Alternative Investment Management Association Representing the global hedge fund industry
The delegation model of fund management, whereby investment vehicles or their management companies appoint third party investment managers and advisers, many of whom are located outside Europe, has become increasingly common in the European context in recent years, in particular with respect to funds authorised as UCITS.
With respect to non-UCITS funds, the Alternative Fund Managers Directive (AIFMD) will be the key European legislation regulating such activity once it becomes operational from mid 2013.
The AIFMD notes in its preamble1 that, depending on their legal form, it should be possible for alternative investment funds falling under the directive (AIFs) to be either externally or internally managed and that AIFs that do not appoint an external alternative investment fund manager (AIFM) will themselves constitute the AIFM. AIFs structured as self-managed investment companies, for example, will typically fall into this category. As such the AIFMD supports the delegation model and in fact it does specifically provide for the right of AIFMs to delegate their functions, subject to applicable conditions2. However, the AIFMD was prepared as a principle-based framework document under the “Lamfalussy Process” and accordingly, following its adoption much of the fine detail, including with respect to the terms applicable to delegation, remained to be determined as "Level 2" measures.
The finalised text relating to Level 2 was contained in a regulation which was approved by the Commission on 19 December 2012 (the “Regulation”) and following this there is now greater clarity regarding how the delegation model will work in practice under the AIFMD.
Concerns had arisen, in light of draft text prepared for the Regulation by the European Commission, which disregarded advice received from the European Securities and Markets Authority (ESMA) in 2011 with respect to delegation, that the terms of the Regulation would prevent the continuation of delegation model. However the final version is not as restrictive as the proposed text in the earlier draft and accordingly, subject to compliance with the requirements detailed therein and discussed below, delegation arrangements may continue to be used.
The Regulation itself has now been sent to the European Parliament and Council for approval and, as it is not expected to be opposed, should be directly applicable in March or April 2013.
Overview of delegation under the AIFMD
The general concept of delegation, as provided for in the AIFMD3, is addressed and expanded upon in Section 8 of the Regulation4 under various headings, including general principles, reasons for the delegation, the nature of the delegate, potential conflicts of interest and the effective supervision of the delegate.
The relevant “General principles” include ensuring that the delegation structure does not allow for the circumvention of the AIFM’s responsibilities, obligations or liability (including in relation to its authorisation). Delegation arrangements must be documented in written agreements between the AIFM and the delegate and there are significant requirements relating to the specific contents of such agreements,5 including obligations to set out in the agreement:
Existing contractual arrangements relating to delegation, i.e investment management agreements, will need to be reviewed and may need to be revised to ensure all of these requirements are addressed where the relevant fund structure falls under the terms of the AIFMD. In addition to specific requirements, such as those above, required to be included in the actual delegation contract itself, a series of on-going obligations are also imposed on the AIFM by the applicable general principles. In addition to potential references in contractual arrangements these requirements will ideally be addressed and documented separately in a procedures manual or business plan of the AIFM. Examples of these obligations include:6
Many investment managers will already have some form of internal procedures and policy manuals which can be adapted to specifically address these requirements. Otherwise, and for self-managed corporate structures in particular, the form of “business plan” currently required for UCITS may constitute a useful basis upon which to base such documents.
Delegation of portfolio or risk management
At present, the decision to delegate investment functions is entirely one at the discretion of management. However, there will be a new requirement under the AIFMD to justify this decision upon “objective reasons”.7 Examples of reasons which would be acceptable for this purpose are included in the Regulation8 and these include: (a) cost savings; (b) expertise of the delegate in specific markets or investments; or (c) access of the delegate to global trading capabilities. It will be necessary for the AIFM to provide the competent authorities with a detailed description of the delegate and explanation of the objective reasons for any delegation with supporting evidence.
Delegates are required to have sufficient resources and to employ sufficient personnel with the skills, knowledge and expertise necessary (including appropriate training and previous experience) for the proper discharge of the tasks delegated. Personnel of the delegate are also required to be of sufficiently good repute and examples of the research to be undertaken to confirm such matters are detailed, for example specific attention is required to be paid to any previous convictions for dishonesty or fraud9. The requirements in this regard are broadly similar to those currently applicable under the “fitness and probity” regime of the Central Bank of Ireland (the “Central Bank“) and therefore this can essentially be regarded as applying concepts similar to those that apply to, for example, directors of Irish regulated funds, to delegates.
Where delegation of portfolio management or risk management is proposed the Regulation sets out the types of EU regulated entities to be deemed to be appropriately authorised for such purposes10. It also notes that non-EU entities authorised under the AIFMD or those authorised or registered for the purpose of asset management and effectively supervised by a competent authority in their home country would also qualify, subject to certain conditions11. Specifically, there must be a written agreement between the competent authorities of the home Member State of the AIFM (the “Competent Authority”) and the supervisory authorities of the delegate which allows the Competent Authority to:
The notion of entering into agreements which will have the effect, in accordance with the final point above, of permitting European supervisory authorities to carry out inspections on their premises outside Europe may pose concerns for some asset managers. However, the explanatory memorandum to the Regulation clearly specifies that the right to carry out on-sight inspections should include the ability to request the local third-country supervisory authority to carry out on-site inspections and also, where permission is obtained from the third-country supervisory authority, the ability of the Competent Authority to carry out the inspection themselves, or to accompany staff of the local supervisory authority to assist with an on-site inspection.
