AIFMD:How it affectsPrivateEquity fundmanagers.www.cummingslaw.com
www.cummingslaw.comA IntroductionOn 19 December 2012, the EuropeanCommission published the draft level 2 delegatedregulations (the “Level 2 Measures”) thatit has adopted, which provide detail on theimplementation of the Alternative InvestmentFund Managers Directive (AIFMD).As is widely known by now, the AIFMD, althoughapparently prompted by certain perceivedissues arising out of the hedge fund and primebrokerage industries, casts a very wide net,and applies in principle to the managementand marketing in the European Economic Area(“EEA”) of practically any form of investmentfund, except those subject to the so-calledUCITS Directive (i.e., in effect, retail mutualfunds authorised in the EEA). The private equityindustry is therefore not immune from its reach.The AIFMD will affect those private equity fundmanagers who manage alternative investmentfunds (“AIFs”) with unleveraged assets of above€500m (this is therefore aimed at private equityand other funds which are typically unleveraged),there being an exemption for managers whomanage unleveraged assets of below €500m(provided there are no redemption rights withinfive years of initial investment in the AIF).Please see below for the methods of calculatingleverage. Note that, in a private equity context,leverage will not include the borrowings or otherleverage of any entity in which the private equityfund invests, as long as the fund is not liable forany amounts (for instance, under any guaranteeobligation) beyond the amount of its investment.A recent consultation paper published byHM Treasury included certain draft regulationsimplementing the AIFMD in relation to (inter alia)private equity.The consultation paper on transposing the AIFMDinto national law sets out the government’sproposed approach towards a number of policydecisions, including how to apply the AIFMDto private equity fund managers. The paperwas accompanied by a draft of the AIFMDRegulations, of which Part 7 of the Regulations(Sections 36 – 46 inclusively) applies toprivate equity. These provisions cover mattersconcerning disclosure obligations and assetstripping in relation to control, which are brieflydescribed in the following summary.B What are the objectives ofthe AIFMD?The two main objectives of the AIFMD are:i to provide a clear and consistent frameworkfor the regulation and supervision of AIFMsin the EU; andii to ensure a high level of investor protectionin the EU.The Level 2 Measures aim to achieve these coreobjectives by creating a single rulebook for allAIFMs to ensure a level playing field and dealingwith the following issues:• a common approach to calculating assetsunder management (“AUM”) and leverage;• a common approach on an AIFM’s levelof additional own funds and level of PIinsurance required by AIFMs (operationalcontinuity);• general operating conditions for AIFMs,including general principles, conflictsof interest, risk management, liquiditymanagement, investment in securitisationpositions, organisational requirements,valuation and delegation of AIFM functions;• a common approach on the scope of custodyand on the depositaries’ liability to returnfinancial instruments lost in custody;AIFMD: How it affects PrivateEquity fund managers.
