International Accounting Standards Board 30 Cannon Street LONDON EC4M 6XH United Kingdom Brussels, 5 January 2012 Re.: EXPOSURE DRAFT ED/2011/4 INVESTMENT ENTITIES Dear members of the International Accounting Standards Board, The European Fund and Asset Management Association appreciates the opportunity to comment on your Exposure Draft Investment Entities (the ED ) as issued on 25 August 2011. EFAMA is the representative association for the European investment management industry. It represents through its 26 member associations and 56 corporate members approximately EUR 13.8 trillion in assets under management, of which EUR 7.7 trillion was managed by approximately 54,000 funds at end September 2011. Just over 36,000 of these funds were UCITS (Undertakings for Collective Investments in Transferable Securities) funds. We welcome the Board s proposal to recognise the unique nature of investment entities, which is essential in order to make available to such entities a higher quality and more relevant financial reporting framework that will be of great benefit to investors. We understand that creating such an exception is a significant step for the Board and we commend you for proceeding with this proposal. However, we believe that in defining the proposed disclosure requirements the Board has missed the opportunity to enhance financial instruments risk disclosures and we recommend that the Board should develop some additional specific disclosure requirements that reflect the specialised nature of investment entities. We expand on this point in our response to question 7. The Board has made tremendous progress towards global application of a single set of high quality reporting standards. Europe played a pivotal role in this evolution by mandating in 2005 the use of IFRS for the preparation of the consolidated financial statements of publicly traded companies. In doing so Europe identified that a harmonised financial reporting framework was essential to the efficient and cost effective functioning of capital markets. As investors in capital markets, our members clients are the beneficiaries of the globalisation of IFRS. rue Montoyer 47, B 1000 Bruxelles +32 2 513 39 69 Fax +32 2 513 26 43 e mail : info@efama.org www.efama.org
EFAMA IFRS Investment Entity ED_response In general, companies use capital markets to raise funds to finance their operations. Investors use capital markets to invest in such companies and rely on financial statements in order to assess the prospects of those companies. For example, an investor might identify future growth potential in global demand for, say, smart phones and decide to seek out a smart phone manufacturer in which to invest. Their decision might be based on research that suggests that a particular company has the requisite skills and resources to enhance their share of the global smart phone market. The investor can increase his holding in the smart phone manufacturer in order to establish control. In this sense the investor could be regarded as a smart phone manufacturer once control is established. In contrast an investor in an investment entity is a customer of a fund management company. Such an investor might not have the ability, inclination or resource to make economic decisions about which companies to invest in. Instead they contribute their capital, along with other investors, and the fund manager makes the economic decisions about how to deploy the capital raised. In this sense the investor s decision is based on their appetite for risk (defined by the investment strategy) and the fund manager s credentials (investment performance record). The fund manager will place their customers contributions into a segregated investment entity and will invest it on a collective basis in accordance with an investment strategy with the aim of maximising benefits to those customers. The fund manager might increase the investment entity s holding in a smart phone manufacturer, in order to benefit from capital appreciation, investment income, or both, but never in order to become a smart phone manufacturer. The investor in an investment entity will expect the fund manager to account for his stewardship of the contributions made to the investment entity and the evolution of the value of those contributions. The investor will be interested to know the financial results of the investment entity and how those results have been achieved; that is, how his contributions have been deployed, the amount of risk taken and whether these have remained consistent with the investment strategy. It is therefore essential the financial results reflect the changes in fair value of the investment entity s holdings, regardless of whether any of those holdings qualify as affiliates, associates or joint ventures. It is also essential that the financial instruments disclosures are relevant to the economic decisions of the investor rather than the fund manager. In the appendix to this letter we have included our responses to your detailed questions. We hope that our comments will be considered by the IASB in finalising its proposals. Our comments have been prepared by an EFAMA working group, chaired by Mr. Thierry Blondeau and Mr. Hans Janssen Daalen. Of course EFAMA will be happy to discuss our comments with you. Yours sincerely, Peter de Proft Director General EFAMA 2
