AIFMD 2014 Update private placements: where did we end up, and where are we going?

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1 SEPTEMBER 8, 2014 INVESTMENT FUNDS UPDATE AIFMD 2014 Update private placements: where did we end up, and where are we going? Introduction The European Union Alternative Investment Fund Managers Directive (AIFMD) was required to be implemented in EU Member States by July 22, The AIFMD contained a one-year transitional period within which EU alternative investment fund managers (AIFMs) could apply for authorisation under the AIFMD. Several EU Member States made this one-year transitional period available to non-eu AIFMs marketing their alternative investment funds (AIFs) in those Member States. The transitional period expired on July 21, This Update examines how non-eu AIFMs have, to date, addressed the issues relating to marketing of their AIFs in the EU under the AIFMD, including: the choices made by non-eu AIFMs; for example, whether to market their AIFs into the EU at all; the experience with the notification or registration process with EU Member State regulators for those AIFMs that have chosen to market their AIFs in the EU; the issue of reverse solicitation ; AIFMD platform solutions; and what is coming up in the next few years. For ease of reference, we have referred to non-eu AIFMs throughout this Update, but most of the issues discussed in this Update apply equally to EU AIFMs marketing non-eu AIFs through national private placement regimes (since the AIFMD marketing passport is not currently available in relation to non-eu AIFs). Please refer to our previous Update AIFMD 2014 Update Action Points for Non-EU Managers in for an analysis of the steps non-eu AIFMs should take if they wish to market their AIFs in the EU. Choices made by non-eu AIFMs In Sidley s experience, a fair percentage of large 2 non-eu (principally United States) AIFMs have decided to market their AIFs under the applicable national private placement regimes (NPPR) of the relevant EU Member For these purposes, those with assets under management (AuM) of US$4 billion and above. Sidley Austin provides this information as a service to clients and other friends for educational purposes only. It should not be construed or relied on as legal advice or to create a lawyer-client relationship. Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, ; One South Dearborn, Chicago, IL 60603, ; and 1501 K Street, N.W., Washington, D.C ,

2 Page 2 States (assuming that the relevant threshold conditions, including that of cooperation arrangements, had been met 3 ). However, some other large AIFMs have chosen not to do so, at least for the time being. This appears partly to be because, either the relevant AIFs are closed or soft-closed to new investors, or the non-eu AIFM does not have a significant EU investor base, or simply that the non-eu AIFM is well-known enough to EU investors that reverse solicitation is in fact how they attract capital from the EU. It would appear that the vast majority of smaller AIFMs (particularly those below US$1 billion in AuM) have decided, at least for the time being, to refrain from marketing actively in the EU altogether. The reasons range from a general lack of understanding of the individual NPPRs, the perceived complexity and cost, and the desire not to disclose staff remuneration (see below). Such managers would therefore be relying entirely on reverse solicitations from EU investors when accepting capital from the EU. Of the non-eu AIFMs (mostly from the United States) who have decided to market their AIFs under the relevant NPPRs, most have chosen to market only in four or five EU Member States; the most popular of these Member States have been the United Kingdom, the Netherlands, Finland and Sweden. This is principally because these Member States (along with some others such as Ireland, Luxembourg and Belgium) have decided to impose only the minimum AIFMD NPPR requirements (that is, disclosure to investors, regular reporting to regulators, the preparation of an annual report and certain asset stripping and notification requirements). 4 While other Member States such as Germany and, to a lesser extent, Denmark also have an AIF investor base, both Member States have, in addition to the AIFMD minimum requirements, also imposed a depositary-lite requirement (see discussion below). Some non-eu AIFMs have taken steps to market in these two Member States under their respective NPPRs, but in general most non-eu AIFMs appear not to be doing so, at least for the time being. Finally, certain other EU Member States which might otherwise have been attractive from a capital-raising perspective are in practice difficult, if not impossible, to market actively into, because: (i) the relevant cooperation arrangements are not in place for the relevant non-eu countries; or (ii) the local NPPR would effectively require that the non-eu AIFM be fully compliant with the AIFMD as implemented in that Member State; or (iii) the relevant AIF would have to satisfy certain conditions which would be impractical for the non- EU AIFM. Experience with the NPPR notification/registration process Because non-eu AIFMs can only, for the time being, market their AIFs under the relevant NPPRs, the process and rules by which the AIFs can be marketed are entirely a matter of local Member State law and process. In general, the United Kingdom appears to have the most straightforward process, involving the completion of a fairly simple spreadsheet and ing the same to the UK Financial Conduct Authority (FCA), after which marketing of the AIF can commence. 5 A fee of 250 is payable for each AIF notified. 3 As at the date of this Update, Member States such as Slovenia and Croatia have not entered into any MoUs at all; Member States such as Italy and Spain have not entered into MoUs with certain popular AIF domiciles such as the Cayman Islands or the British Virgin Islands. While Germany has entered into an MoU with the Cayman Islands, it has not entered into an MoU with either the BVI or the Bahamas. 4 These minimum AIFMD requirements are discussed in detail in our previous Update. 5 In practice, the FCA recommends that the non-aifm wait for an confirming the notification has been received and giving details on how the notification fee may be paid; this would typically be sent within 24 or 48 hours after ing the notification to the FCA.

