AIFMD Hot Topics: Contractual Discharge, Valuation, Remuneration and Private Equity With less than two months remaining until the Alternative Investment Fund Managers Directive ( AIFMD ) transitional period expires, this article considers some of the hot topics relating to AIFMD implementation which have been generating significant debate within the industry, as asset managers seek their authorisation as alternative investment fund managers ( AIFMs ) and the necessary alignment of fund documentation and procedures with the requirements under AIFMD. Whether AIFMD will develop into an international brand for alternative investments globally remains to be seen, however, asset managers are increasingly looking to the opportunities which AIFMD can offer in terms of asset raising through the professional investor passport to ensure that they are not left trailing their competitors by the end of this year. Notwithstanding the transitional period, a number of asset managers have already obtained their AIFM authorisations. Amongst the many issues to be considered under AIFMD, there are a number of hot topics which asset managers need to consider: Contractual Discharge of Liability AIFMD provides that the depositary is strictly liable for the loss of financial instruments that can be held in custody but also that, subject to certain conditions, the depositary can discharge itself of that liability by transferring it to a delegate. AIFMs are understandably reluctant to release the depositary from the strict liability standard and the precise conditions of discharge, and how they may be met, is often a key point in negotiating AIFMD depositary agreements. The fundamental condition is that the discharge be justified by an objective reason, which must be detailed in the contract allowing the discharge (and disclosed to investors also). Establishing an objective reason is not straightforward. For one thing, the AIFM is obliged at all times to act in the best interests of the fund and its investors and so it must be satisfied that transferring liability from the depositary to its safe-keeping delegate (eg, a prime broker) meets that test. If the delegate is a greater credit risk than the depositary, it may be a difficult threshold to meet; objectively a good reason would be needed to justify transferring liability to a less creditworthy entity. In addition, the AIFMD Level 2 Regulation provides that the objective reason must be limited to precise and concrete circumstances that characterise a given activity. It would appear therefore that the fact that a depositary seeks to discharge liability as a matter of course or as its standard practice would not be sufficient on its own. The AIFMD Level 2 Regulation also provides that certain circumstances are automatically deemed to constitute objective reasons, namely circumstances in which the depositary can demonstrate that it had no other option but to delegate its custody duties to a third party. In such cases, the depositary can transfer its liability to that third party. Particular examples of this are where the law of a third country requires that certain financial instruments be held in custody by a local entity or where the AIFM insists on maintaining an investment in a particular jurisdiction despite warnings by the depositary as to the increased risk this presents. AIFMD itself also provides for a specific case where an objective reason is not required, namely where the law of a third country requires that certain financial instruments be held in custody by a local entity and no local entity satisfies the AIFMD delegation requirements.
Regardless of the reason itself, the AIFM will need to be satisfied that options other than discharge of liability were considered, for example, the procurement of an indemnity from the delegate to the depositary, and that those options did not represent the best interests of the fund or its investors. Where liability is discharged, the AIFM s role with respect to custody can change also. As the delegate (eg, the prime broker) is now the entity responsible for certain assets, the AIFM may be expected to conduct due diligence to ensure that the delegate is capable of performing the custody functions delegated to it and may also be expected to monitor the performance of those functions on an ongoing basis. Valuation Prior to the AIFMD, responsibility for the valuation procedures of an Irish alternative investment fund ( AIF ) resided with the AIF s board of directors. Where an AIF has elected to act as AIFM under AIFMD (ie, a self-managed AIF), the board will retain this responsibility. However, where an external entity is appointed as AIFM, that entity will assume responsibility for this function, representing a change from normal practice in the pre-aifmd world. The key issues for consideration in relation to valuation provisions under AIFMD are: (i) (ii) (iii) (iv) which entities are permitted to carry out the valuation function the classification of an external valuation agent; the valuation procedures under AIFMD; and the liability provisions in relation to the valuation function. Who can act as valuer? The AIFM itself can perform this function on the proviso that the process is functionally separate from its portfolio management and remuneration duties, and