As the dust settles over the first anniversary of the deadline for adoption into EU Member States’ national law of Directive 2011/61/EU (“AIFMD”), the European alternative funds industry continues to evolve. As an administrator and depositary operating in numerous jurisdictions directly and indirectly impacted by AIFMD, Langham Hall has a unique insight into how regulators, fund managers and fund promoters are adapting to the significant changes in progress.
This multi-jurisdictional insight means that Langham Hall is able to work with fund promoters and managers and, indeed, regulators to find practical solutions to structuring and distribution issues.
The alternative funds landscape in Europe has changed profoundly
Among the wide-ranging developments to date, the following merit particular acknowledgement:
Our focus in this article is on the developments in points 1 and 2. Our Depositary group issues regular notes on depositary-related issues; the subject of point 3. We intend revisiting the wider issues raised in point 4 at a later date when the longer term impact of the AIFMD becomes clearer.
1. Complying with AIFMD and procuring an AIFMD-marketing passport
The way in which managers and promoters have dealt with AIFMD has generally been predicated by their pre-AIFMD presence and infrastructure in the EU.
Managers with a substantive EU presence, pre-AIFMD
Most fund managers that, pre-AIFMD, had an established presence in the EU and were, prima facie, within scope of the AIFMD have, unsurprisingly, obtained their full Alternative Investment Fund Manager (“AIFM”) licence in their jurisdiction of primary operations in the EU. The majority of managers have opted for a single EU AIFM to act as AIFM for all of the AIFs that they manage, using an AIFM passport to manage AIFs established in other EU Member States. This also enables such managers to market the EU AIFs that they manage throughout the EU under an AIFMD passport, provided that:
(i) those EU AIFs are also AIFMD-compliant (e.g. they have an AIFMD-compliant depositary); and
(ii) the local regulators have been notified of the AIFM’s marketing intentions in respect of those EU AIFs.
Some larger groups have obtained AIFM licences in multiple jurisdictions either:
(i) because their country-specific businesses function independently from rest of the group on a day-to-day basis and, as such, implementing a single EU AIFM model would disrupt the way in which such businesses operate; or
(ii) because explicit or implicit rules in individual EU Member States restrict cross-border AIFMs acting as AIFM under specific domestic fund regimes.
This has meant going through multiple regulatory application processes and now means operating multiple regulated businesses, with the related costs. Again, once authorised, each AIFM has the right to market the EU AIFs that it manages throughout the EU under an AIFMD passport.
For the aforementioned groups, the AIFM application process and the implementation of AIFMD-compliant systems and procedures has been an intensive process. However, in most cases, an existing infrastructure has meant that these managers have been able to implement and begin to comply with AIFMD with minimal disruption to fundraising and fund launches; albeit at not insignificant cost!
Smaller managers and non-EU managers/promoters
For smaller managers and for non-EU groups without a substantive presence, pre-AIFMD, in the EU, we have seen a variety of approaches. Certain smaller managers and non-EU headquartered groups have taken the view that a stand-alone full-scope AIFMD licence is necessary for reasons of internal control or investor influence and have opted to obtain a full-scope AIFM licence either in the location of their EU fund management team (e.g. the UK) or in the location of their European fund range (e.g. Luxembourg). The process for such managers and groups has, broadly speaking, been much more expensive proportionately when compared to those groups already established in the EU, pre-AIFMD. It has tended to necessitate a number of changes to satisfy the not insignificant infrastructure required under the AIFMD such as:
Again, the end result is the valuable AIFMD-distribution passport throughout the EU for their AIFMD-compliant fund range.
The third party or super AIFM
The expense and/or bureaucracy of obtaining a full scope AIFMD licence has meant that some managers and promoters have decided not to seek a full-scope AIFM licence and instead to engage a previously unconnected fully licenced AIFM (a third party or super AIFM) to take responsibility for the investment management function of one or more of their EU AIFs.
There are a number of variations to the third party AIFM model, but the most common works on the basis of the third party AIFM taking responsibility for an AIF’s investment management function, retaining substantially all of the risk management element of the investment management function, but delegating the portfolio management element of investment management function to the AIF’s promoter.