3 Page 3 The notification process for the Netherlands also has been fairly straightforward, except that there is a specific set of questions to be answered, and some of the questions are slightly confusing in terms of the precise scope of the answers required. Helpfully, the Dutch process is similar to the UK s in that the non-eu AIFM can start marketing its AIFs upon sending the notification to the Dutch regulator. In the case of other Member States such as Sweden and Finland, the process is slightly more involved, insofar as it is necessary to provide more detail than the UK and the Netherlands, and the non-eu AIFM is required to wait for confirmation from the relevant regulator before it can start marketing its AIFs. This process can take a number of weeks. Depositary-lite As noted above, some Member States such as Germany and Denmark have imposed a depositary-lite requirement. This in effect means that the non-eu AIFM must appoint one or more entities to carry out the following functions in respect of the AIF being marketed: (i) custody of assets; (ii) cash monitoring; and (iii) general oversight. In general, depending on the service providers being used by the non-eu AIFM/AIF, it should be possible for the relevant prime broker to fulfil the custody function and the relevant administrator to fulfil the cash monitoring function, leaving only the general oversight function to be satisfied by either of those entities or, if those entities do not provide the service, for a new service provider to be appointed in respect of that function (with the attendant cost). Satisfying the minimum AIFMD requirements As noted above, the AIFMD requires that, at a minimum, each EU Member State must impose the following requirements on non-eu AIFMs marketing their AIFs in the EU: disclosure to investors; regular reporting to regulators; the preparation of an annual report; and certain asset stripping and notification requirements. Disclosure to investors In general, the preparation of a disclosure document typically as a supplement to the relevant AIF s existing offering memorandum has not been particularly complicated or expensive. However, non-eu AIFMs have had to get used to certain disclosure standards required under the AIFMD that may not have been the practice for the non-eu AIFM in the past. This includes the more detailed disclosure of preferential treatment (side-letter arrangements), the more detailed disclosure of brokerage relationships and, where relevant, the disclosure of leverage calculated in accordance with the specific methods set out in the main AIFMD Level 2 Regulation. Regular reporting to regulators As noted in our previous Update, the non-eu AIFM is required to file an Annex IV report on a regular basis to the regulator of each EU Member State in which its AIF is being marketed. The frequency of such reporting depends on the AuM of the non-eu AIFM: quarterly reporting where the AuM is above 1 billion (or for any individual AIF having an AuM of over 500 million), half yearly (for AuM below 1 billion) or annually in certain cases more relevant to the private equity sector. Different non-eu AIFMs have taken different approaches in relation to such reporting; some United States AIFMs who have prepared SEC Form PF internally are choosing to prepare the AIFMD Annex IV report

4 Page 4 internally also, while some are choosing to appoint a third party service provider to prepare and file both the Form PF and Annex IV report. The Annex IV report is in the format specified by the European Securities and Markets Authority (ESMA) and appears to be consistent throughout EU Member States. In the case of master-feeder structures, the non-eu AIFM is technically required only to complete the Annex IV report in relation to the feeder fund, and not also the master fund (since it is the feeder fund that is the AIF being marketed in the EU). However, ESMA has recommended that each EU Member State regulator also ask for certain information about the master fund. The UK FCA, for example, amended its rules on 1 July 2014 in order to specify such additional information. In any event, should a non-eu AIFM prepare such additional information for one regulator, it would be more simple administratively to provide such information to every other regulator of each Member State in which its AIFs are being marketed. Annual report of AIF As noted in our previous Update, the annual report for the AIF is required to be made available to EU investors and the relevant Member State regulators within six months of the end of the AIF s financial year. Apart from financial statements and a description of activities of the non-eu AIFM for that financial year, information about the aggregate remuneration paid by the non-eu AIFM to its staff is also required to be disclosed in the annual report. Although based on the same remuneration disclosure principles for banks and investment firms as set out in the EU Capital Requirements Directive (now in the new Capital Requirements Regulation), the type and scope of the disclosure in the AIFMD is not exactly the same. Asset stripping and notification requirements The asset stripping and notification requirements apply only in