UK: The Alternative Investment Fund Managers Directive: Update for Real Estate Funds

Last Updated: 22 September 2010
Article by Deloitte Real Estate Group

Most Read Contributor in UK, August 2017

During May 2010 the European Parliament and European Council voted on their respective draft texts of the proposed Alternative Investment Fund Managers Directive (the "Directive"). This marked the start of the European Union's 'Trialogue Process', involving ECON (the Parliamentary Committee on Economic and Monetary Affairs), ECOFIN (The Economic and Financial Affairs Council) and the European Commission. A final text will emerge once a consensus has been reached.

The process had already stalled before the scheduled 'final' vote in July and has been held over during the summer recess. The earliest date for a final text will be September 2010, perhaps later if agreement still cannot be reached. While we await the final detail, there is an opportunity for the real estate fund industry to take stock to ensure that the Directive's impact is being discussed at the right level and in the appropriate meetings. The Directive will keenly impact product development, fund structuring, marketing and service provider contracting, as well as the long term fund management strategy.

As most market participants are aware, the Directive's "catch all" approach to regulation means that, although it has not been drafted with real estate funds at its core, they fall squarely within its intended scope - including UK REITs. It is important to note that many of the concepts which the Directive aims to address (and the terms in which they are described) are more appropriate to hedge fund strategies, and this means that greater guidance and interpretation will be required to apply the provisions to the real estate fund manager model.

Naturally, in our role as advisers to many key fund management players and investor groups across Europe and further afield, we are highly conscious that our clients' decisions and actions will be affected by the Directive. Its imminent approach and final structure will form a moving backdrop to our wider advisory services.

There are essentially two major areas where the real estate funds industry will be impacted by the proposals as they stand:

  1. structuring and distribution of fund products; and
  2. costs of compliance and contractual change, and the related administrative burden.

We have provided key discussion points covering these areas in this update. As you would expect, Deloitte will be following the Directive's progress keenly, and our advice going forward will emerge from the new environment created by these changes

Structuring and distribution of fund products

The European real estate funds market comprises a mixture of EU and non-EU participants, who are subject to varying degrees and styles of regulation. For the most part, investment vehicles domiciled in Luxembourg, Germany, the Netherlands, the UK, the US and the Channel Islands dominate the real estate fund landscape, and each jurisdiction has well established serviceproviding support networks. The relative regulatory merits of establishing funds and management operations in these jurisdictions are typically weighed up alongside other key considerations such as tax treatment and local reporting requirements as well as investor familiarity with a fund's legal form, to assist Fund Managers in choosing the best product for their target investor base. By applying a new uniform regulatory approach across the EU and into "third country" territories elsewhere, the Directive may unequally impact AIFMs with interests across these jurisdictions, with the greatest impact on those least regulated at present. The 'weighing up' process on establishment of new funds will need to be reconsidered carefully, with renewed contemplation of investor sentiment as well as new factors such as regulation around manager remuneration.

Third country provisions

A key – and controversial – part of this consideration is the likely nature of proposed "third country" provisions in the Directive, which govern the scope and extent of its application to non-EU funds and managers. Such provisions have the capacity to affect acutely the real estate funds industry, owning to the extensive use of non-EU (mostly Jersey and Guernsey) fund vehicles, particularly for investments into the UK. As a result of various UK direct and stamp tax considerations, much of the UK real estate fund business comprises vehicles domiciled in the Channel Islands.

As currently drafted, both texts impose a requirement for the local supervisory body of a non-EU Alternative Investment Fund ("AIF") to have co-operation agreements in place with Member State into which a fund is to be marketed. It is understood that forging an acceptable compromise amongst EU member states in this area is a key stumbling block delaying agreement of the Directive as a whole.

The primary point of principle where the Council and Parliament differ is with regard to the marketing rights afforded to managers established outside the EU including those based in the US. The Parliament is pushing for tighter "equivalence tests" such that non- EU regimes are brought up to an EU acceptable standard of regulation and offers the carrot of a European Passport which would allow non-EU managers authorised under this Directive to market their funds freely around Europe. The Council is opposed to offering the EU passport to non-EU managers but is more pragmatic in relation to the conditions that need to be fulfilled to market in each member state. Additionally the Council draft proposes to keep in place local Private Placement Regimes, enabling marketing to continue to take place outside the Directive as at present, which will be very welcome to non-EU managers. The Parliament draft also contains a prohibition against EU professional investors investing in a non-EU AIF (whether or not managed by an EU AIFM) unless that third country meets the "Passport" conditions outlined above. This makes it essential that any offshore funds seeking EU capital are able to meet these conditions. There is no equivalent condition in the EU Council draft.

Table 1 below shows how some common real estate fund structures may be impacted by the Directive, and highlights sensitivities around the final outcome of discussions on these third country provisions, which remain far from clear.

TABLE 1

Fund Comments

Structure Potential scope of application of AIFM Directive*

Comments

Luxembourg FCP/SICAV/SICAF

EU AIF and AIFM – Directive applicable

A full passport to market within the EU is proposed to be available under both Council and Parliamentary drafts. These fund vehicles are already regulated in Luxembourg with well-established protocols and local regulator relationships and processes. A local service provider network is well established, with experience of working within a wider regulatory framework.