For the third party AIFM model to work, the AIFMD requires:
(i) the third party AIFM to have in place sufficient infrastructure and expertise to manage the AIFs for which it acts;
(ii) any delegation of primary AIFM functions to comply with the extensive rules on delegation; and
(iii) any delegation not to have the effect of a delegate performing investment management functions to an extent that exceeds by a substantial margin the investment management functions performed by the AIFM itself.
Notwithstanding these onerous requirements and responsibilities attached to the AIFM role, this solution is offered by service providers in Ireland, Luxembourg and the UK, with a number of third party or super AIFMs having obtained licences from the Central Bank, the FCA and the CSSF respectively.
This is clearly less expensive than a promoter establishing a new stand-alone proprietary AIFM, but it achieves the goal of obtaining an AIFMD distribution passport for those funds managed by the third party AIFM.
A manager/promoter using this model does also have to get comfortable with the loss of a significant amount of control over the AIF and the investment management process. Furthermore, a third party AIFM will need to be paid commensurately to reflect the requirements, responsibilities and risks associated with the role.
2. Remaining out of scope of the AIFMD
Other fund promoters and managers are operating their businesses and the AIF’s that they promote or manage outside of the scope of the AIFMD. Many smaller groups are not required to obtain authorisation as the assets under management in the AIFs that they manage fall below the applicable threshold in Article 3(2) of the AIFMD. In addition, managers without a presence in the EU are, broadly, only confronted with AIFMD-related issues if they want to distribute their AIF’s within the EU. Finally, despite the broad definition of an AIF, many investment structures are not caught on the basis that one or more elements of the definition do not apply to such structures.
We have seen many smaller EU-based groups deciding to stay outside of full scope using one of the exemptions for smaller managers. Under Article 3(2) of the AIFMD, groups managing (i) AIFs with assets (taking into account leverage) not exceeding EUR100m; or (ii) AIFs that are unleveraged and that are closed-ended with assets not exceeding EUR500m, may opt to remain outside of scope of the AIFMD. Remaining outside of scope does mean that the AIFMD passport for distribution of that group’s AIFs to other EU Member States is not available. However, many smaller EU groups manage AIFs that are primarily targeted at their domestic market such that the AIFMD distribution passport is not necessary.
In the UK, managers choosing this route are either required to become “small authorised AIFM” or “small registered AIFM”. Small authorised AIFMs are required to obtain FCA authorisation to “manage an AIF” and are broadly subject to the rules applying pre-AIFMD to their activities. The light touch, small registered AIFM regime, is a popular option for unauthorised managers of property funds, with such managers working alongside Langham Hall or another UK authorised operator to satisfy UK regulatory requirements.
Many Luxembourg AIFMs have also opted to operate under the small AIFM regime, thus foregoing the right to an EU distribution passport for their AIFs. The CSSF confirmed that, as at 22 July 2014, 487 AIFMs had registered with the CSSF under the small AIFM registration regime. In Luxembourg, small AIFMs are, in principle, only subject to the following requirements laid down in the AIFM Law:
(i) registration and identification requirements with the CSSF;
(ii) certain disclosure and reporting requirements to the CSSF (e.g. investment strategies, instruments traded and principal exposures).
For non-EU managers and promoters, distribution of an AIF in the EU can sometimes still be possible outside of the scope of AIFMD, via an EU Member State’s national private placement regime (if retained by that Member State), subject to the AIFMD overlay requirements including:
In the UK, the pre-AIFMD private placement regime has broadly been retained, subject to the aforementioned AIFMD overlay. The regulatory reporting takes the form of an initial registration
with the FCA by the AIFM of the funds they intend to market to investors in the UK and on-going annual reporting to the FCA in respect of those funds.
For example, a Jersey fund managed by a Jersey manager which targets UK investors can market into the UK on a private placement basis as they did pre-AIFMD, provided, of course, that the investment management function for any such fund is not performed by, or delegated to, a third party within the EU to such an extent that that EU-based third party is the AIFM.