respect of AIFs investing in EU-incorporated companies (both listed and unlisted, although some requirements apply only to unlisted companies). The scope of these requirements is, in some cases, not entirely clear; for example, is an EU acquisition vehicle itself an EU unlisted company to which the asset stripping rules apply? It is hoped that EU regulators will provide some guidance over time. Reverse solicitation As noted above, some non-eu AIFMs have chosen not to market their AIFs at all to EU investors. The AIFMD defines marketing to mean a 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 to or with investors domiciled or with a registered office in the Union. Recital 70 of the AIFMD acknowledges that a professional investor established in the Union may invest in AIFs on its own initiative. That being the case, a non-eu AIFM that chooses not to market its AIFs on the basis of the NPPRs would have to be able to demonstrate that the relevant EU professional investor invested in the AIF at its own initiative. In practice, while it may be possible for a large, established AIFM that is well-known to the market to receive an approach from an EU investor in this manner, it is much more difficult for smaller AIFMs to do so. Different Member State regulators may have different views on what amounts to such a reverse solicitation. For example, the UK FCA has provided guidance that [a] confirmation from the investor that the offering or placement of units of shares of the AIF was made at its initiative, should normally be sufficient to demonstrate

5 Page 5 that this is the case, provided this is obtained before the offer or placement takes place. 6 The French AMF, however, has given far more restrictive guidance, requiring in effect that the investor must have specifically identified the relevant AIF into which that investor wishes to invest. Most other Member States have not provided any guidance on the issue. The inconsistent (or complete lack of) regulatory guidance across Member States means that, by its nature, reverse solicitation will need to be approached with great care. Among other things, a question is raised as to whether a general approach by an investor to a non-eu AIFM on the basis that it wishes to know more about the AIFM and its products is sufficient to amount to an investment at the investor s own initiative. There are also very practical problems that arise in relation to situations where the non-eu AIFM already has a number of contacts (either existing or potential investors) in the EU to which it might naturally think it should be able to continue a relationship. For example, to what extent may a non-eu AIFM discuss with such a contact an investment opportunity it has spotted, for which it is raising capital for a new fund? It is worth considering that the definition of marketing has also been interpreted and implemented differently across EU Member States. For example, the UK has taken the view that marketing takes place when a person makes AIF units or shares available for purchase by a potential investor; this implies that preliminary marketing material may not constitute marketing in the UK. However, other Member States such as France and the Netherlands appear to have taken a far broader interpretation of that term. The UK s narrow interpretation may be beneficial in certain respects; for example, a non-eu AIFM might be able to engage in some general pre-marketing activity in the UK without having to notify the FCA in accordance with the UK NPPR. However, if a UK investor is then interested in the relevant AIF, it is unclear to what extent the non-eu AIFM could claim that the investor invested on its own initiative. In addition, there are a number of structures involving intermediaries such as investment consultants or prime brokerage capital introduction services for which the analysis would depend very much on the particular circumstances at hand; one should not assume that reverse solicitation is necessarily the result of such arrangements. Finally, it is worth noting that in the text of the new Markets in Financial Instruments Directive (recast and revised as MiFID II ) there is in effect a provision dealing with what might be called reverse solicitation. MiFID II contemplates that a non-eu firm may provide investment service to an EU client (without authorisation/registration, etc.) where the EU client initiates at its own exclusive initiative the provision of the investment service or activity by the non-eu firm. The provision goes on to note that an initiative by such a client shall not entitle the non-eu firm to market new categories of investment product or investment service to that EU client. The wording in MiFID II gives an indication as to how EU regulators may approach the similar issue under the AIFMD. AIFMD platform solutions In response to the perceived difficulties faced by non-eu AIFMs in relation to marketing their AIFs in the EU, a number of EU service providers have started to offer certain platform-type solutions to such AIFMs. 6 The FCA notes, however, that AIFMs should not be able to rely on such confirmations if they have been obtained to circumvent the requirements of the AIFMD.

