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The proposed EU
Alternative Investment
Fund Managers Directive
Impact on real estate funds
The European Commission proposed a new Directive on Alternative
    Investment Fund Managers (AIFM) in April 2009. The pro...
Scope
While the main focus of the AIFM Directive is on managers of alternative investment
funds, the Directive will impact...
Requirements
    AIFM will be required, inter alia, to:
    • Comply with conduct of business requirements
    • Implement...
The role of the custodian includes:
     • Receiving subscription payments and booking them in a segregated account
     •...
Practical considerations




    The proposed AIFM Directive raises a number of practical
    considerations for the real ...
Practical considerations


i)   The definition of collective investment undertaking
     While an AIF is defined in the pr...
Practical considerations


    iii) Management services
        It is critical to understand accurately what is meant by m...
Practical considerations


iv) Capital requirements
    The Directive imposes minimum capital requirements and an increase...
Practical considerations


     vi) Independent valuation
             The vast majority of real estate funds in Europe ha...
Practical considerations


vii) Custodian
        The proposed Directive segregates the custodian’s role for the financial...
Practical considerations


     ix) Conflicts of interest
         The Directive requires that the AIFM take all reasonabl...
Practical considerations


xi) Choice of domicile of AIFM and AIF
    By establishing passports both for AIFM and AIF, the...
Conclusion

                                       The European Commission has indicated that it is committed to transpare...
EMEIA Real Estate Leader
Dean Hodcroft                                                   +44 20 7951 4870     dhodcroft@uk...
Ernst & Young

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The proposed EU AIFM Directive September 2009

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Transcript of "The proposed EU AIFM Directive September 2009"

  1. 1. The proposed EU Alternative Investment Fund Managers Directive Impact on real estate funds
  2. 2. The European Commission proposed a new Directive on Alternative Investment Fund Managers (AIFM) in April 2009. The proposal aims to introduce a harmonized European regulatory and supervisory framework for the alternative investment sector. The Commission believes that closer regulatory engagement and supervision of the activities of managers of alternative investment funds across Europe is required. The proposed changes in the AIFM Directive will have a significant impact on the real estate fund sector – the managers, the funds, their service providers and investors. In this paper, we briefly outline the proposed regime and potential issues for the real estate fund sector. Overview of the Directive Objectives The AIFM Directive is designed to address a number of risks identified by the European Commission related to alternative investment funds (AIFs). The Commission does not believe that fragmented national approaches constitute a robust and comprehensive response to these risks. The key objectives of the proposed AIFM Directive are to: • Ensure that all AIFM are subject to appropriate authorization and registration requirements • Provide a framework for the enhanced monitoring of macroeconomic risks • Improve risk management and organizational safeguards at the individual AIFM level • Enhance investor protection • Improve public accountability for AIFs holding controlling stakes in companies • Develop a single market for AIFs Risks identified by the European Commission Macroprudential • Direct exposure of systemically important banks to the alternative investment fund sector • Procyclical impact of herding and risk concentration Microprudential • Weakness in internal risk management system Investor protection • Inadequate investor disclosures on investment policy, risk management and internal processes • Conflicts of interest and failures in fund governance Market efficiency and • Impact of dynamic trading and short selling techniques on integrity market functioning • Potential for market abuse in connection with certain techniques, such as short selling Impact on market for • Lack of transparency when building stakes in companies, corporate control or concerted action in “activist” strategies Impact on companies • Potential for misalignment of incentives in management controlled by of portfolio companies, in particular in relation to the use alternative investment of debt financing fund managers • Lack of transparency and public scrutiny of companies subject to buy-outs 2 The proposed EU Alternative Investment Fund Managers Directive: Impact on real estate funds
