cover arrangements, at least two conducting officers should be appointed. More may be required depending on the complexity of the AIF and nature of investments. The CSSF would require that at least one conducting officer is Luxembourg-resident although depending on the nature of the proposed AIF, the CSSF may require that further conducting officers are also Luxembourg based, to demonstrate adequate local substance of mind and management.
An Irish-domiciled AIF structured in a corporate form (e.g. a company) must appoint a minimum of two Irish resident Directors. Regardless of the domicile of the AIF, it is considered good practice to have locally resident Directors to anchor the tax residency of the fund in the domicile of the AIF. The Irish funds industry has recently issued a voluntary Corporate Governance Code (the “Code”), which sets out, among other things, the requirements as to the role and make-up of the Board of Directors of an Irish fund or management company. Further details can be accessed at www.irishfunds.com. Furthermore, at the end of 2011 the Central Bank of Ireland implemented a new fitness and probity regime, which is proposed to serve as further improvement to investor protection. In addition, the Central Bank’s requirements for internally-managed AIFs, similarly as with Luxembourg, are very much in line with the existing substance requirements imposed on UCITS funds and management companies with a number of additional managerial functions and a greater emphasis on risk management. The Central Bank requires a number of suitably experienced individuals (“Designated Persons”) to oversee the managerial functions. Although not specifically stated anywhere the Central Bank would expect the majority of these functions to be overseen by persons resident in Ireland. As in Luxembourg the designated persons could be members of the Board or separately appointed employees or secondees. Further details are set out later in the booklet under “Organisation of AIFM”, on page 20.
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An alternative manager setting up
a Passported AIF could be able to
attract new investors and money
not otherwise available to them.
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9. Considerations for non-EU AIFMs
The primary consideration for non-EU fund managers is marketing, since AIFMD requirements apply where an AIF is being marketed. As mentioned previously, several EU jurisdictions have implemented definitions of marketing that limit the scope of the Directive to “active” marketing. This definition appears to allow the concept of “reverse solicitation” to continue, however managers should be aware that the documentation should be comprehensive and the burden of proof to evidence whether client interaction was carried out on the basis of reverse solicitation lies with the fund. Additionally, fund managers should be warned that regulators will be sensitive to attempts to circumvent the provisions of the AIFMD via a reverse solicitation veil.
Fund managers who decide to actively market their fund products via the various national private placement regimes should be cogniscent of the minimum required standards and any additional member state specific requirements.
Minimum required standards• A cooperation agreement must be in place between the regulatory authority of the member state
being targeted for distribution and the regulatory authority of the AIFM. In addition the regulatory authority of the AIF’s domicile (typically an offshore jurisdiction) must have in place a cooperation agreement with the member state.
• Neither the country where thenon-EU AIF is domiciled nor the non-EU AIFM is domiciled may be listed as a non-cooperative country and territory by FATF
• The non-EU AIFM must also comply with the disclosure requirements (EU AIF only) and transparency requirements set forth in the regulations which includes additional disclosure to investors in the AIF’s offering documents, the regular reporting to member states outlined in the AIFMD’s Annex IV, and additional information in the AIF’s annual report including disclosure concerning remuneration.
As mentioned above, EU member states have the option of imposing additional requirements to the minimum standards for private placement. Some jurisdictions require the appointment of local agents or have restrictions on the type and content of documentation that can be provided as well as target audience, while other jurisdictions impose an extremely restrictive regime which effectively eliminates private placement opportunities.
The AIFMD also envisions the ability of non-EU AIFMs to obtain a marketing passport for AIFs as early as July 2015, where non-EU AIFMs fully comply with all aspects of the Directive, but the details of the proposed process are not final as the existing AIF passporting regime is due to undergo a review by
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ESMA prior to its extension to non-EU AIFMs, and it is possible that the proposal could be pushed well beyond 2015.
Finally for those fund managers who pursue the private placement road, it should be noted that member states may terminate their private placement regimes at any point and may be required to do so by the end of 2018.
Fund managers seeking longer, more secure options, should consider launching stand-alone EU AIFs managed by EU AIFMs, as well as potentially taking advantage of the streamlined process which allows for the conversion of an existing offshore fund structure into an EU AIF.
10. AIFM authorisation process
While the requirements for AIFMs and AIFs are set out in the Directive the procedural details for authorisation are provided by each EU regulatory authority in its own local transposition of the Directive. The application process will vary from regulator to regulator. Authorisation timescales are typically 4-6 months for the authorisation of an AIFM, however the process could take longer depending on the availability and workload of each regulatory authority, in light of the number of applications having to be considered. Sub-threshold AIFMs are only required to register with the regulatory authorities and the registration process is much quicker.
It should be noted that any EU-domiciled asset manager who manages an AIF (which is not deemed to be out of scope), regardless of where the AIF is domiciled, is required to be authorised as an AIFM, unless the AIF has appointed another entity as its AIFM (e.g. a third party AIFM). This means that, for example, a UK-based asset manager who manages a US 40 Act Fund (which would be considered a non-EU AIF) must obtain approval as an AIFM, unless the fund has appointed another party to act as its AIFM.
