Real estate funds

The European Commission recently published its draft Directive on alternative investment fund managers (the AIFM Directive). The AIFM Directive places significant regulatory constraints on real estate funds that are managed from, or marketed into, the European Union. Although the European Commission’s original intention was to introduce greater regulation of the hedge fund and private equity industries, the AIFM Directive has much broader application and captures managers of all alternative asset classes including real estate, commodity and infrastructure funds. Despite the highly controversial nature of the draft legislation, the European Commission is currently seeking to adopt final legislation at the end of 2009, with transposition of the AIFM Directive into national law expected to take place in 2011.

This briefing focuses on the impact of the application of the AIFM Directive to managers of real estate funds and examines the effect of key provisions in relation to authorisation, capital requirements and conduct of business. For an overview of the AIFM Directive in general, please see the Norton Rose LLP briefing “The draft Directive on Alternative Investment Fund Managers”.

Many sponsors, managers and advisers of, and service providers to, real estate funds (potentially including those based outside of the EU) may require authorisation for the first time, or will fall under a more stringent supervisory and capital intensive regime.

Current exclusions to UK collective investment schemes may cease to apply.

Pressure to domicile funds within the EU.

Strict and cumbersome arrangements for delegation of management, custody and independent valuation functions.

Requirement for a valuation every time shares are issued or redeemed will be cumbersome and impractical.

Disclosure and potential limitations on leverage.

Unclear and problematic application to listed closed-ended funds, master/feeder and multi-manager arrangements.

The AIFM Directive will apply to real estate fund managers domiciled in the EU who:

• provide management services to one or more real estate funds domiciled inside or outside the EU and/or
• market real estate funds in the EU (wherever those funds may be domiciled).

Real estate fund managers with assets under management of less than €100 million are currently exempt from the scope of the AIFM Directive.¹

Arguably the most controversial provisions however are those regulating the marketing of non-EU domiciled real estate funds to “professional investors”² in the EU and those relating to the authorisation of non-EU domiciled real estate fund managers. Whilst these provisions will not take effect until three years after the deadline for the transposition of the rest of the AIFM Directive (expected to be in 2014), they have provoked some of the most critical comments on the AIFM Directive to date.

The AIFM Directive provides that a EU domiciled real estate fund manager wishing to market a non-EU domiciled real estate fund in the EU may only do so if the fund’s country of origin has signed an agreement with the relevant EU member state(s) agreeing to tax co-operation and information exchange requirements.³ Perhaps even more stringently, non-EU domiciled real estate fund managers will only be able to market real estate funds in the EU if the regulatory framework and supervisory framework in that third country are equivalent to that proposed in the AIFM Directive, and EU operators have comparable access to that third country market. As these provisions are currently drafted, it will therefore be much more difficult for EU domiciled real estate fund mangers to market non-EU domiciled real estate funds in the EU and for non-EU domiciled real estate fund managers to continue business within the EU. Although the European Commission expects that off-shore jurisdictions will have a strong incentive to comply with the AIFM Directive, it remains to be seen whether this expectation proves to be correct.

Footnotes

1. It should be noted however that the AIFM Directive is unclear as to how assets under management will be calculated for these purposes (although it is likely that this will be a gross assets test). There is also a higher de minimis threshold for managers of unleveraged assets exceeding €500 million where investors are subject to a 5 year lock-in period. This exemption is unlikely to benefit real estate fund managers.
2. As defined in MiFID.
3. Assuming that all of the agreements which have currently been signed come into force, this would affect real estate funds domiciled in the following countries if the AIFM Directive was in force as at the date of this briefing: Isle of Man funds – marketing could only take place in Denmark, Finland, France, Germany, Ireland, the Netherlands, Sweden and the UK; Bermuda funds – marketing could only take place in Denmark, Finland, the Netherlands, Sweden and the UK; Channel Islands funds – marketing could only take place in Denmark, Finland, France, Germany, Ireland, the Netherlands, Sweden and the UK; Cayman Island funds – marketing could only take place in Denmark, Finland, Sweden and the UK; BVI funds – marketing could only take place in the UK, Denmark, Finland, France and Sweden.

All real estate fund managers that come within the scope of the AIFM Directive must be authorised to provide management services to, or market the shares or units of, real estate funds in the EU. In order to be authorised, real estate fund managers will have to provide:

• details of all their shareholders who hold 10 per cent or more of its share capital or voting rights
• information on the real estate fund manager’s planned activities
• the identity and characteristics of the real estate fund(s) it intends to manage (including the identity of the member state or third country on whose territory they are domiciled) and
• details of its internal arrangements for governance and risk management.

Once authorised however, the real estate fund manager will be able to market freely its real estate funds on a EU-wide basis to professional investors.

Every real estate fund manager authorised under the AIFM Directive will be required to hold and retain a minimum level of capital of at least 125,000 Euro. In addition, where the aggregate value of all of the real estate funds managed by the authorised real estate fund manager exceeds 250 Euro million, the real estate fund manager will be required to hold additional capital equal to 0.02 per cent of the amount by which the aggregate value exceeds 250 Euro million.

There has however been widespread criticism of the impact that these regulatory capital requirements are likely to have on those real estate funds that are not part of larger investment management organisations, particularly as there seems to be little justification for calculating capital requirements by reference to assets under management and for having a capital adequacy threshold higher than that applicable to UCITS managers.

