AIFMs that come within the AIFM Directive must be authorised to provide management services to, or market the shares or units of, AIFs.5
Authorisation is granted to the AIFM by the competent authorities of its home Member State. Once authorisation has been granted it is valid for operating in all Member States under passporting arrangements. Amongst the conditions for authorisation, an AIFM must have its head office in the same Member State as its registered office.6
Article 6 sets out what activities AIFMs can do, drawing a distinction between an “externally appointed AIFM” and AIFs “that are internally managed”. For example, Article 6 provides that:
- no externally appointed AIFM shall engage in activities other than those referred to in Annex I of the AIFM Directive (these match the permitted activities of a UCITS management company), unless also authorised to manage UCITS
- no internally managed AIF shall engage in activities other than the internal management of the AIF in accordance with Annex I of the AIFM Directive.
Additionally (as with UCITS management companies), Member States may authorise an externally appointed AIFM to provide the following services:
- management of portfolios of investments
- as non-core services: investment advice; safekeeping and administration in relation to units of collective investment undertakings and reception and transmission of orders in relation to one or more financial instruments.
Authorisation may be restricted to conducting particular investment strategies.7
Application of and to MiFID
Various provisions of the Markets in Financial Instruments Directive (MiFID) apply to the provision of such services, including those governing a firm’s organisational requirements and conduct of business.8
Article 6(8) stipulates that MiFID investment firms do not need authorisation under the AIFM Directive to provide MiFID investment services, such as discretionary portfolio management, to an AIF. However, investment firms may only offer or place (directly or indirectly) units in an AIF with investors in the EU to the extent that the units in question are able to be marketed in accordance with the AIFM Directive.
Capital requirements9 for AIFMs closely follow the regime for UCITS management firms (on whom no additional capital requirements are imposed). In particular it should be noted that the calculation is based on funds under management. It is difficult to see how this is appropriate in terms of comparative treatment of, for example, real estate and hedge fund managers with billions under management but the very different systemic risks each may pose. Again, following the MiFID capital regime (perhaps with appropriate modifications) might be considered to have resulted in a more proportionate treatment.
Member States shall require that where an AIFM is appointed as an external manager of an AIF, the AIFM has an initial capital of at least €125,000. (Where an AIF is internally managed, it must have an initial capital of at least €300,000.)
Where the value of an AIFM’s AIF portfolios exceed €250 million 10, the AIFM shall provide an additional amount of own funds. The additional amount of own funds shall be equal to 0.02 per cent of the amount by which the portfolio exceeds €250 million. The required total of the initial capital and the additional amount must not exceed €10 million. The justification for this is to ensure alignment with Article 7 of the UCITS Directive.
In order to remove the double counting of delegated funds in AIFM capital requirements, portfolios deemed to be portfolios of the AIFM include AIFs managed by the AIFM in respect of which it has delegated one or more functions but exclude AIFs which are managed under delegation from another AIFM.
Member States may authorise an AIFM not to provide up to 50 per cent of the additional amount of own funds if they benefit from a guarantee of the same amount given by a credit institution or an insurance undertaking which has its registered office in a Member State, or a third country where it is subject to prudential rules considered by the competent authorities as equivalent to those laid down in EU law. The own funds required by this provision shall be invested in liquid assets or assets readily convertible to cash in the short term and shall not include speculative provisions.
Irrespective of the above, AIFMs shall not hold an amount of own funds which is less than that required under the Capital Requirements Directive (CRD).
AIFMs are also required to hold appropriate professional indemnity cover.11
Operating conditions and organisational requirements
Articles 12 to 17 cover ongoing operating conditions for AIFMs, which are very similar to the equivalent provisions of MiFID. Articles 18 to 20 set out additional organisational requirements including those in relation to the valuation function and delegation powers generally.
