A Summary of AIFMD and How it Affects Hedge Funds

AIFMD SummaryStudy Notes

Brief Overview

• The Alternative Investment Fund Managers Directive (AIFMD) arose from a G-20 summit in 2008 that discussed the stability of the financial industry

• Composed by the European Commission in 2010, and set into motion July 21, 2011

• Countries in the European Union who will be impacted by AIFMD have been given two years to prepare for its start date on July 22, 2013

Products of AIFMD

• AIFMD is comparable to the United States’ Dodd Frank Act, but focuses on alternative investment funds (AIFs)

• Managers are required to be licensed under AIFMD if they fall within specified domiciles

• Managers that qualify for the licensing requirements are:– Managers that manage an AIF in the EU or from

the EU

Products of AIFMD

• Managers that qualify for the licensing requirements are:– Markets an AIF in or into the EU

• AIFs can be open or closed-ended funds• If a fund does not fall under UCITS IV, it is

considered an AIF

Products of AIFMD

• Exemptions include:– Joint ventures– Pension funds– Family offices– Holding companies– Securitization special interest entities– Saving schemes – Employee participation

Products of AIFMD

• Closed-ended funds may be exempt if:– They do not perform any more investments after July 22, 2013– The fund closes before July 22, 2016

• Topics discussed in AIFMD include:– Changes to banking– Depository requirements– AIFs– How AIFMs need to adapt– Marketing of AIFs – Impacts to offshore funds and some strategies– Deadlines– Tax concerns

Products of AIFMD

• Administration and transparency help disclose how compliance and accountability will be enforced

• Those who manage AIFs outside of the EU may have to make structural changes to accommodate to AIFMD standards

Depository Requirements

• New depository requirements obligate third party providers domiciled in the EU to administer capital for AIFs

• Third parties that are independent of the AIF will be chosen as the depositories– The depository must be domiciled in the jurisdiction of either

the AIF or AIFM

Overview• Acceptable institutions and requirements• Conflicts of interest involving depositories• Downside for depositories

Acceptable Institutions and Requirements

• AIFs in the EU register with the managers Member State

• Non-EU AIFs can register with an EU credit institution or investment from the AIF’s residence, or with the managers Member State if located within the EU

• Non-EU depositories may be used if they follow the strict guidelines set by the EU– This would require the depository to report all holdings

for tax purposes, and would be liable to the AIF and AIFM


• Depositories will have many responsibilities and will be liable for funds being administered– Any losses of capital would be liable to the

institution with the holdings• Managers are required to confirm that the

depository is adequate for holdings, and holding entities will need to prove they have the required resources to manage the tasks at hand


• Depositories should consider the risk before deciding to control any amount of holdings– Appropriate fees will need to be charged

depending on the risk of holding certain AIFs assets

• Prime brokers are allowed to act as depositories if they can prove there is no conflicts that would interfere with operations as a holding agent


• AIFs take on the liability if they choose to use a prime broker

• It may be more affordable to implement a prime broke as a holding agent, but if circumstances were to change dramatically it may be wise to choose a third party depository

Conflicts of Interest Involving Depositories

• AIFMs who manage more than one AIF are required to have a separate depository for each AIF

• Depositories are obligated to a fiduciary duty• If a depository desires, they may also act as a

prime broker if there is clear separation from its depository and brokerage functions

Downside for Depositories

• There is much to be gained in operating as a depository, but potential risk as well that should be considered

• AIFMs will be required to clearly communicate between depositories and prime brokers for operations flow more smoothly– Depositories will need to track all trades that occur

with the prime broker to know where assets are located at all times, and later register account balances after trading to assure accuracy

Downside for Depositories

• AIFMs will be required to clearly communicate between depositories and prime brokers for operations flow more smoothly– Prime brokers view the total amount in

depositories as investable for even its own trading purposes, depositories are left with all liability

– If a prime broker was to fail, depositories have 27 days under current AIFMD requirements to restore the whole amount, even if they had no fault

Reporting and Transparency

• AIFMD requires licensed managers to produce a annual report and holdings report

• Valuations for the annual report will be performed either by third parties, or the manager if there is no conflict of interest

• Other requirements for reporting involving transparency will assist with previous issues that may have been problematic

Reporting and Transparency

Overview• Annual Report– Remuneration Disclosures

• Disclosures to Investors– Percentage of Assets Subject to Special Arrangements

and Managing Liquidity of an AIF– Risk Profile, Risk Management, and Leverage

• Reporting to Regulators– Frequency, Content and Format– Substantial Leverage

Annual Report

• Annual reports consist of:– Investment holdings– Financials – Changes in holdings and value of the fund – Historical performance – Net asset value per share – Fixed and variable remuneration to the manager

and employees – Plus details of the carried interest

Annual Report

• Annual reports should be delivered to regulators within six months of the ending fiscal year, and available to investors if requested

