In The Great Crash 1929, John Kenneth Galbraith astutely observed: “It requires neither courage nor prescience to predict disaster. . . Historians rejoice in crucifying the false prophet of the millennium. They never dwell on the mistake of the man who wrongly predicted Armageddon.” It’s like the old definition of an economist, as someone who has predicted nine out the last five recessions...
Writing from Ireland, where we have recently, rather unfortunately, achieved our own worldwide 20 minutes of CNBC “doom and gloom” fame, it’s nice to see the naysayers vanquished from time to time. Last Friday (14 January), Intel announced a spanking new US$500 million investment in Ireland. This follows a highly successful 2010, which was the best year for inward investment into Ireland since 2003. Many of the world’s brightest and most successful new industry players from Google to LinkedIn to Facebook have established significant presences here in the past 24 months.
What has this to do with the Alternative Investment Fund Managers’ Directive, (AIFMD)? I suppose the relevance derives from a comparison with where we found ourselves this time last year. Readers of IFC Review 2010, some 12 months ago, will recall that the AIFMD was then still winding its tortuous way through the EU Council and Parliament and had been tossed back and forth as the Swedish, the Spanish, or the Belgian Presidencies had given it their mark, prior to facing the bull pit of a hostile European Parliament.
At the beginning of 2011 a lot has happened and in hedge fund land (at least from an Irish perspective) we can definitely look at the cloud that seems to have delivered more than a little sliver of silver lining. Recent statistics from Hedge Fund Research show that the proportion of the world’s 9,000 hedge funds domiciled in Ireland has doubled over the past year to 7.4 per cent. Assets held in Irish domiciled funds in total also hit a fresh high at €950 billion, surpassing the previous record from 2007 of €808 billion. Ireland is the domicile of choice for 63 per cent of all European domiciled hedge funds, according to the Irish Funds Industry Association (IFIA). There is no doubt that the drift of some promoters from traditional offshore locations to Ireland has been accelerated by the passage of the AIFMD. In the case of those who choose to leave their hedge funds domiciled in the more traditional centres such as Cayman, it seems as if the Irish administrators, who provide back office, transfer agency and NAV services to an estimated 40 per cent of the world’s hedge funds will also continue to prosper.
Approval of the AIFMD
As readers of IFC Review 2010 will recall, where we left the AIFMD was in a ‘trilogue’ process between the EU Council, the Commission and the Parliament. This process, which was intended to be finished by July 2010, dragged on a little longer. A compromise directive, which resulted from the trilogues was approved by the Parliament on 11 November and the EU Council of Ministers on 17 November 2010. This text will become the official version of the Directive, which is due to be published in the Official Journal of the European Union later in January 2011.
From publication date, Member States will have two years in which to transpose the Directive into national law. The preparation by the Commission of so called ‘implementing measures’, which will contain the detailed provisions and rules of the Directive will be critical. The AIFMD is one of the newer Lamfalussy directives, whereby the nitty gritty detail is applied at a higher EU level through ‘implementing measures’, thereby severely limiting the scope, that local Member State regulators previously had for some earlier investment management directives to apply some national tweaking.
What the Directive contains
The two main stated aims of the directive are:
From 2013 the AIFMD will require all EU based AIFM to obtain an authorisation to manage alternative investment funds (AIF), which are defined as any funds that are not UCITS. The authorisation will involve, inter alia:
An EU passport to market to professional investors will be available for EU AIFM and EU AIF immediately on implementation of the Directive in 2013. For non-EU managers and AIF a passport should be available from 2015. National private placement regimes will continue in parallel to the passporting regime at least until 2018, at which time a review of the effectiveness of the AIFMD passport regime is planned by the Commission.
The scope of the AIFMD is confined to entities managing AIF as a regular business, regardless of whether the AIF is open-ended, or closed-ended, of the legal form of the AIF, or of whether or not the AIF is listed. As explained above, the AIF is defined as any fund which is not a UCITS. There are certain exemptions and funds which are out of the scope of the AIFMD. Investment undertakings, such as family office vehicles, which do not raise external capital, are not considered to be AIF. The AIFMD does not apply to holding companies (as defined in Article 4 of the Directive), nor does not apply to, amongst other entities, securitisation special purpose vehicles.