www.cummingslaw.com• a common approach to transparency ofAIFMs towards investors and supervisoryauthorities;• a common approach to co-operation withthird countries; and• a common approach to an AIF’s reportingfrequency and exchange of information onthe potential systemic consequences ofAIFM activity.C Who is an AIFM and what is an AIFand what must they do?The AIFMD will apply to EU-based fundmanagers, wherever their funds are based, andnon-EU-based managers who either manage ormarket one or more AIFs in or into the EU.An AIFM is anyone who, at a minimum, eitherperforms portfolio management services orrisk management services for an AIF and an AIFmeans virtually any fund, regardless of structure,jurisdiction or investment strategy, other than aUCITS fund.The AIFM may delegate its portfolio managementor risk management duties if it wishes but notto the extent that it becomes a mere “letter-box entity”, and accordingly may not do so to a“substantial margin”. It must also manage therisks attaching to the delegation, and remainsresponsible to investors for the activitiesdelegated. The effect of these provisions is that,even where portfolio management activities aredelegated in their entirety, an AIFM must havesufficient resource and expertise to supervise andmanage the risks of the activities delegated. TheLevel 2 Measures give detailed requirements forthe delegation process and delegation contractsand delegation is discussed in more detail below.Where the AIFM carries out both riskmanagement and portfolio management, it mustmaintain a separation between the two and havesatisfactory hierarchical arrangements in place.The AIFM will be required to carry out its dutiesin accordance with the rules of the AIFMD andgeneral operating conditions. Please see below,where more details are given.AIFMs must also comply with capital adequacyrequirements by holding a certain amount ofown funds, either in cash or by insurance policyor a combination of the two. More details aregiven below.The AIFMD also contains requirements relatingto the remuneration of senior management andcertain key staff, and in particular the treatmentof variable and deferred remuneration, whichmust be implemented by the AIFM. While theseprovisions are broadly similar to those in theRemuneration Code, with which FSA-authorisedprivate equity fund managers are already likelyto be familiar, they are not identical, and are notfree from interpretational problems (which havenot been removed by the Level 2 Measures) as tohow they apply to normal private equity practice.While, as stated above, there are exemptions tothe AIFMD, even exempt managers (i.e. thosebelow the threshold of aggregate AUM, whichfor private equity fund managers will generallybe €500 million) are subject to registration underthe AIFMD. In the UK, this means that suchmanagers will have to register themselves andtheir funds with the FSA and provide informationon their investment strategies, the maininstruments in which they are trading and theirprincipal exposures and concentrations. Theywill also have to notify the authorities if they nolonger fall below the relevant threshold within30 days of exceeding the threshold, at whichpoint they will need to apply for authorisationas an AIFM. For a typical FSA-authorised privateequity fund manager, this means extending themanager’s permissions to include acting as amanager of AIFs.It is worth noting that a manager who, thoughFSA authorised, is below the threshold andtherefore merely registered with the FSA forAIFMD purposes will not be entitled to any of thepassporting rights as regards the marketing ofthat manager’s funds into other Member States.In appropriate cases, it may therefore be worthconsidering voluntarily opting into the AIFMD,even where a manager is sub-threshold.
www.cummingslaw.comD What about the AIF and its otherservice providers?While the AIFM will need to consider theimplications of the AIFMD, so will certain keyservice providers, most notably administratorsand custodians, whose contractualdocumentation and roles are significantlyimpacted. Please see below for a summary ofthe rules in relation to depositaries: as manyprivate equity funds have historically operatedwithout custodians, the depositary function willbe a new requirement for them and necessitatethe addition of a service provider.E What action is needed now?Please see our Checklist for Private EquityManagers (or as the case may be , non-EU PrivateEquity Managers). To summarise briefly, AIFMsneed to liaise with their lawyers to:• watch out for the FSA’s issue of applicationforms for application for authorisation underAIFMD (or extension of existing permissions)and then complete and submit the formswhen they are available;• decide who will conduct risk managementand portfolio management, and how;• review and negotiate administrationagreements and appoint a depositary, oramend any existing custodian agreement, tomeet the depositary rules;• update offering memoranda