21st June 2009
As the financial crisis moves through to new phases we are seeing the inevitable reactions from different parts of the industry.
The regulators are stepping up their focus and it appears the real estate industry has been caught slightly unawares by the proposed EU Directive which was originally targeting hedge funds. On a geared basis, £100m of assets is a reasonable target for a new fund and for any individuals in the market hoping at some point next year to raise their debut fund, it is worth monitoring the progress of the Directive. There is a risk that they will need to be regulated and a risk that their regulatory capital requirement could equate to a significant proportion of first year cashflow. In our guest article, Adrian Brown from fund structuring lawyers SJ Berwin summarises the main impacts.
We are seeing continuing tensions between fund managers and investors where funds have underperformed.We examine the role of the operator within the regulatory framework and in particular whether they are stepping up to meet the challenges in the current environment.
We hope you enjoy this edition and as ever please do let us have any feedback.
Rob Short | email@example.com
In the run up to the peak in real estate values there were a large number of collective investment schemes (CIS) where the law deemed that an operator was required. In some cases, the fund manager which set up the scheme did not perhaps fully understand the role of the operator or was unable to judge their competence. Consequently, they based the appointment decision largely on price or it may even have been on the understanding that the operator would not ‘interfere’ with day to day business. The market has changed significantly in the last couple of years and some of those involved may regret not taking more time on the operator selection process.
The Financial Services and Markets Act 2000 contains the provisions for the ‘Establishment, Operation andWinding up of collective investment schemes’. Although there are exceptions, the schemes arise when two or more limited partners form a partnership for making investments. The CIS will not be an intra-group transaction and the limited partners will not have day to day control.
Although typically appointed by the general partner or trustee, the role of operator involves the monitoring of scheme assets on behalf of the investors. In order to do this the operator receives and reviews financial information before it is sent to investors. The operator will also attend board meetings and would sit on Investment Committee meetings if it is deemed necessary.
In good times, the operator is generally consulted on areas where the Limited Partnership Agreement (LPA) can be vague, for example investment criteria or accounting related matters. In difficult times, the operator is being consulted increasingly on areas of conflict between managers and investors and this is where the role starts to become interesting.
We are now seeing a number of schemes where one or more investors are in financial difficulty, the manager’s performance has not met the investors’ expectations or simply where all the stakeholders are trawling through the various agreements to see what was originally set out in the legal framework of the fund. The issue is however, that many of these schemes were set up in a hurry and the documentation is vague. For example the manager wants to know what they can do when the investors default on a draw down and investors want to know what they can do where a minor breach has occurred. Does this release them from future draw downs or even provide them with a potential exit from the fund?
In the middle of this is increasingly, the operator, to whom people are now turning for judgement on the terms of the LPA, to chair meetings rather than possibly attending them and for guidance on ‘what they have seen in their experience’. Operators are being telephoned by investors and they are now occasionally having to take legal advice on areas of specific technical content.
Now that there is a downturn, managers are seeing that the operator is not a passive role after all.Whilst the operator must still conduct its relationship with the manager in a user friendly manner, all parties are now quite happy to have a third party to turn to for guidance. The role of the operator is now to stand up and have the knowledge, experience and commercial awareness to form a judgment on some of these sensitive issues and not be afraid to call it as they see it. Thus when selecting an operator it is important to ensure that they have the proper combination of regulatory and real estate experience together with sufficient resources and depth of team.
The proposed Directive on Alternative Investment Fund Managers (AIFM) seeks to regulate the managers of Alternative Investment Funds (AIF) established in the EU. AIF are defined as all funds that are not regulated under the UCITS Directive, so include private equity funds, real estate funds, hedge funds, commodity funds, infrastructure funds and other types of institutional fund. This lumping together of very different beasts has been a criticism of the Directive, which homogenises bespoke arrangements into one uniformly regulated industry. Furthermore, the Directive will in areas regulate AIF managers more heavily than UCITS retail funds.
The Directive covers AIFM irrespective of where the AIF is domiciled, whether the AIFM provides its services directly or by delegation, whether the fund is open or closed-ended and irrespective of the legal structure of the AIF or the AIFM. Although most private equity fund managers and many real estate fund managers already operate in a regulated environment, those real estate fund managers which currently need not be authorised by virtue of appointing a third party operator and investing only in directly held real estate will also be caught by the Directive.
The Directive seeks to regulate AIFM (rather than funds), who manage portfolios in excess of €100 million, or €500 million if the fund does not employ leverage and locks in investors for at least five years. However, firms not meeting these thresholds may be forced to opt into the AIFM regime in order to market their AIF (see below).