AIF Authorisation Ireland and Luxembourg
The authorisation process for AIFMs in Ireland and Luxembourg is broadly similar, with the Central Bank of Ireland and the CSSF respectively requiring the filing of a number of documents by the AIFM evidencing how the AIFM intends to comply with the various aspects of the Directive. Once the filing is made, the regulatory authorities would engage with the applicant firm to request further information as needed and clarify specific items.
In Ireland the Central Bank has published set application forms to assist with the submission of the application pack. The AIFM is required to prepare a “Programme of Operations” document, setting out in detail its proposed organisational structure, the role of the Board and the oversight framework in place to supervise and monitor the various activities of the AIFs under management, the delegation arrangements, the risk management framework in place, the compliance framework and in particular the arrangements in place to ensure compliance with required conduct of business rules, the arrangements in place to monitor prudential capital requirements and a summary of the various required policies and procedures (e.g. around remuneration provisions, conflicts of interest, valuation etc). The information
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contained in the Programme of Activity must be supplemented by organisational charts and corporate details of the applicant AIFM (e.g. ownership structure, etc).In Luxembourg, the CSSF has also issued set application forms and AIFMs are required to complete these and provide supporting documentation in the same way as in Ireland. The information required by the CSSF is the same as required to be provided in Ireland, even if the format of the submission is slightly different (in Luxembourg there is no requirement to prepare a “Programme of Operations” document, although the information contained therein is the same as would need to be filed with the CSSF).
Legal counsel or specialised consultants (such as Carne) can assist firms with the preparation of the AIFM application pack and in drafting the relevant policies and procedures.
AIF
The AIF authorisation process is very much in line with the previously existing regimes for fund authorisations (e.g. QIFs, SIFs), whereby various legal documentation needs to be filed with the regulatory authorities (e.g. fund constitutional documents and offering documents) as well as material agreements with third parties and delegates (e.g. depositary agreements, investment management agreement, administration agreement, etc). Timescale for approval will depend on the type of structure and jurisdiction, with Ireland offering approval for QIAIFs within 24 hours upon submission of a completed fund application, while CSSF approval for SIFs takes longer (3-4 months).
Post-22 July 2013, any new funds established in the EU must be compliant with the AIFMD regime and therefore must be set up as AIFs and it is required to appoint an AIFM. In this regard an AIFM Agreement also needs to be filed with the regulator setting out the responsibilities of the AIFM and its powers for delegation of certain activities.
Where the AIF is appointing an AIFM in another EU jurisdiction, the authorisation process is reasonably straightforward from a regulatory point of view. The AIFM would need to apply to its home state regulator for a passport to provide cross-border services (as per the provisions of the Directive), which would allow it to manage AIFs domiciled in another EU jurisdiction. The passporting process for AIFMs is based on a regulator-to-regulator notification, whereby the application is made by the AIFM to its own home state regulator and the intention is then communicated by said regulator to the host-state regulatory authority. The most difficult part of the process in this instance is the negotiation of the legal agreements for the cross-border services, particularly the depositary agreement, and agreeing the operational set-up. The home state regulator must be satisfied that the AIFM will be able to oversee and manage the local delegation arrangements in the host jurisdiction, so comfort is usually sought by the regulator in this regard.
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Internally managed AIF
Where it is intended that the AIF is internally managed, the authorisation process becomes much more cumbersome, as in addition to the AIF being authorised, a full AIFM authorisation also has to be granted by the regulatory authorities. The internally managed AIF must demonstrate sufficient local substance and provide details on how it proposes to comply with the full provisions of the Directive from an organisational and operational perspective (for example, through the employment of dedicated individuals to carry out oversight and management tasks, or through secondee arrangements). The timescale for the approval of an internally managed AIF is likely to be in the region of six months.
Organisation of AIFM (Ireland and Luxembourg)
In Ireland, the Central Bank has implemented the provisions of the Directive in relation to the oversight arrangements of the AIFM over the AIFs under management through a framework of “managerial functions”, effectively areas of supervision and review that must be allocated to named individuals within the AIFM (or the internally managed AIF as the case may be). The AIFMD managerial functions framework is akin to that already in place for UCITS funds and management companies and comprises the following functions, which must be allocated to either the governing body of the AIFM or senior management (the “designated persons”):
Ireland - AIFMD managerial functions
In Luxembourg the CSSF has not been as prescriptive with the implementation of the Directive and has not set out specific roles that must be allocated, however the Luxembourg AIFMD framework is based on the same proviso whereby the various areas identified in the Directive as being key areas of an AIFM’s operations must be monitored and supervised appropriately and remain the responsibility of the governing body of the AIFM, or the management function (i.e. the “conducting officers”). The various areas of review must be allocated between named individuals and would include oversight of compliance with conduct of business rules for both the AIFM and the AIFs under management, supervision of delegated arrangements, risk management in its various aspects, etc.
