AIFM Directive

The AIFM Directive At Last

In April 2009, when EU Commissioner Charlie McCreevy announced the proposal for a Directive on Alternative Investment Fund Managers (the AIFM Directive), it was widely viewed as a rushed political response to raging populist anger in France and Germany against alternative investment funds that, due to their perceived excessive leverage and risk-taking, were considered catalysts for the global financial crisis.

The Controversial Debate

The initial draft law, which proposed a broad overhaul of regulation over managers of hedge funds, real estate funds, private equity funds and other collective investment vehicles (save for UCITS¹), was roundly criticized by the alternative asset industries of Europe and the US as (i) not achieving any of its legitimate goals, and (ii) not taking into account substantial differences between the business models and asset classes of various types of alternative investment funds, and thus stifling the interests of investors and managers alike. Nowhere was the draft law more hotly debated than the UK, which is home to more than 80% of European hedge fund managers and where fears of a mass exodus of managers to Switzerland and certain other non-EU financial centres ran rampant.

The Result

Fast-forward 19 months witness to a record 1,700 proposed amendments to the draft, multiple compromise proposals, impact assessments, and lengthy negotiations and the mist surrounding alternative investment fund regulation in Europe finally lifted after 11 November 2010, when the European Parliament adopted the AIFM Directive with an overwhelming majority.² Suddenly, the regulatory picture for the industry looks considerably less ominous than initially anticipated.

The adopted text maintains the core features of the original proposal aimed at achieving better investor protection, enhanced transparency, and effective prudential oversight of systemic risks. The related provisions include requirements regarding the managers future reporting and disclosure towards regulators and investors, their minimum capitalization, remuneration, risk management, liquidity, use of leverage on the fund level, conflicts of interest, fund control positions in portfolio companies, fund portfolio valuation, and marketing/fundraising.

Notwithstanding the broad regulatory scope of the adopted text, it adopts a substantively less draconian and protectionist stance toward industry regulation than that of certain prior versions. This softening in position is most apparent in the relatively watered-down depositary liability regime and the planned introduction (as of 2015) of a passport for the marketing of non-EU funds within the Union. Even before the extension of the passport to non-EU funds, such funds will, subject to certain minimum conditions, be able to access specific EU markets in compliance with their respective existing private placement regimes. The adopted text also stops short of proscribing passive, non-solicited investments by EU investors in non-EU funds.

Market Impact of the AIFM Directive

While stakeholders generally view the AIFM Directive as imposing substantial compliance burdens on the alternative asset universe, the consensus view is that neither a fatal blow to the nearly 2 trillion-strong industry, nor a prompt en masse manager exodus from the EU, is forthcoming. Rather, the expected behavioural consequence of the AIFM Directive is that fund managers will largely self-segregate into one of two groups: those managers with substantial interest in EU-based fund marketing and investment activity, and those focused on fund marketing and investment outside the EU.

Those managers seeking to tap the EU investor base or operate within the EU will need to begin assessing the impending impact of the AIFM Directive on their current and future fund activities and platforms, with a view toward modifying those activities and platforms to ensure compliance. On the other hand, those managers with little or no connection to the EU markets should conduct a cost-benefit analysis as to the perceived advantages and disadvantages of becoming subject to the AIFM Directive and act accordingly.

Exemptions

In addition to the nationality mix of a managers investor base, the size of its fund management operation and its investment strategy will also influence the managers assessment of the AIFM Directive, as certain exemptions from the manager authorization and ongoing compliance requirements may be available. In particular, the agreed text sets forth a lighter supervisory regime for a manager whose fund portfolio does not, on aggregate, exceed (i) 100 million, or (ii) 500 million, provided that the fund platform is unleveraged (with leverage being assessed only at the fund level, not at the portfolio company level) and the investors are locked-in for a minimum five-year period.

Managers that are able to avail themselves of one of the foregoing exemptions will still be required to register with their home-state regulator, satisfy certain initial and ongoing disclosure requirements, and comply with any applicable national regulation in their respective Member States. An exempted manager will be able to largely avoid the compliance costs associated with the AIFM Directive but will be restricted in its marketing efforts due to the non-availability of the EU passport. As a result, managers with a broad pool of existing EU investors, or those managers seeking to expand their marketing efforts into multiple EU Member States, may elect to voluntarily opt into the AIFM Directive framework, thereby subjecting themselves to the full gamut of compliance requirements.

Interestingly, as the AIFM Directive is concerned exclusively with managers of funds, the Euro-denominated thresholds associated with the foregoing exemptions only take into account the value of fund portfolio assets, without regard to assets associated with managed accounts or other non-collective investment management arrangements. As such, some investment managers will be able to manage large single-investor portfolios without falling under the AIFM Directive umbrella.

UCITS as an Alternative

Another option for the avoidance of future AIFM regulation that may appeal to hedge fund managers with a substantial EU investor base or fund platform is the possibility of migrating to or creating mirror investment vehicles under the UCITS regime. UCITS III-compliant hedge funds (NewCITS) represent a trend that has been gaining momentum since the dawn of the financial crisis and may climax with the advent of the AIFM Directive. The UCITS framework offers managers a number of benefits, such as new sales channels (to retail and certain institutional investors), broader geographic reach, economies of scale and a recognized global brand,

while not substantially curtailing absolute-performance, long-bias strategies. The gold-plating³ associated with the UCITS brand has historically come at a higher compliance cost for managers, but the overall impact of the AIFM Directive, coupled with the added flexibility afforded by the upcoming UCITS IV, may ultimately render this distinction meaningless.

Conclusion

The regulatory implications and consequent market reactions to the advent of the AIFM Directive, together with related developments under the UCITS regime, represent the dawn of a brave new world for the EU alternative asset industry. Managers within and without the EU will be confronted with a sweeping array of regulatory challenges of first impression, challenges which will call into question the fundamentals of how and where the alternative asset industry structures, sells and locates its products. The manner in which other leading (offshore) financial centres position themselves to competitively attract elements of the industry and market players also remains to be seen, as does the overall efficacy of the EUs regulatory initiatives in the face of future economic turmoil, though assuredly we are now witnessing merely the opening act of a several-act play, with more drama to follow.

The AIFM Directive is due to be transposed into national law by EU Member States by 2013. In 2017, the European Commission is required to review the AIFM Directives effectiveness in achieving its regulatory goals and market impact. Immediately after the formal completion of the EU legislative process, the European Commission will begin working with the Committee of European Securities Regulators (CESR)⁴ to promulgate technical advice and undertake rulemaking under the AIFM Directive. Finally, in 2018, ESMA is due to review the efficacy of the dual marketing system and potentially end the national private placement regimes.