Private equity and the AIFM Directive
By Olivier Sciales and Rémi Chevalier - Luxembourg's private equity industry faces a range of challenges but also opportunities as a result of the implementation of the European Union's Directive on Alternative investment Fund Managers, which was agreed by the European Parliament in November 2010 and formally adopted by the EU Council, following a lengthy tidying-up process, in May 2011.
The directive aims to create a single European internal market for alternative fund managers and a harmonised regulatory framework for all alternative managers active within the EU, whether they are based within the union or not. It does not regulate alternative investment funds, which continue to be regulated and supervised at national level, allowing member states to apply national rules to funds established on their territory.
Members of Europe’s alternative investment industry acknowledge that the final text represents a significant improvement from the first draft unveiled by the European Commission in May 2009. However, concerns remain about how well suited its provisions are to the continent’s private equity and venture capital sector, and about the competitiveness of EU-based general partners once the legislation comes into effect around mid-2013.
In particular, there are fears that disclosure requirements will place private equity firms at a disadvantage in the acquisition, management and disposal of assets compared with other types of private investor, from high net worth individuals to sovereign wealth funds, although the final draft of the legislation seeks to allay these concerns.
Industry members are also worried about so-called 'asset-stripping' rules that place restrictions on the ability of private equity-owned companies to pay dividends, carry out share buybacks or conduct other transactions that are deemed to weaken their capital base; and about the requirement to appoint a depositary, a function more usual in management of liquid financial instruments.
However, the directive does offer exemptions for managers of closed-ended funds that do not employ leverage. In effect, these provisions mean that the threshold of assets under management triggering regulation under the directive will in many cases be significantly higher for private equity and real estate funds than for open-ended hedge funds.
Private equity firms are watching closely to see how they will be affected by subsidiary legislation and regulations to be drawn up over the next two years to flesh out the directive’s framework in detail. The new European Securities and Markets Authority is due to present its advice on so-called Level 2 implementation measures to the Commission by November following consultation with industry members.
There may also be differences in the details of how EU member states transpose the directive into national law, which is due by mid-2013.
The directive will offer non-EU-based funds and managers the opportunity to benefit from its ‘passporting’ provisions to market products to sophisticated investors throughout the 27-member union – but two years after EU managers with funds also domiciled in Europe, and subject to effectively all the same requirements, as well as additional conditions that must be met by non-EU jurisdictions.
The extension of the passport is scheduled to lead to the abolition of national private placement regimes, the main channel by which non-EU funds are currently distributed to sophisticated European investors, five years after the directive takes effect in 2013. At least for the present, the directive confirms the right of sophisticated investors within the EU to invest with whichever alternative investment firms they choose, if it is on their own initiative.
Despite the concerns, there is acknowledgement that the legislation aims to bring greater certainty to the alternative investment fund industry by providing a clearer picture of the future regulatory landscape in which managers, service providers and investors will have to operate.
The directive seeks to establish common authorisation and regulatory requirements for managers of funds that fall outside the scope of the Ucits directives governing cross-border retail funds, in order to create a coherent approach to the management of systemic risks, and to provide a framework capable of addressing risks to investors, markets and other participants through comprehensive and common supervisory arrangements.
It applies to entities that manage one or more alternative investment funds as a regular business, including both open-ended and closed ended funds, regardless of the funds’ legal form or whether it is listed. Although the directive is not intended to apply to holding companies, this does not provide an exemption for private equity GPs nor for managers of funds traded on regulated markets.
The legislation offers a less burdensome regime for alternative managers whose fund assets under management total less than EUR100m, and for managers of unleveraged funds with assets totalling less than EUR500m where investors do not have redemption rights for at least five years after investment.
This clear concession to managers of private equity and real estate funds reflects acknowledgement by European legislators that such funds do not appear to pose any significant systemic risk individually, although in aggregation they might do so.
According to the directive, managers whose combined fund assets fall below these thresholds should be subject to registration in their home member state and provide regulatory authorities there with information about the instruments in which they are trading and the principal exposures and concentrations of the funds they manage.
However, such managers also have the choice to opt for full regulation, and member states may if they choose impose stricter requirements on such managers.
While managers subject to the directive are required to appoint an independent third-party service provider to carry out depositary functions for their funds, such as the safekeeping or verification of assets and the monitoring of cash flows, the directive allows member states to continue existing practice by allowing the appointment of a notary, lawyer, registrar or another entity as depositary to private equity, venture capital, real estate and other funds.