Question 1 Exclusion of investment entities from consolidation Do you agree that there is a class of entities, commonly thought of as an investment entity in nature, that should not consolidate controlled entities and instead measure them at fair value through profit or loss? Why or why not? Yes, we agree. It is essential to recognise the unique nature of investment entities in this way. Investment entities are a special type of vehicle that exist solely for the purpose of allowing investors to pool their contributions in order to receive benefits in proportion to their contributions from the investment of those contributions in accordance with a defined investment strategy. Investors realise their share of the benefits in the form of a return of their contributions together with a proportionate share of any capital appreciation, investment income, or both. Therefore the most useful information to enable investors to understand the performance of their investment is the change in its fair value. An advantage of collective investment is that it allows investors to access the services of professional fund managers and to achieve a level of risk diversification that would otherwise be unattainable. In selecting a particular investment vehicle an investor accepts a level of risk, which is understood prior to the contribution being made through access to regulatory documentation such as a prospectus or other pre investment literature. The role of the fund manager is to execute the agreed investment strategy with a view to maximising the fair value of the investments within the established risk parameters. The fund manager manages the portfolio of investments and evaluates its performance on a fair value basis. In order to understand the significance of the fund manager s investment decisions, investors need to be able to compare the fair value of investments measured on a consistent basis regardless of whether the investee meets the definition of a controlled entity in IFRS 10 or qualifies as an associate or joint venture. Consolidation of some investments does not allow a consistent comparison across all of the investments held by the entity. Question 2 Criteria for determining when an entity is an investment entity Do you agree that the criteria in this exposure draft are appropriate to identify entities that should be required to measure their investments in controlled entities at fair value through profit or loss? If not, what alternative criteria would you propose, and why are those criteria more appropriate? Overall we agree the criteria are appropriate, subject to our comments in relation to specific criteria in response to questions 3 and 4. We welcome the recognition of master feeder arrangements in paragraphs B4 and B16 and in example 4. We note that the Board describes this situation as the feeder being formed (for legal, regulatory, tax or other business reasons) in conjunction with the master. We do not know the Board s intention in using the words in conjunction with but we are concerned that these words imply that the master and the feeder(s) are required to be formed at the same time. This is often not the case: a fund manager of a master might add a new feeder each time they expand their 3
marketing activities into new geographical markets or to new categories of investor. There might be many years between the formation of the master and the feeder(s). Equally a fund manager might close a feeder in a market with little or no demand but continue to market the master through other feeders in other markets. We recommend that the Board replace the phrase in paragraph B4 if the entity is formed (for legal, regulatory, tax or other business reasons) in conjunction with another investment entity that holds multiple investments with the phrase if (for legal, regulator, tax or other business reasons) the entity is dedicated to investment in a single investment entity that holds multiple investments. Paragraph B9 requires an investment entity to have a documented exit strategy. We are concerned that it is appropriate for a feeder to be able to rely on the exit strategy of a master when assessing the business purpose criterion. Therefore we recommend that the Board clarifies the exit strategy aspect of this criterion using the approach in paragraph B4, amended as we propose above. Question 3 Nature of the investment activity Should an entity still be eligible to qualify as an investment entity if it provides (or holds an investment in an entity that provides) services that relate to: (a) its own investment activities? (b) the investment activities of entities other than the reporting entity? Why or why not? A self managed investment entity, as envisaged in paragraph B2 and question 3(a), should qualify as an investment entity. There is no difference in the substance of an arrangement whereby an external fund manager is paid a management fee by an investment entity and an arrangement whereby an investment entity employs its own resources (either by hiring staff or by owning a dedicated fund management company) to carry out fund management activities. Investors interest in the results of the investment entity is the same regardless of the organisational structure of the investment entity and the fund manager. We agree that where such a self managed investment entity controls a dedicated fund management company, it