On November 16, 2011, following the consultation papers as of July 13, 2011 (ESMA/2011/209) and August 23, 2011 (ESMA/2011/270) (the "Consultation Papers") of the European Securities and Markets Authority ("ESMA") issued its final report (the "Final Report") which provides ESMA's technical advice on Level II measures concerning the Directive on Alternative Investment Fund Managers, which entered into force on July 21, 2011 ("AIFM-D"). The Final Report is ESMA's final response to the European Commission's request for assistance to ESMA's predecessor CESR as of December 2, 2010 (the "Commission's Request"). The European Commission will now prepare the implementing measures in light of ESMA's advice.
P+P has been assisting the European Venture Capital Association in drafting answers to the Consultation Papers. Please refer also to our previous client memorandum dated July 14, 2011.
Like the Consultation Papers the Final Report covers the four parts identified in the Commission's Request with respect to which the Level I text of the AIFM-D refers to further technical details to be determined as part of the Level II process:
- Part I: general provisions, authorization and operating conditions;
- Part II: depositaries;
- Part III: transparency requirements and leverage; and
- Part IV: supervision.
We will be circulating within the next few days a more detailed summary (in table format) of the ESMA advice. In the meantime, please find hereafter a short summary of ESMA's final recommendations regarding the key elements of the Level II topics which have given rise to great concern of the private equity ("PE") industry throughout the consultation phase.
II. Identification of "Assets under Management" for Purposes of the Exemption pursuant to Article 3 AIFM-D
The AIFM-D permits that member states provide for exemptions of the rules under the Directive for "smaller" AIFM whose assets under management do not extent a certain threshold (€500 million for AIFM not applying leverage and €100 million for AIFM applying leverage).
In order to determine for these purposes the assets under management pursuant to Article 3(2) AIFM-D, ESMA simply refers in its Final Report to the "total value of assets under management" approach. ESMA provides no guidelines as to the method of determining the value and it no longer refers to the NET asset value. As proposed in its Consultation Paper ESMA foresees in its Final Report that the value must be calculated at least annually using the latest available asset value calculation (not being older than 12 months) and should include assets acquired through leverage "as defined in the Directive" for each AIF (Box 1 no. 3; section III.I no. 5). With respect to the inclusion of assets acquired through leverage ESMA refers to the gross method of calculating the exposure of the AIF including any borrowing (Box 2 and 95). Given the clarification included by ESMA ("as defined in the Directive") and the definition of "leverage" in the Level I text of AIFM-D pursuant to which leverage is considered as any exposure at the AIF level, borrowing at the level of the acquisition vehicle holding the shares in a portfolio company should not be included for purposes of determining the value of the portfolio company in our reading.
Fortunately ESMA no longer takes the view that AIFs for which the AIFM would not require to be authorized under the grandfathering rules of Article 61 have to be included in the calculation of assets under management. It is now clarified that such AIFs are not taken into consideration.
According to the rules proposed by ESMA the AIFM should implement and apply procedures on an on-going basis to monitor the value of the total assets under management. ESMA proposes that the value should be monitored on a quarterly basis (section III.I.9 of CP). If any "market value" based approach were chosen such quarterly "monitoring" would certainly be difficult especially for the smaller PE fund manager who were meant to be protected by such exemption in the first place. However, if the proposal is to be read such that the AIFM has flexibility as to the method by which it determines the value of the assets, this should be feasible, because it could then base its quarterly monitoring on the latest available annual audited value adapted by the acquisition price of any assets acquired and by the net asset value of any assets sold since then.
Moreover, ESMA suggests that the AIFM assesses situations where the "total value of assets" exceeds the thresholds and it considers such excess not to be of a temporary nature. ESMA specifies that the situation should be considered to be of a temporary nature if it is likely to continue for a period in excess of three months (Box 1 no. 8 lit. (b)).
III. General Operating Conditions
1. Capital Requirements: "Additional Own Funds" and "Professional Indemnity Insurance"
In addition to the capital requirements imposed on the AIFM pursuant to Article 9(1-6) of the AIFM-D, the AIFM must have a Professional Indemnity Insurance ("PII") in place or alternatively further additional own funds. With respect to PII, ESMA has deleted the requirement to have insurance in place for risks relating to fraud by the AIFM but instead foresees failure by the senior management to establish, implement and maintain appropriate procedures to prevent dishonest, fraudulent or malicious acts by the AIFM's directors, officers or staff or third parties for whom the AIFM has vicarious liability. However, it still foresees insurance coverage for risks in relation to improper valuation, business disruption and system failures which are difficult to be insured in practice. The minimum coverage of the insurance for each claim must at least equal the higher of the following amounts:
a) 0.75 % of the amount by which the value of the portfolios of the AIFM exceeds €250 million, up to a maximum of €20 million;
b) €2 million.