6 Page 6 For example, an EU service provider might establish an EU AIFM and have that AIFM apply for and obtain authorisation to manage an EU-domiciled AIF. An EU AIFM managing an EU AIF can market that AIF on the basis of the AIFMD pan-eu passport ; that is, the EU AIFM has the ability to market that AIF freely across the whole of the EU. That EU AIFM might then establish a sub-fund for which a non-eu manager is a delegate/submanager of the EU AIFM. That sub-fund would typically simply replicate the investment strategy of the relevant non-eu manager s own AIF. That EU AIFM would then market the non-eu manager s sub-fund/strategy to EU investors on the basis of the EU passport. It must be clear that the EU AIFM has the proper substance and is established so as to be able properly to monitor and supervise the portfolio management and risk management activities relating to the sub-funds; this requirement applies regardless of the number of sub-funds and types of investment strategies that may be carried out by the non-eu managers/delegates. This is because AIFMD requires that an AIFM may not delegate its functions to the extent that it becomes a letter-box entity. Apart from checking that the EU AIFM meets its AIFMD requirements, a non-eu manager/delegate on such a platform would need to be comfortable with the fact that its sub-fund is ultimately controlled by the EU AIFM, including during periods of market disruption (e.g., a Lehman-type failure). The non-eu manager/delegate would also need to consider the extent to which, in effect, it would end up having to comply with much of the AIFMD in any event. This is because the EU AIFM, in delegating investment management functions to the non-eu manager/delegate, would have to ensure that the non-eu manager/delegate manages the sub-fund in a manner that does not cause the EU AIFM to be in breach of the provisions of the AIFMD. Among other things, the non-eu manager/delegate might be required by the EU AIFM to: comply with the AIFMD remuneration restrictions, including the requirement that 50% of variable remuneration be paid in AIF units, the requirement that variable remuneration be deferred and the requirement that such remuneration may be clawed back in certain circumstances. Even if these particular restrictions are waived on the basis of proportionality, there are other AIFMD remuneration principles (e.g., relating to pension policy) that may be unpalatable to the non-eu manager; be responsible for providing all the information to the EU AIFM for purposes of the Annex IV report referred to above; have a process in place such that the EU AIF can comply with its obligations under the European Market Infrastructure Regulation (EMIR); and comply with prescriptive rules relating to investments in securitisations (including risk retention and due diligence requirements 7 ). What next? Passport for non-eu AIFs/AIFMs? The AIFMD contemplates that the pan-eu marketing passport may become available to non-eu AIFs and non- EU AIFMs. 7 See

7 Page 7 Article 67 of the AIFMD requires that, by July 22, 2015, ESMA shall issue to the European Parliament, the Council of the European Union and the European Commission: (i) an opinion on the functioning of the passport for EU AIFMs and on the functioning of the marketing of AIFs by non-eu AIFMs in the EU; and (ii) advice on the application of the passport to the marketing of non-eu AIFs by EU AIFMs and of AIFs by non-eu AIFMs in EU Member States. If ESMA issues a positive opinion and advice as contemplated above, the European Commission is to then activate the passport in relation to non-eu AIFs and non-eu AIFMs. There is no guarantee, however, that ESMA will issue a positive opinion/advice and that the European Commission will activate the passport provisions. Note that, as part of this process, the European Commission may also activate the requirement for non-eu AIFMs who manage EU AIFs to become fully authorised under the AIFMD (and thus obtain the passport). 