and allmarketing documentation;• put in place internal and complianceprocedures; and• put in place reporting procedures.F Summary of the main articlesCalculation of assets under management(Arts 2 – 5)In accordance with Article 2 of the Level 2Measures, the AIFM has to calculate total AUMby determining the value of all assets it manages,without deducting liabilities, and valuing anyfinancial derivative instruments at the value of anequivalent position in the underlying assets (soas to reflect the AIF’’s exposure to those assets).This calculation must be made at least annually,using the calculation methodology set out in theLevel 2 Measures, and must be communicated tothe competent authorities.AIFMs are then required to monitor AUM onan on-going basis and action must be takenwhen thresholds laid down in the AIFMD areoccasionally breached. In a private equitycontext, the calculation of AUM is not requiredto take account of any undrawn capitalcommitments. However, draw-downs- andindeed distributions of realisation proceeds - willaffect AUM and therefore need to be monitored,and their effect on AUM considered as they arise.Additional own funds and PI insurance(Arts 12 – 15)The AIFMD requires AIFMs to hold appropriateadditional own funds or PI insurance to coverpotential liability risks arising from professionalnegligence, such as a breach of legal orregulatory obligations, confidentiality or fiduciaryduties, improper valuation of assets, operationalprocedural failures or misrepresentation.The Level 2 Measures specify theappropriateness of cover: additional own fundsshould represent at least 0.01% of the valueof portfolios of AIFs managed and PI insuranceshould cover an individual claim of at least 0.7%of the value of portfolios of AIFs managed and0.9% of the value of portfolios of AIFs managedfor claims in aggregate per year.The AIFM shall be obliged to implementeffective internal risk management policies andprocedures to monitor the professional liabilityrisks to which the AIFM is or could be exposed,which must be subject to at least annual review,and to monitor the value of portfolios managedon an on-going basis.Many private equity fund managers caught bythe AIFMD may find that they have to increasetheir capital in any event to take account ofthe basic requirement that an AIFM must have€125,000 of capital, plus additional own funds
www.cummingslaw.comof 0.02% of the amount by which AUM exceeds€250 million (to a maximum total capitalrequirement of €10 million).General Operating Conditions(Arts 16 – 82)Articles 12 – 20 of the AIFMD require AIFMs tooperate under certain harmonised conditionsand the Level 2 Measures clarify and expand indetail the duties and obligations of AIFMs, andalso specify the criteria to be used by competentauthorities to assess the manner in which AIFMsoperate, in respect of the following:• general principles and conflicts of interest(Arts 16 – 37);• risk management (Arts 38 – 45);• liquidity management (Arts 46 – 49);• investment in securitisation positions (Arts50 – 56);• organisational requirements (Arts 57 – 66);• valuation (Arts 67 – 74); and• delegation of AIFM functions (Arts 75 – 82).Turning in brief to some of these points:The Level 2 Measures lay down rules for aconflict of interests policy which AIFMs shouldimplement, a risk management system tobe established and applied, an appropriateliquidity management system to be adopted,policies and procedures for the valuation ofassets to be established and maintained and awell-documented organisational structure tobe established for the proper management ofAIFs, including administrative and accountingprocedures and adequate internal controlmechanisms. In a private equity context,such requirements may dictate (for instance)separation between an AIFM’s investmentcommittee members and any risk managementstaff, and also review and approval of carryarrangements by a renumeration committee.The AIFM must ensure that the governing body,the senior management and, where relevant,the supervisory function, are responsible for theAIFM’s complying with its obligations underthe AIFMD.The Level 2 Measures have considerablyexpanded upon delegation of AIFM functionsand provided clarification upon the issue ofthe “letter-box entity”, which generated muchdiscussion during the drafting stage. Article 75does permit AIFMs to delegate functions (subjectto supervision of the delegate and managementof the associated risks), but AIFMs are expectedto show “objective reasons” for the delegationand are not allowed to delegate in such a way asto alter their obligations or circumvent liabilities.Article 82 prohibits a manager from becominga mere “letter-box entity” i.e. an AIFM isprohibited from delegating to an extent thatexceeds by a “substantial margin” the investmentmanagement function performed by the AIFMitself, but it will also be regarded as a letter-boxentity if it no longer has the necessary resourcesor expertise to supervise the activities it