The minimum coverage of the insurance for all claims in aggregate per year must at least equal the higher of the following amounts:
(a) 1 % of the amount by which the value of the portfolios of the AIFM exceeds €250 million up to a maximum of €25 million;
(b) €2.5 million;
(c) the amount of additional own funds (see below).
With respect to the alternative of keeping additional own funds (in cash) ESMA has generally adopted the industry's preferred option to base the amount of additional own funds on the value of the portfolio of AIF managed by the AIFM (i.e. 0.01% of the value of the portfolios managed by the AIFM) ("quantitative method"). The Consultation Paper (inspired by rules under CRD Directive applicable to credit institutions (!!) stated that the amounts determined under the quantitative method were subject to the so called qualitative method according to which the additional own funds are determined in light of the risks to which an AIFM is exposed. These rules give rise to legal uncertainty as it is unclear whether the additional own funds as calculated according to the quantitative formula set forth above will be sufficient or whether further capital requirements may be imposed under the qualitative method. In our discussions with ESMA we had requested a deletion of the reference to the qualitative method. In its Final Report ESMA seems to provide for a compromise: Referring to the qualitative requirements ESMA states: "On the basis of the assessed risk profile, the AIFM has to ensure that liability risks arising from professional negligence are covered by own funds (calculated according to [the quantitative method in] Box 7) or professional indemnity insurance (calculated according to Box 8) or a combination of both methods (calculated according to Box 9) at all times. ... The competent authority of the home Member State of the AIFM may authorize the AIFM to lower the quantitative percentage [under the quantitative method] to 0.008% [based upon the quantitative method], provided that the AIFM can demonstrate – based on its historical loss data according to Box 6 and a minimum historical observation period of three years [qualitative method] – that liability risk according to Box 5 is adequately captured. Conversely, the competent authority may raise the additional own funds requirements if they are not sufficient to capture liability risk arising from professional negligence".
Hence, the requirements pursuant to the quantitative method and PII are generally considered a minimum and higher capital requirements may be imposed if under the qualitative methods the regulatory authority considers the risks to be higher.
ESMA final recommendations set out details of the conditions under which a delegation of functions by the AIFM is possible. The final recommendations do not substantially divert from the consultation paper. In particular with respect to the delegation of portfolio management and risk management functions it is clarified that such delegation is generally only possible to another, externally-appointed AIFM authorized under the AIFMD, an investment firm authorized under MiFID to perform portfolio management, a credit institution authorized under Directive 2006/48/EC having the authorization to perform portfolio management under MiFID or management companies under the UCITS Directive. Moreover, it is clarified that a delegation cannot have as effect that the AIFM is only a letter-box entity. This would be the case if (i) the AIFM is no longer able to supervise the delegated tasks effectively and to manage the risks associated with the delegation or (ii) when the AIFM no longer has the power to take decisions in key areas that fall under the responsibility of the senior management or to perform senior management functions.
In case of a delegation of portfolio management or risk management conferred on third-country undertakings, still a number of conditions would have to be satisfied in order for such a delegation to take place. In particular, also the ESMA final report suggests the existence of a written agreement between the competent authorities of the home Member State of the AIFM or ESMA and the supervisory authorities of the undertaking to which delegation is conferred. The written agreement should cover such areas as on-site inspections, exchange of information and the existence of sufficiently dissuasive enforcement actions (for details see Box 68). Where the delegation concerns portfolio management or risk management, the third country undertaking should be deemed to satisfy the requirements under Article 20(1)(c) when it is authorized or registered for the purpose of asset management based on local criteria and is effectively supervised by an independent authority.
ESMA no longer explicitly requires that the local criteria must be equivalent to those established under EU legislation.
ESMA's final recommendations regarding risk management to be put in place by the AIFM do not include any substantial changes to the proposal of the implementing measures of this summer. Risk management requirements include in particular heavy due diligence requirements, identification of potential risk exposures and risk limits and management policies dealing with such risks and finally a separation of risk management functions or independent performance of risk management activities. In particular such separation of risk management functions may be difficult to achieve in practice.
The AIFM-D differentiates between custody functions relating to financial instruments which can be held in custody and transfer of ownership functions regarding other assets (including financial instruments which cannot be held in custody). Both in the Consultation Papers and the final recommendation ESMA states that financial instruments which are directly registered with the issuer itself or its agent (e.g. a registrar or a transfer agent) in the name of the AIF should not be financial instruments which can be held in custody unless they can be physically delivered to the depositary or held in an account directly or indirectly in the name of the depositary. It remains to be seen whether this means that unlisted shares acquired by the AIF could be considered as financial instruments for such purposes. In the explanatory text ESMA clarifies that investments in privately held companies and interests in partnerships are not financial instruments which can be held in custody. This aspect should be given further attention as the requirements for the depositary go further in case the AIF is considered to hold financial instruments which can be held in custody.