One of the stated aims of the AIFMD is to ensure more effective oversight of the alternative sector and the directive makes it clear that delegation should not be permitted where it prevents effective supervision. The Regulation clarifies that a delegation shall be deemed to prevent the effective supervision of the AIFM where:12
Conflicts of interest
The AIFMD precludes delegation in circumstances where it conflicts with the interests of the AIFM or investors in the relevant AIF13 and the Regulation clarifies a range of factors to be considered in this regard14. In terms of meeting these requirements, the appointment of a strong independent board to the AIFM will assist, as will addressing these concerns in the conflicts section of the delegation agreement itself, in addition to including disclosures and representations in the offering document of the relevant AIF.
It can be noted that the Corporate Governance Code for Collective Investment Schemes and Management Companies adopted by the Irish Funds Industry Association in consultation with the Central Bank, and which is now applicable to Irish funds, does require the appointment of at least one entirely independent board member so compliance may not necessitate substantial board restructuring.
There are exemptions to the general prohibition on delegation where this may lead to a potential conflict of interest included in the AIFMD itself15, for example where (a) the portfolio or risk management function may be considered to be functionally and hierarchically separated from other potentially conflicting tasks; and (b) where potential conflicts of interest are deemed properly identified, managed, monitored and disclosed to the investors of the AIF. The Regulation addresses these considerations further16 and provides examples of how these concerns might be addressed in practice. These are further examples of matters which could be documented in a business plan or policy and procedures manual (although in this case the documentation by the delegate, rather than only the AIFM, will also be relevant) and referenced or otherwise addressed in the delegation agreement to ensure compliance with the AIFMD.
As mentioned previously, it will be a requirement for any sub-delegation to be subject to the prior approval of the AIFM17. It can be noted that the Regulation clarifies that a general consent will not be acceptable and instead a specific approval will be needed from the relevant AIFM for any given sub-delegation by its delegate18. The AIFM in turn will be subject to a requirement to notify its competent authority and provide it with details of the delegate, the name of the competent authority where the sub-delegate is authorised or registered, the delegated functions, the AIFs affected by the sub-delegation, a copy of the written consent by the AIFM and the intended effective date of the sub-delegation19. The provision in the delegation agreement providing for sub-delegation should accordingly reflect this or provide that sub-delegation will only be permitted in accordance with applicable law.
One of the specific concerns of the AIFMD is to prevent the use of “letterbox” entities20. Such concerns have previously been addressed in relation to UCITS, where the “four eyes” principle now applies. It can be noted that the AIFMD itself specifies that measures would be adopted detailing when an entity would be deemed to constitute a letter-box entity for the purposes of the AIFMD and no longer be considered to be the manager of the relevant AIF. Accordingly the Regulation21 sets out a series such relevant circumstances to be taken in to consideration. Key considerations in this regard include where:
It can be noted that “investment management functions” are defined in the AIFMD to include both portfolio and risk management, so it is expected that the AIFM would retain one of these functions to ensure it meets this requirement and in fact the explanatory memorandum to the Regulation 2 specifically provides that when appointing a delegate the AIFM “has to perform at least functions relating to either risk or portfolio management”.
In practice, it would be anticipated that most AIFMs operating the delegation model would retain the risk management function to meet this requirement, especially in funds with a high level of trading. At the same time, the Regulation provides that determinations in this regard will be based on the structure as a whole, bearing in mind a range of factors including the types of assets held by the relevant AIF22.
The Commission intends to monitor the application of this Article in the light of market developments and shall review the situation after two years to see if it is necessary to further specify relevant conditions23. ESMA may also issue guidelines to ensure a consistent assessment of delegation structures across the European Union24.
Compliance with these requirements will entail (a) ensuring that the delegation agreement affords sufficient oversight powers to the AIFM and that the delegation only pertains to portfolio or risk management and not both; and (b) ensuring that the AIFM has the necessary expertise and resources to show substance and documenting this appropriately.
In summary, the existing delegation model should continue to be effective for non-UCITS, under AIFMD but compliance with the relevant requirements contained in the Regulation will entail amendment to existing contractual agreements and extensive additional documentation evidencing how the applicable requirements are being met.
 Point 20, Preamble to Directive 2011/61/EU
 Section 3, Article 20, of Directive 2011/61/EU
 Section 3, Article 20, of Directive 2011/61/EU
 Articles 75-82 of the Regulation
 Article 75 of the Regulation
 Article 75 (f) of the Regulation
 Article 20 (1) (a), Directive 2011/61/EU
 Article 76 (1) of the Regulation
 Article 77 (2) and (3) of the Regulation
 Article 78 (2) of the Regulation
 Article 78 (3) (b) of the Regulation
 Article 79 (a)-(c) of the Regulation
 Article 20 (2) (b), Directive 2011/61/EU
 Article 80 of the Regulation
 Article 20 (2) (b), Directive 2011/61/EU
 Article 80 (2) and (3) of the Regulation
 Article 20 (4), Directive 2011/61/EU
 Article 81 (1) of the Regulation
 Article 81 (2) of the Regulation
 Article 20 (3) ), Directive 2011/61/EU
 Article 82 (1) of the Regulation
 Article 82 (1) (d) of the Regulation
 Article 82 (2) of the Regulation
 Article 82 (3) of the Regulation