ALTERNATIVE INVESTMENT FUND MANAGEMENT DIRECTIVE (AIFMD)

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1 ALTERNATIVE INVESTMENT FUND MANAGEMENT DIRECTIVE (AIFMD) CURRENT CHALLENGES DECEMBER 2014

2 1 AIFMD CURRENT CHALLENGES The AIFMD goes back to April 2009 when the European Commission proposed a Directive on Alternative Investment Fund Managers (AIFMs). The objective was to create a comprehensive regulatory and supervisory framework for AIFMs at a European level and to provide harmonised regulatory standards for all AIFMs within scope. Generally, the Directive aims to: Ensure all AIFMs are subject to appropriate authorisation and registration requirements. Provide a framework to monitor macro-prudential risks through regular reporting obligations. Ensure proper monitoring and limitation of microprudential risks. Develop a European single market for Alternative Investment Funds. The final agreement on the framework Directive (Level I) was signed in November 2010 and the text entered into force on 21 July On 22 July 2013 the Directive was transposed and a 12 month transitional period began. As of 22 July 2014 we are now under the full requirements of the AIFMD regime.

3 CURRENT CHALLENGES AIFMD 2 INITIAL AND ONGOING CONSIDERATIONS FOR AIFMS There are a number of operational challenges that AIFMs face under the new regime. We have set out a few of the key areas of focus for firms, highlighting some, if not all, of the requirements. 1 REMUNERATION Remuneration Code Full scope AIFM s are required to comply with a number of remuneration rules and principles contained within the Directive. These have been transposed into SYSC 19B AIFM Remuneration Code of the FCA handbook. Additionally ESMA and the FCA have published further guidelines on the code, and in particular, the application of proportionality. Remuneration policies of AIFMs must broadly promote sound and effective risk management and not encourage risk taking which is inconsistent with the risk profiles and rules of the AIFs they manage. Certain firms, who are significant in terms of size will be required to establish a remuneration committee, that will directly oversee all aspects of remuneration within the AIFM. The committee will need to be chaired by an independent non-executive member. For the purposes of AIFMD, remuneration consists of: All forms of payments or benefits paid by the AIFM Any amount paid by the AIF itself, including carried interest; and Any transfer of units or shares of the AIF. Code Staff The code applies to AIFM Remuneration Code Staff which includes those staff whose professional activities have a material impact on the risk profile of the AIFM or of the AIFs the AIFM manages. This includes senior management, risk takers, control functions, and any employees receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers. AIFMs will need to identify the members of staff who qualify as code staff and maintain an update to date list. Furthermore AIFM s will need to ensure that the remuneration policies and principles support the independence of their risk and compliance functions. Proportionality A key aspect of the remuneration code is the proportionality principle which means that not all AIFMs have to apply the remuneration requirements in the same way and to the same extent. In particular, the most stringent rules known as the Pay-out Process Rules may be disapplied to some extent and in certain circumstances. These rules include the deferral, performance adjustment, payment in instruments and post vesting retention of instruments around variable remuneration. Proportionality is assessed by reference to a firm s size, internal organisation, the nature, scope and complexity of its activities. A firm has responsibility for making this assessment and the FCA have published detailed guidelines on the factors and thresholds to consider. A firm must be able to explain the rationale for any rules that is has disapplied. However, there is a rebuttal presumption where a firm s AUM falls below certain thresholds, that the Pay-out rules can be disapplied. Furthermore, the pay-out rules will not generally apply to code staff whose variable remuneration is less than 33% of their total remuneration and if that total remuneration is less than 500,000. For full-scope AIFMs following a private equity strategy, carried interest is deemed to be remuneration under AIFMD, along with any transfer of units or shares in the AIF. In order to be defined as carried interest under the Directive, a share in the AIF s profits is paid to code staff as compensation for management of the AIF. A pro rata return on an individual s investment would not be deemed remuneration. One of the most important aspects of the FCA proportionality guidance is the confirmation that it may be regarded as disproportionate to apply the pay-out process rules to performance fees and carried interest provided that the particular structure satisfies objectives of alignment of interest with investors and avoids incentives for inappropriate risk taking. This can be the case even when the narrow criteria specified in part of the ESMA Guidelines are not met. Disclosure Certain disclosures will need to be made in the AIF s annual report, concerning remuneration, which must be made available no later than six months following the end of the AIF s year.

