On December 19, 2012 the European Commission ("Commission") adopted its draft Delegated Regulation ("Level II Regulation") supplementing Directive 2011/61/EU ("AIFMD").
The Level II Regulation supplements the AIFMD (so called Level I) with regard to exemptions, general operating conditions, depositaries, leverage, transparency and supervision. It is based on ESMA's technical advice to the Commission dated November 16, 2011 ("Final Report", please see our Client Memorandum of the same day).
The Level II Regulation will be directly applicable, a transposition in national laws is not required.
The Level II Regulation is subject to a three-month scrutiny period by the European Parliament and the Council. If no objections have been raised by any of them it will be published in the EU Official Journal and enter into force the day following the publication. As both European Parliament and Council have been consulted extensively in the drafting process it is very unlikely that an objection will be raised.
Hereinafter, we have outlined and commented on some of the most significant issues of the Level II Regulation.
"Small" AIFM whose assets under management do not exceed the threshold of EUR 100 million (including any assets acquired through use of leverage) or EUR 500 million (when no leverage is used and the investors have no redemption rights exercisable during a period of five years following the date of initial investment) under the AIFMD are only subject to registration and not to the full set of regulation. Pursuant to the AIFMD the details of the application of the exemptions are to be provided for in the Level II Regulation.
1. Treatment of grandfathered AIFs
With regard to AIFs for which the AIFM would not require to be authorized under the grandfathering rules of Art. 61 AIFMD ESMA had expressly stated in the Final Report that such AIFs are excluded from the calculation of the total value of assets under management. Unfortunately, this clarification has not been inserted in the Level II Regulation. Such question currently is to be reviewed on EU level.
2. Leveraged financing at AcquiCo level
Pursuant to the AIFMD definition section, "leverage" means any method by which the AIFM increases the exposure at the level of an AIF it manages. Accordingly, debt at the level of an acquisition company which does not expose the AIF should not to be considered leverage. Whereas ESMA's Final Advice explicitly referred to leverage "as defined under the Directive", the Level II Regulation sets out that financings on the level of intermediate companies, specifically being established to increase the exposure of the AIF, shall be included in the calculation of the exposure of the AIF. The political reason of such broad wording is to cover possible circumventions in particular used by hedge funds. The preamble of the AIFMD shows that financings on the level of VC and Private Equity portfolio companies shall not be regarded as leverage. This is confirmed by the Level II Regulation in saying that for AIF whose core investment policy is to acquire control of non-listed companies, the AIFM shall not include any exposure that exists at the level of such non-listed companies.
In our opinion there can only be one definition of leverage for purposes of the application of the AIFMD and borrowings that do not increase the AIF's exposure is not to be included.
The Level II Regulation clarifies that borrowing arrangements should be excluded if they are temporarily in nature and relate to and are fully covered by capital commitments from investors. Revolving credit facilities, however, should not be considered being temporarily in nature.
3. Calculation method, frequency of calculation, ongoing monitoring
As did in the Final Report the Level II Regulation simply refers to the "value of the assets under management" without any further guidelines as to the method of determination of the value and without reference to the net asset value. The value must be calculated at least annually at a specified date using the latest available asset values (not being older than 12 months).
The value of the assets under management has to be monitored on an ongoing basis which has to include the subscription and redemption activity, capital draw downs, capital distributions and the value of the assets invested in. The AIFM can be required to recalculate the value more often if the threshold is near and/or it anticipates subscription or redemption activity that might entail a breach of the threshold.
A temporary breach of the threshold does not trigger a license requirement; periods of more than three months are not considered temporary.
II. ADDITIONAL OWN FUNDS / PROFESSIONAL INDEMNITY INSURANCE
Art. 9 (7) AIFMD stipulates that in order to cover potential professional liability risks, both internally managed AIFs and external AIFMs shall either (i) have additional own funds to cover potential liability risks or (ii) hold professional indemnity insurance against liability arising from professional negligence which is appropriate to the risks covered.