Guernsey/Jersey Unit Trust with offshore manager

Non-EU AIF and (typically) non-EU AIFM – Directive applicable to be able to market in EU countries (Parliament draft) or may be able to rely on current regime (Council draft)

to a form of passport to market within the EU is yet to be determined, and in any event likely to be subject to tough equivalency provisions. Guernsey and Jersey have co-operation agreements with a number of EU Member States therefore may expect to be able to meet this requirement in most cases. Regarding the specific compliance of the Channel Islands authorities with the proposed money laundering and terrorism standards in the draft Directive, it is expected that the Channel Islands authorities will seek to meet these 'equivalency' status requirements as soon as possible, however the practicalities of ensuring this are currently laborious. Reaching agreement on compliance and co-operation is currently done on a case by case basis for each Member State in which the AIF is to be marketed, however lobbying is under way to have this determined centrally.

Access English Limited Partnership ("ELP") with UK GP

EU AIF and AIFM – Directive applicable

A full passport to market within the EU is available under both Council and Parliamentary drafts. - Currently some 'light' regulation of the fund manager applies in the UK, but an ELP fund vehicle is not regulated and the impact may therefore be greater than for Luxembourg vehicles

*There remain questions as to how the AIFM of a given fund is identified, and where 'establishment' of an AIF is determined for the relevant purpose

Costs of compliance, contractual changes and administrative burden

The Directive will also present numerous practical difficulties in its specific application owing to its highly prescriptive approach; this may be further exacerbated on incorporation into local law. A few requirements of the draft Directive which our real estate fund clients are already discussing (and have in some cases been lobbying against) are summarised below in Table 2. There are concerns that the additional compliance burdens imposed by the Directive could be particularly onerous for start-up firms, and could even have the counter-productive longer term effect of reducing choice of manager for investors, and choice of service provider for fund managers.

TABLE 2

Issue

 

Comments

Custodian/ Depositary

requirements

Broadly speaking there is a requirement for each AIF to appoint an independent depositary, to whom liability for the safe-keeping of assets is delegated by the AIFM. This liability is generally not capable of being passed to third party service providers via delegation. This remains a point of some discussion and may cause significant additional costs for fund managers. At present, there is little use of depositary or custodian functions by real estate funds, other than in Luxembourg. The Parliamentary draft text offers exemption from the majority of the depositary requirements for real estate funds, which would be a welcome exclusion.

Disclosure requirements

The requirement to provide an annual report may not be materially more onerous than existing requirements and current best practice. Some notable points on the wider provisions include:

  • An obligation to report fixed and variable levels of remuneration.
  • Investors will need to be informed of any tasks delegated to third parties by the AIFM, including the identity of those third parties and any residual exposures this may present to investors.
  • Investors will need to be informed of the identity (EU Parliament draft) or the existence (EU Council draft) of any investor receiving preferential treatment such as a fee discount (and any connection with the AIFM – EU Parliament draft) and the nature of that arrangement.

 

Leverage restrictions

Both Council and Parliamentary drafts impose disclosure requirements, although these do not appear to exceed current best practice for real estate funds. No ex-ante caps on leverage are imposed (although previous draft texts did so). However information must be provided to local regulators, including key sources of leverage, and in turn to the new European Sales & Marketing Association (ESMA) oversight body. This would give each local regulatory body the discretionary power to impose limits on the leverage employed by any given AIFM, if systemic risks are identified.

Capital requirements

The AIFM must have a minimum of €125,000 in cash or assets readily convertible into cash (€300,000 for internally managed AIF), and where Assets Under Management (AUM) exceed €250million, an additional 0.02% of AUM must be held up to a maximum of €10million.

Exemptions

Council text excludes smaller fund managers based on AUM; for AIFM managing leveraged funds (i.e. most real estate funds) the AUM limit is €100million. The latest Parliamentary text has a number of partial exemptions for certain types of AIFM class rather than a de-minimis limit.

Remuneration

Both drafts have expanded since the original text to include significant additional regulation of the remuneration of AIFMs. Both envisage significant deferral of compensation to individual managers whose roles impact the risk profile of the AIFs they manage The Parliament draft includes more prescriptive rules on deferral and claw back, and is expressed to include carried interest (which appears to be scoped out of the Council draft). Whilst the principles of interest alignment and deferred compensation are quite usual for real estate fund managers, the degree of prescription will clearly require review and potentially some adjustment.

 

Conclusion

Previously tried and tested fund models and service provider structures may need to be reconsidered rigorously against the backdrop of the new regulation. The challenge lies in restructuring funds without losing benefits which may have taken years to fine tune, such as tax and VAT efficiency, transfer pricing equilibrium, investor familiarity and relationships with local authorities.

The additional burden of ensuring and monitoring compliance is also likely to have a cost impact, bringing into even greater focus the need for efficient management and performance fee and remuneration structures.

Assuming the Directive is finalised in, say, October 2010 (although this may be optimistic), it will become law in each Member State within two years, which is likely to mark the start date for the third country distribution rules, for example. AIFMs will need to have applied for authorisation within twelve months of this date. It may not yet be time to act, but it will be shortly

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.

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