AIFMD:

changes and benefits in store for the European alternative fund industry

Alternative fund managers face changes but also opportunities arising from the AIFM Directive. This article aims to address the main implications and challenges for alternative investment firms in implementing the directive, focusing on the practical aspects in gearing up investment management system processes to accommodate the legislative provisions.

By Camille Thommes, Director General, the Association of the Luxembourg Fund Industry (ALFI); Charles Muller, Deputy Director General, the Association of the Luxembourg Fund Industry (ALFI)

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On 11 November 2010 the European Parliament and EU Commission approved the proposed Alternative Investment F und Managers Directive (AIFMD). Having taken 19 months to negotiate, the directive represents a major step in the regulation of the alternative investment industry within Europe.

From mid-2011, when AIFMD is officially published, member states have two years to implement the directive. From the outset it was clear that the directive would substantially change the rules applying to managers of alternative investment funds in the EU domain. But much of the hard work – the Level 2 implementation phase – still lies ahead.

The way in which AIFMD came into being was not a procedure that is normally used, however. Normally a consultation phase is gone through, resulting in a draft directive. Here the EU Commission was under pressure due to decisions by the G20 that were motivated by the 2008 financial crisis to immediately come up with a proposal, which was then extensively debated and criticised during the entire process.

What emerged from this process was a directive at a very high political level and where many of the more technical elements were left to be resolved at Level 2. And the Level 2 measures are currently under discussion and in the preparation phase with the European Securities and Markets Authority (ESMA formerly known as CESR). A first consultation has been published by ESMA asking for feedback and information from the alternative investment fund industry stakeholders and many of them, located in and outside the EU, have answered.

THE BIG PICTURE

There remain outstanding quite a number of question marks as to the details of some rules, or the influence and the rise of third-country funds to be distributed in Europe, etc. Put another way, we have the big picture but not the details as yet.

What we at ALFI have stated from the start is that we understood the willingness by EU authorities to try and regulate non-UCITS funds as well. This could be viewed not necessarily as a burden but also as an opportunity to create a second fund category to match the success of the Undertakings for Collective Investment in Transferable Securities (UCITS) category, which has proved very successful over the past 20 years, emerging as an essential cornerstone in the development of the European investment funds industry.

Despite the claimed technical successes of AIFMD, the implementation phase is likely to be fraught with difficulties. Whereas UCITS was a voluntary quality brand offered to managers who wanted to benefit from it, AIFMD stems from the G20 and does not have that element of voluntary approach. How to combine them and make them work certainly represents a medium-term challenge.

Subject to a very limited set of exemptions, the provisions of AIFMD affect all managers of non-UCITS investment funds, such as hedge funds, real estate or venture capital and private equity funds, which are located in Europe (or even outside Europe if they are managed by an EU manager or distributed in Europe) and which fall outside the scope of the UCITS Directive, irrespective of their legal form and regime.

AIFMD will, for the first time, introduce a harmonised European regulatory regime for managers of alternative investment funds. The AIFM Directive is designed to address a number of risks identified by the EU Commission relating to alternative investment funds, including systemic risk. It will require from the managers of alternative investment funds above a certain size to register and provide regulators with detailed information on the principal markets and activities of the funds that they manage.

The directive also contains provisions on capital maintenance, risk management, valuation, delegation, depositary, reporting, leverage, remuneration policies, etc. It also regulates the EU management of third-country alternative investment funds and EU market access for third country alternative investment funds and their managers.

PRACTICAL IMPLICATIONS

In addition to subjecting alternative investment fund managers to compulsory regulation in the EU, AIFMD will require significant modifications to the structures, strategies and operations of fund managers and funds in the non-UCITS sphere and will also directly and materially affect those that service this industry.

AIFMD will oblige service providers to the industry (i.e. depositaries, custodians, prime brokers, administrators, and other outsourced services) to adapt to a very different market for alternative investment funds.

As a consequence, AIFMD substantially redefines the relationships between fund managers, alternative funds and their service providers, who will need to adapt their product offerings effectively to the new requirements.

In addition, AIFMD presents major operational, compliance and reporting challenges for fund managers. For one, depositary and (where used) prime brokerage arrangements will need to be re-aligned. For the second, products and services will need to be designed (or reconfigured) to provide for a greater flow of information, either to allow a depositary to perform its required functions under AIFMD or where administrators are asked to cope with the increased demand for reporting capacity by managers who now have reporting obligations to both regulators and investors. For the third, valuation processes and procedures will require modification. And finally, demand for third-party assistance and assurance will almost inevitably increase as a result of AIFMD.