Decision making Financial control
Monitoring of investment policy, investment strategies and performance
Monitoring of capital
Monitoring compliance Internal audit
Risk management Complaints handling
Liquidity management Accounting policies and procedures
Operational risk Recordkeeping
Conflicts of interest Remuneration
Supervision of delegates AIFMD reporting process
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11. Costs for set up
Ireland and Luxembourg
The costs involved will depend on the complexity of the structure of the fund, whether the AIF will have an AIFM appointed to it or be an internally managed AIF, and how much work (e.g. legal work) can be carried out by the fund manager versus how much will be outsourced. The main costs incurred will be legal fees and consultancy costs where some of the project set-up work is outsourced. Should the AIF be internally managed, the costs are likely to be significantly more as the AIFM application documents will have to be prepared and submitted for approval with the relevant financial regulator (Central Bank of Ireland or CSSF) along with fund legal agreements, constitutional documents and offering documentation.
12. Delegation arrangements
Delegation is a key concept of the Directive. The core activities of an AIFM are portfolio management and risk management (these are listed in Annex 1 of the Directive). It is possible for the AIFM to delegate certain aspects of these activities to third parties, but not to the extent that the delegation results in the AIFM becoming a “letter box entity”. While there is no exact definition or guidance as to what would constitute being a letter-box entity, the Directive sets out that delegation of the portfolio management and risk management functions is only permitted where delegation does not result in the AIFM becoming a letter box entity and:
- it can be objectively justified by the AIFM,- the delegate has sufficient resources and qualified personnel to perform the delegated functions, and - the delegation arrangements do not prevent the effective supervision of the AIFM by the relevant regulatory authorities.
The AIFM may delegate a number of functions to third parties to take advantage of the expertise of the delegates in their own fields and to allow for business functions and processes to be optimised, but it must always retain overall responsibility for ensuring that the delegates perform their duties in line with applicable regulations and at all times in the best interest of the AIFs and their investors, as well as remaining fully liable towards the AIFs and their investors, so that the delegation arrangements would not affect such liability.
Where the AIFM decides to delegate certain aspects of risk management and portfolio management, it must ensure that the parties to whom these activities are delegated are authorised or registered for the purposes of asset management and subject to supervision (or, where this condition cannot be met, that their appointment is subject to prior approval) by the relevant regulatory authorities.
In order to comply with the delegation requirements the AIFM must have objective reasons for delegating the activity.
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The delegation arrangements will be monitored on an ongoing basis. Should the AIFM fail to properly implement and oversee the delegation arrangements it may be deemed to be a so-called ‘letter box’ entity. The impact of this would mean that the letter box entity would no longer be an AIFM removing any ability to market and potentially opening up the AIF and the letter box entities to additional regulatory sanction.
It is important that where delegation of portfolio management or risk management occurs, the AIFM still retains the ability to intervene in the direct management of the AIF and override any decision taken by delegates in respect of the delegated functions when necessary, where the delegates’ decisions may be contrary to the duties owed to the AIFs and their investors, (e.g. retaining the power to set appropriate investment limits and risk parameters). Overall the AIFM must be able to monitor and manage the risks associated with each delegation.
A documented delegation policy must be in place, setting out the AIFM’s framework of supervision of the delegates throughout the full life cycle of the delegation arrangement, from initial delegate selection and appointment, through ongoing monitoring and with regards to termination arrangements. A key component of the AIFM’s delegation framework is a process of due diligence on the delegates, both initial and ongoing.
In this regard, when appointing any delegates, the AIFM is responsible for ensuring that the delegate has sufficient resources and employs sufficient personnel with the skills, knowledge and expertise necessary for the proper discharge of the tasks delegated to it, as well as having an organisational structure which is appropriate to support the performance of the delegated tasks. Such assessment should be the basis of the AIFM’s initial due diligence process on the delegates while on an ongoing basis the AIFM should ensure that these requisites continue to be complied with.
The Directive also requires that any delegation arrangements are subject to written contracts and where appropriate these should set out certain details, such as the AIFM’s rights for instruction, monitoring and termination of the arrangements, the AIFM’s inspection rights and access to books and premises, provisions around AIFM notification/approval of sub-delegation arrangements, liability provisions, notification of material changes to delegates’ operations etc.
It is vital that delegation arrangements be effectively implemented, resourced and supervised. For an internally managed AIF this can be achieved by appointing dedicated directors or persons to carry out the required functions. These individuals will be required to have day to day responsibility for managing the oversight of any delegated functions.
As an alternative, having the resources and substance of a staffed management company with expertise in the application of the Directive, the oversight of delegates and a robust program of activity is an effective way to demonstrate compliance with the requirements of the regulations.
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13. Risk management requirements
Organisation and structure
One of the key areas of focus of the Directive is in relation to risk management and each AIFM is required to implement an effective and suitable risk management framework to allow the identification, monitoring and management of the risks that the AIFM and the AIFs under its management are exposed to.
One of the central components of the risk management framework is the permanent risk management function, which must have a primary role in shaping the risk policy of the AIFs under management of the AIFM, risk monitoring and risk measuring in order to ensure that the risk level complies on an ongoing basis with the AIF’s risk profile. The permanent risk management function should have the necessary authority, access to all relevant information and regular contacts with the senior management and the governing body of the AIFM in order to provide them with updates so that they can take prompt remedial action where needed.
