"aifmd & private equity managers - an implementation checklist" - global...

Date 23 July 2013

AIFMD & Private Equity Managers

An implementation checklist

By Shane Brett, Managing Director Global Perspectives

www.globalperspective.co.uk

A Global Perspectives White Paper

Contents

Introduction 2

Background 2

1. Identifying the AIFM 3

2. Illiquid investments 3

3. Remuneration 4

4. Depositary 4

5. Risk management 5

6. Reporting 6

7. Fund Valuation 6

8. Managing non-listed companies6

9. Asset stripping 7

10. Leverage calculations 7

Conclusion 7

Introduction

The new European AIFMD regulations

will significantly impact the private equity (PE) industry. The regulations were primarily designed for hedge

funds but are being applied wholesale to the private equity industry.

Compliance will present a challenge for many PE managers.

In this white paper we will look at the main impacts of AIFMD on private

equity managers and what they should be doing to comply.

This will include:-

1. Identifying the AIFM 2. Illiquid investments,

3. Remuneration policy, 4. Depositary requirements 5. Risk management,

6. PE reporting requirements, 7. PE Fund valuations

8. Managing non-listed companies 9. Asset stripping regulations 10. Leverage calculations

Background

AIFMD will impact private equity

managers who manage in aggregate of €500 million unleveraged. They will also impact those managers who

manage or market funds into Europe as well as funds that have European

investors. Under AIFMD in scope funds are

referred to as Alternative Investment Funds (“AIFs”). In scope fund

managers are referred to as

Global Perspectives www.globalperspective.co.uk

Email: [email protected] Phone: +44 (0) 20 3239 2843

Alternative Investment Fund Managers (“AIFMs”)

There are a large number of

impacts to Private Equity managers, which include:-

1. Identifying the AIFM

One of the key questions for PE managers under AIFMD is to

identify who is the fund manager (the AIFM).

This may be a challenge because of the structure of PE

funds, using General and Limited Partners. Many PE funds

also use Special Purpose Vehicles to structure investments and this may make

identifying the correct fund manager more difficult.

The regulation also clamps down on “Letterbox entities”.

This means that if a PE

manager is registered in one

non-EU country (e.g. Cayman, BVI etc) but the core

investment management functions are based within the EU, AIFMD deems that they are

in scope for full AIFMD compliance.

PE managers that wish to be outside the scope of AIFMD will

have to show that their risk and portfolio management functions

take place outside the EU. AIFMD focuses on substance

rather than form.

Fund managers may need to take legal advice on this because under

AIFMD the AIFM is responsible for ensuring the funds they manage (the

AIF) complies with the directive. AIFMD places the onus on the fund manager, not on the fund.

2. Illiquid investments

AIFMD has specifies requirements for funds that hold investments with “limited liquidity”.

To confuse matters AIFMD does not

properly define “limited liquidity”! Nonetheless private equity will obviously fall into this category.

The directive does not preclude or

prohibit investment in unlisted companies or illiquid assets. Instead it

prescribes a process that must be put in place regarding how these assets should be managed and documented

by the PE manager.

If a PE manager holds assets with limited liquidity they must prepare a business plan for how these

investments will be managed. This must be regularly updated by the

manager. Transactions must be conducted in accordance with the business plan and due diligence must

also be completed and documented on the assets in question. Performance of

the PE fund must then be monitored on an on-going basis by the PE manager.

These requirements will obviously

have a significant impact on PE managers. Managers should currently be drafting their business plan in

respect of all in-scope illiquid



investments, as well as setting up the required internal

processes to document and manage these requirements.

For some larger PE managers this will be a substantial task.

3. Remuneration

Some of AIFMD’s most

controversial new rules are around the area of remuneration (which includes

“carried interest”). The directive has specific requirements which

will impact PE managers. ESMA, the European super

regulator, issued new remuneration guidelines on July

3rd 2013. These guidelines provide more operational detail

regarding reporting remuneration details to the regulators, setting up a

remuneration committee and identifying which staff is

impacted by the new remuneration rules.

AIFMD’s remuneration regulations will affect senior

management, staff in control functions in the organisation or individuals who have a material

impact on the risk profile of the PE fund they manage.

Remuneration must be weighted towards long-term

incentives. This means that

employees must be paid at

least half their bonus as shares in the fund. Furthermore they are not allowed to sell those

shares for a minimum of 3 (and preferably 5) years.

PE managers are also being asked to

introduce prudent remuneration policies and organisational structures to avoid a conflict of interest or which

may encourage excessive risk-taking. The implementation of the AIFM’s

remuneration policy must be reviewed at least annually. Remuneration policy must be disclosed to investors and

regulators.

PE managers should be engaged in an internal review of their remuneration policies and taking steps to ensure

they comply with AIFMD. This will mean the establishment of a

remuneration committee (if the managers total AUM is above €1.25

billion).

4. Depositary

All private equity funds in scope for

AIFMD will be required to have a depositary. This is a new entity created under AIFMD, which will

provide oversight of the fund for the investors.

They will have a very wide scope of liability and will be expected to

provide detailed monitoring of the fund on an on-going basis. These will

work like super-charged custodians who will closely monitor the assets in the fund, reconcile daily cash

movements and provide independent

verification that the fund is being run

properly and the assets are where the manager says they are.



This level of external intrusion is a sea-change for private

equity funds.

Private equity managers will need to engage in a detailed depositary selection process,

ensuring their short list matches their cost, investor’s

expectations as well as investment strategy.