• Other changes in reporting will rely upon the GAAPs used and the disclosures that writers of the AIFMD deem necessary for proper transparency

Annual Report

• Remuneration Disclosures– Details involving the disclosure of compensation

will vary depending upon the size of the AIF– Disclosure of remuneration will not be made

public, but will be available through disclosures of an • Annual report • Separate compensation policy • Any other form

Annual Report

• Remuneration Disclosures– Requirements of the disclosures are listed in

AIFMD– The compensation amount that is disclosed will be

itemized in given several ways– Those under the private placement regime are still

required to produce a remuneration disclosure

Disclosures to Investors

Annual reports to investors are a required minimum of AIFs• Percentage of Assets Subject to Special

Arrangements and Managing Liquidity of an AIF– Disclosures of redemption rights on special

arrangements should be made available to investors along with details of how the special arrangements are set up


• Percentage of Assets Subject to Special Arrangements and Managing Liquidity of an AIF– Notifications should be delivered to investors

when changes to liquidity or the risk management of liquidity are made

• Risk Profile, Risk Management, and Leverage– Details involving risk management must be

transparent prior to investments being made


• Risk Profile, Risk Management, and Leverage– Risk profile should be made available in offering

documents and annual reports– If a risk profile is compromised, investors should

be notified immediately to develop a solution– Changes made to leverage caps and collateral

should be informed to investors– All levels of leverage that are used or may be used

should be disclosed to investors

Reporting to Regulators

• Reporting requirements found in AIFMD were developed to control the flow of risk in AIFs– These requirements are upon all EU AIFMs who desire

to market their AIFs within the EU• Frequency, Content and Format– AIFs who manage between 100 million and 1 billion

Euros must disclose reports semiannually, while AIFs that manage over 1 billion Euros must disclose reports quarterly• There is a 30 day deadline for both, but is extended to 45

days for fund of funds


• Frequency, Content and Format– Special AIFs, like private equity funds that are

unlevered must only report on an annual basis with the same deadlines arranged

– AIFMs have many details to include with the reports and have additional requirements if using leverage or non-listed companies in their strategies

– AIFMs who manage more than one AIF must list all in a single report, as well as each AIF individually


• Frequency, Content and Format– The report that is filed consists of over 41 questions

and has many details• Substantial Leverage– Regulators plan on limiting leverage that is

considered substantial• Substantial leverage is considered three times the NAV

– Disclosures on AIFs that manage substantial levels of leverage have an extraneous amount of details to report


• Substantial Leverage– Authorities are responsible for amounts of

leverage AIFs use, and can limit the amount of leverage an individual may use if it can endanger a financial systems status

– AIFMs must notify authorities when changes to the infrastructure involving leverage is made, and inform regulators on how the change aligns with policies that have been made

Regulations on Remuneration

Overview• Remuneration on Delegators• Remuneration Committee• Timing and Intertwining of Remuneration

Provisions

Remuneration on Delegators

• AIFMD encompasses delegators beneath the AIFM who were associated with responsibilities of assisting risk and portfolio management

• AIFMs must assess whether the delegator(s) are accountable to the compensation subtext under the AIFMD, or if they will demand a contractual agreement that excludes them from submitting information relating to their remuneration

Remuneration Committee

• AIFs are required to develop a Remuneration Committee (RemCo) if it meets requirements of:– Specific size – Organization – Nature of operations

• AIFs consisting of 1.25 billion Euros or less in assets under management, and employing 50 or fewer individuals may be exempt from this

Remuneration Committee

• AIFs may be able to circumvent these compensation provisions completely if:– A RemCo is started – 50% of remuneration is received as shares in the

AIF – Risk management involved with compensation is

maintained

Timing and Intertwining of Remuneration Provisions• AIFMs managing AIFs before the initiation date are

allowed one year to comply• Those receiving salary and remuneration before

2014 may need prior evaluation to the compliance date

• Managers receiving compensation from domiciles with different directives will be evaluated on a pro rata substance

• Materials required of multiple regulators will be adjusted to fit proper provisions

Risk Management

New policies that are brought on by risk management clauses develop assessments for risk, risk management, and liquidity of investments• Permanent and Segregated Risk Management Divisions• Risk Management Policies• Measuring and Management of Risk and Risk Limits