  3. 3. Scope While the main focus of the AIFM Directive is on managers of alternative investment funds, the Directive will impact: • EU and non-EU AIFM • EU and non-EU domiciled AIFs • Service providers to these funds • Investors In summary, the Directive applies to all AIFM established in the EU that provide “management services” to AIFs, irrespective of whether they provide the services directly or by delegation, and that have more than either: • €100 million of assets under management (including assets acquired through the use of leverage) • €500 million of unleveraged assets under management with at least a five-year lock-up period for each AIF “Management services” means the activities of managing or administering one or more AIFs on behalf of one or more investors. AIFs are any collective investment undertaking other than a UCITS,1 pension funds, endowments or sovereign wealth funds - for example, hedge funds, private equity and real estate funds. The Directive will also impose requirements on other service providers to AIFs, such as custodians and valuators. AIF passport AIFM may market shares or units of their AIFs to professional investors in their home EU Member State, and in other EU Member States subject to a notification procedure. Under the notification procedure, the AIFM communicates required information to its home Member State authority. Once the home Member State authority has transmitted this information, together with an attestation that the AIFM concerned is authorized, to the host Member State authority, the AIFM receives a notification permitting it to start the marketing of AIF in the host Member State. The definition of “professional investor” is that of MiFID.2 AIFM domiciled in a third country may market the shares or units of their AIFs to professional investors in the EU providing that certain conditions are met. In particular, they must be subject to prudential regulation and supervision that is deemed equivalent to the provisions of the Directive and effectively enforced. These provisions are deferred for a three-year period, during which third-country AIFs may continue to be marketed in EU Member States under the current national regimes. AIFM passport AIFM domiciled in one Member State may also provide management services in relation to an AIF domiciled in another Member State, either directly or via the establishment of a branch, provided that the AIFM is authorized to manage that type of AIF. In both cases, a notification procedure is followed starting with the AIFM communicating required information to its home Member State authority. 1 An undertaking for collective investment in transferable securities, in accordance with the UCITS Directive. 2 The Markets in Financial Instruments Directive, Directive 2004/39/EC. The proposed EU Alternative Investment Fund Managers Directive: Impact on real estate funds 3
  4. 4. Requirements AIFM will be required, inter alia, to: • Comply with conduct of business requirements • Implement adequate organizational and administrative arrangements to identify conflicts of interest between it and the investors, and between investors, and implement adequate organizational and administrative arrangements to prevent conflicts of interest from adversely affecting the interests of the AIF and its investors • Implement separate portfolio management and risk management functions • Implement risk management systems in order to measure and monitor appropriately all risks associated with the AIF, review the risk management systems at least once a year and adapt them, whenever necessary. Risk management should include an appropriate, documented and regularly updated due diligence process when investing on behalf of an AIF. • Implement appropriate liquidity risk management systems and procedures • Comply with initial and ongoing capital requirements of: − €125,000 plus 0.02% of assets under management exceeding €250 million − 25% of annual expenditure (if greater than the capital required under the previous sub-bullet) • Provide disclosures to investors when they invest (and inform them of any subsequent changes) including: − A description of the investment strategy and objectives of the fund − The eligible assets and techniques, and their associated risks − The use of leverage and associated risks − Process to be followed when the investment strategy is modified − The identity of all service providers − A description of the AIF’s liquidity risk management, including the redemption rights both in normal and exceptional circumstances, and how the AIFM ensures a fair treatment of investors − The fund’s valuation procedures and pricing models − Description of fund fees, charges and expenses − Any favorable agreements with specific clients • Provide periodic disclosures to investors on: − The percentage of the AIF’s assets that are subject to special arrangements arising from their illiquid nature − Any new arrangements for managing the liquidity of the AIF − A description of the risk profile and risk management systems employed • Report to regulators, including: − Principal markets and instruments traded − The percentage of the AIF’s assets that are subject to special arrangements arising from their illiquid nature − Risk profile and risk management tools − Liquidity risk management arrangements − The use of short selling • Provide further reporting to investors and regulators where one or more AIF managed by the AIFM employs high levels of leverage on a systematic basis • Notify unlisted companies and their shareholders when the AIFM acquires 30% of the voting rights (small and medium-sized companies are not covered by this requirement). These provisions also apply where the AIFM has concluded an agreement with one or more other AIFM that would allow the AIF managed by these AIFM to acquire 30% or more of the voting rights of the issuer or the nonlisted company. AIFM will be required to appoint custodians and valuators that are independent from the manager. When delegating functions, AIFM will require prior authorization from the competent authorities of the home Member State. Portfolio management and risk management functions may only be delegated to AIFM authorized to manage the same type of AIF. 4 The proposed EU Alternative Investment Fund Managers Directive: Impact on real estate funds