is appropriate for the investment entity to consolidate that fund management company. However, we have no comment in relation to the circumstances envisaged in question 3(b). Question 4 Pooling of funds (a) Should an entity with a single investor unrelated to the fund manager be eligible to qualify as an investment entity? Why or why not? (b) If yes, please describe any structures/examples that in your view should meet this criterion and how you would propose to address the concerns raised by the Board in paragraph BC16. Yes, an entity with a single unrelated investor should be eligible to qualify as an investment entity. Indeed there are circumstances when otherwise legitimate investment entities might not have any unrelated investors. This would occur, for example, when a new investment entity is launched and a 4
related entity (another company, such as an insurance company, in the same group as the fund manager), or the fund manager itself, provides the initial starting capital ( seed capital ). The fund manager will actively market the investment entity with the aim of attracting investors. Alternatively the fund manager may manage the investment entity for a certain period of time in order to build up a performance track record before actively marketing it. Where the investment entity is aimed at large institutional investors, the process of securing contributions to the investment entity can take a significant period of time; a timescale of years rather than months is not uncommon. Where the investment entity is aimed at small retail investors, the investment process may be much quicker; however it might well take a considerable period of time to build up a track record and to attract a significant unrelated ownership of the investment entity. Moreover, even where no seed capital is involved, some entities could have a single investor that can demonstrate through its intentions and activities that it represents or supports the interests of a wider group of unrelated investment beneficiaries (e.g. Pension Fund, Charity, Life Fund, Nominee, etc). Again, for this type of entity, the fair value is the most relevant basis to assess the performance of the investments. In addition, entities dedicated to a single investor may be managed in a similar way to an entity held by multiple investors and thus, such entities should be eligible to account for their investments at fair value as this best represents the way the investments are managed. Such dedicated entities are often used by large institutional investors in order: to benefit from a specific investment strategy with specific investment limits; to negotiate their own fees; and to avoid their performance being impacted by non expected redemptions from other investors. The key notion in that case is that these entities are managed by a professional investment manager and the investor is not involved in the investment decisions after the set up of the entity. We agree with the Board that some measures have to be implemented in order to prevent abuses. We think that these measures should relate to the way the entity functions instead of the way it is structured. To avoid misuse of the exemption, entities with a single investor should meet all of following criteria in addition to the general criteria defined in the exposure draft: the entity does not hold significant investments in any instrument issued by the single investor or any other company that is a related party (IAS 24 definition should apply); the entity s activity is limited to investment in financial instruments which are not of a strategic nature for its investor; the investor only enjoys the benefits or bears the risks, directly or indirectly, that are usually associated with a portfolio of financial instruments and are proportional to the holding; the entity has no financial liabilities or other commitments other than those resulting from its ordinary business; the entity is managed by a professional asset manager. 5
We think that these measures will be sufficient to distinguish genuine investment entities from other special purpose vehicles. We ask the IASB to reconsider this topic to align with the current practises in the investment fund industry. Question 5 Measurement guidance Do you agree that investment entities that hold investment properties should be required to apply the fair value model in IAS 40, and do you agree that the measurement guidance otherwise proposed in the exposure draft need apply only to financial assets, as defined in IFRS 9 and IAS 39 Financial Instruments: Recognition and Measurement? Why or why not? We do not agree that entities that invest in real estate should be eligible to qualify as investment entities for the purpose of this exposure draft. For a variety of legal and tax reasons it is very common for real estate to be held in a special purpose vehicle that is wholly owned by the reporting entity. Such arrangements can be structured in a number of ways involving debt and equity. The investment entity exemption would give the reporting entity the appearance of investing in these financial instruments. Therefore, it is more appropriate in the case of real estate to consolidate the special purpose vehicles. Question 6 Accounting in the consolidated financial statements of a non investment entity parent Do you agree that the parent of an investment