The risk management function within the AIFM should be functionally and hierarchically separate from other operational units, up to governance level. In particular, this means that the risk management function should be separate from the portfolio management function and that staff involved in the risk management function should be remunerated under clearly defined criteria, separate from other staff, and in accordance with the performance of the risk management function. The risk management function must be reviewed at least annually to assess its adequacy and effectiveness.
Risk management policy
Another key component of the risk management framework is the risk management policy. The Directive requires each AIFM to have in place an appropriately documented risk management policy detailing, in particular, measures and procedures employed to measure and manage risks, the safeguards for independent performance of the risk management function, the techniques used to manage risks and the details of the allocation of responsibilities within the AIFM for risk management and operating procedures. The risk management policy must be reviewed at least annually by the AIFM’s governing body or senior management.
In particular, the risk management policy should include:
• the identification of all the material risks that AIFs are exposed to;• an explanation of the structures used to guard the independence of the risk management function
within the AIFM;
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• the techniques, tools and arrangements used by the AIFM to manage risk, including operational risk and liquidity risk;
• the roles and responsibilities pertaining to the risk management function;• the risk limits placed on each AIF, in line with the AIF’s offering documents and any applicable
regulatory restrictions;• the nature of any conflicts of interest identified between the AIFM and the AIFs under management
and between different AIFs, together with details of the measures that have been put in place to manage and monitor these conflicts;
• details of the reporting and escalation processes within the risk management function.
Details of the risk management arrangements in place within the AIFM must be communicated to the AIFM’s regulatory authority as part of the AIFM’s application for authorisation. Additionally, the AIFM must advise its national regulator of any material changes to the RMP as they arise.
AIF risk profile
Although the Directive does not impose any investment restrictions on AIFs, the risks incurred by each AIF cannot be managed effectively if the risk limits have not been set in advance by the AIFM. The risk limits should be in line with the risk profile of the AIF and should be disclosed to the AIF’s investors, in accordance with Directive. Limits should be set for the following categories of risk:
- market risk - credit risk- liquidity risk- counterparty risk- operational risk Limits may be either quantitative or qualitative in nature. In setting these limits, the AIFM must ensure they are consistent with the risk profile of the AIF as disclosed to investors (e.g. in the AIF’s offering documentation). Actual risk levels employed by each AIF must operate within the agreed risk limits and appropriate reporting and escalation procedures must be established with the AIFM to ensure compliance with these limits.
Disclosure to the AIF’s investors must include:
- details of the AIF’s fund’s investment objective, policies and strategy and how these are consistent with the AIF’s risk profile;- any applicable risk or investment limits and restrictions placed on the AIF; - details on the risk management systems used to measure, manage and monitor the applicable risks for each AIF (e.g. portfolio risk and liquidity risk);- details on how operational risks for each AIF are identified, monitored and managed;- details on the most relevant risks to the AIF and an assessment of the risk levels pertaining to each.
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An AIFM can delegate functions
but must not become a “letterbox
entity”
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Leverage
The Directive requires that for each AIF, the AIFM should establish a limit on the maximum leverage level it will employ and this limit must be disclosed to investors. Leverage may be calculated under both the gross and commitment methods.
Under the gross method, all positions of the AIF are taken into account, and derivative exposures are translated into the market value of equivalent positions; the leverage is the gross sum of all the translated exposures.
Under the commitment method, hedged or offsetting positions are netted against each other before the leverage is calculated.
If the leverage figure calculated under the commitment method is 3X or greater, the AIF is deemed to be employing leverage on a substantial basis and additional reporting requirements will apply to the AIF.
The AIFM must also conduct periodic stress tests and scenario analysis to assess the vulnerability of the portfolio to extreme or unusual market events or conditions. The Directive is not prescriptive on how these tests may be conducted, but they would typically comprise testing the portfolio against historical scenarios and market shocks as well as against set movements in the underlying asset classes invested in by the AIF.
In addition, the AIFM must conduct periodic back testing of its own risk management arrangements to assess the robustness and reliability of the models employed within the risk management function.
Liquidity risk management
The AIFM must ensure that consistency exists between the investment strategy, liquidity profile and redemption policy for each AIF, so that investors may redeem their investments in a manner fair to all investors and in accordance with the AIF’s redemption policy and obligations as set out in the fund offering documentation.
The AIFM must monitor the liquidity profile of the AIF’s portfolio and assess the profile of the AIF’s investor base, the type and size of individual investments, as well as the redemption terms investors are subject to. The AIFM must have a full understanding of the factors that may affect the liquidity of the assets of the AIF’s portfolio and have in place appropriate tools and arrangements to monitor the liquidity profile of the AIFs under its management.
The AIFM may maintain liquidity limits on each AIF consistent with the stated redemption policy and must have in place measurement tools to monitor the actual liquidity profile of the AIF against these limits.
The actual liquidity characteristics of the AIF should be stress-tested on a regular basis to assess the AIF’s sensitivity to extreme market conditions and its ability to meet its redemption obligations in exceptional circumstances.
