As the Alternative Investment Fund Managers Directive (“AIFMD”) was being developed prior to 2011, there were serious concerns across the funds industry that it might force managers to set up their funds offshore to avoid the burden of regulation that appeared to be heading their way. Thankfully, those concerns did not really materialise and many fund managers found they could work with AIFMD and that it even brought with it the benefits of the EU “marketing passport”, allowing EU-based managers to market their EU-based funds freely across all member states. A review of AIFMD was always going to take place — Article 69 of the Directive itself obliged the European Commission to assess its impact on investors, funds, fund managers (both inside and outside of the EU) and report on its progress and areas for improvement.
Similarly, the industry has been nervous in the build up to the Commission’s review and proposals (although to a lesser extent than pre-2011), with the main concern being potential changes to the delegation model, whereby EU-based fund managers delegate certain functions (particularly portfolio management) to entities based in other jurisdictions. Delegation plays an important part in the structure of international investment managers, ensuring they can provide services efficiently based on the location of specific personnel, both inside and outside of the EU.
The Commission’s recent proposals should be well received by the industry as they are not as bad as some people may have feared. The delegation model is addressed, but it seems to be more along the lines of a strengthening of the supervision of the model rather than wholesale changes. Other points are in relation to loan-origination funds, depositary services and liquidity management for open ended funds.
The main issues on delegation are in relation to monitoring and supervision. The regulator in the member state of the AIFM will need to be provided with more details on delegation (including the functions that are to be delegated and those that are to be retained) if the AIFM is delegating more portfolio management or risk management than it is retaining. The regulator will then need to report on an annual basis to ESMA, the European regulator. There will be further rules introduced in relation to these delegation notifications as ESMA has been tasked with developing regulatory technical standards on the content and form. ESMA is then tasked with reporting, at least every 2 years, to the Parliament, the Council and the Commission on market practice and compliance regarding delegation of functions to non-EU entities. In effect, this is ESMA scrutinising each of the member state regulators to ensure that they maintain a tough stance on delegation and not allow AIFMs in their member states to be mere “letterbox” entities. In the Commission’s report though, it is clear that granting ESMA more enforcement powers on delegation was considered, but they have stated “at this point this option was considered to be in contrast with the principle of subsidiarity”, which suggests that further action could be taken in the future if they are not happy with what they see.
Interestingly, the draft rules also expand the issue of delegation to more than just portfolio and risk management by referring to all functions listed in Annex 1 of AIFMD. This brings in services such as administration and marketing, two functions which are quite often carried out by third party administrators and placement agents.
There is also a new requirement for an AIFM to have at least “[two] full-time employees” or “[two] individuals who are committed full-time to the business of the AIFM” and who are resident in the EU, in order to demonstrate proper substance.
LOAN ORIGINATION FUNDS
Credit funds that have a focus on loan origination are also a focus in the Commission’s report, as it believes AIFMD does not have specific requirements to address the risks of direct lending activities, and different rules and regulations at a member state level have the effect of “promoting regulatory arbitrage and varying levels of investor protection”. The proposals include: a 20% limit on loans to a single borrower if that borrower is a financial undertaking or a collective investment undertaking; the requirement for the fund to be closed ended if the notional value of all loans originated is greater than 60% of the fund’s net asset value, and a restriction on selling entire loans on the secondary market that a fund has originated (the fund is required to retain at least 5%). Open ended loan origination funds will also be caught by the more general requirement for all open ended funds (regardless of asset class) to have at least one additional liquidity management tool (LMT) (in addition to suspending redemptions) and that a regulator can require a manager to activate a relevant LMT.
These proposals do not look too problematic for loan origination funds; the 20% diversification limit should not be a commercial issue, but may impact some underlying fund structures. The requirement to always maintain 5% of a loan that the fund has originated means a fund could not fully divest all remaining investments on the secondaries market but would have to retain at least a part of all loans until maturity. The reasoning behind this is to prevent loans being originated and immediately sold off on the secondary market — an alternative could have been to retain at least a 5% interest for a set period of time, rather than until maturity, this would provide flexibility if there were legal or regulatory reasons why the fund should dispose of the interest in full, or to allow the fund to fully wind up its affairs at the end of its term.
The Commission recognises that the requirement for a depositary to be based in the same member state as the fund does not fully serve investors interests, as in smaller markets this leads to a lack of competition and increased costs. As such, the proposals include giving regulators the power to allow funds and managers to appoint depositaries in other member states pending a review of the possibility of introducing a “depositary passport”. The concept of a passport for a depositary based in one member state allowing it to provide services throughout the EU seems like a sensible idea which will give both fund managers and depositaries much more flexibility — but there is some resistance due to fears it could lead to large depositaries controlling the market and further stifling competition, as well as making it harder for regulators and funds to supervise and enforce their rights against depositaries in other jurisdictions.
DISCLOSURE OF FEES AND NPPRS
Finally, there are other proposed amendments such as changes to Article 23 in relation to the periodic reporting that AIFMs must make to their investors. The clause that managers should take note of is the requirement to report to investors on a quarterly basis on all direct and indirect fees and charges allocated to the fund or to any of its investments. Investors and regulators have been pushing for greater transparency on fees for several years now, and many investors insist on detailed reports from their managers on fees charged to the fund, so while conceptually additional transparency under AIFMD shouldn’t cause a concern, there is a legitimate worry that the language is not clear as to exactly what fees and charges actually need to be disclosed. Also, a requirement to disclose fees quarterly (investors typically require annual disclosure) seems overly burdensome. There is also a prohibition on non-EU funds marketing into the EU under Article 42 (the “NPPR” regime) if the fund or the manager is based in a jurisdiction that is deemed un-cooperative in tax matters. Annex IV reporting may also be subject to changes as ESMA have been tasked with developing regulatory technical standards to replace the current reporting template.
The changes to AIFMD will be made through another European Directive, meaning member states will have to incorporate these changes into their national laws within two years of official publication, and so it is anticipated that the changes will not be in force until at least 2024. It is worth noting that this initial proposal may well be subject to change during the legislative process, and further detail will come to light through Level 2 legislation, so the final arrangements are far from certain. However, for those managers structuring funds now and over the next few years, it is important to think carefully how delegation will work, as these arrangements could well be subject to even more scrutiny going forward.