  5. 5. The role of the custodian includes: • Receiving subscription payments and booking them in a segregated account • Safekeeping of financial instruments of the AIF • Verifying whether the AIF or the AIFM on behalf of the AIF has obtained ownership of all other assets the AIF invests in The custodian will be liable to investors for any losses suffered as a result of its failure to perform its obligations. This includes any loss of financial instruments unless the custodian can prove that it could not have avoided the loss. Custodians may delegate their tasks to other custodians. The independent valuator must implement appropriate and consistent procedures to value the assets of the AIF in accordance with existing applicable valuation standards and rules, and ensure AIF valuation rules are in line with the law, and the fund rules or instruments of incorporation. It must ensure that the assets, shares and units are valued: • At least once a year • Each time shares or units are issued or redeemed The domicile requirements for EU AIFM are set out as follows: EU AIF • Custodian: EU credit institution • Sub-custodian: EU credit institution • Valuator: in EU or third country, if subject to “equivalent” requirements • Administrator: EU or third country subject to certain EU AIFM requirements Non-EU AIF • Custodian: EU credit institution • Sub-custodian: in AIF domicile with “equivalent” legislation • Valuator: in EU or third country, if subject to “equivalent” requirements • Administrator: EU or third country subject to certain requirements Timeline for implementation If the AIFM Directive were to be adopted according to plan by the European Parliament and the Council of the European Union, it would enter into force in 2011. A number of areas in the Directive must be clarified by the European Commission before the Directive enters into force; these will be included in a separate implementing Directive. The expected timeline for adoption and implementation for the AIFM Directive is as follows: Discussions with the industry and with EU Member States April 2009 AIFM draft 2014 2011 Passport to market Directive published Directive enters AIF domiciled outside into force EU available } 2009 2010 2011 2012 2013 2014 } AIFM Directive should be approved by EU Parliament and EU Council Publication of by the end of 2009 implementing measures The proposed EU Alternative Investment Fund Managers Directive: Impact on real estate funds 5
  6. 6. Practical considerations The proposed AIFM Directive raises a number of practical considerations for the real estate fund industry. The regulation of AIFM will substantially impact those real estate fund managers who are currently not subject to any regulatory supervision in Europe at either a product or manager level. In particular, the private equity and opportunistic fund managers who are not associated with larger financial services organizations and typically use unregulated fund structures, will face the most substantial burden. 6 The proposed EU Alternative Investment Fund Managers Directive: Impact on real estate funds
  7. 7. Practical considerations i) The definition of collective investment undertaking While an AIF is defined in the proposed AIFM Directive as any collective investment undertaking excluding UCITS, “collective investment undertaking” is not clearly defined. The preamble of the Directive refers to “collective investment undertakings which raise capital from a number of investors with a view to investing it in accordance with a defined investment policy on the principle of risk-spreading for the benefit of those investors.” However, in practice, this is very generic. There are different relevant references to the concept of collective investment (e.g., the UCITS Directive, OECD, UK Financial Services and Markets Act 2000). Whereas a common feature of such definitions is that there is pooling of assets, there are often distinctions made between different legal forms. It may be difficult to establish which alternative vehicles are covered by the definition – for example, would a listed and traded investment fund with fixed capital (which is in substance similar to a public limited company) or a Luxembourg SICAR (which operates with pooling and variable capital but is technically not an investment fund) fall under this regulation? In addition, it It is fundamental that the is unclear which portion of the population of Real Estate Investment Trusts (REITs) in Europe (which can either be private or listed products, all of which exact scope of this Directive be are regulated but do not fall under the UCITS regime, and are often self- clearly defined in relation to managed) would be covered by the Directive. existing products and also that the Directive establishes clear It is interesting to note that a number of managers exclusively managing principles to determine whether closed-ended real estate funds (which have a duration generally exceeding new products will be in scope. seven years) could have benefited from the exemption for managers with less than €500 million under management with at least a five-year lock-up period. Exemptions for closed-ended However, the requirement for the assets under management to be unleveraged institutional real estate funds means that such managers will not be eligible (we discuss the importance of as they exist today should be establishing consistent rules on how leverage is