In order to find practical, integrated solutions to the challenges posed by these multiple regulatory developments, alternative investment management organisations will need to consider their strategic positioning, identify areas for change, and plan for implementation. They will need to understand the issues they are facing and undertake an adaptation process through practical, economic, financial and software system solutions that are fully compliant with AIFMD requirements.

DEPOSITARY REQUIREMENTS

One of the key areas alternative investment managers will have to consider when adapting to AIFMD will be depositary requirements. For banks that offer depositary facilities (and many of them do), AIFMD in its current form is likely to have a huge impact on their ability to service funds and assets at the riskier end of the investment spectrum. In the wake of the Lehman collapse and Madoff scandal, AIFMD has been framed to considerably tighten the unharmonised rules under which depositary banks operate for the moment.

For a start, all funds – traditional and alternative alike – must now provide custody of their assets. For the depositary banks, the extent of their fiduciary duties is now clearly laid out at a European level. Some of the more important duties they must now perform include: monitoring cash flows; safekeeping assets and monitoring the day-to-day transactions of a fund, including the accurate and timely valuation of assets in a fund.

AIFMD contains extensive provisions on the depositary’s role and responsibilities, its ability to delegate and its liability to the fund and investors. The harsher strict liability provisions previously proposed have been modified to better take into account the effective business conditions, developments, structures and variety of assets to be safe-kept by a depositary. There is now potential scope for a discharge of that strict liability, notably in the case of the use of a sub-custodian if certain conditions are met, and if the fund managers can demonstrate that the local depositary satisfies certain quality criteria (due diligence process).

Alternative investment managers will need to ensure they have the resources (people and systems) to meet the AIFMD requirements, and pro-actively demonstrate their preparedness to clients. Contractual arrangements will need to be revised to reflect the new regime and ensure appropriate information flows. Alternative investment management organisations need to assess the impact on their business model, operations, product offerings and pricing, to work out what is done by whom, for whom and in what business area, in order to start evaluating what changes may need to be made, both in response to obligations imposed directly on them and to respond to client-driven demand.

VALUATION PROCESSES

Another key area to consider when adapting to AIFMD provisions takes the form of valuation processes and procedures. Alternative investment managers may need additional assistance to comply with the detailed requirements on these processes and procedures under AIFMD. Each fund’s assets will have to be valued and the net asset value (NAV) calculated at least on an annual basis. Open-ended funds will be required to carry out more frequent valuations and NAV calculations at a frequency appropriate to the assets they hold and their issuance and redemption frequency, whereas closedended funds have to carry them out each time the capital of the fund increases or decreases. More details on valuation requirements will come in the Level 2 implementing measures.

Many alternative fund managers have traditionally carried out valuation activities in-house, and will be able to continue to do so under AIFMD. But regulators are now enabled to require that an external valuer or auditor verifies the internal valuation. They will be required to ensure and demonstrate that valuation functions are independent from the portfolio management function and the persons responsible for implementing the firm’s remuneration policy. Some fund managers may simply not have the personnel or organisational structure to permit them to do this; others may choose to outsource as a more convenient and cost-effective option.

Alternative investment managers will need to revisit their valuation services, and factor this and their increased liability exposure into their business models and product offerings. They will need to revise valuation processes and procedures to comply with AIFMD. Software systems may require upgrading, and fund documentation and suppliers will need to be updated to reflect the new requirements.

DISCLOSURE REQUIRE MENTS

Alternative investment managers will also require more assistance with AIFMD’s extensive disclosure and reporting requirements. Software system suppliers will have to assure that the reporting they provide is fully compliant with the level of detail expected, and that their systems are able to produce the required data. Compliance and legal departments will need to ensure that all contractual arrangements are appropriate in case the data provided is deemed to be insufficient by the regulator.

Under AIFMD, alternative investment fund managers will be obliged to make full disclosure to investors (before they invest), including a description of the investment strategy and objectives of the fund, the types of assets the fund may invest in, the techniques it may employ, and the procedures to be used to alter the investment strategy. In addition, they will have extensive ongoing reporting requirements to investors. To help meet these obligations, suppliers will be required to assist fund managers with their increased reporting workload for investors.