Due to the severe level of liability AIFMD imposes, only

large companies with deep pockets will be able to offer this service (often tier 1

administrators who are part of global banks). There is

confusion in the industry regarding how much

depositories are expected to charge for this service. This will be clarified as we move into

2014 when private equity funds complete their depositary

engagement. Private equity managers will

require a depositary that understands their business. This

will include a deep knowledge of business valuation, cash monitoring and the safekeeping

of assets. Some depositories may not be willing to support an

investment strategy weighted towards illiquid or exotic asserts.

This means in-depth depositary

due diligence will be required. This process should be on-going at present. For managers the

selection of a suitable, cost effective depository aligned to

their investment strategy will be a key consideration.

Once a suitable depositary had been

engaged, private equity fund managers will need to put in place procedures with their administrator to

ensure the depositary receives all the regular reporting they will require to

complete their oversight duties. Under AIFMD it is the responsibility of the PE manager to ensure the depositary has

the data and reporting they require.

5. Risk management

AIFMD requires that PE managers functionally and hierarchically

separate their risk management and portfolio management functions.

This means risk management

responsibility must be given to a senior member of the management team; someone who is not involved in

the investment management function. Smaller Private Equity houses, with

fewer resources, may find it difficult to achieve this functional separation.

PE managers must also put in place risk management systems which will

identify, measure and manage all the risks in the fund’s PE investment strategy. Risk monitoring is of key

importance.

Risk management processes must be adequately documented and managers must ensure detailed due diligence is

completed as part of their due

diligence process. AIFMD places

emphasis on due diligence across the regulations and this includes reviews of new and existing service providers



and appropriate documentation of all investments made by the

PE fund.

6. Reporting

Under AIFMD PE managers must complete two forms of

reporting.

These are:- · Annual reporting to

investors – Managers must send an annual report to their

investors. This will include details of the type of investments the fund is making,

its concentration, management fees and the valuation of the

assets.

· Regulatory reporting – PE managers will have to submit regular reporting to their

“home” EU country regulator. This will include similar details

as in the annual report as well as information regarding fund liquidity, stress tests, “special

arrangements” etc. Reporting will be required quarterly for

larger PE funds (over €1.5 billion).

The reporting template and ESMA guidelines are now

available. The format and detail required is very similar to Form PF in the US, however

unfortunately the proposed

format of the answers is

prescriptive and inflexible.

7. Fund Valuation

Under AIFMD PE managers must value

their investments on at least an annual basis. This valuation must be

done by either an independent external valuator (for example an administrator or specialist 3rd party

valuator) or by the fund manager itself – provided that the valuation is

completed by those functionally separate from both the remuneration

policy and investment management functions within the company.

PE managers must also document their valuation policy and processes in

detail as part of AIFMD’s

requirements. Most managers will already be doing this to a degree.

AIFMD formalises this process.

8. Managing non-listed companies

AIFMD will impact investments into underlying portfolio companies, specifically if the company is based in the EU, employs over 250 people or

has a turnover of €50 million.

PE managers must notify the appropriate portfolio company register

as they build up or change their holding of voting shares. There are a large number of thresholds which

require notification (e.g. 10%, 20%, 30%, 50% and 75%) and this must be

done as the holding exceeds or falls below each threshold. PE managers

need to put in place processes to monitor, calculate and notify these changes.



Similarly if a PE manager gains control of a portfolio company

there are additional requirements stipulated under

AIFMD. Control is defined as >50% of shares in an unlisted company and >30% of a listed

entity.

Finally, PE managers must also disclose their intentions regarding the future of the

portfolio company, its business operations and how the

acquisition has been financed to either the employees themselves or their

representative body.

9. Asset stripping

AIFMD has specific rules

regarding asset-stripping from portfolio companies. For 2 years following the acquisition of a

large EU company, PE managers are prohibited from

executing and distributions, or capital reductions that would reduce the company’s capital

base or exceed its distributable profit and reserves. These rules

also apply to share redemption and repurchases. These provisions apply to all large EU

companies, either listed or unlisted.

This restriction on corporate actions of portfolio companies

will have a substantial impact

on some PE managers. The

importance of long term strategy when making the portfolio investments will

increase. This will feed into the

need for greater due diligence in the acquisition process.

10. Leverage calculations

AIFMD stipulates two new ways to

calculate leverage. These are the “Gross” & “Commitment” methods.

The “Gross” method attempts to give a picture of the funds overall

exposure. The “Commitment” method focuses more on the hedging and netting techniques used by the fund

manager.

The key point here is that these are new, compulsory methods for leverage calculation. The more common “Value

at Risk” (VAR) methodology is not acceptable.

PE Managers will need work with their

system vendors and internal departments to ensure these calculations are built into their

software applications. They also need to be making initial leverage

calculations using these new methodologies in preparation for AIFMD.

This is important because PE

managers will have to report leverage to their home regulators and to investors on an on-going basis. They

will also have to monitor it closely and advise their investors if they breach

their stated leverage threshold.

Conclusion

The impact of AIFMD on PE managers is substantial. AIFMD is a “one size fits

all” regulation, primarily aimed at the hedge funds industry. The fact that its



main focus is not actually on private equity may make its

implementation all the more challenging for PE managers.

The wide scope of the regulation may even mean managers outside Europe fall

into its net.

PE managers across the industry are now getting down to the task of implementing this

legislation across their business.

The next year up until July 2014 is the crucial transitionary period to build out full

compliance to the PE specific requirements identified in this

checklist.

Global Perspectives can assist in all areas of compliance, impact assessment and

operational implementation.

Sign up for all our white papers.

Email:-

[email protected]



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