AIFMD Investment Funds Briefing

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Tamsyn Webb
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1 Page 1 AIFMD Investment Funds Briefing 25 March 2013 Are you AIFMD ready? The Alternative Investment Fund Managers Directive (AIFMD) is due to be transposed into UK law on 22 July It heralds a period of enormous change for the fund management industry. The impact will be felt by all managers of non-ucits funds located in the EU as well as many non-eu managers marketing funds in the EU. Implementation of the AIFMD will change how alternative investment fund managers (AIFMs) operate their businesses, how they interact with third party service providers (through outsourcing), their depositary arrangements, their administration and the valuation of the assets that they manage. This Briefing (the first of two which we are publishing before AIFMD goes 'live' in the summer), summarises the key changes that AIFMD will bring. 1. What is the AIFMD? a refresher The AIFMD prescribes the new rules for the authorisation, ongoing operation and transparency of the managers of alternative investment funds (AIFs) marketed to professional investors in the European Union. The initiative forms part of the wider international drive to harmonise the regulation and supervision of the financial services industry and stem any systemic risk arising from the operation of alternative investment funds and in particular the leverage that they employ. The AIFMD (and the EU Delegated Regulation which accompanies it) will regulate the managers of any collective investment undertaking that is not a UCITS and which has activities in the EU. It will apply across all legal structures; whether open-ended or closed-ended, authorised, listed or unregulated. The rules will capture a wide range of UK vehicles, including non-ucits retail schemes (NURSs), onshore funds, qualified investor schemes (QISs), unauthorised unit trusts, charity funds, investment trusts, and specialist vehicles such as hedge funds, private equity funds, venture capital funds, listed funds and real estate funds. The AIFMD also introduces new requirements for firms acting as a trustee or a depositary of an AIF. AIFMs are legal persons whose regular business is managing one or more AIFs. AIFs are collective investment undertakings, including investment compartments thereof, which raise capital from a number of investors with a view to investing it in accordance with a defined investment policy, for the benefit of those investors and are not covered by the Directive on Undertakings for Collective Investments in Transferable Securities (UCITS). To implement the directive, HM Treasury will change the Regulated Activities Order and include 'Managing an AIF' and acting as a 'depositary of an AIF' as additional activities subject to regulation and supervision. The AIFMD will be implemented through a combination of HM Treasury Regulations and Rules made by the Financial Conduct Authority (the FCA). 2. When will AIFMD apply? EU AIFM The AIFMD comes into effect in the UK (and across the EU) on 22 July A UK firm that wishes to begin managing an AIF for the first time after 22 July 2013 will have to apply to the FCA for authorisation and be fully compliant with the requirements of the AIFMD before it can begin managing an AIF (irrespective of whether the AIF concerned is an EEA or non-eea AIF). A grandfathering provision allows a 12-month transitional period for EU AIFMs that manage AIFs prior to this date. This means that firms already carrying on the management of AIFs from an establishment in the UK will have until 21 July 2014 to be AIFMD compliant and by that date must have submitted an application for authorisation or registration to the FCA. The application process is likely to take three months.

2 Page 2 During the transitional period from 22 July 2013 to 21 July 2014, the FSA/FCA do not propose to make supervisory assessments of a firm's delegated arrangements until the firm applies for authorisation or variation of permission to become an AIFM. Non-EU AIFM A non-eu AIFM must become authorised under the AIFMD to manage EU AIFs or to market EU or non-eu AIFs in member states. However, this authorisation requirement will not apply until September 2015 (assuming that the European Commission adopts the legislation in this regard). Until September 2015, a non-eu AIFM will be permitted to manage EU AIFs and market AIFs in the EU in accordance with national private placement rules. When the AIF is marketed in the EU, the AIFM will need to comply with the AIFMD requirements relating to: (1) annual reports; (2) investor disclosure (in relation to EU investors) and regulatory reporting; and (3) AIFMs managing AIFs that acquire substantial stakes in EU companies (if relevant). The FSA has indicated that the private placement rules will be 'switched off' in 2018, after which time the only option for cross-border marketing will be the AIFMD passport. A number of States have already indicated their earlier intention to remove or amend their existing private placement regimes. We are watching the proposals in this regard very carefully. Time is short and the FSA and the HM Treasury consultations are still open on a number of areas where the rules remain unsettled. 3. Where must an AIFM become authorised? An EU AIFM must become authorised in its home member state (that is the member state in which it has its registered office) (Article 7(1)). A non-eu AIFM must become authorised in its member state of reference (Article 37(1)). 4. Scope: will AIFMD affect you? The AIFMD will apply to all managers of non-ucits funds operating in the EU, subject to a number of exceptions and defined financial thresholds, regardless of where the AIF is established. It therefore affects those managers where: its registered office is in the EU; or it manages an AIF which is authorised or registered in the EU; or where it markets any AIF (including non-eu AIF) to EU investors 5. The qualifying thresholds Outside the regime: AIFMD does not apply to AIFMs in so far as they manage AIFs whose only investors are the AIFMs themselves or their parent undertakings or the subsidiaries of the AIFM or other subsidiaries of those parent undertakings, provided that none of those investors is itself an AIF. 1 1 Article 3 of AIFMD.