measured in v) Leverage). considered. ii) Investors The Directive limits the distribution to professional investors, as defined under MiFID. Today, High Net Worth Individuals (HNWIs) invest in such products to access benefits not achievable in privately managed portfolios. These include potential yields or capital gains, access to diversified portfolios of investments, benefiting from professional management of the portfolio and spreading costs. The authors of the Directive We believe that one of the end results of the proposed Directive should be should seriously consider the enhancing and protecting the flow of capital into such products in the future. impact on the total amount of The Directive would, however, be potentially damaging to the sector by capital flowing into the sector as excluding HNWIs investing internationally in such funds. a result of excluding a significant Furthermore, excluding HNWIs as eligible investors would significantly limit number of qualified investors. their individual options and potentially increase their overall investment risk They should also consider the by driving them, in the medium term, to listed securities or nondiversified rights of qualified individuals to personally managed portfolios. access such products. The proposed EU Alternative Investment Fund Managers Directive: Impact on real estate funds 7
  8. 8. Practical considerations iii) Management services It is critical to understand accurately what is meant by management services in the proposed Directive. In reality, “management services” could cover a number of different activities within typical real estate fund structures. Generally management services could fall into four generic types. These are: • Fund management: This sets the overall strategic direction of the fund. This is done by management companies or boards of self-managed funds. • Investment management: This provides advice to fund management regarding transactions or the execution of specific tactical asset management programs. This is often subcontracted to investment advisors; however the final decisions based on the advice provided are taken by fund management. • Property management: This provides day-to-day tenant and physical property management services. • Administration: This covers a broad range of activities including accounting at fund or Special Purpose Vehicle (SPV) level, domiciliation, paralegal and corporate secretarial services and processing transactions in fund shares or units. In regulated funds, many of these activities are currently performed by service providers approved and supervised by the regulator. There are several important open questions requiring further clarification regarding the scope of management services as defined by the Directive: • The Directive requires that when portfolio management services are delegated to a third party, the third party must be authorized to manage equivalent AIFs. Today, although a significant part of fund management is regulated, investment management is typically not directly supervised as the responsibility for such activities ultimately lies with fund management. It is unclear whether the scope of the proposed Directive extends to investment management in this sense. If it were to be the case, this would have a significant structural impact on the real estate asset management Clearly the scope of sector. “management services” needs • The individual property managers are generally small local entities that to be clarified and needs to take are often generally not subject to licensing requirements in the EU. It is account of current regimes and unclear whether the proposed Directive also applies to individual property the organization of the sector. managers. If investment management, • Although the proposed Directive refers to administration within the property management and/or definition of management services, it is unclear whether it is the intention pure administration were being of the authors to cover pure “administration activities.” In fact, currently for regulated funds, fund administration services are already carried out targeted under management by regulated entities; these activities are not considered as “management services, the impact would be services.” substantial and disproportionate. 8 The proposed EU Alternative Investment Fund Managers Directive: Impact on real estate funds
  9. 9. Practical considerations iv) Capital requirements The Directive imposes minimum capital requirements and an increase in proportion to the assets under management above €250 million. The Directive suggests that minimum capital requirements will “ensure the continuity and the regularity of the management services provided by the AIFM” – i.e., to ensure there is sufficient capital to cover the ongoing The capital required for AIFM operations of the manager. should be proportional to the running expenses rather than The running expenses of a real estate fund are, however, not necessarily assets under management. It proportional to the size of the fund – many are fixed or semi-variable. should not exceed the capital However, the Directive also refers to capital requirements to cover professional required for UCITS management liability, which is a very different concept. It is highly unlikely that capital companies. It is unrealistic to requirements would cover professional liability; such risks are normally assume that professional liability mitigated through insurance. exposure can be covered by minimum capital requirements; Furthermore, it