hasdelegated, or has no power to take decisions inkey areas, or no contractual rights to inquire of,inspect, gain access to or instruct its delegates.In this context, it has never been wholly clearhow the AIFM concept applies to the generalpartner of a typical private equity fund structuredas a limited partnership. In the standard suchstructure, the general partner, although legallyresponsible for the management of the limitedpartnership, delegates the entirety of its dutiesto a fund management firm, which (in the UKat least) will typically be FSA authorised. Theworking assumption must be that the AIFM insuch a structure would be the fund managementfirm and not the general partner, given that thelatter will generally retain none of the portfolioor risk management functions regarded byAIFMD as inherent to the nature of the AIFM.General partners, therefore, should not requireauthorisation or be affected themselves by theobligations imposed on AIFMs by the AIFMD, aslong as their funds have a duly authorised AIFMwho carries out the AIFM functions.Furthermore, AIFMs will also need to lookat where they delegate, as there are certain
www.cummingslaw.comrestrictions on delegating to delegates incountries outside the EEA which do not havecooperation agreements with the relevant EEAMember State.Confidential information (Art 39 of the Level2 Measures)Article 39 of the Level 2 Measures reflects Article58 of the AIFMD and provides that if informationis provided in confidence by an employer, theemployee (or his representative or expert) will besubject to the requirements of regulation 25 ofthe Information and Consultation of EmployeesRegulations 2004.Acquiring control of a non-listed company(Arts. 40 – 44 of the Level 2 Measures)Articles 27 to 29 of the AIFMD impose obligationsupon an AIFM to provide certain informationto the competent authority when it acquirescontrol of a non-listed company or issuer. Theseare transposed in sections 40 – 44 of the Level 2Measures and the Financial Conduct Authority(FCA) is the competent authority for thesepurposes (see Art. 46).Article 40 states that when an AIF acquires,disposes of or holds shares of a non-listedcompany, the AIFM must notify the FCA of theproportion of voting rights of the non-listedcompany held by the AIF at any time when thatproportion reaches, exceeds or falls below thethresholds of 10%, 20%, 30%, 50% and 75%.Such notification must be made no later than10 working days after the relevant threshold iscrossed. Notification to the FCA by the AIFM isalso required when an AIF acquires control ofa non-listed company, control being defined asholding more than 50% of the voting rights(see Art. 38).Article 41 lists the general information requiredto be disclosed by the AIFM upon the AIFacquiring control.Article 42 specifies the additional disclosuresrequired of the AIFM upon the AIF acquiringcontrol of a non-listed company, namelynotification to the company and its shareholdersof the future business and the likelyrepercussions on employment by the company,including any material changes to the conditionsof employment. Additionally, the AIFM mustprovide the FCA and the AIF’s investors withinformation on the financing of the acquisition.Article 43 provides a carve-out to the disclosureobligations in Articles 40 – 42 where thecommunication would seriously harm thefunctioning of or be seriously prejudicial tothe company.Section 44 sets out what information the AIFmust provide in its annual report in respect ofthe non-listed company which it controls.Asset Stripping (Art. 45 of the Level 2Measures)Article 45 of the Level 2 Measures reflects theasset stripping restrictions set out in Article 30 ofthe AIFMD and provides that for a period of 24months after an AIF acquires control of a non-listed company, the AIFM must not facilitate,support or instruct any distribution, capitalreduction, share redemption or acquisition bythe company of its own shares or vote in favourof such action and must use its best efforts toprevent any such action.Depositaries (Arts 83 – 102)The consultation paper notes that thegovernment proposes to exercise the derogationprovided by Article 21(3) of the AIFMD, whichallows certain entities other than creditinstitutions to be a depositary for certain AIFswith a five-year lock up period. The reasongiven for exercising the derogation is to supporta competitive market for private equity AIFMs.Those entities wishing to provide depositaryservices will be required to hold the permissionof “acting as the depositary of an AIF” but will besubject to appropriate depositary requirements.This provision is in effect an acknowledgementof the fact that, typically, private equity funds(and certain other types of fund investedotherwise than in listed securities or otherassets generally held in custody) have operatedwithout the type of custody arrangementsentered into by securities funds, and indeedoften without custodians at all. It remains to