The general principle is that AIFMs shall use at all times adequate and appropriate resources that are necessary for the proper performance of their management activities, including accounting, data processing and personal account dealing.12
The AIFM Directive sets out some very wide ranging general principles13 with which the AIFM must comply, including the requirement to act in the best interests of the AIF it manages, the investors of the AIF and the integrity of the market. An AIFM is required to treat investors fairly and no individual investor may receive preferential treatment unless this is disclosed in the AIF’s rules or incorporation documents. Whilst this will be a major restriction on side letters with the AIF itself, it is not clear whether it would also restrict side letters between an investor and the AIFM in relation to fee rebates, for example. Level 2 legislation or guidance clarifying how regulators should interpret these principles is envisaged.
Furthermore, there is a requirement for an AIFM to “have, and employ effectively, the resources and procedures necessary for the proper performance of its business activities”. Moreover, an AIFM that conducts discretionary portfolio management will not be permitted to invest all or part of the client’s portfolio in units or shares of an AIF it manages unless it receives prior general approval from the client.
The AIFM Directive details the categories of staff of an AIFM subject to the remuneration policy, which include senior management, risk takers, control functions and any employee receiving total remuneration that takes them into the same remuneration bracket as senior management and risk takers. An AIFM’s remuneration policy must be “consistent with and promote sound and effective risk management” and should not “encourage risk-taking which is inconsistent with the risk profiles, rules or instruments of incorporation of the AIFs they manage”. The principles which must be taken into account when establishing a remuneration policy are similar to those being recommended by the Commission for introduction for all investment firms (which are reflected, for example, in the Financial Services Authority’s Remuneration Code) eg, in relation to performance related remuneration, the aggregate remuneration should be based on a combination of the assessment of the performance of the individual (including an assessment of financial and non-financial criteria) as well as the business unit or AIF concerned and the overall results of the AIFM. Furthermore, guaranteed variable remuneration is stated to be exceptional and should only occur when hiring new staff and should be limited to the first year. Payments relating to the early termination of a contract should reflect performance achieved over time and should not reward failure.
After extensive lobbying, an element of proportionality has been introduced in terms of how such principles should be applied to fund management firms, so that now an AIFM is obliged to follow the remuneration policy “in a way and to the extent that it is appropriate” 15. However, this proportionality principle has been included in an annex and not the main provisions of the AIFM Directive, which means the drafting is far from ideal and a truly proportionate implementation is not ensured. The guidelines on sound remuneration policies to be developed by ESMA will be a major concern for the industry.
Conflicts of interest 16
The general requirement is for AIFMs to take all reasonable steps to identify conflicts of interests between it and the investors in the AIF or between one investor and another that arise in the course of managing one or more AIF. AIFMs are also required to maintain and operate effective organisational and administrative arrangements with a view to taking all reasonable steps designed to prevent conflicts of interest from adversely affecting the interests of the AIF and its investors. Significantly, there is a requirement for an AIFM to segregate incompatible tasks and responsibilities with the potential to generate conflicts. Where such arrangements are not reasonably certain to be sufficient, the AIFM is required to make disclosures of the conflict of interest to investors before undertaking business on their behalf.
Risk management 17
The general principle is for AIFMs to separate the risk management function from the portfolio management function both “functionally” and “hierarchically”, which shall be subject to review by the regulator. This would presumably require such functions to be carried out by separate divisions or groups of employees. AIFMs will be required to review their risk management systems at least once a year and to adapt them when necessary. As a minimum, AIFMs will be required to implement and document a due diligence process when investing on behalf of the AIF and ensure that the risks associated with each investment position of the AIF and their overall effect on the AIF’s portfolio can be accurately identified, measured and monitored at any time through stress testing procedures. The AIFM must be able to demonstrate that the risk management process satisfies the requirements of Article 15 and is consistently effective. There is also an obligation on the Commission to adopt measures to specify the risk management system to be employed and the appropriate frequency of review of such system.