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14. Remuneration provisions
The Directive imposes a requirement on all AIFMs to have in place a remuneration policy, to ensure that the compensation arrangements of staff that could materially impact the risk profile of the AIF do not cause the AIFM or the AIFs under its management to incur improper and unacceptable levels of risk.
While the provisions of the Directive in this regard are relatively broad, they have been supplemented by detailed requirements set out in ESMA’s “Guidelines on sound remuneration policies under the AIFMD” which was finalised in July 2013 (ESMA 2013/232 HR).
The remuneration provisions set out in the Directive and detailed in the ESMA guidelines apply in relation to the remuneration policies and practices of the AIFM’s “Identified Staff”, which comprises members of the AIFM’s Board (both executive and non-executive), senior management and officers of the AIFM, staff whose activities may have a material impact on the risk profile of the AIFs under management, as well as staff whose total remuneration package brings them into the same category as senior management.
In addition to the individuals identified within the AIFM, the definition of Identified Staff also includes persons within the entities to which portfolio management and risk management for a specific AIF have been delegated, whose job functions and responsibilities may have a material impact on the risk profile of that particular AIF (i.e. CIOs, CEO, CFOs, risk officers, portfolio managers, traders, etc).
Where portfolio management or risk management activities have been delegated, the AIFM must ensure that:
a) the entities to which portfolio management or risk management activities have been delegated are subject to regulatory requirements on remuneration that are equally as effective as those applicable under these guidelines; or b) appropriate contractual arrangements, to cover any payments made to the delegates’ identified staff, as compensation for the performance of portfolio or risk management activities on behalf of the AIFM, are put in place with entities to which portfolio management or risk management activities have been delegated in order to ensure that there is no circumvention of the remuneration rules.
The ESMA guidelines provide a definition of total remuneration that covers both fixed and variable components of remuneration as well as other additional benefits (pension, company cars, etc). In addition, the ESMA guidelines set out a number of detailed requirements including conditions for how the variable portion of remuneration should be paid, the type / nature of such compensation and its
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proportionality with any fixed remuneration, the appropriateness of performance assessment periods, vesting of payments, clawback / malus arrangements, restrictions around “golden parachutes” or guaranteed discretionary payments, etc.
Where appropriate to the nature, type and complexity of the AIFs under management, the AIFM should consider the establishment of a remuneration committee and there must be adequate disclosure in appropriate AIF documentation (such as financial statements) regarding both qualitative and quantitative aspects of the AIFM’s remuneration arrangements.
It is important that identified staff are assessed for the materiality of their influence over the AIFM’s risk profile or that of the AIFs under management through an analysis of:- whether that person’s role has significant impact on the AIFM’s results and/or balance sheet;- whether that person’s role has significant impact on the performance of the AIFs under management;- the risk taking profile of particular business units.
There is a certain element of proportionality that can be applied to the implementation of the remuneration provisions of the Directive and the ESMA Guidelines and a number of EU regulatory authorities have issued consultations or guidance papers on their interpretation and proposed implementation of certain aspects of the ESMA guidelines, most notably the UK’s FCA.
Ultimately it is the Board of the AIFM that is responsible for ensuring that the ultimate goal of having sound and prudent remuneration policies and structures is not improperly circumvented and that procedures at the AIFM and the delegates as relevant are aligned to the requirements of the Directive and the ESMA Guidelines.
15. Transparency reporting
The Directive introduces new requirements on AIFMs in relation to transparency reporting obligations to the AIFs under management. These reporting obligations include initial and ongoing reporting to investors, as well as reporting to regulatory authorities.
Most of the details that are required to be disclosed to the investors on a pre-investment basis in relation to the AIF will typically already be covered in existing fund offering documentation, for example the prospectus (such as details of the investment strategy, risk warnings, use of leverage and collateral, etc), however there are a few items that would have been typically included in prospectus / offering memorandums for alternative funds and which must be provided to investors in advance of any investment made in the AIF. Such items include a description of what cover for professional indemnity may be in place, details of the latest NAV / fund price and historical performance. They can be separately covered in marketing presentations.
Once the investor has invested in the AIF, certain information will require ongoing investor disclosure,
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such as details of the AIF’s current risk profile, the percentage of assets subject to special liquidity arrangements (e.g. side pockets), a description of risk management systems used, as well as details of the maximum and current leverage and any rehypothecation rights or guarantees.
The AIFM must ensure that annual reports are prepared in accordance with the provisions of the Directive and that these are made available to the regulatory authorities and investors for each AIF under management and for each AIF that may be marketed in the EU no later than six months following the end of the financial year.
On a regular basis, AIFMs are required to provide reporting to the regulators in the format specified in Annex IV of the Delegated Regulation with details of their activities as an AIFM and of the AIFs under management, including specific risk data for each AIF, investor geographical spread, portfolio holdings breakdown, etc. The frequency of the reporting is determined by the aggregate AUM volume of the AIFM as well as by the AUM of individual AIFs under management and is detailed in the ESMA Guidelines on AIFM Reporting Requirements2.