Operating and organisational requirements

The AIFM Directive sets out some very wide and general operating and organisational requirements which will be applicable to real estate fund managers. A real estate fund manager will be required to:

• act honestly, with due skill, care and diligence and fairly in conducting its activities
• act in the best interests of the real estate fund it manages, the investors of the real estate fund and the “integrity of the market” (the practical effect of this remains unclear) and
• ensure that all investors are treated fairly.

Of particular interest to those real estate fund managers that have previously entered into side letters with certain key investors is that the AIFM Directive provides that no individual investor can receive preferential treatment unless this is disclosed to the other investors (either in the real estate fund’s rules or incorporation documents).

Conflicts of interest

During the course of managing a real estate fund, a real estate fund manager will be required to take all reasonable steps to identify conflicts of interest that arise between it and the investors in the real estate fund or between one investor and another. More generally, real estate fund managers will be 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 real estate fund and its investors. Where such arrangements are insufficient, the real estate fund manager will be required to make disclosures of the general nature (or sources) of conflicts of interest to investors before undertaking business on their behalf.

Although many real estate fund managers are well used to having policies in place to deal with the management of conflicts of interest, the requirements on real estate fund managers to identify conflicts between it and investors or vis a vis one investor and another, seem unduly onerous and difficult in practice to manage operationally.

Delegation of functions

The AIFM Directive will require real estate fund managers to obtain prior authorisation from the relevant competent authority before delegating any services to third parties. The AIFM Directive also makes it clear that the real estate fund manager’s liability will not be affected by the fact that it has delegated functions to a third party. For most real estate fund managers, this will just reflect the existing widespread market practice in drafting service agreements.

There is also a requirement on real estate fund managers to appoint an independent valuer that is both legally and functionally independent of the real estate fund manager. Although the appointment of such an independent valuer has long been market practice for real estate funds, where the valuer is based outside the EU, delegation will only be permitted under the AIFM Directive if that valuer is licensed by an equivalent regime. More controversially however will be the requirement for a real estate fund manager to ensure that the assets of the real estate fund are independently valued each time shares (or units) are issued or redeemed. This requirement therefore has the potential to add significant costs to the operation and management of real estate funds given the illiquid nature of the underlying asset class.

For each real estate fund managed by a real estate fund manager, there will also be a requirement to appoint a bank incorporated in the EU to act as a depositary to receive (amongst other things) subscriptions from investors in the real estate fund. Given that subscriptions from investors are usually received directly into a real estate fund’s bank account, it is not clear why the AIFM Directive requires subscriptions to be received by a bank instead.

Given the wide scope of regulation of delegated functions under the AIFM Directive, many real estate fund managers will not only need to re-assess the roles and responsibilities of existing third party service providers, but will also need to factor these additional regulatory compliance requirements into the real estate fund’s administrative, operating and management costs.

Transparency and disclosure

Despite the marketing of real estate funds being limited to professional investors, the AIFM Directive establishes certain transparency and disclosure requirements to ensure a minimum level of investor protection. For example, the following disclosures will have to be made to potential investors before they invest in a particular fund (as well as there being a requirement to notify those investors of any changes thereafter):

• the investment strategy and objectives of the real estate fund, all the assets which the real estate fund can invest in and the techniques it may employ, details of all associated risks and any applicable investment restrictions and the types of leverage used
• the procedures by which the real estate fund may change its investment strategy and/or investment policy
• a description of the real estate fund’s risk management and valuation procedures
• a description of all fees, charges, costs and expenses
• the identity of third party service providers and
• a description of any preferential treatment given to particular investors.

Real estate fund managers will also be required to make available to its competent authority and to each investor in the relevant fund an audited annual report no later than four months following the end of the fund’s financial year. In addition, various other reporting disclosures must be made periodically by real estate fund manager’s to the fund’s competent authority (for example, the real estate fund manager must provide a list of all the real estate funds managed and details of the risk management procedures used by the real estate fund manager).

Use of leverage

The AIFM Directive introduces requirements to impose limits on high levels of leverage. Real estate fund managers will be required to check whether their real estate funds employ a high level of leverage on a systematic basis every quarter. Under the AIFM Directive, real estate funds will be deemed to employ a high level of leverage where combined leverage from all sources exceeds the value of the equity capital of the real estate fund in two out of the four preceding quarters. Where this is the case, the real estate fund manager will have to make certain disclosures to the fund’s investors and to inform the competent authorities accordingly. The AIFM Directive provides that member state regulators will share this information to identify any build up of systemic risk. The AIFM Directive also gives member state regulators emergency powers to restrict leverage to the extent required in order to ensure the orderly operation of the EU market.

Although these obligations will be of most relevance to hedge fund managers, it has been stated that further rules will be introduced to limit the leverage that managers may employ, depending on the nature of the underlying fund. This is therefore an area that real estate fund managers will need to monitor closely.

In its current form, the AIFM Directive is extremely wide ranging and draws no distinction between real estate funds on the one hand and other alternative investment vehicles on the other. Notwithstanding the political nature to these proposals against the backdrop of the current financial crisis, it is difficult to see the justification for effectively “grouping together” real estate funds with hedge funds when many of the former hold their investments over the long-term and present less systemic risk. Similarly, the AIFM Directive’s focus on enshrining investor protection into law also appears to be disproportionate in the context of a regime which is focussed on professional investors.

Although regulation is not new to EU domiciled real estate fund managers, the increased levels of supervision and compliance required under the AIFM Directive could be detrimental to the real estate fund industry and may lead many real estate fund managers, particularly the smaller industry players, to re-assess the competitiveness of the EU business environment.