seems difficult to understand why the capital required for AIFM targeting professional investors is set at a similar level to that required the Directive should foresee for UCITS management companies that are concerned with retail investor other means of achieving this protection. objective. v) Leverage The Directive imposes additional disclosure and reporting requirements on funds with “high levels of leverage on a systematic basis” defined as where the combined leverage from all sources exceeds the value of the equity capital of the AIF in two of the last four quarters. This will impact many real estate funds. Clearly, the degree of leverage is a significant risk factor that should be taken into account. One of the issues arising from the European Commission’s definition of leverage relates to how it is calculated. While real estate funds will typically prepare consolidated accounts, and are therefore in a position to calculate leverage at a consolidated level, private equity and hedge funds do not generally consolidate their results, meaning that potentially a significant portion of leverage remains off-balance sheet. The determination of the debt-to-equity-ratio, and hence leverage, is a highly A key objective of the Directive is complex technical issue. Accounting standards (e.g., IFRS) establish common rules for the identification and measurement of equity, debt and hybrid to monitor risk at systemic level, instruments. This includes a detailed framework covering among other things and therefore it should sharply off-balance sheet and orphan entities, derivatives and hybrid instruments. A focus on this point. The Directive key question, therefore, is whether the measurement of leverage should be needs to clarify not only how aligned with existing accounting rules, or whether the authors had something managers will report on leverage, additional in mind for the purposes of the Directive. but more importantly how they To ensure the stability and integrity of the financial system, the Directive will measure it. Fair and consistent requires the Commission to adopt measures setting limits to the level of rules should be applied across all leverage AIFM can employ, taking into account the type of AIF, its strategy types of funds, based on existing and sources of leverage. Member State authorities may temporarily impose industry standards. An additional additional limits. Current national regulation in a number of Member States layer of rules redefining leverage requires regulatory approval of the proposed level of leverage or limits would create a significant burden leverage, mainly for the purposes of investor protection. For regulated funds, it would appear that there would be no additional requirements in this sense, on EU real estate fund managers assuming that levels of leverage are set below the current levels. Obviously, for and investors with arguably currently unregulated funds, this is a new concept. minimum added value. The proposed EU Alternative Investment Fund Managers Directive: Impact on real estate funds 9
  10. 10. Practical considerations vi) Independent valuation The vast majority of real estate funds in Europe have an independent valuation process for property. Independent valuators generally implement industry valuation standards, such as those of the Royal Institute of Chartered Surveyors (RICS). In terms of valuing the real estate assets themselves, we conclude that these long-established valuation practices should not be impacted, in principle. Many non-listed real estate funds permit subscriptions and/or redemptions on a quarterly basis, and some even more frequently, while the independent valuation of the underlying property assets does not necessarily match the timing of the issue and redemption cycle. The frequency of the valuation is adapted to the fund style. There are current, generally accepted industry guidelines on this subject (e.g., from INREV3 and EPRA4). However, the proposed AIFM Directive requires that the independent valuator ensure that the assets, shares and units are valued at least annually and each time shares or units of the AIF are issued or redeemed. External appraisals of property cannot be conducted on more than a monthly basis and are often only done annually for closed-ended funds. Given the nature of the independent property valuation process, it is impractical to call for independent valuations each time shares or units of the real estate fund are issued or redeemed in frequently traded funds. If this is the case, it either means more frequent valuations resulting in a significant additional expense burden for investors, or a reduction in investor liquidity due to a reduced subscription and redemption frequency. Furthermore, there are significant other assets and liabilities held on the balance sheets of real estate funds, including among others debt, derivative If the Directive imposes hedging instruments, equity in joint ventures and associated companies, along additional independent valuation with working capital balances and cash. The question is, what was in the minds requirements on real estate funds, of the authors with respect to the independent valuation of these other assets and liabilities that form a significant part of the determination of the net asset this would be without precedent value? for any type of company or fund, including listed entities, in which Today, for regulated real estate funds, an independent central administrator the public can trade. Furthermore, in conjunction with the custodian monitors the valuation of all assets and the authors need to take account liabilities, including the work of an independent property valuator, in the of the specific nature of the calculation of the net asset value. Is this the type of arrangement that the Directive aims to implement? If this is not the case, this may create an asset class and how valuations operating model without precedent for real estate funds and may have an of immovable property are adverse impact on investor liquidity and returns. conducted in reality. 3 European Association for Investors in Non-listed Real Estate Vehicles. 4 European Public Real Estate Association. 10 The proposed EU Alternative Investment Fund Managers Directive: Impact on real estate funds