AIFM covered by the Directive may only provide management services and market shares or units of AIF if authorised in advance in its home Member State.All AIFM covered by the Directive will be required to demonstrate that they are suitably qualified to provide AIF management services, and will be required to provide detailed information on the planned activity of the manager and its internal arrangements with respect to risk management. Of more concern is a requirement for AIFM to separate the functions of risk management and portfolio management.Whilst this might be entirely appropriate in the context of, for example, a hedge fund, it is less obvious that it is practicable in the context of a private equity or real estate fund.
The AIFM must employ an appropriate liquidity management system for each AIF it manages to ensure that the liquidity profile of the investments of the AIF complies with its underlying obligations. Again, this does not seem appropriate for closed-ended funds with long lock-in periods and with underlying assets of an illiquid nature.
One of the most concerning features of the Directive is that AIFM are to have own funds of at least €125,000.Where the value of the portfolios of the AIF managed by the AIFM exceeds EUR €250 million, the AIFM must hold additional own funds equal to 0.02% of the amount in excess of €250 million. Regardless of that, such own funds are not to be less than one quarter of their preceding year’s fixed overheads as required by the Capital Adequacy Directive. Some commentators believe that in reality it will be this latter calculation which will apply to most AIFM. For example, a real estate fund with five deal guys each earning £200,000 and an office and staff costing £100,000 will have to maintain capital of £275,000. But what protection does this capital really give? It will certainly not cover investors’ losses. Following the collapse of Lehmans, it seems to be agreed that capital is for loss absorption and general liquidity which are both irrelevant to closed-ended funds, therefore such capital requirements can be seen as a barrier to entry and an unnecessary cost.
The AIFM must appoint a ‘valuator’ (sic) independent of the AIFM to establish the value of the assets acquired by the AIF and the value of the shares and units of the AIF. For closed ended funds, it has been suggested that such a system is irrelevant and increases costs. Real estate and other closed-ended funds should have no interest in manipulating the value of assets, as fees are calculated on managed funds and values realised upon sale.
For each AIF it manages, the AIFM must appoint an EU regulated bank to act as independent depositary to receive all payments made by investors, and verify whether the AIF has obtained effective ownership of all assets in which it invests. The depositary will be liable to the AIFM and the AIF’s investors for any losses suffered by them as a result of its failure to perform its obligations. This seems to be another unnecessary and costly requirement in the context of real estate and private equity funds which do not require the services of a custodian in the same way that a fund investing in listed securities does.
For each of the AIF it manages the AIFM must prepare an annual report for investors. Even before investing in the AIF, the AIFM must make detailed disclosures to investors. Such disclosures very broadly include a description of the investment strategy and objectives of the AIF; the identity of the AIF's depositary, valuator and auditor; a description of all fees, charges and expenses; and the identity of any investor receiving preferential treatment and a description of that treatment. The final disclosure would effectively end the use of side letters, creating something akin to a statutory most favoured nation clause, whereby no alternative deals could be agreed with investors without having to reveal such deals. Revealing the identity of investors could also be problematic, allowing funds of funds for example to see competitors’ EU positions.
To be able to market units in the EU, a UK AIFM must notify the FSA, which must in turn notify its EU counterparts of any proposed fund marketing including any information on the AIF available to investors. The FSA must approve the marketing materials. Subject to these procedures, the manager may market the fund throughout the EU to ‘professional investors’ (as defined in MiFID). There is currently no ability to market units to anyone not meeting the very high MiFID professional investor standard. The Directive has left scope for member states to vary this, but currently it remains to be seen if member states will relax this threshold. It was suggested that being given a passport to market AIF around Europe would be one of the great benefits of the Directive, but the imposition of such notification requirements would still create a huge administrative burden and time delays whilst waiting for approvals.
AIFM managing an AIF which either individually or in aggregation with another AIF acquires 30% or more of the voting rights in a non-listed company domiciled in the Community, has to notify the non-listed company and all other share-holders. It also has to notify representatives of employees of such an acquisition, providing a business plan for the company. In the event of a P2P, the AIFM will have to continue to provide all information required by the Transparency Directive for two years after de-listing. Any other buyer of an EU company, no matter how sensitive or important, will have no such obligation, such as oligarchs, Continental banks, and even US private equity funds which have no European investors.
The Directive only allows AIFMs to market in the EU AIFs established outside the EU from three years after the Directive is implemented (so, probably 2014). Such third country AIFs will only be permitted to be marketed in the EU if:
During the three year period AIFMs will be permitted to market non-EU AIFs under existing private placement regimes but once this transitionary period is over non-EU AIFs are likely to be put at a significant competitive disadvantage.
The EU Parliament and Council will be debating the terms of the Directive over the next few months and it is likely to be implemented in 2011. SJ Berwin is actively involved in the lobbying process and is representing the interests of its clients in the AIF sector.
SJ Berwin is a pan-European law firm with a particular focus on private equity. It has offices in London, Frankfurt, Munich, Berlin, Madrid, Paris, Brussels, Milan and Turin.
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