1. Additional own funds
In line with the proposals set out in the Final Report, the additional own funds have to be recalculated at the end of each financial year and the amount of additional own funds have to be adjusted accordingly. As an additional requirement, the Level II Regulation states that if the value of the portfolios of the AIFs increases significantly prior to such annual recalculation, the AIFM should recalculate without undue delay the additional own funds requirement and adjust accordingly. This recalculation during one and the same financial year might lead to a costly and time-consuming internal work load and is also problematically as the term "significant increase" is rather unclear and has not been defined yet.
Unfortunately, the Level II Regulation confirms the position ESMA had expressed in the Final Report that the competent authority of the home Member State of the AIFM is entitled to request the AIFM to have additional own funds exceeding even 0.01% of the value of the portfolios of AIF for covering liability risks arising from professional negligence. Such qualitative own funds requirement is not only disproportional but also gives rise to legal uncertainty with respect to the final amount of own funds, in particular as there is no cap, and might therefore lead to significant problems for AIFMs.
On the other hand, the competent authority may authorise the AIFM to hold lower additional own funds not less than 0.008% of the value of the portfolios if the competent authority is satisfied on the basis of a three years historical loss data that the AIFM holds sufficient additional own funds.
2. Professional indemnity insurance
The Level II Regulation specifies the requirements for the professional indemnity insurance. Unfortunately, not only have existing problematic provisions been retained but also additional rules have been inserted which might lead to new problems.
a) Definition of "relevant person"
The Level II Regulation sets out that "professional liability risks" to be covered pursuant to Art. 9 (7) AIFMD are risks of loss or damage caused by a relevant person through the negligent performance of activities for which the AIFM has legal responsibility. For these purposes, "relevant person" not only means the director, partner, manager or employee of the AIFM, but also any natural or legal person "who is directly involved in the provision of services to the AIFM under a delegation arrangement to third parties for the purpose of the provision of collective portfolio management services by the AIFM". This definition is clearly much too broad, as a relevant person in that sense could be close to anybody retained by the AIFM, even if such person is only performing minor supplementary activities relating to the portfolio management.
b) Notice period for cancellation
As a new provision, the Level II Regulation stipulates that the insurance policy has to have a notice period for cancellation of at least 90 days.
c) Authorized insurance company
Further, the Level II Regulation requires that the insurance undertaking must authorized to provide professional indemnity insurance in accordance with EU or national law.
d) Coverage amount
The coverage of the insurance for an individual claim must be at least equal to 0.7% and for claims in aggregate per year at least 0.9% of the value of the portfolios of AIFs managed by the AIFM. Whereas the rates have been slightly reduced compared to the rates set out in the Final Report (from 0.75% and 1.0%, respectively), the Level II Regulation no longer provides for a maximum amount, which might be a problem in particular for large AIFM.
e) Coverage of "improper valuation" and "business disruption"
The Level II Regulation requires that professional liability risks shall also cover improper valuations of assets and calculations of unit/share prices as well as business disruption, system failures, failure of transaction processing or process management. Such risks are not typically covered by professional indemnity insurances and AIFMs may have difficulties finding an insurer covering such risk at reasonable cost.
III. OPERATING CONDITIONS FOR AIFM
1. Due diligence requirements
The Level II Regulation provides for due diligence requirements for AIFMs, in particular concerning the selection and ongoing monitoring of investments. In this respect AIFMs are required, amongst others, to set out policies and procedures for the due diligence and implement effective arrangements for ensuring that investment decisions are carried out in compliance with the objectives, the investment strategy and, where applicable, the risk limit of the AIF. Such policies and procedures for the due diligence have to be reviewed and updated regularly.
2. Functional and hierarchical separation of risk management
Art. 42 Level II Regulation requests a full functional and hierarchical separation of the risk management function. Most important for private equity, subsection (1)(c) requires that "persons engaged in the performance of the risk management function are compensated [...] independently of the performance of the operating units, including the portfolio management function". The provision does not set out how such should be applied proportionately as requested by Art. 15 (1) sub-paragraph 2 AIFMD. It only provides that the competent authorities should review the application of Art. 42 (1) and (2) Level II Regulation by the AIFM "on the basis of the criteria laid down" in Art. 15 (1) sub-paragraph 2 AIFMD.