Liquidity management 18
The AIFM Directive stipulates that AIFMs (other than in relation to unleveraged closed-ended AIFs) should use an appropriate liquidity management system and adopt procedures that ensure that the liquidity profile of the investments in the AIF complies with its underlying obligations. AIFMs should also regularly conduct stress tests both under normal and exceptional liquidity conditions. AIFMs should also ensure that for each AIF it manages the investment strategy, the liquidity profile and the redemption policy are consistent.
All regulatory provisions relating to short selling have been removed from the AIFM Directive, thus leaving such arrangements to be dealt with separately under the forthcoming European Commission legislation on short selling.
In order to ensure consistency between the interests of firms which repackage loans into tradable securities, originators and an AIFM who invest in such securities, Article 17 provides that the Commission will adopt requirements to be met by the originator and qualitative requirements to be met by an AIFM which invests in tradable securities. This includes a requirement that the originator, the sponsor or the original lender retain at least a five per cent net economic interest.
The AIFM Directive provides that AIFMs will ensure appropriate and consistent procedures are established so that a proper and independent valuation of the assets of the AIF can be performed.
The valuation of assets and the calculation of the net asset value per share or unit should occur at least once a year and be disclosed to investors. In the event that the AIF is open-ended, such valuations and calculations shall be carried out at a frequency appropriate to the assets held by the AIF and its issuance and redemption frequency. In the event that the AIF is closed-ended, such valuations and calculations shall be carried out in case of an increase or decrease of the capital by the relevant AIF.
The AIFM Directive calls for ‘functional independence’ of the valuation function and the portfolio management function. An external valuer may be used but the AIFM must be able to show that the third party is, inter alia, subject to mandatory professional registration, can provide sufficient professional guarantees to enable it to perform effectively the relevant valuation function, is qualified and capable of undertaking the functions in question and has been selected with due care. When an external valuer is not used the home Member State may require the AIFM to have its valuation procedures and/or valuations verified by an external valuer or auditor.
“Proper” valuation remains the responsibility of the AIFM and liability is unaffected by any delegation to an external valuer. Notwithstanding, the contract with any valuer must ensure that it is liable to the AIFM for negligence or intentional failure to perform its tasks.
Delegation of AIFM functions 20
The provisions governing delegation to third parties, whilst much improved from the draft directive, are still highly restrictive and delegation of portfolio management to other best of breed managers, particularly outside the EU, will become more challenging for managers of multi-manager products.
Before an AIFM can delegate any functions it needs to notify its regulator and certain conditions need to be complied with, which will be the subject of further detail in Level 2 legislation from the Commission. In particular:
- the AIFM must objectively justify the entire delegation structure, which must not prevent management in best interests of investors
- the delegate must be qualified and capable and have sufficient resources and be of sufficiently good repute and experienced
- portfolio management or risk management may only be delegated to an authorised and supervised entity, unless with the prior approval of the AIFM’s regulator
- a delegate may only be a third country entity where a co-operation agreement is in place between that third country and the AIFM’s own jurisdiction.
An AIFM’s own liability will be unaffected by delegation. Moreover the AIFM must demonstrate that the delegate has been selected with all due care, can be monitored effectively, that instructions may be given at any time and that the appointment may be terminated immediately where it is in the interests of investors, all of which will require existing investment management agreements to be revisited. All delegation must be subject to ongoing review.
Sub-delegation is permitted but the conditions attached to delegation must be applied down the delegation chain.
An AIFM may not delegate to the depositary or to a delegate of the depositary, or to any other undertaking whose interests may conflict with the AIFM or the investors of the AIF. AIFMs are not allowed to delegate their functions to such an extent that, in essence, they could no longer be considered to be the manager of the AIF.
- Article 6.
- Article 8(1)(e).
- Article 8(4).
- Article 6(6).
- These are set out in Article 9.
- Not applicable to internally managed AIFMs.
- Article 9(7).
- Article 18.
- Article 12.
- Article 13.
- Annex II.
- Article 14.
- Article 15.
- Article 16.
- Article 19.
- Article 20.