– Setting Risk Limits and Managing Potential Risks• Liquidity• Examining and Reviewing the Risk Management Policy

Permanent and Segregated Risk Management Divisions

• Segregated risk management independent of the AIFM is now mandatory to reduce risk in AIFs

• This is troublesome for the structure when risk management was previously integrated with investment operations

• Audits of the segregated risk management team will be performed annually by either a third party or an inside source if there are no conflicts of interest

Permanent and Segregated Risk Management Divisions

• Employees on the segregated risk management team will be compensated for goals met for managing risk and not performance of the fund

Risk Management Policies

• The policies involved with risk management are critical to the implementation of risk management in AIFMD

• Crucial elements of the policies are:– Distribution of responsibilities in the AIF – Safeguards to segregate risk duties – Constructing a risk profile and monitoring potential risks

Ways in which to monitor risk and make checkpoints for it to clear

– Set risk limits – Description of the kinds of reports – Frequency of reporting for AIFs and the AIFM

Risk Management Policies

• More intricate AIFs may bring on Risk Officers to communicate with upper level management

Measuring and Management of Risk and Risk Limits

• Scenario and stress tests may be performed to monitor potential risks

• When placing risk limits, issues to be considered include:– Market– Liquidity – Credit – Operational – Counterparty risks


• Risk management provisions may affect the strategy of the fund and influence changes to– Market risk in volatility – Bilateral transactions that raise risks for the

counterparty – Operational risks influencing performance – Liquidity of investments – Credit investments


• Provisions in place require AIFs and AIFM to – Implement risk management and prevention

methods– Perform pre-tests to analyze accuracy of the

measures taking place – Perform scenario and stress tests frequently to

adjust to fluctuations in the market – Design reliable measures for liquidation when

needed


• Setting Risk Limits and Managing Potential Risks– Risk limits should be checked on a day-to-day basis

by the independent risk management team – AIFMD does not restrict investing decisions, but it

does have two steps to be taken beforehand:• Ensure the decisions made do not contradict with risk

limits set• Construct a fail safe in case anything were to go terribly

wrong so that it can be solved poste haste

Liquidity

• AIFMs will need to link the liquidity profile and redemption policies to how they structure their strategy, once it has been chosen

• If they plan on supplementing less liquid assets into their portfolios, they will need to contemplate – Redemption restrictions – Pre-launch – And other characteristics involved

Liquidity

• Special tools will be needed to control risk in liquidity

• AIFMs be responsible for supervising – Liquidity profiles – Conflicts of interest that may arise with investors– Enlightening potential investors of the redemption

restrictions that apply in great detail before they invest – Initiating stress tests to ensure the liquidity profile – Reporting liquidity policies along with fail safes that

have been set in place

Examining and Reviewing the Risk Management Policy

• AIFs must continually supervise its risk management procedures and notify regulators if changes are made

• AIFMs should assure that – Compliance is followed – Safeguards are currently inline with risk

management functions – Necessary actions are taken when the

accurateness of current policies have changed

Disclosures of Control over Non-listed Companies

• Funds must report in addition to changes in holdings of non-listed companies when they have voting rights that surpass or descend below 10%, 20%, 30%, 50%, or 75%

• If an AIFM acquires a company, he has to inform investors of the purchase and proper authorities in the Member State

Disclosures of Control over Non-listed Companies

• AIFMs must– Inform employees of the acquisition immediately – Furthermore enlighten the board of directors and

shareholders of changes to operations of the company and outcomes that would effect employment

– and update employees on conditional changes to employment

Restrictions on Asset Stripping

• AIFs managed in the EU by EU and non-EU AIFMs are prohibited from – Distributing – Reductions in assets – Allowing redemption of shares – And acquiring additional shares through one’s

separately managed AIFs during the first two years of ownership under the passport regime

• This applies to public and private portfolio companies


• Responsibilities fall on the AIFM and it is illegal for him to perform or instruct these actions upon others, as he is liable for preventing these actions from taking place to the best of his abilities

• Exceptions to these restrictions include:– Companies with net turnover of less than EUR 50

million – Balance sheet totals under EUR 43 million


• Exceptions to these restrictions include:– Special purpose real estate funds– SMEs that make portfolio companies with fewer

than 250 employees exempt – And portfolio companies whose registered office is

located outside of the EU • Dividend payments may be affected by this,

but AIFMD did not discuss interest payments on bonds

Tax Consequences

• AIFMs may be confronted with double taxation that may come with the passport regime