Denmark and Germany also allow restricted private placement of funds managed by non-EU AIFMs, subject to the aforementioned AIFMD overlay and provided that the funds being marketed have appointed an appropriately qualified third party to perform some of the depositary requirements under the AIFMD.
The distribution of funds managed by non-EU managers in other jurisdictions, is more of a challenge due to (i) the severe restrictions on the distribution of funds outside of the AIFMD (e.g. France); or (ii) national laws relating to private placement outside of the AIFMD not yet having been passed and related uncertainty (e.g. Portugal and Spain).
Some managers have managed to satisfy themselves that they have remained out of scope of AIFMD due to “reverse solicitation” (i.e. on the basis that their EU investors approached the manager in relation to an investment and invested without any marketing taking place). In the UK, the FCA has helpfully stated that, a confirmation from an investor that it took the initiative to invest in an AIF, should be sufficient, provided that this confirmation was not provided as a way of circumventing the requirements of the AIFMD. This is, clearly, an approach that only a small minority of managers will be fortunate enough to be able to use and is highly risky for any manager or promoter engaging distributors to procure European investors.
Investment Structures that are not AIFs
We have seen an array of investment and business structures established and managed from within the EU which operate outside of the scope of AIFMD. The AIFMD defines AIFs as “collective investment undertakings … which (i) raise capital from a number of investors, with a view to investing it in accordance with a defined investment policy for the benefit of those investors; and (ii) do not require authorisation pursuant to article 5 of Directive 2009/65/EU (the “UCITS Directive”).
Each of the elements of the definition must be fulfilled for a structure to be an AIF. As such, many managers have been able to operate outside of AIFMD due to their investment propositions not fulfilling one of the elements of the definition of an AIF. The analysis of each element of the AIF definition has been the subject of significant consideration in determining whether a structure is an AIF and is a topic that will continue to evolve in its own right.
It is impractical to review the application of each element of the definition in this article. Instead, I have attempted to summarise below how certain managers are remaining outside of scope in the private equity and real estate space, based on their structures not fulfilling certain elements of the AIF definition.
Other managers continue to work outside of scope using joint venture-type arrangements. As joint ventures are not expressly excluded from scope in the main body of the AIFMD (the only reference in the AIFMD to joint ventures being outside of scope is in Recital 8), each arrangement must be assessed in its own right against the AIF definition. There has been very little specific guidance at EU/ESMA level in relation to joint ventures, so practitioners and managers have been using other guidance when structuring in this area. In particular, the FCA has published some helpful indicators in Chapter 16 of its Perimeter Guidance Manual (PERG), using, among other things, the guidelines relating to the various elements of the definition of an AIF contained in ESMA’s Guidelines on Key Concepts of the AIFMD report (dated 24 May 2013, ESMA/2013/600).
It is particularly helpful for joint venture parties wishing to remain outside of scope that the FCA states (in paragraph 2.47 of PERG 16) “it is still possible to have a joint venture in which not all the parties have day-to-day control” and that a venture may still be outside of scope of AIFMD “if the strategic financial and operating decisions are under the control of all the parties”. This is because all of the investors have “a continuous involvement in …… overall strategic management” and the venture is therefore outside of scope by virtue of not being a “collective investment undertaking”.
The FCA also state that joint venture arrangements can fall outside of scope on the basis that another element of the AIFMD definition is not fulfilled (e.g. capital is not being raised or there is no defined investment policy).
The FCA refers specifically to the use of English limited partnerships for joint venture arrangements. In circumstances where the partnership’s business is managed by a general partner entity, which is controlled (through the exercise of voting rights or the appointment of nominees to the board of directors) by the investors (who are also limited partners), then, the FCA states, “[notwithstanding that separation of roles, as a matter of commercial substance, that arrangement can…fall outside of scope].”
Absent specific guidance issued by the EU/ESMA or by other national regulators, managers and investors are using the FCA’s guidance in Chapter 16 of PERG to help analyse the applicability of the AIFMD to structures in other EU jurisdictions. For example, references to PERG 16 are becoming increasingly common for legal papers issued by Luxembourg law firms in relation to the applicability or otherwise of Luxembourg structures.