entity that is not itself an investment entity should be required to consolidate all of its controlled entities including those it holds through subsidiaries that are investment entities? If not, why not and how would you propose to address the Board s concerns? No. If it is more relevant for the activities of an investment entity to be presented on a fair value basis rather than as consolidated financial statements, then we consider that it will also be more relevant for the investment entity s parent to present the investment entity s assets on a fair value basis. We recommend that the Board considers allowing the investment entity exemption to apply to noninvestment entity parents of investment entities where the accounting for the participation of the parent entity is most usefully presented on a fair value basis. Such a circumstance may exist if the entity is managed on a fair value basis and only with the view to provide investment opportunities for investors. In order to apply the exemption at the parent company level and to avoid abuse, the Board may consider additional criteria that limit the application of the exemption at the parent entity level: the investment entity does not hold significant investments in any instrument issued by the parent entity or any other company that is a related party (IAS 24 definition should apply); the investment entity s activity is limited to investments in financial instruments which are not of a strategic nature for its parent; 6
the parent entity only enjoys the benefits or bears the risks, directly or indirectly, that are usually associated with a portfolio of financial instruments and are proportional to the holding; the investment entity has no financial liabilities or other commitments other than those resulting from its ordinary business; the investment entity is managed by a professional asset manager. In addition, unlike the IASB s view, we believe that a significant number of investment entities do have non investment entity parents and therefore once more we recommend that the IASB reconsiders this topic. Question 7 Disclosure (a) Do you agree that it is appropriate to use this disclosure objective for investment entities rather than including additional specific disclosure requirements? (b) Do you agree with the proposed application guidance on information that could satisfy the disclosure objective? If not, why not and what would you propose instead? It is appropriate to use a disclosure objective that is specific to investment entities and not simply to rely on the objectives of IFRS 7. Although these are similar, the objective in paragraph 9 of the exposure draft is more appropriate because it recognises that investment entities can invest in assets other than financial instruments, for example commodities. However, by not including specific disclosure requirements, the Board is missing the opportunity to fine tune the IFRS 7 disclosures applicable to investment entities. We recommend that, in addition to the disclosure objective, the Board should include some investment entity specific disclosure requirements. Investors in investment entities contribute capital, along with other investors, and a fund manager makes the economic decisions about how to deploy the capital raised. In this sense the investor s decision is based on their appetite for risk (defined by an investment strategy) and the fund manager s credentials (investment performance record). The fund manager invests an investment entity s resources (the investors contributions) on a collective basis in accordance with an investment strategy with the aim of maximising benefits to the investors. In other words, the fund manager exposes the investment entity to an acceptable level of market risk in order to generate capital appreciation, investment income, or both. Investors are interested in the evolution of the value of their contribution and are therefore in the financial results of the investment entity and the risks taken to achieve those results. It is essential that disclosures are relevant to the economic decisions of the investor rather than the fund manager. Fund managers actively monitor and manage risk and respond to changes in risk factors. Changes in risk factors are mitigated by adjusting the portfolio rather than passively allowing the risk profile to shift. Investment decisions reflect a combination of risk factors and it would be misleading to separate out risk factors into individual components as this may imply they are managed individually which is not typically the case. It is a fund manager s responsibility to expose an investment entity to an acceptable range of market risk with the aim of generating capital appreciation, investment income, or both. Investors are interested in knowing that the investment entity has operated in 7