16. Role of the depositary
The role of the depositary breaks down into three broad areas defined under Articles 21(7), (8) and (9) of the Directive; the safekeeping of assets held in custody; monitoring of cash flows and an oversight role. For full depositary these roles must be carried out by a single entity. However, a depositary may delegate the safekeeping of assets to sub-custodians, but may not delegate the cash monitoring or oversight duties.
To those familiar with UCITS the role of the depositary, or trustee or custodian as it has previously been called, will be well known. However, there are key differences from the UCITS regime, namely the requirements to monitor cash flows and a stricter level of liability for loss of assets held in custody.
In the world of alternative funds these roles are not as well utilised. For many hedge funds the prime broker will fulfil the role of custodian and for private equity funds a custodian has been traditionally surplus to requirements.
Strict liability
Under AIFMD the depositary remains liable for the loss of any of the AIF’s assets held in custody unless
2 15.11.2013 | ESMA/2013/1339 (revised)
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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. This effectively makes the depositary strictly liable for the loss of assets in custody which is a significantly higher standard than has pertained to date. The pre AIFMD standard of liability contractually assumed by depositaries did not extend to loss of assets by their agents or sub-custodians, except where they breached their legal standard of care in the selection, appointment and monitoring of such agents or sub-custodians. This contrasts to the AIFMD position where, absent force majeure events, or a discharge of liability, or a safe harbour for assets held through a central securities depositary, a depositary is strictly liable for loss of assets in custody by any party beneath them in the chain of custody, including all sub-custodial agents and prime brokers (and their own independent sub-custody networks).
Assets in custody versus other assets
The strict liability standard imposed on depositaries under AIFMD only applies to assets which are held in custody. Such assets would include transferable securities which can be held in custody such as listed shares, debt securities, money market instruments and collective investment schemes which can be held in custody. The Directive also assigns responsibilities to depositaries for so-called ‘other assets’ which are typically assets which cannot be held in safekeeping. These assets include derivative contracts, shares of unlisted companies which cannot be held in custody, bank loans, real property, etc. In relation to other assets the depositary must keep a record of these holdings and periodically verify the legal entitlement of the AIF to the assets.
Oversight duties
The Directive imposes a number of oversight duties on depositaries. These duties are similar to those imposed on depositaries of UCITS funds and in summary include oversight of the calculation of the NAV, share dealing and adherence to investment and borrowing restrictions.
Prime brokers
Given the additional liability faced by a depositary in its role as custodian of an AIF’s assets right through the custody chain, the issue of delegating custody to third parties and prime brokers in particular has exercised the minds of many general counsels over the past two years. Unsurprisingly custodians are cautious about being strictly liable for assets held by a third party who may have been chosen by the manager rather than themselves.
The Directive does permit the discharge of liability for the safekeeping of assets where there is an objective reason for doing so. It imposes a number of conditions on the depositary if it is using a contractual discharge of liability. Whether the appointment of a prime broker is an objective reason to warrant a depositary’s discharge of liability has been the subject of considerable debate. In deciding on the depositary arrangements, funds with prime brokers should pay careful attention to the apportionment of liability between the depositary and prime broker.
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Who acts as depositary and who appoints the depositary?
The depositary is appointed by the AIFM on behalf of the fund and the depositary agreement should be a tri-party agreement between the AIFM, the AIF and the depositary. Entities eligible to act as depositaries include EU credit institutions, certain EU investment firms and other institutions which are subject to prudential regulation and ongoing supervisions and are eligible to act as a depositary under the UCITS Directive.
An AIFM may not act as a depositary nor may a prime broker who acts as counterparty to an AIF unless it has functionally and hierarchically separated the performance of its depositary function from its tasks as prime broker and complies with certain conflicts of interest provision.
For EU AIFs the depositary should be established in the same country in which the AIF is domiciled.
What is 'depositary lite'?
Depositary lite is the term used to describe the obligations of a depositary appointed to a non-EU AIF managed by an EU AIFM which markets in Europe under a private placement regime under Article 36 of the Directive. The obligations of a depositary lite are similar to those applied to a full depositary with a few key differences. The liability standard for the loss of the AIF’s assets in custody is negligence rather than the strict liability standard. It is possible for different entities to undertake the different depositary lite tasks; therefore, a prime broker could be responsible for safekeeping (assuming it had segregated the depositary function from the prime broker one), an administrator for cash monitoring and a supervising entity for oversight.
Factors to consider in appointing a depositary
A service level agreement (“SLA”) between the depositary, the AIFM and the AIF should be entered into outlining duties, reporting obligations and relevant sharing of information.
Fund promoters should assess the suitability of arrangements that the depositary may have in place with the chosen administrator, in particular as, in light of the obligation by the depositary to monitor cash flows and to verify the ownership of non-custodied assets, the flow of information between these entities is key. Furthermore, given the additional liability of depositaries, fund promoters must be comfortable that the chosen depositary has the financial strength to make good any losses.
The operational model of AIFs is based on a strong relationship with prime brokers, so assessing the depositary’s attitude to dealing with prime brokers is also essential.
