The first thing many people don’t realise about the Alternative Investment Fund Managers Directive (AIFMD) is that its scope extends far wider than the alternative financing industry. In this regard the ‘alternative’ of the directive’s title is misleading: with the exception of managers who run exclusively Undertakings for Collective Investment in Transferable Securities (UCITS) funds, every asset manager selling funds into the European Union (EU) is affected.
The EU directive imposes requirements on fund managers as well as funds – another area where the name is misleading. The scope is all non-UCITS investment funds, including long-only funds and – until the Commission finalises a directive concerning them – money market funds (MMFs) also. The only funds excluded (among those investing in EU securities) are those based outside the EU and not sold into the EU.
Although the precise detail of national transposition may vary, in every case EU asset managers face new rules over risk management, remuneration, general operating conditions, capital, delegation, reporting and disclosure. They have one year to comply from the 22 July 2013 implementation date. As soon as they do, firms will be granted an EU passport, allowing them to market alternative investment funds (AIFs) throughout the EU on the basis of the authorisation granted by their home country. (The EU passport may become available to non-EU AIFMs and non-EU AIFs from 2015, although this is still subject to an opinion from the European Securities and Markets Authority (ESMA).)
All EU AIFs must appoint a depositary – a regulated entity, most likely a bank, with a registered office in the home country of the AIF, which holds the title assets of the funds. AIFMD level 2 measures means depositories will be liable for lost assets held in custody. Their other responsibilities include: overseeing a fund’s compliance with applicable laws, regulations and the fund’s own legal requirements. They must also monitor funds cash flows, collect evidence of asset ownership and control net asset value (NAV) calculation. This will be a change for many funds, whose home regulators have not previously required them to use a depositary. If a treasury has invested in an MMF, these new rules will affect them.
The depositary requirement will have major implications for hedge funds, many of which have historically used prime brokers for safekeeping. Under this model, fund assets held by their prime brokers is collateral on financing or leverage. The prime broker has also a right to re-use the fund assets to refinance itself, to facilitate its trading activity of other clients, or for its own account.
Because the depositary now has legal liability for the assets, prime brokers are unlikely to receive this type of unencumbered access to fund assets. Instead, the depositary may insist that the assets are held primarily by the depositary and not by the prime broker. The depositary will, however, ensure that the prime broker continues to benefit from a security interest over those assets in case of the fund’s default. In case of re-hypothecation, the depositary will require that assets are delivered to the prime with full title transfer. The prime broker having taken ownership, the depositary will no longer be responsible for those assets.
It’s very hard to see how prime brokers can avoid having to increase their fees to reflect the greater restrictions they face around rehypothecation. Funds which do not rely on prime brokers for financing may review whether they need to use one.
Early Compliance Benefits
There may be advantages to managers achieving compliance before the July 2014 final deadline, particularly if institutional investors regard AIFMD as desirable proof of good risk management. Some large asset managers are seeking to achieve full compliance for their fund range in some jurisdictions by July 2013
But not everyone will be willing, or able, to follow this lead. Fund managers face a slew of tough regulations this year – compliance with the US Foreign Account Tax Compliance Act (FATCA) is also due by the start of 2014 for example. Regulators, too, will vary as to when and how they process applications for authorisation as part of the wider process of national transposition.
Fund managers should approach the compliance exercise in three stages, while treasurers need not worry but should nonetheless check that any fund managers they deal with have complied.
- Chose a compliance strategy: Fund managers should first look at their range of funds and distribution strategy. Do they believe there are advantages to immediate authorisation in investors’ eyes? Should they comply through the existing private placement regime, or migrate their distribution under the AIF passport? Choosing the latter option may mean moving funds onshore. Some of EU asset managers are, for example, shifting offshore funds to Luxembourg or Ireland. Malta’s authorities are marketing the island as an attractive onshore EU jurisdiction to Cayman-domiciled funds that may want to move.
- Appoint a depository: All European funds should appoint a depository. Many funds will be doing so for the first time, so will need to build systems to ensure the accurate and timely flow of information between the fund, the administrator and the depository bank. If fund administration has been outsourced this will mean a dual reporting line between fund and depositary bank and funds must be confident their administrators can deliver this. Funds will have to choose depositary banks carefully, not only to ensure that they can execute their oversight duties but also to reassure investors that their assets are well protected.
- Review the detail: There is much complicated detail in the new directive that will shock managers when they discover it and they will require help from service providers. Lawyers will need to spend a long time getting contracts of delegation right, for example. In the UK, there may too few lawyers to do the work if things are left to the last minute.
If the whole hedge fund and private equity funds industry only wakes up at the eleventh hour, there are grave risks. Firms relying on countries securing cooperation agreements to continue distributing under private placement regimes, for example, may find themselves out in the cold if their home regulators don’t agree these in time.
Managers should by now have combed the AIFMD for the questions it asks of their business. If they don’t yet have answers, they should hurry to obtain them.
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