4 3 AIFMD CURRENT CHALLENGES INITIAL AND ONGOING CONSIDERATIONS FOR AIFMS 2 AIFMs are beginning to consider whether they have the appropriate mechanisms to produce the data that the regulator is asking for as part of the Article 3 and 24 reporting requirements. This includes reporting on the portfolio concentration, risk measures, liquidity profiles and leverage of alternative investment funds. This will be a whole new ball-game for some firms, in particular those in the private equity space who have not previously been subject to regulatory scrutiny. Similarly, non-uk AIFMs will be contending with the reporting obligations they will need to comply with under the NPPR where they will be required to report separately to each EEA member state regulator in which they market their AIFs. A huge amount of information will be required by the Annex IV reporting and for those accustomed to Form PF in the US, the AIFMD reporting goes further. Much of the required data to be produced for reporting will often be outside the fund s accounting and trading systems. While there is a significant amounts of static data that will be reported, there are several period specific data points, requiring calculations to be performed, many that are new and not part of typical day-to-day operations of a fund manager. For this reason, firms could find it particularly challenging when producing the report for the first time. The majority of the fields are mandatory, however some are conditional based on answers provided in other sections. Whilst some sections are not expected to apply to all clients, the level of detail required to be submitted in the form could prove challenging. Please note that after October 2014, it should also be submitted in XML format which will require the appropriate technical capability.. The Annex IV template should disclose essential information on the principal markets and instruments in which the AIFM trades on behalf of the managed fund, along with details of key instruments that are actively traded and principal exposures and concentrations for each AIF. The template includes the following key sections and data provisions: AIFM Data ANNEX IV REPORTING Identification of details of the AIFM Five principal markets and instruments traded on behalf of the managed fund Values of assets under management for all AIFs. AIF Data Identification of details of the AIF Breakdown of investment strategies and geographical focus Principal exposures and most important concentration Instruments traded and individual exposures Challenges of Annex IV reporting: AIFMs will need to identify what data is required, where it will come from and be able to validate the completeness and accuracy of data. The complexity of this exercise will be dependent on the strategy of the AIFM. Firms should also be aware that Annex IV reporting is not a Compliance only process and will need the involvement of front, middle and back office teams while also fitting this new reporting requirement in a alongside other regulatory reporting. 3 TRANSPARENCY & REPORTING AIFMD aims to increase the transparency of reporting relating to the AIF s risk profile in order to reduce system risk and increase investor protection. For this reason, AIFMD sets out transparency requirements for annual reports, disclosures to investors and reporting to regulators.

5 CURRENT CHALLENGES AIFMD 4 4 VALUATION 5 RISK MANAGEMENT The Directive aims to guide firms in creating policies and procedures that achieve appropriate independence for the valuation of assets. A written valuation policy, approved by senior management, should be in place, detailing methodologies for the independent valuation of all types of assets owned by the AIF(s). Any models used for valuation must be approved by senior management and adequately described in the policies and procedures. Valuations must be performed by either an external valuer, independent of the AIF/AIFM, or the AIFM itself, provided the function is independent of the portfolio management function. It is possible for the depositary to also act as the external valuer. However, it must have separate functions for the valuation and depositary functions. Where a firm chooses to perform valuation in-house, as will often be the case, there must be safeguards in place to ensure independence and prevent any conflicts of interest. Unlike the risk management requirement, the principle of proportionality cannot be invoked which will present a real challenge to small AIFMs. It is important to note that ultimate responsibility for oversight, the valuation policy, the calculation of NAV and the appointment of any external valuer sits with the AIFM. Where an external valuer is appointed then it will be necessary for the manager to evidence that appropriate due diligence processes have been followed in the selection process. One of the key tenants of the AIFMD is the requirement for the manager to establish a permanent and independent risk management function that is functionally and hierarchically segregated from the portfolio management function. While the FCA and the Level II text recognises the principle of proportionality, AIFMs will need to be able to demonstrate the independent performance of risk management through the use of safeguard against conflicts of interest, where necessary. The FCA has indicated that the same proportionality principles should be used as have been put in place under the remuneration rules. Under FUND UK AIFMs should that the performance of the risk management function is reviewed regularly by the internal audit function, or, if the latter has not been established, by an external party appointed by the governing body. Firms will also need to ensure that they have a comprehensive, documented risk management policy that is AIFMD compliant. That will require the policy to include, inter alia, a description of roles and responsibilities; safeguards for the independent functioning of risk management; tailored risk limits; systems and tools for the identification, measurement and monitoring of risks; and an identification of all the material risk that the AIF(s) are exposed to. The policy will need to be subject to regular review and approval by senior management. Good governance will also be an important ingredient for the risk management function. This will involve appropriate oversight of risk management by senior management, including appropriate delegations of authority, and appropriate reporting across the business. AIFMs may wish to establish a risk committee and a Chief Risk Officer to provide appropriate, independent management and oversight