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17. Distribution opportunities, issues and challenges
For an EU AIFM managing an EU AIF, the AIFMD passport is the most efficient solution to effectively improve the AIF’s distribution footprint. The AIFMD passport facilitates the distribution of AIFs to institutional investors on a cross border basis by way of a passport notification procedure. Once an EU AIF is created, it can be distributed in all EU jurisdictions by informing the host regulator in advance. This facility to market AIFs to institutional investors in the chosen EU markets and reduce the administrative burden associated with the past pan-European distribution strategy is similar to the UCITS passport in place for many years.
Since July 2013, aside from reverse solicitation, there are two options open to fund promoters to market AIFs to EU investors:
1. Where the fund promoters have appointed an EU AIFM with an EU AIF or set up an EU- AIF that is internally managed, they can utilise the AIFMD passport; and
2. Non-EU AIFs may distribute in each EU jurisdiction in line with National Private Placement Rules (“NPPRs”) to the extent that these rules remain available up to 2018, and they properly monitor their evolution.
The AIFMD passport is currently only available to EU AIFMs of EU AIFs but, following ESMA assessment, it may be extended to non-EU AIFs from July 2015 at the earliest (the “Third Country Passport”). However, for non EU fund promoters wanting to market across the whole of Europe for now, waiting for the Third-Country Passport regime to be implemented is not a real option.
For non-EU fund promoters, targeting a small number of investors, in a few territories, distributing funds in line with the NPPRs in each EU jurisdiction may be a distribution solution. However, the challenge is that existing NPPRs vary from jurisdiction to jurisdiction and the regimes are constantly evolving across territories. In addition, some EU countries have tightened their NPPR in preparation for their eventual abolition, scheduled under AIFMD for 2018. For example Germany effectively requires non-EU managers to undertake a full registration process instead, if they want to sell alternative funds. Further restrictions or outright abolition of the NPPR are possible over the coming years. In addition greater enforcement of distribution rules is likely, and regulators will be alert to the possibility of abuse of reverse solicitation rules.
ESMA’s planned “impact assessment” of the NPPR is due between the end of 2017 and July 2018, and this will potentially result in the phasing out of NPPRs. If the Third Country Passport does become available from July 2015 or soon thereafter, it would enable all forms of AIFs (EU and non-EU) and managers (EU AIFMs and non-EU AIFMs) to make use of an AIFMD passport.
In the meantime, in this evolving distribution landscape, reliance on NPPRs or reverse solicitation may not be a viable way for non-EU fund promoters to target the EU market as a whole.
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AIFMD provides a robust risk
management framework through
its prescribed rules on governance,
risk, regulation of service providers
and safekeeping of assets.
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The use of the AIFMD passport has been possible since July 2013 for EU AIFMs managing EU AIFs and is creating straightforward distribution possibilities in countries like France, Italy and Spain where efficient private placement regimes do not exist. Having an AIF benefit from the passport in these jurisdictions can provide a clear competitive advantage.
Fund promoters who want to make immediate use of the AIFMD’s passporting provisions and not be compelled to rely on NPPRs and reverse solicitation regimes can either make use of third party EU AIFMs such as established management companies, or set up an EU domiciled internally managed AIF. In either case the EU AIF can avail of the AIFMD passport for distribution across the EU.
18. Converting existing structures to EU AIFs
As with most structural changes (which are not compelled by regulation), the driving consideration for converting an existing offshore structure to an EU AIF will be client demand (potential and/or existing clients). Fund managers considering this significant change should have a fair degree of confidence that capital raising or capital retention will be positively impacted in a substantial manner.
That being said, EU regulators (notably in Ireland and Luxembourg) are anxious to attract fund managers converting their offshore fund structures and have developed streamlined processes to facilitate the conversions.
While there are several options, the movement of the fund’s registered office is the least disruptive and allows the legal personality of the fund to remain intact and will in most cases not give rise to a taxable event for either the fund clients or the fund itself.
Once the decision has been made to move forward with converting the structure, a full review of all operating elements of the existing product should be conducted and compared to the requirements established under the AIFMD for an EU AIF with gaps and required enhancements noted. The potential capability of existing service providers to support the revamped product will be a major consideration since full conversions to new providers will impact both the associated cost and internal effort. A review of potential product domiciles should also take place because, while the basis requirements of each domicile are consistent, there are differences (both apparent and nuanced) which will drive the determination of the appropriate “home” for the product. The structure of the fund itself (e.g. internally managed, use of internal or third party management company, etc) will impact the timing and costs associated with the conversion and will likely have an impact on the marketability of the product down the road. It will also be important for fund managers to be able to articulate to existing investors that the positive changes associated with the conversion are significant and outweigh the incremental on-going costs associated with the fund operating as an EU AIF under a more tightly controlled regulatory regime.
Clearly a decision to convert an existing structure is a big one and should only be taken after a comprehensive analysis. However, the path to conversion is quite clear and once the decision is in place, competent service providers are able to guide the product into its new home without disrupting the existing client base, all the while setting the fund up for future sustainability and growth.
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Many offshore funds have been
successfully redomiciled as
regulated AIFs
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19. How can Carne help?