www.cummingslaw.combe seen however whether other entities (forinstance, administrators) choose to enter intothis potential market.Transparency of AIFMs (Arts 103 – 110)The extensive disclosure requirements laid out inthe Level 2 Measures cover disclosures in annualreports, disclosures to investors generally andperiodic disclosures to competent authorities.The provisions relating to the annualreports impose a number of extra disclosurerequirements, such as the need to discloseremuneration and carried interest, as well asmaterial changes over the previous year.Periodic disclosures of various matters also needto be made to investors, for example changesin maximum leverage levels and the risk profileand risk management systems employed by theAIFM. These matters need to be disclosed atthe outset in the offering document, and, at aminimum, also in the annual report and in anyother periodic reporting to investors.There is also a significant list of matters which arerequired to be disclosed periodically - whetherquarterly, semi-annually or annually, dependingon the size of the AIFM - to the competentauthorities. These include the principal assetsinvested in, with sectoral and geographicbreakdowns, where they are invested in and anyprincipal exposures or concentrations, the riskprofile of the AIFs, special liquidity arrangements(generally less relevant to private equity thanto hedge funds) and the results of the periodicstress tests which the AIFMD requires AIFMs tocarry out.Co-operation with third countries(Arts 113 – 115)The AIFMD requires co-operation arrangementsto be established between European competentauthorities and supervisory authorities fromthe country of origin of a non-EU AIFM or anon-EU AIF.Some aspects of these arrangements arespecified in the Level 2 Measures in orderto design a common framework to facilitatethe establishment of such co-operationarrangements with third countries. Thesearrangements must establish such mechanisms,instruments and procedures as are requiredto enable third country competent authoritiesto assist the EU to enforce EU legislation andnational implementing legislation which isbreached by a third country entity.The Level 2 Measures also require thearrangements to include a data protectionsafeguard in line with the AIFMD. Where thirdcountries are unable to sign such co-operationagreements meeting the minimum requirements,there will be restrictions on marketing, managingand delegation in relation to such third country.Exchange of information relating to potentialsystemic consequences (Art 116)Article 116 specifies the exchange of informationbetween the competent authorities of theMember States, European Securities and MarketsAuthority and the European Systematic RiskBoard which is required under the AIFMD forthe purpose of identifying potential systemicconsequences of AIFM activity.ConclusionThe deadline for responses to the consultation is27 February 2013.HM Treasury’s second consultation paper is dueto be published shortly and will cover issuesarising from the Level 2 Measures that HMTreasury is not able to consult on at this time.G Next StepsThe Level 2 Measures are subject to a threemonth scrutiny period by the EuropeanParliament and the Council of the EU and willenter into force, providing that neither co-legislator objects, on the 20th day followingpublication of the Regulation in the OfficialJournal of the EU (OJ). As they have been enactedin the form of a regulation, they will be directlyapplicable in all Member States, which meansthat the Member States can do nothing morethan incorporate them lock, stock and barrel intodomestic law. Certain matters following fromthe Level 2 Measures, however- for instance, the
www.cummingslaw.comforms to be used for applying for authorisation asan AIFM or for extension of existing permissions-have not as yet been made available, nor has the“write-across” of the provisions into UK law andregulation yet been carried out.The Level 2 Measures have significantramifications for many AIFMs who either operatein the EU or manage any AIF in, or market oneinto, the EU and AIFMs should now be activelyreviewing what they need to do in order tobecome compliant with the requirements ofthe AIFMD, whether in terms of their actualoperations, and the division of functions withinthose operations, or their documentation anddisclosure arrangements.We have produced AIFMD checklists for(respectively) EU and non-EU private equitymanagers which (along with other AIFMDresources) is available on our website under“Publications”. A 25 minute podcast on theAIFMD is also available as a download from ourwebsite under “Webinars and podcasts”.To discuss how the AIFMD might affect you,please contact Claire Cummings firstname.lastname@example.org on 020 7585 1406.
42 Brook Street, London W1K 5DB +44 20 7585 1406 | Neuhofstrasse 3d, CH-6340 Baar +41 41 544 5549Regulated by the Solicitors Regulation AuthorityThis document is for general guidance only. It does not constitute adviceJanuary 2013