  11. 11. Practical considerations vii) Custodian The proposed Directive segregates the custodian’s role for the financial instruments and other assets. For financial instruments, it imposes a safekeeping role. For other assets, it requires the custodian to verify “whether the AIF or the AIFM on behalf of the AIF has obtained ownership of all other assets the AIF invests in” as well as ensuring that title to assets has been effectively transferred. The supervisory role of custodian in relation to real estate titles is thus properly addressed in the proposed Directive. However, the Directive also raises concerns over the custodian’s liability for ensuring that legal title has been established. There are divergent standards in Europe for establishing legal title. Much of the work, prior to, during and after an acquisition, is currently performed by service providers that are generally not The custodian’s liability should EU credit institutions (including lawyers). The custodian’s role in acquisitions be limited to ensuring that an is generally to ensure that due care has been undertaken in the transaction adequate due diligence process assessment and completion. This includes ensuring that the acquisition has been for property transactions is discussed and agreed, that all advisable due diligence has been undertaken, that conducted and an ongoing role there is no apparent factor that may prohibit the fund from owning the property and that all documentation is consistent with the transaction as agreed. The of monitoring safekeeping. The actual safekeeping of documents relating to legal title is generally not performed Directive needs to clarify this role. by EU credit institutions, but is monitored by the custodian. The custodian’s role should be A separate issue is that the custodian is required to book subscription payments from investors in a segregated account; however, such activities may currently be monitoring rather than booking performed by other authorized entities. This is monitored, rather than executed, subscription and redemption by the custodian; it is difficult to see how investors would benefit from the change. payments. viii)Risk management It is in all parties’ best interest that real estate funds implement an adequate risk management framework, irrespective of regulatory requirements. In this area, the main thrusts of the proposed AIFM Directive are: • Risk management systems must be implemented by the AIFM in order to measure and monitor appropriately all risks associated with each AIF investment strategy • Separate annual reviews of risk management systems are required • A documented and regularly updated due diligence process is necessary when investing on behalf of an AIF While financial services organizations are used to such requirements, niche players with no previous experience of complying with such regulatory requirements will be challenged to formally document their existing risk management procedures and subject them to independent reviews. In the roll-out of risk management regulation in the past, there was a significant role for independent auditors in providing comfort on risk management standards. We are not sure whether this is what is anticipated under the current proposals regarding annual reviews. However, investors in AIFs are sophisticated professional investors who are well Clearly, AIFM need to implement aware of the risks they are taking when investing in a fund. A distinction needs to adequate risk management be made between standards applied for professional investors and those applied processes and procedures to for the general public. The level of contractual due diligence undertaken by professional investors is generally high and therefore the standards applied and ensure that their fiduciary levels of comfort required in this area should take this into account. responsibilities towards investors are being met. Practically, the Given the nature and practicalities of risk management frameworks, it is difficult provisions of the Directive to achieve pragmatic regulation in this area. To many commentators, the roll- need to ensure that the level of out of Sarbanes-Oxley regulation in the US created a disproportionate burden on companies and resulted in dramatic shifts in capital flows. Also, there are formalization of risk management already global standards, such as the COSO5 framework, covering the design and requirements is proportionate to functioning of risk management models. the effort and expense. 5 Commitee of Sponsoring Organizations (COSO). The proposed EU Alternative Investment Fund Managers Directive: Impact on real estate funds 11