3 Page 3 Registration of AIFs below the threshold: the AIFMD provides a lighter compliance regime where the 'assets under management' (defined by reference to the value of the assets that an investment company manages on behalf of investors) are either below 100 million or below 500 million where the assets under management are unleveraged and there are no redemption rights within a five-year period. The total value of assets under management must be calculated at least annually. Moreover, to ensure that the AIFM remains eligible to benefit from the lighter regime, it is required to put in place a procedure for monitoring the value of the assets under management on an ongoing basis. The first HM Treasury consultation paper and the latest consultation paper released by the FSA last week explain that their intention is to have three categories of 'sub-threshold' manager: 1) managers of authorised funds which will be subject to existing regulatory requirements and the majority of the new AIFMD requirements; 2) managers of UCIS and external managers appointed by AIFs that are not collective investments schemes, which will be subject to existing regulatory requirements but will have limited additional obligations under AIFMD, mainly relating to reporting; and 3) internally managed closed-ended investment companies (where the company is its own AIFM), which will be subject to the registration only regime under FSMA, in addition to any obligations that they have as a result of being UK listed (where they are). The first two categories will be authorised under FSMA, the third will not. Authorised persons will need to obtain a Part 4A permission to manage an AIF. All three categories will be regarded as 'registered' under AIFMD. HM Treasury intends to treat sub-threshold AIFMs of UK authorised funds as generally being subject to the same requirements as full scope UK AIFMs, but to disapply the specific requirements of the Level 1 AIFMD and the Delegated Regulation on: the assessment of what constitutes a 'letterbox entity' when an AIFM delegates its functions; remuneration of individuals; and transparency (pre-sale information, periodic reporting to investors and reporting to the FCA and other competent authorities). These 'sub threshold' AIFMs must register with the regulator in their home state and file information regarding the main instruments in which they are trading. If their position changes and they move above the threshold, they are obliged to notify the regulator. The Treasury has decided that the FSA approved persons regime should not apply to sub-threshold AIFMs and full scope UK AIFMs that are internally-managed closed-ended investment companies. There is an 'opt in' procedure where an AIFM falls below the threshold but wishes to be fully authorised, for example to benefit from the AIFMD marketing passport. Above the threshold: an AIFM within the scope of AIFMD and above the minimum threshold must obtain full authorisation from their domestic regulator. In the UK, AIFMs will be subject to both conduct and prudential regulation by the FCA. 6. Calculating assets under management The AIFMD and the Delegated Regulation establish the formula and procedure to be followed when calculating the assets under management as well as the methodology to be applied in respect of specific categories of assets.