• AIFs will primarily be a tax resident of the location in which it is domiciled, but if AIFMs are managing from across borders, it can become complex and rely upon the authorities in the jurisdictions that are being dealt with

Tax Consequences

• Investors of the AIF and delegates of the AIFM bring even more complexity when AIFs have to monitor multiple jurisdiction tax guidelines and/or maintain tax treaties

• A recent change to the taxation of AIFs was brought on through the Value Added Tax (VAT) Directive

AIFMs have to adapt

• AIFMs are required to attain an AIFMD license when specific criteria is met

• Managers are now accountable for – Directing of depository and risk management

requirements – Accounting and compliance requirements – Compensation requirements– Prudential capital requirements

AIFMs have to adapt

• . Managers are only allowed to delegate their portfolio and risk management roles to the proper regulated entities defined by AIFMD

• Depository and risk management will add a safety net in managing the portfolios, and accounting and compliance regulations will assist with transparency and minimize deceptive practices

AIFMs have to adapt

• Compensation requirements will reduce the amount of risk a manager is willing to take

• Prudential capital regulations set a minimum amount of capital that must be on hand at all times

• Managers who fall under the AIFMD are confronted with special marketing and passport regulations

AIFMs have to adapt

• Other guidelines include details about – Annual reports Tracking of assets under

management – Due diligence – Observing cash flow – Annual audits from disparate third parties Setting

limits on leverage

AIFMs have to adapt

Overview• Impact on Hedge Funds– Risk Management and Compliance– Other Provisions

• Impact on Private Equity Funds– Depositories– Risk Management

AIFMs have to adapt

Overview• Impact on Private Equity Funds– Remuneration– Capital Requirements– Reporting, Control of Non-listed Companies,

Delegating of Manager Functions, and Transparency

– Anti-asset Stripping Regulations

AIFMs have to adapt

Overview• Impact on Real Estate Funds– Depositories– Remuneration and Conflicts of Interest– Risk Management and Compliance

• Marketing and Passports in the EU– EU Marketing Passports– Private Placement Regimes

Impact on Hedge Funds

• Risk management and compliance– Numerous larger firms had already employed

Chief Risk Officers to their funds in the recent past, and now mid to small size firms are following the trend

– Potential investors who inspect AIFs before investing examines where risk level is on the operational pyramid and how intimate the Risk Officers are with the investment teams work


• Risk management and compliance– Not all firms will require a compliance team but it

is well advised to stay accountable – Third party compliance teams can be hired

frequently to perform tasks of valuations that would be requisite under AIFMD


• Other provisions– Depository and reporting requirements will reflect

the same standards upon hedge funds – Compensation received by the fund manager will

be reported with the annual report in compliance with AIFMD, as a way of discouraging managers from taking excessive risks

– Changes to leverage will be executed as well to lessen liabilities


• Other provisions– Contracts will need to be adapted for the entities

associated with the operations of the AIF, and for those contemplating co-domiciliation of an AIF will require “mirror” entities in any dominion outside of the EU

Impact on Private Equity Funds

• Unless the fund is closed-ended and dissolves before July 16, 2016, private equity funds are included as an AIF under AIFMD

• All AIFs are only permitted a single AIFM who manages the fund

• Administration and marketing functions are available to AIFMs that are outside the boundaries of AIFMD


• AIFs that have multiple EU and non-EU domiciled managers, have the opportunity to select a desired manager and transport the AIF to the managers domicile

• Depositories– Because investments involved with private equity are

most often illiquid, managers see this as a hassle that wastes time and money

– Adjustments to the AIFMD may be changed in the future to adjust for different AIFs and their investment positions


• Risk Management– Risk management teams would be hired on to

assist with monitoring potential risks involved with investments

– The risk management section covered by AIFMD is for the most part, already used by private equity funds through the due diligence process in valuating prospective investments.


• Remuneration– Up to 40% of compensation must be received over a

spread of 3 to 5 years • Compensation that is in holding for the time being could

be placed into the fund temporarily

– Lead roles that would be associated with risk involved in remuneration are

– The investment manager – Fundraising managers – Investment management team and board members


• Capital Requirements– Capital requirements that are set require

managers to either hold their own assets aside, in very liquid investments or cash, or to possess adequate insurance


• Reporting, Control of Non-listed Companies, Delegating of Manager Functions, and Transparency– The only changes incorporated into reporting that

is not usually performed by private equity funds is the separation of portfolio management, remuneration policy, and valuations

– Outside valuators would use service providers as third party contributors to access needed information from private equity funds