There is also an important exemption from the Directive for certain managers, who manage “either directly or indirectly through a company with which the AIFM is linked by common management or control” funds with assets of:
This exemption may be of assistance for some smaller hedge funds, or private equity funds. However, it is not clear what happens when a fund meets one of these criteria on launch, but, as a result of positive returns subsequently breaks through the upper limit. The Commission is mandated to adopt measures to deal with occasional breaches of this limit.
Article 5(1) of the AIFMD provides that where the legal form of the AIF permits internal management and where the AIF’s governing body chooses not to appoint an external AIFM, the AIF may, itself, be authorised as an AIFM. This may open up the possibility of establishing self-managed AIFs in the same manner in which self-managed UCITS are established to comply with the requirements of the UCITS management company directive. If an AIF is self-managed and where the functions such as portfolio management are delegated, the delegate does not need to be an AIFM.
Article 19 – Valuation
The Directive aims to address certain fundamental issues which arose from the financial crisis. In particular, the AIFMD looks at the critical concept of ‘valuation independence’ from parties which are potentially conflicted. In addressing this issue, it should be recalled that most of the occasions where such problems have arisen in the past are not within the EU, which has a long established business tradition of third party independent valuation, but rather in the US, where ‘own valued’ hedge funds were the predominant model.
The Directive makes clear that it is the AIFM who is responsible for the proper valuation of the AIF. All fund assets must be valued at least yearly, but more frequently when this is appropriate to the dealing frequency and asset type of the fund. If the fund is closed-ended, such valuation must be carried out in the case of an increase or decrease of the capital of the AIF. Valuations of the AIFM itself, as opposed to those conducted by an external valuer, must be conducted in a way that is ‘functionally independent’ of portfolio management and in a way that conflicts of interest are mitigated.
Notwithstanding that the Directive attempts to bring ‘industry best practice’ to valuation, much of the language of the Directive continues to be problematic. There is a general consensus that a lot of work remains to be done on valuation, not least as it pertains to the delegation of functions. In this regard problems will arise with the requirement that external valuers will be able to “furnish sufficient professional guarantees to be able to perform the relevant valuation function”. The negotiation of the implementing measures will be critical here.
Article 21 - Depositary
The AIFMD introduces certain requirements regarding a Depositary to an AIF managed by an AIFM. Some of these requirements are detailed below.
A Depositary shall be either:
The Directive requires that the AIFM ensures the appointment of a single Depositary for each AIF it manages. A prime broker acting as counterparty to the AIF will not be permitted to act as Depositary, unless it has separated its prime broker and Depositary functions and any associated conflicts of interest are addressed.
Where, as is common for global custody, custody tasks are delegated to a third party, if there is a loss of financial instruments held in custody by a third party, the Depositary can discharge itself of its liability if it can prove:
Articles 32 to 40 – Third Country Issues
These articles have become very pertinent to those offshore locations, such as the Channel Islands, BVI, Cayman and Bermuda, which would wish to continue to be able to have their funds available for professional and institutional investors in the EU.
A delayed passport for non-EU funds and non-EU managers will come into effect two years after implementation of the AIFMD, around early 2015, in parallel with the retention of private placement regimes of Member States until 2018. The continuance of private placement beyond 2018 will be considered by the new European Securities and Markets Authority (ESMA) in 2017 and it will recommend continuation, or a gradual phasing out.
Below is a chart, which sets out broadly the provisions of the AIFMD under which AIFs may be marketed in the EU.
EU AIFM Non-EU AIFM
EU AIF European passport European passport
May market to professional May market to professional
Investors from implementation investors from early 2015
of AIFMD, (early 2013) provided in full
compliance with AIFMD, authorised by EU Member State and meets conditions including (a), (b) and (c) below.
National private placement regime National private placement regime
Not applicable as passport has May market to
immediate effect. professional investors provided in full compliance with AIFMD (including requirements for depositary function) and conditions (a), (b) and (c) below.