4 Page 4 7. Exemptions A number of activities are specifically excluded from the scope of AIFMD. These include family investment vehicles, holding companies, certain occupational retirement vehicles, central banks, national, regional and local governments, bodies or other institutions which manage funds supporting social security and pension or employee participation schemes and securitisation special purpose entities. 8. Externally managed/self-managed AIFs Each AIF must have a single AIFM which will be responsible for compliance with the Directive. An AIF may be internally (effectively 'self' managed) or externally managed and the relevant requirements under the AIFMD differ in some cases depending on whether the AIF is internally or externally managed. An external AIF is a legal person (outside the AIF) appointed by the AIF to manage it. 9. Key regulatory requirements the headlines In order to become and remain authorised, AIFMs which are within the scope of AIFMD and above the threshold will be obliged to comply with detailed regulatory requirements the substance of which are as follows: 9.1 minimum regulatory capital - an AIFM which is an internally managed AIF must have an initial regulatory capital of at least 300,000. Where an AIFM is an external manager of an AIF, the AIFM is required to have initial capital of at least 125,000; 9.2 additional capital - where the value of the managed portfolios exceeds 250 million, the AIFM is required to hold additional capital as a function of the value of the AIF portfolios they manage (0.2% of assets under management subject to a cap); 9.3 professional indemnity insurance or additional own funds - AIFMs are required to hold a third layer of capital able to absorb losses arising from their operation in the form of additional own funds or professional indemnity insurance. The amount required is calculated as a percentage of the AIF managed; 9.4 organisational requirements - including general high-level governance, conduct of business, conflicts of interest policies, fair treatment of investors, complaints handling, internal audit and electronic data; 9.5 approved persons regime - the FSA applies an 'approved persons' regime to individuals carrying out 'controlled functions' within authorised firms, including fund managers. The latest HM Treasury Consultation Paper proposes that the approved persons regime will not apply to internally managed investment companies (both above and below the threshold) but will apply to external managers of investment funds (both above and below the threshold); 9.6 remuneration policies and practices - a remuneration code is required for senior management, risk takers, employees performing controlled functions and any employees having comparable remuneration to senior staff; 9.7 delegation - the AIFMD allows AIFMs to delegate the performance of some of their functions in order, effectively, to make the conduct of their business more efficient. The AIFM has at least to keep the decisionmaking functions (its primary business role). It therefore must perform at least functions relating to either risk or portfolio management. The delegation must be supervised on an ongoing basis and, crucially, must not result in the delegation of senior management responsibility; 9.8 letter box entity - delegation by an AIFM must not be such that the AIFM could be described as a 'letter box entity'. This would be the case where an AIFM fails to retain the necessary resources and expertise to supervise the delegation and manage the risk and/or where the AIFM no longer retains the power to make decisions in key areas. The FSA has indicated that it proposes to take a proportionate supervisory assessment on whether a proposed delegation would lead to a 'letter box entity' and make a 'qualitative rather than quantitative' assessment;

5 Page valuation rules and procedures - for each AIF that they manage, the AIFM must ensure that appropriate and consistent valuation procedures are established so that a proper and independent valuation of the assets can be performed at least annually. Where the valuation function is performed by the AIFM itself, the valuer must be independent from the portfolio management and the remuneration policy. Article 19 of AIFMD sets out how assets must be valued. Valuation methods will vary according to the type of assets held; 9.10 an appropriate liquidity management system - AIFMs must be able to demonstrate to the regulator that an appropriate liquidity management system and effective procedures are in place taking into account the investment strategy, the liquidity profile and the redemption policy of each AIF; 9.11 leverage - leverage is a key concept in the AIFMD. The AIFMD provides a definition of leverage in order to ensure that the effect of leverage is properly taken into account in the activities of AIFM and their supervision. Leverage is defined (article 4 of the AIFMD as any method by which the AIFM increases the exposure of an AIF it manages whether through borrowing of cash or securities, or leverage embedded in derivative positions or by any other means). The AIFMD makes the use of leverage subject to several obligations. For example, the AIFM has to report figures on leverage to investors and supervisory authorities, it has to set out the policy with regard to leverage when applying for authorisation and it has to set a maximum level of leverage which it may employ on behalf of each AIF it manages. The Delegated Regulation contains detailed rules as to the calculation of assets under management and leverage (the so-called 'gross' and 'commitment' methods). The gross method gives the overall exposure of the AIF whereas the commitment method is intended to give insight as to the hedging and netting techniques used by the fund manager; 9.12 liquidity - AIFMs are required by the AIFMD, for each AIF that they manage which is not an unleveraged closed-ended AIF, to employ an appropriate liquidity management system and adopt procedures which enable them to monitor the liquidity and ensure that the liquidity profile of the investments of the AIF complies with its underlying obligations; 9.13 transparency obligations one of the main objectives of the AIFMD is to increase the transparency for investors and supervisory authorities. Minimum reporting requirements are introduced as to the timing and contents of reports and information disclosed to investors; 9.14 depositary - the assets of the AIF must be transferred to a depositary for safe keeping. The AIFMD provides that the AIFM must appoint a single depositary in respect of each AIF it manages. The depositary must be a credit institution, an investment firm or other entity permitted under the AIFM Directive. In the case of an EU AIF, the depositary must be located in the home member state of the AIF. To implement the AIFMD, HM Treasury (as set out in its January 2013 consultation document) intends to make changes to the Regulated Activities Order including the creation of a new regulated activity of acting as trustee or depositary of an AIF. Transitional provisions in the AIFMD allow the competent regulators of a home state to permit credit institutions that were established in another member state to be the appointed depositary until 22 July With respect to non-eu AIFs, the only entities that qualify as depositaries under AIFMD are the third country (i.e. non-eu) equivalents of credit institutions of a MiFID investment firm; 9.15 passporting the AIFMD introduces new EU wide passports for authorised full scope AIFMs to market funds to professional investors throughout the EU. With effect from 22 July 2013, each EU AIFM wishing to passport will need to be fully compliant with the obligations in the Directive. Provided they do so, they will be able to passport. From 22 July 2013, the FCA will have just three months in which to determine completed passporting applications for UK full scope AIFMD (that is by 22 October 2013). With that short time frame in mind, the FSA has invited firms who need to be authorised to enable passporting from 22 July 2013, to register their interest now by completing the AIFMD Regulatory Survey which it launched on 11 March We are waiting with interest for the FSA/FCA's finalised rules in this regard.