accordance with its investment strategy and accepted range of risk and whether the risk profile has changed during the reporting period. In Europe a retail investment entity (UCITS 1 ) is required by law to employ appropriate risk management methodologies and to make detailed disclosures in its prospectus describing the risks associated with the UCITS and the methodologies for managing those risks. In addition UCITS using derivatives are required to calculate exposure on a daily basis and, if they use complex investment strategies or exotic derivatives, they must use an advanced risk measurement methodology, such as VaR. Similar laws for managers of all other European investment entities entered into force in July 2011 and the European Commission is currently in the process of finalising the detailed disclosure rules. Investment entities are exposed to the same types of risk as other entities, but the extent of the exposures and the methods for managing the risks are considerably different. Clearly, investment entities are primarily and necessarily exposed to a variety of forms of market risk. Exposure to credit risk is largely regarded as a form of market risk (ratings downgrades or defaults manifest themselves as capital depreciation, lost investment income, or both). Residual credit risk relates to the counterparties with which investment transactions are executed and is often referred to as counterparty risk. Liquidity risk arises from the obligation to redeem investors units of investment on demand. Therefore, an understanding of the liquidity risk to which an investment entity exposes an investor is a function of the liquidity of the assets rather than the liabilities. Investors are interested in the nature and significance of risks and how the fund manager manages those risks. Qualitative disclosures such as those required by paragraph 33 of IFRS 7 are essential for an investor s proper understanding of the risk profile of an investment entity and in general will provide sufficient information in respect of risk to inform the economic decisions of investors. The regulatory requirement to use an advanced risk measurement methodology is indicative of the significance of risk and so the absence of such a requirement should be sufficient to negate the need to provide additional quantitative disclosures. Where market risk is magnified through the use of leverage; investors are interested to know the extent to which this might affect their investment and quantitative disclosures are appropriate. Sufficient flexibility is required in order that the risk disclosures can be aligned with the risk methodologies employed by the fund manager. Therefore, where an advanced risk measurement methodology, such as VaR is used to manage risk, it should be necessary to make quantitative disclosures. It is not appropriate to make quantitative disclosures about individual risks in isolation where this is not consistent with the methodologies used by the fund manager to manage those risks. We recommend that the Board develop specific disclosure requirements based on IFRS 7. The scope of IFRS 7 should be amended such that paragraphs 31 to 42 do not apply to investment entities and new disclosure requirements developed to reflect the high level of regulation within the industry 1 Undertakings for Collective Investment in Transferable Securities (UCITS) are European investment entities that comply with detailed product regulations in order to be eligible for marketing to ordinary European citizens. 8
and the specialised nature of investment entities. We have provided some drafting suggestions to amend IFRS 7 in the appendix to this response. We also recommend that the Board take this opportunity to amend IAS 1 to introduce a conditional exemption from producing a cash flow statement for investment entities, provided substantially all the investments are highly liquid. Such a conditional exemption currently exists in US GAAP Topic 230 10 15 4. Moreover European investment entities are not generally required to produce cash flow statements. In response to question 7(b), we do not agree with the proposed application guidance in paragraph B19. Although much of the illustrative disclosure might be familiar to investors in North America, it is substantially different to the regulatory disclosures required in annual reports on other continents. Moreover the inclusion of non binding examples in the application guidance would appear to be contrary to proposals in a recent report to the Board. The Board asked the Institute of Chartered Accountants of Scotland and the New Zealand Institute of Chartered Accountants to undertake a project to review the levels of disclosure requirements in existing IFRS and to recommend deletions and changes to disclosure requirements. The Institutes Joint Oversight Group published its report Losing the excess baggage reducing disclosures in financial statements to what s important in July 2011. It includes a proposal not to include in standards lists of encouraged or example disclosures as these tend to encourage disclosure without proper consideration of the contribution to a specific disclosure objective. We recommend that the Board deletes paragraph B19 in its entirety and leaves the determination of what constitutes appropriate additional disclosure to the regulators responsible for the protection of the investors in their territory. Question 8 Transition Do you agree with applying the proposals prospectively and the related proposed transition requirements? If not, why not? What transition requirements would you propose instead and why? We agree with prospective application of the proposals and agree that the transitional arrangements should be consistent with the approach in the circumstances in paragraphs 4 and 5 where an entity becomes, or ceases to be, and investment entity. We agree that it should be possible to