One important issue that was discussed was the role and functions of the depositary. According to the Level I text the depositary must assume oversight functions, cash monitoring and verification of ownership functions. It was heavily discussed whether these functions apply on an ex ante or on an ex post basis. ESMA does not impose any ex ante control with respect to cash monitoring, but it aims to have a strong requirement on the AIFM to ensure the depositary has access to all information related to each cash account (Box 77). In the Final Paper ESMA recommends that the depositary must ensure that there are procedures in place to appropriately monitor and review periodically the AIF's cash flow (Box 78).
Fortunately, ESMA has removed the option that the depositary shall mirror every transaction in a record keeping system to ensure the verification of ownership.
In its Final Report ESMA no longer suggests that with respect to AIF's investing in illiquid assets an ex ante oversight duty may be advisable. On the contrary it now clarifies that an ex ante control requirement would not be possible to be met in most cases which is why the advice sets out a general principle which consist of setting up a procedure to verify on an ex post basis "in most cases" the compliance of the AIF with applicable law and the AIF rules. However, ESMA also clarifies that the depositary is not prevented from adopting an ex-ante control where it deems appropriate and in agreement with the AIFM (section V.IV. no. 40 and no. 56).
Unfortunately ESMA has not taken into account the requests expressed by the industry not to look through with respect to the safekeeping function of the depositary to verify the valid transfer of ownership of the assets acquired by the AIF. ESMA clarifies in its final advice that the depositary's safekeeping duties apply on a look-through basis to underlying assets held by financial and/or legal structures controlled directly or indirectly by the AIF or the AIFM on behalf of the AIF.
Moreover, ESMA sticks to its advice in the consultation paper pursuant to which the depositary should ensure that there are procedures in place so that assets so registered cannot be assigned, transferred, exchanged or delivered without the depositary or its delegate having been informed of such transactions.
The AIFM-D foresees certain special requirements applicable to AIFM managing AIFs employing leverage. One topic which (surprisingly) came up in the pre-consultation phase was the question whether a PE-AIF should be considered as an AIF using leverage due to the fact that often financing is employed by the underlying holding company holding the shares in the portfolio company. The debate was surprising given that Article 4(1)(v) AIFM-D clearly defines leverage as any method by which the AIFM increases the exposure of an AIF. Pursuant to this definition, a PE-AIF should not be considered leveraged as borrowing at the level of the holding entity is not exposing the AIF in any way.
ESMA seems to confirm this view in its final recommendations by clarifying that when calculating exposure, it shall be "looked through" corporate structures [only] to the extent that those structures have recourse to the AIF via cross-collateralization or guarantees (section VI. no. 15). It seems therefore that where the AIF itself does not provide guarantees or collateral for any borrowing at the holding vehicle level, such financing would rightly not be considered. The same seems to result from the proposed legislative text in Box 94 of the Final Report which reads "exposure which is contained in any financial and/or legal structure involving third parties controlled by the relevant AIF should be included in the calculation of the exposure where the structure referred to are specifically set up directly or indirectly increase the exposure at the level AIF". However, the meaning of the following sentence in this same Box is yet unclear: "For AIFs whose core investment policy is to acquire control of non-listed companies or issuers AIFM should not include in the calculation of exposure any leverage that exists at the level of those non-listed companies and issuers." It triggers the (surely unintended) question whether in case of the investment in minority stakes in portfolio companies any borrowings at the level of the portfolio company need to be included. One reason for this somewhat misleading language may be ESMA's concern of regulatory arbitrage which it sees in relation to financial and/or legal structure involving third parties controlled by an AIF (section VI. no. 24).
A clear improvement is the clarification brought forward by ESMA in its Final Report (Box 94 no. 5) pursuant to which borrowing arrangements entered into by the AIF are excluded if these are temporary in nature and relate to and are fully covered by capital commitments from investors in its explanatory notes ESMA clarifies that this would not include revolving credit facilities.
would not include revolving credit facilities.
The Final Report brought some improvement and seems to be going in the right direction with respect to certain aspects of PII, the clarification of ex post control by the depositary, the clarification that borrowing at SPV level not exposing the AIF is generally not considered as leverage although the drafting often is not as clear as it could be and sometimes misleading. Other points still need be further looked into and debated.
Finally, important questions arising under the AIFM-D which are not subject to Level II technical measures still remain open. Some will be subject to further guidance to be issued by ESMA (outside the Level II process); others will be further clarified in the course of the implementation into national laws and/or the by the national regulatory authorities. Among such open questions are in particular the treatment of limited partnership structures as internal or external AIFMs, the determination of the AIFM in a classical closed ended partnership structure, the exact interpretation of "closed-ended" funds (for which the AIFM-D foresees special rules at several occasions) and the scope of the grandfathering for closed ended funds. The rules on compensation on the other hand still remain subject to further guidance to be issued by ESMA.
We will further keep you posted and already draw your attention to the next Funds Forum Frankfurt which will take place on December 1, 2011.
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.