6 Page 6 Marketing and management passports will not be available to non-eea managers of AIFs or to EEA managers in respect of their non-eea AIFs until 2015 (subject to ESMA reports and Commission delegated acts). Marketing of such funds to professional investors will continue to be allowed under national private placement regimes although the intention is that the private placement regime will be phased out by 2018 (subject to the EU passporting system working effectively by then). 10. 'Managing' who is the AIFM? Key to AIFMD is establishing who the manager of a fund is. For the AIFMD, 'managing' means performing at least investment management functions. These are described in Annex I to the AIFMD as (i) portfolio management; and (ii) risk management. The AIFMD permits AIFs to undertake 'non-core' services (set out in Annex I to the AIFMD). These include: a) administration for example legal and fund management accounting services, valuation and pricing; b) marketing direct or indirect offerings or placements at the initiative of the AIFM; c) activities related to the assets of the AIF and the companies and other assets in which it has invested (for example real estate administration). 11. Depositary Under AIFMD, depositaries 'systemically important' (this will include for example the major banks) in which case they will be prudentially regulated by the Prudential Regulation Authority (the PRA). Other (smaller) depositaries will be regulated by the FCA. The Delegated Regulation contains detailed rules as to the rights and obligations by which they will be bound. 12. Treatment of particular fund types under AIFMD - specialised regimes The provisions of the AIFMD will apply to all types of alternative investment funds and the rules do not differentiate between, for example, common investment funds' and private equity funds, non-ucits retail schemes (NURSs), onshore funds qualified investor schemes (QISs), unauthorised unit trusts, investment trusts, and specialist vehicles such as hedge funds. That said, the AIFMD does provide for the different application of the rules in a limited number of cases: a) Open-ended or closed-ended investment schemes the rules make a distinction with regard to liquidity management, the valuation of assets and transitional provisions; b) Internally-managed versus externally-managed AIFs - Article 9 imposes different initial capital requirements; c) AIFMs that are significant in terms of their size or the size of the AIFs they manage, their internal organisation and the nature, the scope and the complexity of their activities - are required to establish a remuneration committee (Article 13 (by reference to Annex II, paragraph 3)). d) Where the AIFM on behalf of an AIF uses the services of a prime broker - Article 14 applies specific requirements in relation to conflicts of interest management. e) Common investment funds (CIFs) and common deposit funds (CDFs) CIFs and CDFs are funds established under charities legislation which allow charities to pool their funds and gain access to more diversified investments, while benefiting from charitable tax reliefs and exemptions. In order to support CIFs and CDFs with the transition to AIFMD, the Charity Commission will provide an updated model scheme on its website shortly. The UK government's analysis (reported in the latest HM Treasury consultation) is that church funds are outside AIFMD because they do not raise external capital and the funds are not managed as a regular business.

7 Page Marketing to retail investors The AIFMD gives member states the discretion to permit selective marketing to retail investors and to impose greater restrictions on such activity than those for marketing to professional investors. AIFMD defines 'professional investor' as an investor which is considered to be a professional client or may, on request, be treated as a professional client within the meaning of Annex II of the MiFID directive. AIFMD defines 'retail investor' as an investor who is not a professional investor. 14. Concluding remarks Clearly AIFMs have a huge amount to think about in the run-up to AIFMD. In particular how you structure and market your business going forward and tackle the regulatory burden. If you are a UK full scope investment company you need to look at who is going to be your depositary. We are all awaiting the outcome of the latest HM Treasury and FCA consultations and the final text of the rules that will apply as a result of the implementation of AIFMD. The FSA/FCAs proposals on the regulation of sub-threshold AIFMs are clearly of great interest and the sooner the rules are settled, the better. Unless you are planning to use the cross-border marketing passport, there seems to be little if any 'first mover' advantage. That said, clearly with the focus now on domestic implementation, it is now the time for detailed analysis of the impact of AIFMD on your business. In our June Briefing we will update you as to the outcome of the open consultations and consider the structuring implications that follow from the implementation of the AIFMD in the UK. If you require further information on anything covered in this briefing please contact Grania Baird or you usual contact at the firm on This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances. Farrer & Co LLP, March 2013

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