Written by Michael Wu
On November 11, 2010, the European Parliament adopted the EU Directive on Alternative Investment Fund Managers (the “Directive”). The Directive will affect a significant number of alternative investment fund managers (“AIFMs”) that manage and/or market alternative investment funds (“Funds”), including hedge funds, commodity funds, private equity funds and real estate funds, within the European Union (“EU”). The text of the Directive is expected to be published in the Official Journal sometime in the first or second quarter of 2011. The Directive will be effective 20 days after publication and the EU Member States will have two years from such date to implement the Directive.
Scope: The Directive regulates AIFMs, rather than the Funds that they manage. Specifically, the Directive regulates (a) EU AIFMs and (b) non-EU AIFMs that either (i) manage a Fund that is domiciled in the EU or (ii) market a Fund to investors in the EU. A “small fund manager” that is regulated by its home EU Member State will be exempt from the majority of the Directive’s provisions if the AIFM manages less than €100 million in assets (or €500 million in assets, if its Funds do not use leverage and have at least a 5-year lock-up).
Marketing of Funds: The Directive defines “marketing” to mean “any direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM of units or shares in a [Fund] it manages to or with investors domiciled in the [EU].” Under this definition, passive marketing (i.e., responding to inquiries from investors) would not be considered “marketing” under the Directive. However, an AIFM’s use of a marketing or placement agent to conduct marketing activity in the EU would be considered “marketing” under the Directive. The Directive implements a dual regime for marketing Funds in the EU. An AIFM may market its Funds either (a) into an EU Member State if the EU Member State’s securities regulator expressly allows it, or (b) into all EU Member States under the EU “passport” regime. However, the availability, applicable starting date and possible ending date will depend on whether the AIFM and/or the Fund is based in the EU or based outside of the EU.
Capital Requirements: If an AIFM only manages its own Funds, it must have initial capital of at least €300,000. If an AIFM manages third party Funds, it must have initial capital of the higher of (a) ¼ of its annual expenditures and (b) €125,000. In addition, if the Fund(s) managed by the AIFM have over €250 million in assets, the AIFM must have additional capital equal to 0.02% of the Fund(s) assets over €250 million. However, in no event is the AIFM required to hold initial capital of more than €10 million.
Conduct of Business: The Directive will require AIFMs to meet certain conduct of business requirements, including the following:
- No investor may obtain preferential treatment unless such treatment is disclosed in the Fund’s documentation. Thus, side letter provisions would need to be disclosed to all investors in the Fund.
- Conflicts of interest between the AIFM and the Fund or its investors must be disclosed and managed by the AIFM.
- Risk management and portfolio management must be kept separate.
- AIFMs must conduct stress tests and monitor the liquidity risk of open-ended Funds regularly. The investment strategy, liquidity profile and redemption policy of each Fund managed by the AIFM must be consistent with each other.
- In order to invest the Fund’s assets in any securitization positions, the originator of the securitization must retain at least a 5% net economic interest in the securitization.
Remuneration: AIFMs must have remuneration policies and practices that are consistent with and promote sound and effective risk management and do not encourage excessive risk taking. For example, AIFMs may not guarantee multi-year bonuses, 50% of bonuses must be paid in the form of interests/shares of the Fund and 40-60% of bonuses must be deferred at least 3 to 5 years. The remuneration policies and practices must apply to senior managers, but also to “control staff.”
Valuation: If an AIFM performs valuations internally, it must ensure that the valuation process is independent of the portfolio management and remuneration policies of the Fund and that measures are in place to identify and resolve conflicts of interest. However, EU Member States have the authority to require an AIFM to subject its valuations to verification by external valuation agents or auditors.
Depositary: An AIFM must appoint a single depositary, such as an EU regulated bank or an EU securities firm, for each of its Funds. If an AIFM manages a private equity fund, the depositary may be an “entity” that carries out depositary functions as part of its business activities. For a non-EU Fund, generally, the depositary must be established in the jurisdiction where the non-EU Fund was formed or the jurisdiction of the AIFM’s principal place of business.
Delegation of AIFM Responsibilities: An AIFM must notify its regulator prior to delegating any of its responsibilities. AIFMs may only delegate portfolio and/or risk management functions to regulated entities or with prior authorization from the AIFM’s regulator. However, regardless of any delegation of functions, the AIFM will remain liable to the Fund and its investors as though no delegation was made.
Disclosure: Among other things an AIFM must satisfy the following disclosure requirements:
- If the AIFM’s publicly available annual financial report does not satisfy the disclosure requirements of the Directive, each of its Funds must be audited annually. The annually audited report must be made available to investors and the relevant regulatory agencies. The report must provide details of remuneration.
- An AIFM must provide its investors with information about the Fund, including its strategy (which may not work for “black box” hedge funds), what assets it may invest in, its valuation procedures, any descriptions of preferential treatment, the percentage of assets that are illiquid and subject to side pockets, changes in managing liquidity and its risk profile. The AIFM must also regulatory disclose the amount of leverage the Fund employs.
- An AIFM must report to its home EU Member State regulator(s) matters relating to the Fund, including those disclosed to its investors. In addition, if the Fund uses leverage on a “substantial basis,” the AIFM must report the specifics regarding the Fund’s use of leverage.
- If a Fund acquires 50% or more of the voting rights of a private company, the AIFM would have to provide information of its holding (a) to the company, (b) to all other shareholders of the company and (c) to its home EU Member State regulator. The AIFM would need to disclose, among other things, the future development of the private company either in the company’s annual report or in the AIFM’s annual report.
Leverage: An AIFM must set and comply with reasonable leverage limits for each Fund that it manages. EU Member States will have the authority to impose restrictions on the use of leverage.
The Directive will become effective in January 2011. The EU Member States will then have two years to transpose the Directive into their respective national laws. Over the next four years, the European Commission will pass further legislation to ensure consistent interpretation and effective implementation of the rules by the EU Member States. The European Commission will also review the application and scope of the Directive four years after the Directive’s effective date, including its impact on private equity and venture capital funds.