that measures are taken to mitigate any potential conflicts of interest. Alternatively, the AIFM may appoint an external valuer, which must be independent from the AIFM, the relevant AIF and any other persons with close links to the AIFM or the AIF, which will generally exclude an AIF s investment manager, traditional providers of valuation assistance for AIFs. Importantly, it is not permitted for this external valuer to sub-delegate this function to a third party. Additionally, the AIFM must ensure that the external valuer is professionally recognised, can furnish professional guarantees, and is appointed pursuant to the delegation provisions of AIFMD. It is worth noting that the valuation of the AIF s assets can be performed by one or several external valuation agents. Who is an external valuation agent? The AIFMD clearly distinguishes between the valuation of assets and the calculation of the net asset value ( NAV ). The European Securities and Markets Authority s ( ESMA ) guidance on this topic clarifies that an administrator carrying out the calculation of the NAV is not considered to be an external valuer as long as the administrator is merely incorporating values which are obtained from other sources (as opposed to providing values itself). As such, the administrator does not automatically assume the role of external valuer and the AIFM may retain the valuation function and determine the AIF s pricing policy whilst also delegating calculation of NAV to the administrator. 2
Valuation procedures The AIFM must ensure appropriate procedures are in place for the proper and independent valuation of assets. Valuation must take place on at least an annual basis (noting that open-ended funds may be required to value more frequently, whereas closed-ended funds must carry out a valuation each time the capital of the fund increases or decreases). Additionally, the AIFM will be required to determine the valuation methodologies that will be used for each of the types of asset in which the AIF may invest. Importantly, valuation policies and procedures should be reviewed by the AIFM at least annually. Liability of the AIFM The AIFM s liability towards the AIF and its investors is not affected by the delegation of the valuation function. The external valuer is, however, liable to the AIFM for any losses suffered by the AIFM as a result of its negligence or intentional failure to perform its tasks. This liability standard cannot be waived or amended by contract. Remuneration Since July 2013, clarity is beginning to emerge in respect of two key issues around remuneration under AIFMD: whether or not remuneration requirements are applicable to an AIFM s delegates and the options which are available to AIFMs and their delegates in assessing the extent to which these requirements apply to these entities and their staff. This clarity is largely attributable to ESMA s guidelines on remuneration, which were published in July 2013 (the ESMA Guidelines ), and ESMA s questions and answers document on the application of the AIFMD which was updated in February 2014 (the ESMA Q&A ). The ESMA Guidelines indicate that ESMA believes that the remuneration requirements should apply to delegates, as their definition of Identified Staff (ie those to whom the remuneration rules apply) includes staff at entities to which portfolio or risk management has been delegated. While, the nature of the ESMA Guidelines generally means that each member state had the option of notifying ESMA that it would not be implementing these guidelines, it appears that only one has taken this option. In terms of assessing the extent to which the remuneration requirements apply, there are a number of aspects of the AIFMD rules which may be of assistance to AIFMs and their delegates. First, ESMA s Guidelines make it clear that the rules will only apply to staff who have a material impact on the risk profile of the AIFM or the risk profiles of the AIF they manage. Consequently, where the parameters of a delegation of portfolio or risk management by an AIFM are sufficiently restrictive that a delegate or its staff cannot have such an impact, the remuneration rules will not apply. Moreover, according to the ESMA Q&A on the application of the AIFMD, even if there are Identified Staff within a delegate, the appropriate contractual arrangements to be put in place with a delegate to ensure that there is no circumvention of the remuneration rules apply only in respect of the remuneration of those Identified Staff for such delegated activities. Second, the proportionality principle may enable AIFMs and delegates to disapply the so-called pay out process rules, which may require variable remuneration to be paid in units of funds under management, to be deferred for three to five years and to be subject to clawback provisions where warranted by subsequent performance. 3