Carne can provide a flexible solution to investment managers that may be looking for an external EU-domiciled AIFM for their AIFs, or that may need assistance with discharging oversight, the risk management function and substance obligations for their own AIFMs. Carne can also assist and has considerable experience in project management of fund re-domiciliations.
The Carne group comprises management companies domiciled in both Ireland and Luxembourg, each having dual authorisation as UCITS management companies and AIFMs. The management companies are supported by the additional resources of the Carne group and have access to the multi-discipline and multi-jurisdictional expertise of senior individuals within Carne.
Carne provide AIFMD and other services across multiple jurisdictions including: EU, US, offshore centres (Cayman, Bahamas, BVI) and the Channel Islands (Jersey, Guernsey). The principal solutions under AIFMD that Carne can provide are:
1. A third party AIFM in either Ireland or Luxembourg;2. Provision of directors for internally managed AIFs who discharge the substance and risk
management requirements of the Directive;3. Risk management and substance services supporting the board of an AIFM or internally managed
AIF (this includes supporting US 40 Act Funds);4. Other services supporting the AIF e.g. Directors, Company Secretarial, MLRO (in Ireland), foreign
registration services.
Carne AIFM Management Company
Typically the Carne AIFM solution will entail the delegation of the portfolio management function to the investment manager and retention (as required under the provisions of the Directive) of the risk management function.
The Carne management companies can be appointed as AIFM to third party AIFs, but can also provide substance to existing client AIFMs and internally managed AIFs, offering the following advantages:
• Embed experienced risk management team.• Incorporate the additional capital requirement introduced by the AIFM Directive.• Deliver a regulatory solution for businesses that may not want to be the ‘structural’ AIFM. • Provide a solution for businesses that do not want to compromise their MIFID licensed business.• Allow delegation of certain activities to specialist service providers.• Provide an efficient governance solution with a simple organisational structure.• Management and supervision by an experienced team.• Offer cost efficiencies derived from economies of scale.
In particular the Carne offering provides:
• A robust oversight framework on the funds under management and the delegated activities, with an experienced team responsible for:
• an effective compliance framework;• a comprehensive risk management framework.
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KnowledgeExpertise
Experience
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Foreign registrations
In addition to the above, Carne can also assist with the registration of EU AIFs across EU jurisdictions under the passporting provisions of the Directive and in this regard can perform the necessary filings with the local regulators to obtain the passport for cross border distribution of the AIFs as the client may require. Carne’s multi-national and multi-lingual foreign registration team has significant experience in assisting fund sponsors and can act as a single point of contact in overseeing the relationships with all relevant third parties.
For full details of Carne services please refer to www.carnegroup.com
Appendix: Abbreviations
AIF Alternative Investment FundAIFM Alternative Investment Fund ManagerAIFMD Alternative Investment Fund Managers DirectiveCCF Common Contractual FundCIS Collective Investment SchemeCSSF Commission de Surveillance du Secteur Financier (Luxembourg financial regulator)ESMA European Securities and Markets AuthorityFCP Fonds Commun de PlacementICAV Irish Collective Asset-management VehicleLP Limited PartnershipMiFID II Markets in Financial Instruments DirectiveNPPR National Private Placement RulesPart II Fund Part II of the law of 20 December 2002 (retail funds)SPC Segregated Portfolio CompanyQIAIF Qualifying Investor Alternative Investment FundRIAIF Retail Investor Alternative Investment FundRMP Risk Management Policy SICAV Société d’investissement à Capital VariableSICAR Société d’Investissement en Capital À RisquéSIF Specialised Investment FundUCITS Undertakings for Collective Investment in Transferable SecuritiesVCC Variable Capital Company
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DublinJohn Donohoe Carne Global Financial Services Limited2nd Floor, Block E, Iveagh CourtHarcourt RoadDublin 2t: +353 1 489 6800 e: [email protected]
Channel IslandsMark Hodgson Carne Global Financial Services (C.I.) Limited4th Floor, Union HouseUnion StreetSt HelierJersey JE23RFt: +44 1534 511786e: [email protected]
Cayman IslandsPeter Heaps Carne Global Financial Services (Cayman) LimitedGrand Pavilion Commercial CenterWest Bay RoadGrand Cayman KY1-1107t: +1 345 769 9900e: [email protected]
Chicago Scott Craven Jones t: +1 312 804 1823 e: [email protected]
LuxembourgThomas NummerCarne Global Financial Services (Luxembourg) S.á.r.l.25b Boulevard RoyalL-2449 Luxembourgt: +352 2673 2338e: [email protected]
New YorkJoe Hardimant: +1 732 642 5808e: [email protected]
SwitzerlandVeronica BuffoniCarne Global Financial Services (Switzerland) GmbHGubelstrasse 5 P.O. Box 15246301 Zug, Switzerlandt: +41 78 936 1976e: [email protected]
LondonAymeric LechartierCarne Financial Services (UK) LLP107 – 111 Fleet StreetLondon EC4A 2ABt: +44 207 936 9139e: [email protected]
Carne Contacts