Background and timing of ESMA consultation process on the AIFM Directive
The new Directive on Alternative Investment Fund Managers ("AIFM Directive") entered into force on 21 July 2011, following its publication in the "Official Journal" of the European Union on 1st. of July. However, as the AIFM Directive only sets out the high-level framework for future rules for the management of alternative investment funds in the European Union, implementing measures are needed to flesh out the specific legal, technical and regulatory details of the new regime.
On 13 July 2011 the European Securities and Markets Authority ("ESMA", formerly known as CESR) issued draft advice on implementing measures for the AIFM Directive and launched a consultation process. The draft advice, presented in the form of a "Consultation Paper", responds to a request of the European Commission for assistance addressed to CESR (i.e. the predecessor organisation of ESMA) end of last year.
The substantial Consultation Paper (438 pages) addresses the following three areas singled out by the European Commission as substantial for the implementing of detailed technical aspects under the AIFM Directive:
•General provisions including scope and exemptions, authorisation and operating conditions;
•Role of custodians;
•Transparency issues (such as annual reporting and disclosure to investors) and leverage (including methods for calculating the leverage and the exposure of the Alternative Investment Fund ("AIF").
The Consultation Paper does not address issues of scope in any detail, beyond a consideration of how the threshold for the value of assets should be calculated in order to exclude small AIFMs. In particular, there is no reference to joint venture arrangements.
A further area concerning supervisory aspects under the AIFM directive, which was also raised by the European Commission, is not covered by this Consultation Paper. ESMA launched a separate consultation for these aspects on 23 August 2011 by issuing a new consultation paper covering any topics dealing with third countries in the AIFM Directive. These span from supervisory cooperation, marketing of non-EU AIFs, the delegation of certain functions to service providers outside the EU to the appointment of non-EU depositaries.
Definition of "Assets under Management" for exemption under Article 3 of AIFM Directive
For the calculation of the "assets under management" as mentioned in Article 3 of the AIFM Directive ESMA relates to the "total value of assets"-approach. ESMA states that it considers further methodologies, such as the calculation of acquisition cost of assets held.
Moreover ESMA suggests that the calculation of the "total value of assets" should include assets acquired via leverage, that is using a gross method of calculating the exposure of the AIF including any borrowing. ESMA seems to refer to the leverage which exposes the AIF directly, any borrowing at the level of an intermediate or holding vehicle would therefore not be included for the purpose of calculating the "total value of as-sets".
ESMA also proposes that the Alternative Investment Fund Manager ("AIFM") assesses all situations where the "total value of assets" would exceed the thresholds on an ongoing and lasting (not temporary) basis. In this respect ESMA specifies that the situation may be considered as temporary when it is likely to remain as such for a period longer than three months. ESMA suggests that the value of the AIF is to be monitored quarterly.
General Operating Conditions
Capital Requirements regarding additional own funds and insurance coverage
Article 9 of the AIFM Directive sets out a minimum capital requirement consisting in a fixed amount (EUR 125,000 for external AIFM resp. EUR 300,000 for self-managed AIFM); for portfolios of AIFM exceeding EUR 250 million an additional 0.02% of the value must be added in own capital or - if higher - 25% of the fixed overhead costs. A maximum in underlying own monies of EUR 10 million is provided for by the AIFM Directive. All capital must to be held in cash. In addition to these amounts the AIFM Directive imposes the requirement to have a professional indemnity insurance in place or to have additional own funds which are also to be held in cash. ESMA was asked to provide its technical advice on such insurance and additional own funds and in the Consultation Paper ESMA proposes a method for calculating additional own funds providing qualitative and quantitative requirements.
The qualitative requirements contains the implementation of effective internal operational risk management policies and procedures by the AIFM in order to identify, measure, manage and monitor appropriately operational risk including liability risks to which the AIFM is or could be reasonably exposed. This implies inter alia:
•the record of any operational failures and loss experience and the set up of an historical loss database by the AIFM; within the risk management framework the usage of the historical internal loss data and of external data, scenario analysis and factors reflecting the business environment and internal control systems;
•the implementation of a regular internal reporting if operational risk exposures and loss experience;
•the implementation of procedures for taking appropriate corrective action;
•the documentation of the AIFM's operational risk management policies and procedures;
•regular reviews of the operational risk management policies and procedures and measurements systems;
•the maintenance of adequate financial resources covering liability risk arising from professional negligence by own funds or an insurance at all times.
