How will the implementation of the European Union's AIFMD impact on Ireland's investment funds industry, ask Adam Donoghue and Ann-Marie Teehan.
The global financial crisis of 2008, most notably the Lehman and Madoff affairs, highlighted certain gaps in the regulatory framework of the alternative investment fund industry and led to many questions regarding the due care and diligence that fund managers were exercising on behalf of their investors. Thus, work began on both sides of the Atlantic on putting a comprehensive and harmonised regulatory structure in place. In the EU the result is AIFMD (Alternative Investment Fund Managers Directive), which was due to be implemented across all member states by last July, but which in many cases allowed a 12-month 'grandfathering' period and is only now clearly coming into focus.
The Directive is designed to regulate the actions of alternative investment fund managers (AIFMs) that manage alternative investment funds (AIFs) within the EU, and/or market AIFs to EU investors, while at the same time creating an internal European market for AIFMs to carry on their business. The Directive is supplemented by secondary regulations, which provide more granular detail and guidance on many of the requirements.
The scope of the Directive is very broad in terms of the definition of an AIF, catching all collective investment schemes that are not Undertakings for Collective Investment in Transferable Securities (UCITS) and allowing only a limited number of exemptions. While the Directive focuses on the activities of the AIFM and purports not to regulate AIFs directly, it does have a huge impact on fund products in terms of structural requirements and reporting obligations.
What are the key requirements?
The Directive has introduced extensive changes aimed at establishing a coherent approach to risk and its impact on investors and markets in the EU. While this article cannot comprehensively discuss what is the most significant regulatory restructure in the history of the alternative asset management industry, the main provisions can be summarised under the following headings.
AIFMs that have never previously been subject to any regulatory oversight in terms of remuneration now find themselves faced with onerous rules designed to promote sound and effective risk management and discourage excessive risk-taking, for example requirements to defer a portion of any bonuses and to pay at least half of bonuses in shares of the relevant AIF. AIFMs must implement remuneration policies for all 'identified staff' (senior management, risk takers, control functions), whose professional activities have a material impact on the risk profile of the AIFM or the AIFs it manages.
One particularly contentious issue is that the AIFM's remuneration obligations will also be indirectly applicable to 'identified staff' within investment management delegates of the AIFM. However, a principle of proportionality is included so that an AIFM may apply certain rules 'in a way and to the extent that it is appropriate'.
A single depositary must be appointed for each AIF with responsibility for monitoring cashflow, safe-keeping of assets and general fiduciary oversight. The fallout from the Madoff scandal has also led to a very onerous, near-strict liability standard being imposed for loss of custodied assets by depositaries. In very limited circumstances, a depositary can discharge this liability to its delegates (eg prime brokers). Although Irish regulated funds have always required the appointment of a custodian/depositary, the additional obligations and liability imposed by the Directive have forced a substantial review of the business model between depositaries and prime brokers. Fortunately for investors and AIFMs, the predicted major increase in depositary fees following the introduction of this new liability standard has not materialised, although the industry is still grappling with the implications and implementation of the new and more invasive depositary role.
An AIFM can delegate to third parties provided it can justify its entire delegation structure on objective reasons. It is not, however, permitted to delegate to the extent that it becomes merely a 'letterbox entity' – ie where it doesn't retain sufficient power and/or resources, delegating to such an extent that it can no longer be considered the manager of the AIF. Given the extensive delegation of functions which prevails in most alternative fund structures, the lack of regulatory clarity on this concept of a letterbox entity has been a cause of great concern and confusion in the industry. Due care is required in the selection of any delegate as well as effective monitoring on an ongoing basis.
Specific disclosure must now be included in the audited financials and offering documents of each AIF.
AIFMs are required to make certain information available to investors before they invest in addition to periodic disclosure requirements. Detailed systemic risk reporting must also be submitted to regulatory authorities, such as the Central Bank of Ireland. In the case of private equity funds, further detailed disclosure and notification is required in respect of large positions taken in EU-unlisted companies.
While many aspects of the Directive have presented challenges to the industry, one of the key benefits is the introduction of a pan-EU passport for marketing AIFs to professional investors, similar to that available under the UCITS Directive (Directive 2009/65/ EC on Undertakings for Collective Investment in Transferable Securities), which has been highly successful on a global scale. While there is no passport for marketing to retail investors, each member state can choose to allow such marketing under its own national private placement rules.
Marketing is defined as any 'direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM of units or shares of an AIF it manages or with investors domiciled or with a registered office'. Therefore, passive marketing or 'reverse solicitation', where an investor initiates contact with the AIFM, does not fall within the scope of the Directive.
However, in the absence of any clear guidance on what, in fact, constitutes passive marketing, each foray into an EU market must be looked at on a case-by-case basis with local legal counsel. Currently, different rules apply depending on the domicile of the AIFM and the AIF it manages.
Since 22 July 2013 (subject to transposition of the Directive into national law), the passport has been available to authorised EU AIFMs managing EU AIFs (eg a London-based manager managing an Irish Qualifying Investor Alternative Investment Fund [QIAIF]).
Non-EU AIFMs (eg US managers) cannot currently benefit from the passport and must continue to rely on national private placement rules to market in-scope AIFs within the EU (subject also to complying with the transparency requirements (as summarised above) and certain additional conditions specified in the Directive). However, certain member states are using AIFMD as an opportunity to revisit their private placement rules so this needs to be examined on a case-by-case basis.
In July 2015, the European Securities and Markets Authority will issue an opinion on whether the passport should be extended to non- EU AIFMs and to EU AIFMs marketing non-EU AIFs. If a positive opinion is issued, non-EU AIFMs will be able to apply for authorisation, subject to full compliance with the Directive. However, we have seen a number of non-EU clients 'opt in' at an early stage by using an EU AIFM (either an external 'host' AIFM or an internally managed AIF domiciled in Ireland), to gain full market access to European investors.
All EU member states were due to implement the Directive by 22 July 2013. As of the date of this publication, the Directive has been transposed by most, with the exception of Belgium, Italy, Spain and several of the smaller member states. Although formally implemented, the volume and complexity of restructure required by the Directive has resulted in most member state regulators (including the Central Bank) granting pragmatic grandfathering/transitional provisions for managers to obtain compliance. Indeed, while implementation of the Directive has led to a period of much uncertainty in many member states, the Central Bank has provided welcomed clarity through its reasonable and proactive approach. That, combined with the desire of the Irish funds industry to maintain its position as the leading European fund domicile, has resulted in Ireland being one of the most AIFMD-ready jurisdictions.
What impact on Ireland?
While the increased transparency and investor protection brought about by the Directive have been welcomed, there were significant concerns that, as a result of the new depositary model, the increased demand for risk management expertise to service Irish AIFMs and the required overhaul of fund documentation, these positives would be outbalanced by increased costs, which could negatively impact Ireland's competitiveness as a funds domicile. However, the attractiveness of the pan-EU passport and moves by Ireland to protect itself as the best EU domicile for AIFs have resulted in a more bullish outlook than initially expected.
There is a sense that the hardest years in accommodating AIFMD are now behind us, and so while the traditional offshore centres continue to be the natural home for most hedge and private equity funds, we are seeing a clear trend of managers choosing to 'co-domicile' by establishing Irish QIAIFs in parallel to their existing offshore funds so as to access the European market. As long as that trend continues, the net impact of AIFMD on the Irish industry will be positive.
This article was first published in ACCA member magazine Accounting and Business in February 2014.
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.