Such funds are defined as those that do not allow investors to make redemptions for at least five years from the date of their initial investment and whose core investment policy is generally not to invest in assets that must be held in custody under the terms of the directive, or whose policy is to invest in issuers or non-listed companies potentially to acquire control over them.
For all other funds, the depositary must be a credit institution, investment firm or other entity permitted under the Ucits IV Directive. The depositary must have its registered office or a branch in the fund domicile jurisdiction, although the directive suggests that the Commission consider proposing legislation that not only clarifies the responsibilities and liabilities of a depositary but sets out rules for the provision of services in one member state by a depositary based in another.
The directive requires alternative fund managers to implement procedures for the proper valuation of assets and the funds they manage, a function that should be independent of the portfolio management activity of the business and may be carried out by an external provider. Managers may also delegate responsibility for some management functions for efficiency reasons and sub-delegation is also allowed, as long as the manager remains at all times responsible for proper performance of these functions and compliance with the directive.
As with other categories of alternative fund manager, authorisation of private equity firms under the directive is dependent upon their home regulator being satisfied that the manager is capable of complying with the directive, has sufficient capital and assets, and is run by individuals of good reputation and with sufficient experience of the strategies they propose to manage.
Authorisation is limited in scope to the management of alternative (and Ucits) funds and of segregated portfolios under individual mandates, as well as services such as the provision of investment advice and the safekeeping and administration of fund shares or units. Regulators should normally deliver a decision on authorisation within three months of application.
The AIFM Directive sets out minimum capital requirements for alternative managers in order to ensure the stability of the management of funds and cover exposure to professional liability. Internally-managed funds must have initial capital of at least EUR300,000, while an external manager of one or more funds must have initial capital of at least EUR125,000, increasing on a sliding scale according to the level of assets under management up to a maximum of EUR10m.
Managers are required to devise remuneration policies and practices consistent with sound and effective risk management and the avoidance of conflicts of interest for staff whose roles have a material impact on the risk profile of the funds managed. These provisions may be applied in different ways depending upon the size of the manager and of the funds they manage, their internal organisation, and the scope and complexity of their activities.
Managers authorised under the directive must issue an annual report for each fund domiciled or marketed in the EU and disclose information on leverage employed through borrowing of cash or securities, derivative positions and the reuse of assets. Additional disclosure requirements apply to companies over which funds managed by alternative managers – in practice usually private equity firms – exert control, especially unlisted companies.
A manager of one or more funds that acquires control over an unlisted company must provide its home regulator with information on the financing of the acquisition, and also if its funds acquire control over an issuer of shares admitted to trading on a regulated market.
In addition, for 24 months following the acquisition of control, ‘asset-stripping’ rules bar managers from carrying out, facilitating or encouraging – and indeed require them to use their best efforts to prevent – any distribution, capital reduction, share redemption or repurchase that would reduce the company’s capital base or exceed its distributable profits and reserves.
These notification and disclosure requirements and the explicit asset-stripping safeguards should be subject, the directive says, to a general exception for control of small and medium-sized enterprises as well as special purpose vehicles created to purchase, hold or administer real estate. It also says these requirements should not lead to the publication of proprietary information that would make the manager or the controlled company vulnerable to competitors.
Notification and disclosure obligations should be subject to conditions and restrictions relating to confidential information set out in the EU’s 2002 Information and Consultation of Employees Directive, which stipulates that subject to national law employees’ representatives should not reveal confidential information affecting the legitimate interests of the company to employees or third parties. The directive’s provisions on notification and disclosure and on asset stripping do not prevent member states adopting stricter rules.
The AIFM Directive’s passporting provisions allow managers to market funds to sophisticated investors in their home jurisdiction or other member states through notification of their national regulator; authorisation (or notification of the target market regulator) must take place within 20 days unless the manager is not in full compliance with the directive. Managers may also manage funds domiciled in another member state directly or through a branch.
Oversight and enforcement of the directive are largely in the hands of the manager’s home regulator. As well as its involvement in drafting detailed rules, Esma will have a co-ordinating role and in some cases mediate between member states in the event of disagreements. It will also advise on the functioning of the passporting regime in mid-2015, ahead of its planned extension to non-EU managers, and draw up regulatory and other standards for the eligibility of jurisdictions in which non-EU managers and funds are domiciled. A full review of the directive’s operation and scope is scheduled to be carried out by the Commission in 2017.
Olivier Sciales and Rémi Chevalier are partners with the Luxembourg law firm Chevalier & Sciales
Further information can be found on the Chevalier & Sciales website at: www.cs-avocats.lu