Alternative investment fund managers will also be obliged to make extensive disclosures to regulators in areas such as gearing, liquidity, risk management, trading activity, and information about portfolio  investments. In addition, further ad-hoc reporting may be necessary for effective monitoring of systemic risk. Many fund managers simply will not have the capacity to do all this in-house, and will need technical assistance with planning around the presentation of information as well as reporting services to cope with these increased disclosure requirements.

COMPLIANCE FUNCTION

AIFMD will oblige alternative fund managers to review their compliance functions, particularly in relation to the way conflicts of interest and risk management are handled. They are likely to require more compliance resources to cope with the burden of ensuring compliance with AIFMD. In many instances, the compliance function will be ramped up and will assume a far more important role in the practical operations and administrative tasks of the individual alternative fund manager.

When dealing with a set of asset classes considered as not being plain vanilla, but rather hedge funds, real estate, private equity and the like, obviously the operational and administrative capabilities will have to be adapted to the specific needs of servicing these types of products. These include NAV calculations, managing portfolio registrations, portfolio holdings, and specific reporting requirements of a compliance nature.

LOCATION OPPORTUNITIES

In addition to creating opportunities for the alternative fund management industry, AIFMD also presents benefits and advantages for certain European fund industry locations and hubs. A case in point is Luxembourg. It was the first country to implement the latest version of UCITS – UCITS IV – and it has announced its ambition to be very early in the process of transposing AIFMD.

Over the years, Luxembourg has gained experience in fund structuring and distribution, and developed an extensive fund-servicing infrastructure. It is familiar with concepts like capital maintenance, risk management, valuation rules, reporting obligations, etc. and their implications in terms of fund structuring and supervision - many of them inspired by the UCITS legislation. And due to its regulated structure, Luxembourg has been able to build the competencies needed in setting up and administering alternative structures, i.e. private equity funds, real estate funds and hedge funds.

With its Specialised Investment Fund (SIF) vehicle introduced in 2007 and now accounting for almost a third of all Luxembourg-registered funds, the Grand Duchy has in place most of the provisions laid down in AIFMD. Regulated by law, SIF is an operationally flexible and fiscally efficient multipurpose investment fund regime for an institutional and qualified investor base.

Luxembourg’s current SIF legislation offers promoters the option of establishing investment structures, which comply with the main features of AIFMD. Luxembourg also has the know-how to use and apply an investment management passport enabling alternative fund managers to offer their services and market their funds throughout the EU.

AIFMD, then, will more likely than not increase the establishment and relocation of alternative investment funds in European jurisdictions like Luxembourg and Ireland. The challenge in Luxembourg’s case will be to replicate UCITS’ success and know-how in the alternative investment world. The support of a local government authority, the pro-active approach of a domestic financial regulator, and the capacity of a country to anticipate and quickly adapt itself to any new requirements make a strong case for a country like Luxembourg or Ireland as a location for alternative investment funds and their managers.

For their part, those investment managers that react swiftly and effectively to the strategic and operational opportunities created by AIFMD will be in a position to capitalise on the changing environment to gain competitive advantage by adjusting their business models.

Camille Thommes is Director General of the Association of the Luxembourg Fund Industry (ALFI). Prior to joining ALFI in 2007, he worked for Banque et Caisse d’Épargne de l’État, Luxembourg, where he held senior positions in the Securities Department before heading the bank’s Investment Fund Department in 2001. Camille Thommes started his professional career in 1986 at Banque Générale du Luxembourg (now BGL-BNP Paribas) where he held various positions in the custody area. He is a member of several advisory committees to the Supervisory Commission for the Luxembourg Financial Sector (CSSF) and represents ALFI at the Board of Directors of the European Fund and Asset Management Association (EFAMA), Finesti S.A., Profil S.A. and XBRL asbl. Camille Thommes holds a Master’s degree in Economics (section Business Administration) from the University Louis Pasteur in Strasbourg, France.

Charles Muller has been Deputy Director General of ALFI since 2003 and is also responsible for Legal Affairs, Promotion, Communication and Press Relations. After studying law in Paris („maîtrise en droit“ at the Sorbonne) and London (LLM at University College), Charles Muller became a Luxembourg barrister („avocat à la Cour“). In 1994 he joined Banque Générale du Luxembourg, where he held various legal positions in the retail, corporate and private banking departments, before being appointed the bank’s Deputy Secretary General. Charles Muller is also a former Board member of the International Investment Fund Association (IIFA), a Board member of the European Federation for Retirement Provision (EFRP) and a member of the Management Committee of the European Fund and Asset Management Association (EFAMA).