apply the provisions early in conjunction with the IFRS 10 package of standards. Question 9 Scope exclusion in IAS 28 (a) Do you agree that IAS 28 should be amended so that the mandatory measurement exemption would apply only to investment entities as defined in the exposure draft? If not, why not? (b) As an alternative, would you agree with an amendment to IAS 28 that would make the measurement exemption mandatory for investment entities as defined in the exposure draft and voluntary for other venture capital organisations, mutual funds, unit trusts and similar entities, including investment linked insurance funds? Why or why not? The scope exclusion is specifically designed to deal with investment entities and has been proposed in order to ensure a consistent basis for measuring the change in fair value reported to investors. It 9
is essential that all investment entities measure investees on the same basis, regardless of whether they meet the definition of a controlled entity, qualify as an associate, or neither. Therefore the IAS 28 exemption should be mandatory for investment entities. However, we see no reason why creating the investment entity exemption should change in any way the options currently available to other types of entity applying IAS 28. We like to point out that the exemption in IAS 28 is widely used by banks, insurance companies and asset managers. Banks may use the exemption for private equity and venture capital investments held in separate organisations that are usually considered venture capital organisations. Insurance companies and asset managers may use the exemptions for the investment fund units held. 10
Appendix: Suggested amendments to IFRS 7 Financial Instruments: Disclosures 5A Paragraphs 42I 42M apply only to investment entities as defined in IFRS 10 Consolidated Financial Statements. Investment entities that apply paragraphs 42I 42M do not apply paragraphs 31 42. Nature and extent of risks arising in investment entities 42I An investment entity shall disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from the investment activities in which it engages. Qualitative disclosures 42J For each type of risk arising, an investment entity shall disclose: (a) the exposures to risk and how they arise; (b) its objectives, policies and processes for managing the risk and the methods used to measure the risk; and (c) any changes in (a) or (b) from the previous period. Quantitative disclosures 42K An investment entity shall disclose by class of financial instrument: (a) a description of collateral held as security and of other credit enhancements (including its fair value and the terms and conditions attached to the collateral), and the extent to which these mitigate credit risk; and (b) information about the credit quality of financial assets. 42L When an investment entity obtains financial or non financial assets during the period by taking possession of collateral it holds as security or calling on other credit enhancements (eg guarantees), and such assets meet the recognition criteria in other IFRSs, an entity shall disclose for such assets held at the reporting date: (a) the nature and carrying amount of the assets; and (b) when the assets are not readily convertible into cash, its policies for disposing of such assets or for using them in its operations. 42M An investment entity that uses an advanced risk measurement methodology, such as value atrisk, that reflects interdependencies between risk variables and uses it to manage financial risks, it shall disclose that advanced measure. The disclosure should at least include: (a) the highest, the lowest and the average utilisation of the measure during the reporting period; (b) an explanation sufficient to enable users to understand the disclosed information and any limitations of the measure used; 11
Appendix: Suggested amendments to IFRS 7 Financial Instruments: Disclosures (c) an explanation of the method used in preparing the amounts disclosed, and of the main parameters and assumptions underlying the data provided; and (d) changes from the previous period in the methods and assumptions used, and the reasons for such changes. Nature and extent of risks arising in investment entities (paragraphs 42I 42M) B40 The disclosures required by paragraphs 42I 42M shall be either given in the financial statements or incorporated by cross reference from the financial statements to some other statement, such as a management commentary or risk report, that is available to users of the financial statements on the same terms as the financial statements and at the same time. Without the information incorporated by cross reference, the financial statements are incomplete. B41 Paragraph 42M requires disclosure by an investment entity that uses an advanced risk measurement methodology that reflects interdependencies between risk variables, such as a valueat risk methodology, and uses this methodology to manage its exposure to financial risks. This applies even if such a methodology measures only the potential for loss and does not measure the potential for gain. Such an entity might comply with paragraph 42M(c) by disclosing the type of value at risk model used (eg relative VaR or absolute VaR), an explanation about how the model works and the main assumptions (eg the holding period, confidence level and length of data history). 12