Non-EU AIF European passport European passport
May market to professional investors May market to
from early 2015 provided in full professional investors
compliance with AIFMD and each of the from early 2015 provided
conditions of (a), (b) and (c) below and in full compliance with
ESMA issues a positive opinion on AIFMD, authorised by a
passporting. Member State and both AIFM and AIF meet conditions including (a), (b) and (c) below and ESMA issues a positive opinion on passporting.
National private placement regime
May market to investors provided compliance with the annual report,
disclosure to investors and reporting obligations to national regulators. Where relevant, AIFM will also have to comply with the disclosure of acquisition of control, contents of annual report and asset stripping requirements of AIFMD and conditions (a) and (b) below. It is intended that national private placement regime will be phased out in early 2018.
Conditions (a) An appropriate co-operation agreement is put in place between
the competent authority of the AIFM’s home Member State or the Member State of reference (typically where the AIF is established) and the supervisory authority of the third country where the AIF/AIFM is established.
(b) The third country where the non-EU AIF/AIFM is established is not listed as a Non-Cooperative Country or Territory by the Financial Action Task Force on anti-money laundering and terrorist financing.
(c) The third country where the non-EU AIF/AIFM is established has signed a tax information sharing agreement with the competent authority of the AIFM’s home Member State or the Member State of reference and each competent authority where the AIF is proposed to be marketed.
Source, AIFMD Information Note, IFIA
Over the course of 2011, a period of secondary rule making will take place with ESMA, the successor to CESR, playing a key role in the drafting of legislation in many areas of the AIFMD. Work is also now commencing (see Ref. 4 below) on detailed Level 2 and Level 3 implementing measures on which extensive consultations are expected.
ESMA has identified and requested evidence and submissions on what it considers to be the key sub-headings of the Directive:
It is anticipated that the AIFMD will be transposed into national law and come into effect from early 2013. At this time, marketing passports are due to replace national private placement regimes for EU managers of EU funds.
From 2015, marketing passports are due to begin for third country non-EU AIFMs and non-EU AIFs. From this time, the third country passport will run in parallel to national private placement regimes until 2018, when national private placement regimes are to be phased out.
The introduction of a third country passport (and subsequent phasing out of the private placement regime) is conditional on a positive report by the new ESMA.
To say that all the above is complicated is something of an understatement. A large part of the reason for its complexity is undoubtedly the fact that the Directive started as a political project, sloppily drafted and encouraged by people who hadn’t the remotest clue about the industry they were seeking to regulate.
That the industry itself has had to attempt, (largely successfully to date), to reverse engineer some class of a horse out of the camel thus initially created speaks volumes about the creativity, persistence and ingenuity of the hedge fund industry. Unfortunately, we now have to gird out loins for the Level 2 and Level 3 consultations. While, we are not even at half time, one remains cautiously optimistic that the worst is behind us.
Additional references, sources
1. Fund News, November and December 2010 KPMG
2. AIFMD Information Note, November 2010 IFIA
3. FTfm, 17 January 2011 FT
4. Implementing measures on the AIFMD,
December 2010 CESR/ESMA
5. EU Directive on Alternative Investment Fund
Managers – impact on Cayman Islands and BVI,
November 2010 Maples and Calder
6. Update on AIFM Directive
Impact analysis for Jersey and Guernsey
Investment funds, November 2010 Ogier
Peter J. O’Dwyer is a business and financial consultant with a number of interests. He primarily specialises in providing bespoke advice to cross-frontier businesses, in particular to those involved in international investment funds, holding company structures and structured finance and to Governments and regulatory authorities. He is Managing Director and proprietor of Hainault Capital Limited, based in Ireland. He is a non-executive director of several private and public companies, including investment companies, mutual funds, energy, property and hedge funds domiciled in Ireland and the Cayman Islands for amongst others; HBOS, Barclays Capital, Citigroup and BNP Paribas. He is a former director of a Shari’a hedge fund and has lectured widely on the subject of Shari’a investment funds.