It remains to be seen how this will be applied proportionally to private equity AIFM that only have a small team and where investors request all senior team members to commit to the AIF in order to align the interests of investors and team. Some come to the conclusion that the risk manager(s) cannot receive carried interest; in our view, this should not be excluded if structured appropriately.
Art. 67 Level II Regulation provides for new requirements with respect to the policies and procedures for the valuation of the assets of the AIF. These policies and procedures should address at least the following:
- the competence and independence of personnel that is effectively carrying out the valuation of assets;
- the specific investment strategies of the AIF and the assets the AIF might invest in;
- the controls over the selection of valuation inputs, sources and methodologies;
- the escalation channels for resolving differences in values for assets;
- the valuation of any adjustments related to the size and liquidity of positions, or to changes in the market conditions, as appropriate;
- the appropriate time for closing books for valuation purposes; and
- the appropriate frequency for valuing assets.
V. DELEGATION OF MANAGEMENT FUNCTIONS/ LETTER-BOX ENTITY
Art. 82 Level II Regulation describes certain situations in which the AIFM will be deemed a letter-box entity and no longer be considered to be the AIFM of the respective AIF:
- the AIFM no longer retains the necessary expertise and resources to supervise the delegated tasks effectively and manage the risks associated with the delegation;
- the AIFM no longer has the power to take decisions in key areas which fall under the responsibility of the senior management or no longer has the power to perform senior management functions in particular in relation to the implementation of the general investment policy and investment strategies;
- the AIFM loses its contractual rights to inquire, or inspect, or to have access or give instructions to its delegates or exercising such rights becomes impossible in practice;
- the AIFM delegates the performance of investment management functions to an extent that exceeds by a substantial margin the investment management functions performed by the AIFM itself. When assessing the extent of delegation, competent authorities need to assess the entire delegation structure taking into account not only the assets retained under management by the AIFM but also a number of qualitative criteria. The qualitative criteria that may be taken into account are enumerated in the Level II Regulation.
ESMA has the right to issue guidelines to ensure a consistent assessment of delegation structures across the EU.
1. Safekeeping duties with regard to assets held in custody
Compared to the Final Report, Art. 89 Level II Regulation contains a new depositary obligation with respect to financial instruments to be held in custody. The depositary has to verify the AIF's ownership right or the ownership right of the AIFM acting on behalf of the AIF over the assets. Such obligation goes beyond the wording of Art. 21 (8)(a) AIFMD. The verification of ownership is only required for assets that do not fall under the definition of financial instruments to be held in custody (cf. Art. 21 (8)(b) AIFMD). This should, however, not be relevant for private equity and venture capital funds as their investment policy is not focused on financial instruments to be held in custody.
2. Look-through approach
The safekeeping duties relating to assets to be held in custody, i.e. the ownership verification and record keeping duties, will apply on a look-through basis to underlying assets, Art. 90 (5) Level II Regulation. This look-through is restricted to financial and legal structures, which are established by the AIF for investment purposes and controlled by the AIF. Likewise, no look-through will be necessary through the target funds of a fund of funds and the master fund of a feeder fund, respectively, if the target or master fund itself has a depositary with corresponding obligations.
The Level II Regulation still does not make clear that unfunded obligations to portfolio companies and commitments of a fund of funds to underlying target funds which have not been drawn down are not considered to be leverage if they are fully covered by undrawn capital commitments from the investors. In this case they do not increase the exposure of the AIF and, hence, should not be seen as leverage.
With regard to the issue of leveraged financing at the level of acquisition companies please see our comment in section I.2 above in relation to the exemptions.
The Level II Regulation provides that borrowing arrangements should be excluded that are temporary in nature and fully covered by undrawn capital commitments. This is unsatisfactory as any obligation that is fully covered by undrawn capital commitments, be it temporary or not does not increase the exposure of the AIF and should thus not be considered to be leverage. Further, it is unclear whether revolving credit facilities would be regarded as temporary.
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.