6 5 AIFMD CURRENT CHALLENGES INITIAL AND ONGOING CONSIDERATIONS FOR AIFMS 6 CONDUCT OF BUSINESS: CONFLICTS OF INTEREST 8 CAPITAL REQUIREMENTS AIFMs will need to ensure that they have a documented, AIFMD compliant, conflicts of interest policy that outlines the procedures for record keeping as well as a description of how conflicts are identified, tracked, monitored and mitigated. Conflicts of interest may arise where activities have been delegated or sub-delegated, and where the Directive requires the independence of a business function, as identified with risk management and valuation, above. 7 DELEGATION & LETTER-BOX ENTITIES Under the Directive s Level II text, an AIFM has to perform, as a minimum, functions relating to either risk management or portfolio management. Any delegation must not result in the circumvention of the AIFM s responsibilities or liability, must not alter the AIFM s responsibilities towards the AIF and investors, must not undermine the authorisation conditions of the AIFM, and must be documented through a written agreement. The notion of a letter box entity and the test for its existence is covered in Article 82 of the Level II text. The AIFM should monitor any delegated arrangements and review services provided on an on-going basis. Where an AIFM intends to delegate functions to third party providers, it must notify the regulator and justify the delegation on an objective basis while the delegate must have sufficient resource, experience and sufficiently good repute to discharge the function adequately. The identification and management of conflicts of interest is an important tenant of the AIFMD and as such, AIFMs must be very careful to manage conflicts when it comes to delegation. The AIFMD sets out the requirement for a minimum level of initial capital at a fixed amount. There is then a further capital requirement of 0.02% of assets under management where AUM exceeds 250m but with a cap set at 10m. In order to manage professional liability risk, the firm will need to either insure against it or use further own funds. Firms should be aware of the FCA s guidance on the definition of fund under management for the purpose of Article 9(3), published earlier in the year. The definition is used to calculate the amount of additional own funds where the value of the portfolio of AIFs exceeds 250m. The FCA has revised its approach to allow derivatives to be valued at market value rather than requiring them to be converted to their underlying positions when calculating the value of the portfolios. 9 DEPOSITARIES It is necessary for firms to appoint a depositary where they are a full scope AIFM. There is no depositary requirement for firms that fall below the de minimus threshold exemption. The principal obligations of a depositary under the Directive are to safeguard financial instruments and other assets of the AIF; carry out monitoring and oversight of the AIF; and cashflow monitoring.

7 CURRENT CHALLENGES AIFMD 6 HOW CAN BDO HELP? BDO is able to assist with any concerns or questions you may have about how the AIFMD might affect your business. We can help firms to identify opportunities to create efficiencies and a competitive advantage in the market. There are a number of areas where the regulator will expect firms to have documentation in place that meets AIFMD requirements and BDO is well placed to advise on ensuring on-going compliance in these areas. They include: Regulatory gap analysis Governance & Controls gap analysis and assurance Annual report additional disclosures Remuneration disclosures Investor due diligence procedures Conflicts of interest policy Disclosures to investors Leverage and AuM calculations Liquidity and risk management policies Valuation policies and procedures Tax impact planning AIFMD compliance monitoring health check Our specialist AIFMD team offers an integrated multidisciplinary approach covering areas including advisory, tax and technology; deep knowledge of the fund management industry; and a proven track record of excellent client satisfaction. We have experience of managing the change programme to ensure compliance with AIFMD. For further information please visit the AIFMD pages on our website: Or contact: Michelle Carroll, Partner Tel: E: michelle.carroll@bdo.co.uk Felix Bottomley, Manager Tel: E: felix.bottomley@bdo.co.uk

8 FOR MORE INFORMATION: To discuss your requirements please contact: MICHELLE CARROLL Partner Financial Services t: +44(0) m: +44(0) e: This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO LLP to discuss these matters in the context of your particular circumstances. BDO LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it. BDO LLP, a UK limited liability partnership registered in England and Wales under number OC305127, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. A list of members' names is open to inspection at our registered office, 55 Baker Street, London W1U 7EU. BDO LLP is authorised and regulated by the Financial Conduct Authority to conduct investment business. BDO is the brand name of the BDO network and for each of the BDO Member Firms. BDO Northern Ireland, a partnership formed in and under the laws of Northern Ireland, is licensed to operate within the international BDO network of independent member firms BDO LLP. All rights reserved. HB07150

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