Does the AIFM Directive apply to private equity?
For more than two and a half years the private equity sector has been examining how the European Union’s Directive on Alternative Investment Fund Managers will affect their operations in areas such as remuneration, leverage and transparency. But Aztec Group general counsel James Bermingham (pictured) argues that the way the directive is drafted may result in much private equity activity falling outside the scope of the legislation altogether.
“Although everyone is focusing on the contents of the directive and whether the depository is a good idea or not, or whether you will need EUR10m in share capital on the balance sheet, I believe the most important question to consider is whether private equity funds are actually covered by the directive at all,” he says.
“That’s not clear, because the definition of an alternative investment fund is a matter of national law - which means there will be 27 different definitions. From the UK perspective, the definition of a collective investment scheme is deliberately vague to enable the FSA to restrict the promotion of unauthorised schemes. But in Luxembourg, and also in Jersey, the term ‘fund’ has a technical meaning covering vehicles specifically designed for collective investment. To qualify, there must generally be units, collective investment on an equal basis, pooling of monies inside the fund and, of course, an obligation of risk-spreading.
“But in a private equity fund there are no units; it is contractually negotiated on a one-by-one basis, so there is no mutuality; it is parallel investment because it’s not pooled; , it’s transparent; and, obviously, there is no risk spreading. The question is whether it is a joint venture or a fund, and the answer to this depends on your nationality. The better view in Luxembourg and Jersey, for example, is that a private equity limited partnership is not necessarily a fund.”
Bermingham argues that the issue has become more complicated by divergences in the approach taken by the European Commission, which drafted the original proposal for the AIFM Directive published in April 2009, and the European Parliament and European Council, which subsequently came up with their own versions that had to be reconciled to obtain a consensus. “It appears that they may actually have been discussing different things.”
Other questions thrown up by the text of the directive have yet to be answered. He says: “If you accept that securitisation vehicles, joint ventures, holding companies and so forth fall outside the directive, what are the rules for marketing those products in the future? Presumably the current private placement regimes will continue forever. Obviously non-alternative investment funds will have a slightly different definition jurisdiction by jurisdiction, and no passport, but no-one has really asked about how they will be treated.
“But assuming that third-country private equity funds do fall under the directive, how do you calculate their assets? If it’s by the investments made by the fund or its stand-alone manager, at the time of first closing they will never have any assets and it’s unlikely to have much more even at second closing, unless the fund does a very big deal indeed within the first 12 months. That raises the question of when and whether such private equity managers will fall under the regime according to their level of assets.
“Even if firms do come under the regime on some kind of commitment test, by the time they’ve reached first closing, it’s reverse marketing anyway. Marketing and management in the EU don’t occur at the same time – by the time you start managing, you’ve largely stopped marketing. In any case, who cares about marketing restrictions? On paper these only apply to EU investors in the EU in contrast to international investors, and the reality is that all private equity funds are negotiated, they’re not offered as envisaged by the directive.”
Many of the directive’s other provisions make no sense in a private equity context, Bermingham argues. “The disclosure provisions cover everything such as deal finance and the terms of the management team, commercially sensitive information that firms will certainly not want to disclose to regulators, competitors and the public,” he says.
“I was always taught in the City that private equity funds are effectively SPVs whose investments effectively manage themselves, because if the general partner or the management company actively managed the portfolio companies, they would be a shadow director and the risk would arise of claims by the creditors of one portfolio company against another. To prevent cross-contamination within the fund, you keep the GP an ultra-light SPV, with no management services being supplied to portfolio companies – each asset is a freestanding investment.
“Unfortunately this directive anticipates a manager that provides portfolio, risk and other management services, which just doesn’t exist with the regularity expressly required by the directive. How are you going to impose rules on businesses that don’t exist, managers without employees, etc? In a private equity context, this directive just doesn’t work. If private equity houses have any sense, they will stick to the tried and tested model as this model has evolved over many years and did not come about by accident.”
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