For example, it has been suggested by the UK Financial Conduct Authority ( FCA ) and the Irish Funds Industry Association, among others, that assets under management thresholds should be considered when determining whether it is proportionate to apply the remuneration rules, with AIFMs with assets under management below de minimis levels being presumed to be exempt. Indeed, the finalised FCA guidance on the AIFM Remuneration Code, published in January 2014, states that there is a presumption that it is appropriate to disapply pay-out process rules in the following cases, depending on the other characteristics of the AIFM or its AIFs: AIFMs which manage portfolios of AIFs with assets under management of less than 5 billion where those portfolios are unleveraged and have no redemption rights exercisable during a five year period following the date of initial investment in each AIF AIFMs which manage portfolios of AIFs in other cases, where assets under management are less than 1 billion, including any assets acquired through the use of leverage Equally, it is thought that where management of AIFs represents a small proportion of a delegate s overall business, it may not be proportionate to require the delegate to put in place systems and other infrastructure to comply with the remuneration rules. Third, according to the ESMA Guidelines, staff of the delegate who have a material impact on the risk profiles of the AIFs managed by the delegate need only be subject to regulatory requirements on remuneration that are equally as effective as those applicable under the Remuneration Guidelines. The ESMA Q&A also deals with this issue and according to those Q&A, in a delegation arrangement, provided that the Identified Staff within the delegate are subject to CRD rules, the delegate is regarded as subject to equally effective remuneration requirements. The FCA guidance states the MiFID remuneration regime should also be considered as equally effective as AIFMD requirements It is worth noting that, in the context of the application of the pay-out process rules, the finalised guidance issued by the FCA states that firms may disapply the requirement to pay 50% of any variable remuneration in the form of units, shares or other instruments in circumstances where the legal structure or constituting instrument of the AIF makes the requirement impracticable. By way of guidance, the FCA stipulates a non-exhaustive list of considerations for judging impracticality in this context, including legal barriers and adverse tax consequences. It also states that where a firm decides to disapply this rule, it is not required to make payments in units linked to other entities, but it has the option of doing so in order to align the incentives of relevant staff with those of the relevant AIFs, the investors of the AIF and the AIFM. The Central Bank has not yet issued guidelines on the application of AIFMD remuneration requirements, however, with respect to the FCA guidance, the Director of Market Supervision at the Irish Central Bank, Gareth Murphy, has noted in a speech given earlier this year that [we] see considerable merit in the interpretations which the UK FCA have provided which align the interests of risk-takers and investors and which seek to ensure that the effective management of AIF assets is preserved. 4
Impact of AIFMD on Private Equity Managers The broad definition of alternative investment fund under AIFMD means that previously unregulated private equity fund managers may now find themselves falling within the regulatory scope of AIFMD, with its resultant challenges and benefits. We have seen a marked increase in the number of private equity fund managers considering Ireland as a domicile as AIFMD sees such managers moving from the unregulated to regulated environment with the additional marketing opportunities afforded by the AIFMD marketing passport. In this regard, the Irish AIF vehicle offers the characteristics and flexibility of the typical private equity fund product, while being authorised and regulated by the Central Bank and offering the AIFMD compliant standard which is likely to be increasingly sought by investors. Industry is also liaising with the Irish government in order to make amendments to the existing investment limited partnership legislation to further enhance the attractiveness of this structure as an option for private equity managers. The coming year will certainly be an interesting time as far as the asset management industry is concerned as a host of regulatory developments follow in the wake of AIFMD. In addition, it is expected that 2014 will also see the introduction in Ireland of the Irish Collective Asset-management Vehicle (the ICAV ), a new corporate fund vehicle tailored for the needs of asset managers, which should prove to be a popular alternative to the existing Irish fund vehicle range for both UCITS and AIFs. Ireland is certainly well-placed to further cement its position as the domicile of choice for the establishment of AIFs and the growth in assets under management of Irish AIFs over the past number of years, with 120% growth since 2008, is testament to this. Authors: Liam Collins and Philip Lovegrove A version of this article originally appeared in Compliance Matters in January 2014. If you require detailed advice relating to AIFMD, please get in touch with your usual Asset Management and Investment Funds Group contact who would be delighted to assist you. Full details of the Asset Management and Investment Funds Group, together with further updates, articles and briefing notes written by members of the Asset Management and Investment Funds team can be accessed at www.matheson.com. 5
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