UK: The Alternative Investment Fund Managers Directive Changing the Fund Management Horizon

Introduction

On 11 November 2010, the European Parliament adopted the text of the Alternative Investment Fund Managers Directive (the "Directive"), which will significantly change the legal framework in which fund managers operate and how investment funds are marketed in Europe. The controversial Directive has been in the making for over a year and a half and has faced intense lobbying from the fund industry.

Scope

The Directive will regulate investment fund managers which are not authorised under the UCITS Directive as follows:

• alternative investment fund managers ("AIFMs") in the EU managing alternative investment funds ("AIFs") whether or not the AIF is based in the EU and irrespective of whether the AIF is marketed in the EU or not;
• non-EU AIFMs managing EU AIFs irrespective of whether the AIF is marketed in the EU or not;
• non-EU AIFMs marketing EU or non-EU AIFs within the EU.

The scope of the Directive is broad and it will catch a wide range of AIFMs, including those which manage private equity, hedge, real estate, infrastructure, venture capital and listed funds. Neither the form of the AIF nor whether it is open or closed ended will have a bearing on whether the Directive applies. This "one size fits all" approach to the regulation of AIFMs has been one of the key criticisms of the Directive and whilst the approved text makes some distinctions between certain types of funds, this is still an overriding issue.

The Directive requires an AIF to have a single manager. Accordingly, in a structure where there are multiple managers, it will be necessary to assess which manager will be the AIFM in the context of the Directive and how this impacts on the rest of the structure.

There is some good news for small managers, who, provided they meet certain threshold conditions, will benefit from a limited scope. The limited scope regime applies if an AIFM manages portfolios of AIFs whose assets under management in total do not exceed €100 million (with the use of leverage) or €500 million (without the use of leverage and where there are no redemption rights exercisable during a 5 year period from the date of initial investment in each AIF). Interests held by common management vehicles will be considered when assessing these threshold limits. Limited scope AIFMs will still need to register with the regulator in the relevant Member State and will need to provide details (both on registration and on an on going basis) about it and the AIFs it manages, including details on investment strategies and investments made. A limited scope AIFM can elect to opt in to the wider scope of the Directive, which will allow it to benefit from the rights under the Directive such as the passport regime (see below). However, if it does opt in, the entire Directive will apply.

Key provisions of the Directive

The Directive is detailed and a large proportion will be supplemented and hopefully clarified by implementing legislation. However, in very broad terms, the key provisions are:

Marketing passport – An authorised EU AIFM can market EU AIFs that it manages to professional investors in the EU by way of a marketing passport. The approval of the regulator in the Home State must be obtained before marketing commences and material changes to the documents submitted must be provided to, and in certain circumstances approved by, the regulator. Whilst this will be an improvement from the current system, where fund managers must comply with local private placement regimes which differ from Member State to Member State, the need to seek prior approval will impact on the fundraising timetable.

Third country provisions – These provisions have probably been the most heavily negotiated of the Directive and have received significant press coverage. Consequently, these provisions are complex and the application of the Directive differs depending on the location of the AIFM and the AIF. For example, the possible permeations may include an EU AIFM managing a non-EU AIF but not marketing it in the EU, an EU AIFM managing and marketing a non-EU AIF, a non-EU AIFM managing an EU AIF and a non-EU AIFM marketing a non-EU AIF in Europe. The rules also differ depending on whether marketing is undertaken under a passport or using the private placement regimes (see below).

In broad terms, non-EU AIFMs managing EU AIFs or marketing EU or non-EU AIFs in Europe will need to comply with the Directive (although certain provisions will not apply in some circumstances). For non-EU AIFMs marketing or managing AIFs, there is a derogation from this where local law makes compliance with the Directive incompatible. However, in these circumstances local law needs to be equivalent, which may make compliance an issue for non-EU AIFMs. Further, cooperation agreements relating to information sharing are required between third countries and the Home State (or Member State of Reference for a non-EU AIFM) and, in certain circumstances, agreements between third countries regarding compliance with the OECD Model Tax Convention are also required with each Member State an AIF is marketed in.

Non-EU AIFMs and EU AIFMs marketing non-EU AIFs in Europe can benefit from the passporting rights available to EU AIFMs marketing EU AIFs provided certain conditions are satisfied. However, this right will not be available until two years after the implementation of the Directive into national law. Until then, the current private placement regimes will remain in place and the two regimes will continue to apply in parallel for a further three years (currently expected to end in 2018).

Capital – The Directive imposes capital requirements on AIFMs. An internally managed AIF must have initial capital of at least €300,000. An external AIFM must have initial capital of at least €125,000. In addition, where the value of the portfolios of AIFs managed by the AIFM exceed €250 million, the AIFM shall provide an additional amount of own funds equal to 0.02% of the amount by which the value of the portfolios exceed €250 million (subject to a cap of €10 million). Notwithstanding this, the amount of own funds can never be less than ¼ of the preceding year's fixed overheads. For a number of UK fund managers this will be a substantial increase from their current regulatory capital requirement.

Depositories – This is another area which met with significant resistance during the negotiation process as a number of fund managers, in particular private equity managers, considered this an unnecessary expense. The Directive requires that a single depositary is appointed for each AIF. The depositary must either be an EU credit institution or EU investment firm subject to certain capital requirements. There are specific rules in relaiton to depositaries for non-EU AIFs and relaxed rules, in effect for private equity managers (the depositary may be an entity which carries out depositary functions as part of its professional or business activities).

Remuneration rules – The remuneration rules, which were not included in the first draft of the Directive, require AIFMs to have remuneration policies and practices in place. These include performance elements of remuneration being assessed over a multi year time frame, limitations on guaranteed variable remuneration, adjustments to remuneration to take account of current and future risk and variable remuneration to comprise of at least 50% interests in the AIF.

Specific rules in relation to private equity funds – Specific rules in relation to private equity funds which acquire control of portfolio companies (either individually or jointly) apply, including disclosures to the local regulator, the portfolio company and its employees. These rules do not apply to portfolio companies which are SMEs or special purpose vehicles with the purpose of purchasing real estate. In addition, rules relating to the prevention of asset stripping by AIFs acquiring control, either individually or jointly, of unlisted companies have been introduced. Broadly, the AIFM must not, for a period of 24 months following acquisition, facilitate or instruct any distribution, capital reduction, share redemption and/or acquisition of own shares by the portfolio company.

Reporting and disclosure requirements – The Directive introduces increased disclosure requirements, both to the local regulator and also to investors, including the provision of an annual report (which must include details about remuneration and carried interest paid).

Valuations – Independent valuations of the assets of an AIF must be carried out. Whilst the AIFM can undertake the valuation itself, the valuation task must be functionally independent form the portfolio management and the remuneration policies of the AIFM and measures must be implemented to mitigate against conflicts of interest.

Other provisions – Other provisions included in the Directive relate to delegation of responsibilities and certain conduct of business provisions (such as not giving another investor preferential treatment without disclosing details in the AIFs' constitutional documents (which may impact on the use of side letters), risk management, liquidity management, conflicts of interest and leverage).

Next steps

The current timetable is for the Directive to come into force in January 2011. Member States will have two years following this to transpose the Directive into national law. During this period, Level 2 implementing legislation will be published by the Commission, which will hopefully provide clarity to certain aspects of the Directive. This process will need to be monitored as until these measures are introduced the full impact of the Directive cannot be assessed

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.