General commercial companies
We also see a number of structures falling outside of scope on the basis that they are considered to be ordinary companies with general commercial purposes (as opposed to AIFs which are collective investment undertakings with defined investment policies).
Certain managers, whose only activities in the EU are the management of portfolios of investments for single investors, are also able to operate outside of scope of the AIFMD. The managed account model permits non-EU fund managers to establish EU investment vehicles for single investors, without the burden of AIFMD compliance.
The European alternative funds industry has more fundamental changes to come
Notwithstanding the significant changes to date, it also remains absolutely clear that the evolution of the European alternative funds market has some way to go before stabilising. In many ways, the upheaval has just started!!
1. AIFM Compliance in Practice
The AIFMD’s grandfathering period has only just ended and the full force of the current regime is now beginning to be felt by fund managers. Although managers subject to the full scope of the AIFMD have now made the necessary structural changes to their business models, they are now having to practically address the on-going compliance requirements including satisfying the new valuation rules and fulfilling the new regulatory reporting obligations. The full impact of these requirements has not yet been tested.
2. Harmonisation of AIFMD implementation across Member States
Approaches in individual Member States are likely to continue to evolve as ESMA continues to update its AIFMD Q&As to elaborate on the provisions of the AIFMD, subsidiary legislation or ESMA guidelines with a view to developing harmonised supervisory approaches and practices across Member States. Harmonisation pressures could lead to certain EU Member States having to adapt their requirements for AIFMs (e.g. by increasing their minimum substance requirements).
3. Authorisation for Non-EU AIFMs
Looking forward, there are also a number of further significant developments envisaged by the AIFMD. Under Article 67(5), subject to certain conditions being met, non-EU fund managers will, in 2015 or later, have the right to become full-scope AIFMs in their “Member State of reference”. ESMA has confirmed that it has started its preparatory work in this area, but it is an immense project in itself giving rise to questions such as: What presence will a non-EU AIFM be required to have in its Member State of reference to obtain an AIFM licence? How, practically, will an EU Member State regulator be able to supervise on an extra-territorial basis the activities of an AIFM established in, say, Brazil or India? If the European authorities do manage to get comfortable with this possibility, it does have the prospect of widening Europe’s doors to those non-EU managers (and their AIFs) with the resources to comply with the requirements of the AIFMD. Thus, cranking up the competition and broadening investor choice.
4. Prohibition of Private Placement
In 2018 or later, a blanket prohibition on the marketing of funds under national private placement regimes may be imposed throughout the EU. A further fundamental reshaping the European alternative funds landscape yet again! This would make the only remaining way for non-EU AIFMs to market to EU investors outside of the AIFMD impossible. Such a development would mean that the only non-EU AIFMs that could market their AIFs in the EU would be those that were authorised as full scope AIFMs in their Member State of reference, effectively freezing out from the EU completely, those smaller non-EU AIFMs without the resources to achieve full scope authorisation. Depending on your perspective, this might mean one or both of (i) a tighter, highly regulated environment for all EU investors; and/or (ii) a highly protective fortress which severely restricts innovation and entrepreneurship in favour of a status quo.
The regulatory storm notwithstanding, life goes on for the massive European alternative funds industry. Managers and promoters that are clients of Langham Hall have, in the main, coped well raising and managing funds in this backdrop and they continue to thrive. Many managers have chosen to embrace the AIFMD regime – there was often no other option! Other managers and promoters have found ways to operate outside of the full scope of AIFMD, by limiting their EU marketing activities or by adjusting the terms of the investment products they offer. And, more than ever before, the industry is keeping a close eye on the regulatory regime as it continues to evolve.
Langham Hall continues to pride itself on being able to support managers and promoters of private equity and real estate structures in the post-AIFMD world as an administrator, accountant, depositary and general sounding board to its clients.
Director and Head of Office
Langham Hall Luxembourg S.àr.l.
t: +352 2785 1521