AIFMD Impact on AIF Documentation
This article was first published in HFMWeek in February 2013.
Following the European Commission’s recent publication of “Level II” implementing measures for the Alternative Investment Fund Managers Directive (AIFMD), the alternatives industry finally has sufficient certainty to commence meaningful analysis on how business models will be affected. One regrettable consequence of the delayed conclusion of Level II is that the industry now has less than six months to react before the 22 July deadline by which Member States must transpose the new rules into national laws. As a result, the clock is ticking for all alternative investment fund managers (AIFMs) within scope of AIFMD to identify what practical changes are needed for their ranges of alternative investment funds (AIFs) to comply with the new regulatory landscape.
Practical impact on AIF documentation
For manager groups assessing AIFMD, the initial focus should certainly be on high-level strategic issues such as evaluating the importance of the EU as an investor market; identifying which entity or entities within a group will be considered AIFMs; and reviewing whether delegation of investment management to an EU or non-EU entity might achieve a more optimal outcome.
However, it is important when scheduling AIFMD compliance projects that managers factor in enough time to reflect all strategic/ structural changes to their AIF documentation and service provider agreements. A comprehensive analysis of likely changes is beyond the scope of this article, and it is possible that national regulators will impose additional requirements, but the following is intended as a high-level overview of what types of changes to AIF documents may be required:
1. AIF managed by non-EU AIFM (for example, QIF managed by U.S. manager)
Although a non-EU AIFM will avoid the full AIFMD burden until at least 2015, the AIFM will still need to comply with the AIFMD transparency and (where relevant) private equity provisions from 22 July 2013 if it wants to retain the possibility to actively market its AIFs to EU investors on a private placement basis (subject to conclusion of the necessary cooperation agreements and unless the AIFM qualifies for an exemption). In practice, this will require for each such AIF:
(a) an annual report and audited financial statements. Much of the required disclosure is industry standard, but one notable addition is the need to disclose the AIFM’s aggregate remuneration.
(b) detailed disclosure to investors, both before investment and upon any material changes to the information. Again most of the disclosure would already be covered in a well-drafted prospectus. However, certain items exceed current industry norms, such as disclosure of any types of preferential treatment to investors (for example, side letters). We anticipate that these additional items may be most efficiently dealt with by a separate AIFMD prospectus supplement.
(c) periodic disclosure to investors regarding the AIF’s liquidity, risk profile and use of leverage.
There are additional AIFM obligations regarding systemic risk reporting to regulators and notifications of acquisitions in unlisted EU companies, but these shouldn’t specifically impact on the AIF documents.
2. AIF managed by EU AIFM (for example, QIF managed by U.K. manager)
In this scenario, full AIFMD compliance will be required and the documentation impact will be significant. In addition to the obligations above, we believe that at least the following will be affected:
(a) constitutional documents (for example, trust deed or articles of association)
Certain AIFMD provisions require the constitutional documents to provide express authority, for example regarding the manner in which a fund’s NAV shall be disclosed to investors; the ability to provide preferential treatment; and the ability of the AIF’s depositary to transfer liability to its delegate. If these provisions necessitate changes to constitutional documents, the need for investor approval and corresponding notice periods should be borne in mind.
(b) agreement with AIFM
Although AIFMD purports to regulate AIFMs rather than the AIFs that they manage, and although the AIFMD obligations ultimately rest with the AIFM, in reality many key provisions will be implemented at the fund level and will depend on the relevant AIF taking certain actions and adopting certain procedures. The prudent approach may therefore be to ensure that the agreement with the AIFM imposes contractual obligations on the AIF to reflect its indirect AIFMD obligations, potentially including an indemnification of the AIFM for loss caused by the AIF’s failure to fulfil those obligations.
(c) depositary agreement
Depositary agreements will at least require amendment to reflect the new AIFMD depositary obligation of cash-flow monitoring; the new mandatory depositary liability standard and conditions upon which liability may be discharged by a delegate; escalation procedures in the event of breaches; and detail of the circumstances under which assets may be rehypothecated.
(d) prime brokerage/ sub-custody agreements
The depositary/ prime broker relationship will be fundamentally impacted by AIFMD, as securities held by a prime broker will be considered within the custody of the depositary when reused, and it remains to be seen which operational models will become the norm. Regardless of the outcome, the new dynamic will require prime broker and sub-custody contracts to be revisited, particularly in respect of rehypothecation and the holding of collateral.
3. “Internally-managed” AIFM (for example, self-managed QIF investment company)
Finally, AIFMD allows for ‘internally-managed’ AIFMs (where the AIF and AIFM are the same legal entity), which is a well-established model for UCITS funds. In Ireland, the Central Bank of Ireland (CBI) has confirmed that it will permit this structure, subject to the relevant AIFM retaining sufficient investment management substance in Ireland to ensure that it does not fail the “letter-box entity” delegation test. In this scenario, all AIFM obligations will necessarily fall within the same AIF/ AIFM entity. At the time of going to press, the specifics of what substance the CBI will require have not been finalised, so we can only predict for now that on top of the various AIF-specific considerations above, the self-managed AIF documents will also need to be updated or supplemented to address all other AIFM obligations, such as conduct of business rules and valuation procedures. Based on experience of the UCITS and MiFID regimes, we anticipate that most of these new measures will need to be fully documented in some form of operations and procedures manual.
Ireland: the compelling domicile for EU AIFs
For managers looking at EU AIFs/ AIFMs to pursue ‘first mover’ advantage for the new AIFMD cross-border marketing passport, it is important when selecting the EU domicile to assess how the various Member State fund regimes match up to the AIFMD requirements.
In that regard, Ireland’s Qualifying Investor Fund product (which will be renamed the Qualifying Investor Alternative Investment Fund, or QIAIF) has already been aligned for many years with the key AIFMD provisions, such as the need for fund assets to be held by an independent depositary and the obligation to produce an annual report. This existing product alignment, combined with the expertise and experience of the Irish alternative funds industry, has seen QIF assets increase by over 65% in the four years since the initial AIFMD draft, to just over €200bn.
The CBI is using AIFMD as an opportunity to take further positive pro-active steps to enhance its non-UCITS fund regime. Notable agreed improvements will include the removal of the current promoter regime for Irish AIFs; removal of the Irish prime brokerage and OTC counterparty credit rating rules; a greater flexibility to use side pockets; an allowance for share classes having different liquidity terms within the same fund; a new ability to engage in bridge financing and other private equity-friendly measures; and a consolidation of all existing rules and guidance into a single, user-friendly AIF Handbook.
A new non-UCITS retail fund product (the RIAIF) will also be introduced, which could gain traction in due course as a hybrid for products designed for the retail market but which may not meet the UCITS parameters. The CBI intends for its new AIFMD-compliant regime to be in place by the end of March, to facilitate AIFM approvals for managers who wish to avail of the passport from the earliest possible date of 22 July.
AIFMD will radically restructure the alternatives industry in Europe. We expect many managers to respond with a co-domiciliation approach, by building multi-jurisdictional fund platforms to service their different investor bases. While the Cayman Islands and British Virgin Islands look set to continue as the leading offshore domiciles for global investors, the Irish QIAIF has all the tools to become the default choice for managers who require an EU AIF. Regardless of the fund domicile, though, AIFMD will necessitate an amendment of existing fund documentation to different extents. So it is essential that managers engage early with legal counsel to determine what practical changes are needed to chart the best path through the choppy AIFMD waters.