  12. 12. Practical considerations ix) Conflicts of interest The Directive requires that the AIFM take all reasonable steps to identify conflicts of interest between themselves and the investors, but also between investors, and implement adequate organizational and administrative arrangements to prevent conflicts of interest from adversely affecting the interests of the AIF and its investors. Where such arrangements are not sufficient to ensure that the risks of damage to investors’ interests will be prevented with reasonable confidence, the AIFM is required to disclose the It is unreasonable to require real nature and sources of conflicts of interest before they invest and develop estate fund managers to be in a appropriate policies and procedures. position to identify all conflicts While real estate fund managers are used to managing conflicts of interest of interest between investors, between themselves, the fund and its investors, identifying all conflicts of especially in large open-ended interest between investors will be practically impossible. Our reading would funds with hundreds of investors. indicate that this is more an obligation of means rather than results, but The existence of commercially further clarification would be useful. negotiated arrangements to align It is interesting to note that the proposed Directive is silent on common interests should be considered by techniques used in the industry to align the interests of the managers and regulators and give them some investors. Currently, players in the sector consider these types of financial comfort. alignment techniques as critical in balancing different agendas. x) Side letters The Directive stipulates that no investor may obtain preferential treatment, unless this is disclosed in the AIF fund rules or instruments of incorporation; furthermore, it requires the disclosure to investors of the identity of investors receiving preferential treatment and a description of the preferential treatment. If there are to be provisions covering side letters, we suggest Side letters, such as agreements with individual investors to reimburse fees or providing for other preferential arrangements outside the legal framework that the Directive should not go of the fund, are commonplace in real estate funds. There is an intense debate beyond requiring the existence, within the industry on whether the existence and content of side letters should framework and limits of side be disclosed. Current INREV guidelines only go as far as calling for the manager letter arrangements be disclosed. to explain the general approach to disclosure of side letter arrangements to The identity of the investor and investors. exact content of each individual The Directive could target general disclosure of the framework and limits side letter should, however, of such arrangements. It goes further, however, by requiring individual remain confidential to the parties arrangements be disclosed. This approach raises significant investor involved. confidentiality issues. 12 The proposed EU Alternative Investment Fund Managers Directive: Impact on real estate funds
  13. 13. Practical considerations xi) Choice of domicile of AIFM and AIF By establishing passports both for AIFM and AIF, the proposed AIFM Directive permits AIFM to choose to establish themselves and their AIF in the domiciles that offer the most advantageous conditions. Their choices of domiciles will depend on factors such as: • Flexibility of the regulatory environment • Fiscal environment for investors and fund managers • Reputation of financial center Although perhaps not • Accessibility of the authorities intentionally, the AIFM Directive • Expertise and cost competitiveness of locally based service providers may lead to concentration • Ability to outsource both within the domicile and cross-border of AIFM and AIF in the most • Qualifications and knowledge of workforce (including languages) attractive domiciles. xii) Non-EU AIFM and non-EU AIF Non-EU managers Under the proposed Directive, non-EU AIFM will be able to market their funds in the EU subject to certain requirements, including equivalent regulation and supervision. There are no practical principles or processes defined in the Directive for establishing equivalence. Establishing “equivalence” will be a challenging task for the European Commission, which struggled with IFRS equivalence under the Transparency and Prospectus Directives. Furthermore, there is a three-year delay for the implementation of these measures. Non-EU real estate fund managers will have significant incentives to establish themselves in the EU to be able to passport their products to investors in other EU Member States. More important, as a practical matter, it makes business sense to have a physical presence close to investors and assets – i.e., in the EU for an investment strategy primarily focused on European investors and/or property. Non-EU funds Going forward, as a practical The shares or units of a non-EU AIF may only be sold to investors in EU matter, and in the light of the Member States if the Member State has signed tax cooperation agreements proposed Directive, non-EU real and implemented information exchange on tax matters with the third country in which the fund is domiciled – again, there is a three-year delay before estate fund managers will need implementation. It remains to be seen how many offshore jurisdictions will to establish a base in the EU and enter into such agreements with EU Member States. No doubt this will drive a domicile their funds in the EU at significant migration of funds to onshore domiciles. least for the foreseeable future. The proposed EU Alternative Investment Fund Managers Directive: Impact on real estate funds 13
