Alternative Investment Management Association
By Bill Prew, Founder and CEO
INDOS Financial Limited
There is now little more than a month to go before the Alternative Investment Fund Managers Directive (AIFMD) becomes law across the EU. It has been a long journey since AIFMD was first announced over four years ago. We have all needed to become accustomed to working through the uncertainty which surrounds AIFMD and which still remains in a number of areas today.
In the UK at least, where most hedge fund managers manage non-European hedge funds domiciled in the Cayman Islands, there are signs that many managers plan to make use of the UK’s flexible interpretation of AIFMD’s one-year transitional provision. Managers appear to accept that this might be at the expense of not being able to market their funds through private placement to certain non-UK, EU professional investors for several months. In return, it will allow managers more time to implement the Directive, let others learn from being a ‘first mover’ and avoid the remuneration provisions until 2014.
Yet, despite the uncertainty which still remains, and irrespective of whether managers are planning to delay authorisation as an AIFM until 2014, there are a number of questions or strategic decisions that UK hedge fund managers should have considered by now and started to develop and commence AIFMD implementation plans.
Is your firm within scope of AIFMD?
The answer for most hedge fund managers is likely to be yes, given the low threshold which determines whether your firm is in scope. If you manage alternative investment funds with gross assets, including leverage, of greater than €100 million, then you are within scope of AIFMD.
Have you identified the Alternative Investment Fund Manager (AIFM)?
For many UK based managers managing offshore hedge funds, this is likely to be a simple question. The answer will most likely be your existing UK MiFID management entity. You will apply to the FCA to vary your permission and your existing entity will become the AIFM. Even if you have an offshore, say Cayman Islands, management entity you will probably be unlikely to meet the substance, or so-called ‘letterbox’ requirements of the AIFMD.
This question can clearly be more complex, for example, if you form part of a broader group with overseas entities which could become the AIFM or non-EU AIFM. Most managers in this situation should, by now, have a good feel for where they plan to end up strategically and understand the advantages and disadvantages of being an EU or non-EU AIFM.
Have you identified and classified your Alternative Investment Funds (AIF)?
By now, it should be clear which entities under your management are AIFs and whether they are EU or non-EEA AIFs. The question can become more challenging in relation to managed accounts where it is important to agree the identity of the AIFM with the sponsor of the account. Generally speaking, it is preferable to avoid being the AIFM in order to avoid taking on all of the AIFMD responsibilities in relation to the account and that, in many respects, you are unable in influence.
Have you considered whether you plan to delegate portfolio or risk management?
The AIFMD allows firms to delegate portfolio management or risk management but not to the extent that the AIFM becomes a ‘letterbox’, which broadly means a firm has not delegated substantially more of these activities than it retains. In the majority of cases I expect most UK managers will retain both functions and develop their risk management policies and procedures to become AIFMD compliant. In some cases, managers may opt to delegate risk management to a specialist firm, several of whom are now marketing their services in this regard.
When do you plan to become an authorised AIFM?
In the UK, managers must comply with AIFMD and apply for authorisation no later than 22 July 2014. I expect most managers will want to be authorised as an AIFM by this deadline rather than run the risk their application is rejected after July 2014. Working back from this date therefore, you need to allow at least 3 months to submit your variation of permission application to the FCA. Bearing in mind it seems inevitable the FCA will receive a very large number of applications at the same time, it will face a real challenge to process all applications within 3 months. Managers probably want to allow 4 to 5 months to be safe which means being in a position to submit their application by the end of January 2014.
Will your existing capital and insurance requirements be adequate to meet the AIFMD requirements?
For many managers AIFMD ought not to have a material impact on the amount of capital they are required to hold. A quick analysis should confirm whether this is the case. At the time of writing, there is still uncertainty as to whether the base capital requirements are based on gross or net assets so it is worthwhile calculating on both measures.
Insurance brokers are reviewing the wording of their hedge fund professional indemnity insurance (PII) policies and liaising with the insurers. Most hedge fund managers already have PII cover therefore, it is worth checking whether existing cover will cover the optional PII requirements of the directive, as an alternative to maintaining additional own funds. Engage with your broker and be prepared to articulate how the AIFMD impacts your firm and why you don’t believe your operational risk profile will be impacted, in order to limit or negate any impact AIFMD may have on premiums.
Do you plan to market a non-EEA AIF to EU professional investors through private placement or seek to rely on reverse solicitation?
Firms marketing through private placement are required to comply with a number of provisions of the AIFMD. These include certain disclosure and reporting requirements and the so-called ‘depositary-lite’ regime. Reliance on, and compliance with, reverse solicitation (i.e. at the initiative of the investor) will avoid a number of these requirements altogether. Those wanting to market through private placement will need to monitor the private placement rules in the countries they are targeting, many of which are still unknown. Those relying on reverse solicitation will require clearly defined procedures, as well as enhanced compliance monitoring and oversight, to ensure that they do not undertake marketing.
Will your administrator be prepared to act as External Valuer for some or all of your portfolio?
Fund administrators will still calculate the net asset value of the AIF in much the same way as they do today. Despite this, under AIFMD the AIFM is responsible for valuation. Some administrators have now confirmed they are willing to act as External Valuer (EV) for certain types of assets.
Do you know your administrator’s position with respect to your funds?
Despite the fact the manager remains responsible for valuation even where an EV is appointed, it should be worthwhile engaging the administrator as an EV. This is because the EV is required to contract to a negligence standard of care. For some administrators this will be a lower standard than at present, whether this is gross negligence or an outright liability cap.
Have you identified and started discussions with a depositary?
This will be a priority for UK managers of EU funds where it will be mandatory to ensure a single depositary is appointed. Early engagement with your prime brokers and potential depositaries is essential here. Hopefully by the time this article is published, depositaries and prime brokers will have resolved how they will work together, including how depositaries will mitigate their risk from taking on strict liability for loss of assets.
For the larger number of UK managers of offshore funds, you only need to be concerned about depositaries if you market to EU investors through private placement. If you do, then you must comply with the ‘depositary-lite’ regime which requires that one or more firms is appointed to perform the depositary duties of safe keeping of assets, daily cash flow monitoring and oversight.
The signs are that the prime brokers will perform the safe keeping of assets, much as they do today and administrators will perform the cash flow monitoring, again, much as they do today particularly if they already perform daily reconciliations. You will need to identify a depositary to perform the traditional trustee duties of oversight of the fund valuation, subscriptions and redemptions, compliance with laws and regulations and monitoring of compliance with investment guidelines and leverage. Your starting point will be to ask your administrator with whom they plan to work to perform these duties. Some administrators may introduce you to an affiliated trustee, however it is also sensible to consider whether an independent firm could offer a genuine arms-length service.
Have you reviewed the Annex IV regulatory reporting requirements to identify any significant issues in deriving and reporting the data?
For those managers that have completed the FCA’s six monthly hedge fund manager survey, the AIFMD reporting requirements will be very familiar and indeed you may already have a system or process in place for maintaining and reporting the necessary data. For others, it is sensible to review the requirements early in order to start putting processes in place to enable you to report the data. The indications are, reporting by UK managers will not commence until you become an authorised AIFM, however the level of work which may be required to prepare for the commencement of reporting should not be underestimated.