8 It is possible that the NPPRs may be terminated by the European Commission at the end of 2018 (following a similar ESMA opinion/advice process), leaving the passport (and the attendant requirement to be fully authorised under the AIFMD) as the only option, but it is too early to tell at this stage what will happen (see AIFMD II below). Information requests by EU regulators? In connection with the delivery of ESMA s opinion and advice, ESMA has already given technical advice to the European Commission on the information that each EU Member State regulator should provide to ESMA in order for it to be able to deliver the opinion and advice. Among other things, ESMA proposes that each EU Member State regulator must provide: an indication of enforcement or supervisory actions or sanctions imposed on non-eu AIFMs in relation to their obligations under the relevant NPPR (i.e., disclosure to investors, regular reporting to regulators, etc.); the number of non-eu AIFMs that market AIFs in the relevant EU Member State in accordance with its NPPR, and the number of those AIFs; information about requests for information or assistance that the EU Member State regulator has submitted to non-eu authorities in accordance with the relevant AIFMD MoU; the number of on-site visits that the EU Member State regulator has performed at the premises of non-eu AIFMs in accordance with the AIFMD MoU; and the number of complaints addressed to the EU Member State regulator from investors in relation to non-eu AIFs marketed in the relevant EU Member State. Individual EU Member State regulators are required to provide the above information to ESMA every quarter. In order to gather the above information for purposes of reporting to ESMA, it is possible that Member State regulators will seek information about the marketing practices of non-eu AIFMs. As noted in our previous Update, one of the significant changes introduced by the AIFMD is that EU Member State regulators now have the ability, through the MoUs, to request for information and to conduct on-site visits directly on non-eu AIFMs. 8 See

8 Page 8 AIFMD II? The AIFMD contemplates that, by July 22, 2017, the European Commission shall start a review of various aspects of the AIFMD including the marketing of AIFs by non-eu AIFMs. This may result in a proposal for AIFMD II. Conclusion Now that July 22, 2014 has come and gone, and some non-eu AIFMs have taken their first steps to market their AIFs in the EU on the basis of the NPPRs, it remains to be seen whether other non-eu AIFMs will follow suit. On the whole, it does not appear that the NPPR processes have been particularly difficult or costly, when balanced with the potential risks associated with reverse solicitation. However, many non-eu AIFMs might simply decide to continue to stay away from capital-raising in the EU altogether. Time will tell. For further information regarding this Update please contact: Leonard Ng, Partner LNg@sidley.com Stephen Ross, Partner SRoss@sidley.com James Oussedik, Counsel JOussedik@sidley.com Sidley Investment Funds Practice Sidley has a premier, global practice in structuring and advising investment funds and advisers. We advise clients in the formation and operation of all types of alternative investment vehicles, including hedge funds, fund-of-funds, commodity pools, venture capital and private equity funds, private real estate funds and other public and private pooled investment vehicles. We also represent clients with respect to more traditional investment funds, such as closed-end and open-end registered investment companies (i.e., mutual funds) and exchange-traded funds (ETFs). Our advice covers the broad scope of legal and compliance issues that are faced by funds and their boards, as well as investment advisers to funds and other investment products and accounts, under the laws and regulations of the various jurisdictions in which they may operate. In particular, we advise our clients regarding complex federal and state laws and regulations governing securities, commodities, funds and advisers, including the Dodd-Frank Act, the Investment Company Act of 1940, the Investment Advisers Act of 1940, the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act, the USA PATRIOT Act and comparable laws in non-u.s. jurisdictions. Our practice group consists of approximately 120 lawyers in New York, Chicago, London, Hong Kong, Singapore, Shanghai, Tokyo, Los Angeles and San Francisco. To receive future copies of this and other Sidley updates via , please sign up at BEIJING BOSTON BRUSSELS CHICAGO DALLAS GENEVA HONG KONG HOUSTON LONDON LOS ANGELES NEW YORK PALO ALTO SAN FRANCISCO SHANGHAI SINGAPORE SYDNEY TOKYO WASHINGTON, D.C. Sidley Austin refers to Sidley Austin LLP and affiliated partnerships as explained at