  14. 14. Conclusion The European Commission has indicated that it is committed to transparent, evidence- based policymaking founded on a dual commitment to open consultation and impact assessments.6 The proposed AIFM Directive was, however, drafted without the usual industry consultation process; therefore it is no surprise that there are many practical issues, some of which are raised in this paper, that need to be resolved if the authors’ objectives are to be met. It has generated much discussion and been the subject of heavy criticism. AIFs have seen substantial growth in recent years and have now become significant players in global markets. Thus, overall, we understand the political viewpoint that the regulation of AIFM is a necessity. In the current political climate, it is almost inevitable that a new regulatory framework, in one form or another, will become a reality. Real estate funds are not the primary target of the AIFM Directive. They do not present many of the types of risks that the AIFM Directive is designed to mitigate or expose. European real estate funds are generally well regulated and comply with industry standards, such as those of INREV. Recently, European open-ended real estate funds were being considered as potential investments for European retail investors. While most of the proposed Directive was drafted as a one-size-fits-all approach, there are important distinctions that need to be made between the operations of hedge funds, real estate funds and private equity to ensure the authors’ intentions are translated into an appropriate regulatory regime. From the perspective of real estate funds, we are particularly concerned that: • The collective investment undertakings covered by this Directive need to be clearly identifiable • HNWIs may no longer be able to invest in these products internationally • The scope of “management services” needs to be clarified • Fair and consistent rules should apply to the measurement of leverage, based on industry standards • The scope of the requirement for independent valuation needs to be clarified • The provisions on risk management should not be overly burdensome on the industry • The provisions on conflicts of interest need to be practical and proportionate to the The challenge is to make required result, in particular in relation to potential conflicts of interest between sure that the new Directive investors is targeted and effective • While the existence and typical content of side letters should be disclosed, the on the one hand, and identity of the investors and exact content of each individual side letter should remain pragmatic, practical to confidential implement and proportional to the objectives on the There is no doubt that the Directive, if implemented, will drive significant structural other. The specificities of the change in the real estate asset management sector. It may lead to a concentration of real estate fund sector need asset managers seeking to optimize their operations - and funds - in certain locations or to be taken into account if it to the migration of offshore products to European domiciles. It may even force, at least is to continue to flourish. in the short term, non-EU asset managers to establish regulated operations in Europe. 6 White Paper on Financial Services Policy (2005-2010). 14 The proposed EU Alternative Investment Fund Managers Directive: Impact on real estate funds
  15. 15. EMEIA Real Estate Leader Dean Hodcroft +44 20 7951 4870 dhodcroft@uk.ey.com EMEIA Real Estate Asset Management Leader Michael Hornsby +352 42 124 8310 michael.hornsby@lu.ey.com EMEIA Real Estate country contacts Belgium Patrick Rottiers +32 3 270 1233 patrick.rottiers@be.ey.com Channel Islands Geraint Davies +44 1534 288 639 gdavies11@uk.ey.com France Bernard Charrue +33 1 4693 72 33 bernard.charrue@fr.ey.com Marie-Henriette Joud +33 1 4693 67 49 marie-henriette.joud@fr.ey.com Germany Karl Hamberger +49 89 14331 13662 karl.hamberger@de.ey.com Dietmar Fischer +49 6196 996 24547 dietmar.fischer@de.ey.com Ireland Des Quigley +353 1 2212 550 des.quigley@ie.ey.com Italy Stefano Cattaneo +39 027 2212 452 stefano.cattaneo@it.ey.com Alberto Romeo +39 027 2212 445 alberto.romeo@it.ey.com Luxembourg Michael Hornsby +352 42 124 8310 michael.hornsby@lu.ey.com Netherlands Jeroen Preijde +31 8840 71679 jeroen.preijde@nl.ey.com Ad Buisman +31 55 5291 428 ad.buisman@nl.ey.com Central and Southeast Europe Harry Kyrkos +30 210 288 6211 harry.m.kyrkos@gr.ey.com Spain Francisco Fernández Romero +34 91 57 27 303 francisco.fernandezromero@es.ey.com José Carlos Hernandez Barrasus +34 915 727 291 josecarlos.hernandezbarrasus@es.ey.com Switzerland Rolf Bach +41 58 286 3870 rolf.bach@ch.ey.com UK Dean Hodcroft +44 20 7951 4870 dhodcroft@uk.ey.com Craig Hughes +44 20 7951 8397 chughes@uk.ey.com Matt Maltz +44 20 7951 1886 mmaltz@uk.ey.com James Stuart +44 20 7951 5349 jstuart@uk.ey.com Rob Otremba +44 20 7951 0607 rotremba@uk.ey.com
  16. 16. Ernst & Young Assurance | Tax | Transactions | Advisory About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 135,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. For more information, please visit www.ey.com. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. © 2009 EYGM Limited. All Rights Reserved. EYG no. DF0090 This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. www.ey.com/luxembourg

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