ESMA proposes two alternatives to calculate the quantitative requirements of the additional own funds for liability risk:
The first option is based on the variable assets under management and suggests one basis point (0.01 %) of the value of the portfolios of AIF managed by the AIFM as capital basis whereas the second proposal takes into account the variable income as well, in addition to the assets under management, proposing an amount of 0.0015 % of the value of the portfolios of AIF managed by the AIFM with an additional 2 % of the relevant income in own funds. The relevant income is defined as the sum of all income received in relation to the collective portfolio management activities of the AIFM minus the sum of commission and fees payable in relation to collective portfolio management activities, based on a calculation of the average income ./. costs) over three years.
In certain circumstances the competent authority of the home Member State of the AIFM may authorise the AIFM to lower the percentage with regard to the additional own funds requirement (first option: from 0.01% to 0.008% of the value of the portfolios; second option: from 2% to 1% of the relevant income).
With respect to the alternative professional insurance ESMA proposes that the insurance should cover specific risks listed and relating to fraud by "relevant persons", risks in relation to investor products and business practices and risks in relation to business disruption, system failure and process management. ESMA also proposes minimum coverage in numbers (i.e. per claim a minimum of the higher of
•EUR 2 million; and
•0.75% of the value of the portfolios exceeding EUR 250 million and in the aggregate the higher of:
◦EUR 2.5 million; and
◦1% of the value of the portfolios exceeding EUR 250 million; and
◦the required additional own funds (see above).
ESMA proposes general principles for due diligence which an AIFM has to comply with. More specifically an AIFM is supposed to:
•ensure a high level of diligence in the selection and ongoing surveillance of its investments, and this in the best interests of the AIF, the underlying investors and of the market integrity;
•ensure that the AIFM has adequate knowledge and understanding of the assets in which the AIF are invested;
•establish written policies and procedures on due diligence and implement effective arrangements in order to ensure that investment decisions on behalf of the AIF are carried out in compliance with its objectives, investment strategy and risk limitation (if any) of the AIF. The due diligence processes and procedures must be regularly reviewed and updated, as need may be.
In addition to these general principles, ESMA suggests more specific due diligence requirements for AIFM who invest in (more) illiquid assets of a long duration:
•AIFM managing AIFs which invest in long duration, less liquid assets such as real estate or "partnership interests" (e.g. private equity investments), typically carry out the investments upon a comprehensive and detailed due diligence process and an extensive negotiation of the agreement. ESMA considers that the due diligence requirements apply also during the negotiation phase itself;
•AIFM who invest on behalf of AIFs in such specific assets should set out a business plan consistent with the duration of the AIF and market conditions. They should update such a plan whenever substantial changes occur with regard to the investment strategy of the AIF or to market conditions;
•AIFM should deliver to its senior management the proposal to invest in a certain target company or real estate highlighting the advantages/disadvantages and the exit strategy as well as any further proposal related to such an investment during the AIF's duration.
''Furthermore ESMA proposes best execution principles based upon the rules applicable to UCITS (i.e. undertakings for collective investments in transferable securities).
''Furthermore ESMA proposes best execution principles based upon the rules applicable to UCITS (i.e. undertakings for collective investments in transferable securities).''
Moreover ESMA also proposes detailed implementing measures on risk management adapted to the nature, scale and complexity of their business and of the AIF it manages.
With respect to the custodian function of cash monitoring as set out in the AIFM Directive it was highly controversial if the cash monitoring would require an ex ante control. ESMA in its Consultation Paper does not recommend an ex ante control for the cash monitoring, but rather strongly supports that the AIFM ensure that the custodian be granted access to all information related to any cash account of the AIF. ESMA suggests two alternative approaches regarding the custodian's cash monitoring obligations:
•The custodian may be installed as a central hub where all information related to the AIF's cash flow is centralised to ensure effective cash monitoring; or
•the custodian ensures there are procedures in place to appropriately monitor and review periodically the AIF's cash flow.
The custodian must mirror every transaction in a record-keeping system. To ensure the verification of ownership, ESMA recommends imposing an obligation that the assets are either registered in the name of the custodian, or in case they are registered in the name of the AIF or in the name of the AIFM, that the custodian must be able to ensure that it can any ant time provide a comprehensive and up-to-date inventory of the AIF's assets.
ESMA recommends general principles on the custodian's oversight function. In particular, the custodian should monitor compliance of the AIF with investment restrictions and leverage limits defined the offering materials.
The AIFM Directive foresees certain special requirements applicable to AIFM managing AIFs employing leverage. In this context a further highly controversial issue was the question whether financing is used by a holding company under an AIF would be considered as an AIF using leverage. Pursuant to the definition of leverage in the AIFM Directive as "any method by which the AIFM increases the exposure of an AIF" an AIF should not be considered leveraged as borrowing at the level of the holding entity is not exposing the AIF in any way. ESMA confirmed this view in its Consultation Paper by clarifying that when calculating exposure it should be looked through corporate structures only to the extent that those structures have recourse to the AIF via cross-collateralisation or guarantees. It seems therefore that where the AIF itself does not provide guarantees or collateral for any borrowing at the holding vehicle level, such financing would not be considered as leverage in the meaning of the AIFM Directive.
Third country topics
The ESMA consultation paper on third country issues covers the following topics:
•cooperation arrangements for third country AIF and AIFM;
•delegation of portfolio/risk management functions to third country undertakings;
•assessment of third country depositaries; and
•identifying the "Member State of reference".
Cooperation arrangements for third country AIFs and AIFMs
Admission of third-country AIFs and AIFMs to EU markets through national private placement regimes or (later than 2015) a passport regime will involve a framework of supervisory cooperation and exchange of information between EU regulatory authorities and their counterparts in third countries. ESMA proposes that the relevant cooperation agreements allow for the exchange of information for both supervisory and enforcement purposes. The agreement should ensure cooperation by the third country regulator in assisting the relevant EU Member State regulator in enforcing EU or national legislation. ESMA has recommended documents prepared by the International Organisation of Securities Commissions (IOSCO) as benchmark for the cooperation agreements. ESMA is willing to propose an own sample cooperation agreement, a positive approach as a standardised agreement would have the benefit of consistency vis-à-vis separate uncoordinated bilateral agreements.
Finally ESMA stated that third country passport rules would be addressed at a later stage, since these rules would not enter into force before 2015. Therefore the consultation paper on third country topic does not cover any passporting issues.
Delegation of portfolio/risk management functions to third country undertakings
The AIFM Directive provides that, where an AIFM as authorised under the AIFM Directive delegates portfolio management or risk management activities to third parties, the delegation may only be to "undertakings which are authorised or registered for the purpose of asset management and subject to supervision". ESMA proposes that a third-country undertaking should be deemed to satisfy the above requirement "when it is authorised or registered for the purpose of asset management based on local criteria which are equivalent to those established under EU legislation (...)"
The AIFM Directive further requires cooperation arrangements to be in place between the AIFM's home Member State regulator and the regulator of the delegate. The cooperation arrangements proposed by ESMA in this regard are similar to those mentioned above.
Assessment of third-country custodians
Under the AIFM Directive a non-EU AIF's custodian can be located either in the jurisdiction of non-EU AIF (i.e. third country), in the home Member State of the AIFM (in the case of an EU AIFM) or in the EU "Member State of reference" of the AIFM (in the case of a non-EU AIFM). In order for a custodian to be located in a third country, that third country custodian must be "subject to effective prudential regulation, including minimum capital requirements, and supervision which have the same effect" as EU law and are effectively enforced.
ESMA has set out its proposals for the criteria to be taken into account when determining whether a third country custodian is subject to such equivalent standards. ESMA notes that the European Commission may issue decisions declaring a given third country as equivalent if it determines that the criteria have been fulfilled. To the extent third country AIF jurisdictions wish to take advantage of the possibility that AIF custodians may be located in those jurisdictions, those third countries will need to consider whether the equivalence requirement can be met.
Identifying the "Member State of reference"
The AIFM Directive provides that, where a non-EU AIFM intends to market several AIFs in the EU, that non-EU AIFM's "Member State of reference" is "the Member State in which that AIFM intends to develop effective marketing for most of those AIFs...". ESMA proposes that that phrase be interpreted to mean the Member State where the non-EU AIFM intends to target investors by promoting and offering most of the AIFs.
Timeline and Outlook
The consultation process for the Consultation Paper closes on 13 September, whereas the deadline for responses to the second consultation paper is 23 September 2011.
In light of the feedback ESMA will have received it will finalise and submit its advice to the European Commission by 16 November of this year. The definite implementing measures will then be adopted by the European Commission in the course of next year.
However technical the propositions of ESMA may appear, the AIFM Directive is beginning to take shape. It is now to the professional associations and any concerned stakeholders to duly screen and evaluate the proposed measures and revert to ESMA with their comments and practical input on behalf of the European fund industry which will be subject to the new regulatory regime for any investments beyond the UCITS mainstream for the years to come.