• Reporting, Control of Non-listed Companies, Delegating of Manager Functions, and Transparency– Issues at hand for operations would lean towards asset

stripping for future acquisitions, miscommunication regarding objectives for production of the company and the impact on employment

– The delegation of manager functions clause is primarily not applicable to private equity funds since the bulk of the work performed is internal


• Reporting, Control of Non-listed Companies, Delegating of Manager Functions, and Transparency– Transparency is predominantly not an issue– Private equity funds have been known to keep their

investors current with what holdings are within the fund, AIFMD only re-states what has already been done in the past

– How the report is manifested is the only significant area of improvement for transparency


• Anti-asset Stripping Regulations– Regulations on asset stripping will restrict

activities in structuring that was previously performed in most private equity firms

– If there were to be an economic crisis equivalent to 2008, the fund would be unable to implement exit strategies for assets enclosed by the regulation

Impact on Real Estate Funds

• Even though real estate funds, also known as REITs, are a type of mutual funds, they are still incorporated with AIFs after German regulators pushed that they should be embraced under AIFMD

• With investors more leery about REITs since the crash in 2008, they have been less popular and the regulations that have been implemented recently do not contribute many positive aspects to these vehicles


• Depositories– Depositories are a considerably pricy vehicle for

REITs and require clear communication between the two for confirmation of where investments are located and when

– Custodians will have to face sizeable liability and may have to regulate which investments are too risky for it to accept


• Depositories– Performing annual valuations would be

convoluted due to the structuring of operations through multiple entities

– Many who are working on interpreting AIFMD are still uncertain of how regulators propose to implement depository, reporting, and numerous other requirements involved with REITs


• Remuneration and Conflicts of Interest– Disclosure of compensation in annual reports is

common for REITs, but new provisions will need clarification before they can be initiated

– Conflicts of interest have also been covered in the past; some when involving investors and clients with various investors under them consider the additions that come with AIFMD inequitable


• Risk Management and Compliance– REITs have previously performed risk management

in the past without the sanctioned regulations that enforced teams to be implemented, but this can come across as challenging for some

– Latest provisions of the compliance implications are considered very arduous compared to the compliance platforms that had formerly been in place

Marketing and Passports in the EU

• Two exceptions marketing in the EU are the pursuit of retail investors, and investors who introduce the AIF to others

• Member states oversee marketing to retail investors, so AIFMs must check with the applicable jurisdiction to see what restrictions are in place


• EU Marketing Passports– Special marketing passports will be made accessible to

AIFMs who qualify under specific criteria, and allow them to market in the EU

– Specific criteria must be met before an AIFM passport may be obtained

– Passports will be accessible to all EU AIFMs marketing AIFs domiciled within the EU by July 22 of 2013, non-EU AIFMs marketing EU AIFs or non-EU AIFs and EU AIFMs marketing non-EU AIFs July 22 of 2015


• EU Marketing Passports– Applications for AIFMs in Member states will be

processed within 20 days of submitting and obtaining the application • Processing entities would then notify all EU domiciles in

which the AIFM intends to market his AIF(s) after the AIFM has received notification of its acceptance


• Private Placement Regimes– EU AIFMs who market non-EU AIFs, and non-EU

AIFMs who market EU and non-EU AIFs in the EU would be allowed to proceed with operations if compliant with the national private placement regimes guidelines

– AIFMs must conform to the standards of AIFMD that are installed during 2013, with exceptions to the depository clauses to be eligible


• Private Placement Regimes– Compliance and reporting for the transparency of the

fund must be functioned through a third party valuator who is not the AIFM

– Authorities, which require reporting, are the countries in which the AIFM is marketing his or her AIF

– Risk management of the AIF(s) will be co-monitored between/ among the regulators of the domiciles within the EU where they are marketed, the regulators of the non-EU AIFM’s country of residence and/ or residence of the non-EU AIF


• Private Placement Regimes– Non-EU AIFMs and AIFs may not reside within

domiciles that are in violation of FAFT policies – This national private placement regime would be

established in July of 2015 through July of 2018 along with the passport regime, but may very well be removed after 2018 and substituted with the passport regime altogether

Impact on Investment Strategies

• AIFMD does not specifically outlaw certain investments strategies, the safeguards which have been set with risk management, depositories, disclosure requirements and everything else will assist in AIFMs cherry-picking their investment choices

• A due diligence process is also required of current and prospective ventures before managers make investment decisions

Conclusion

• There are many safeguards that have been set in place for this directive

• Risk management, reporting, and depository requirements presented will be inconvenient for many managing AIFs

• The benefits of implementing AIFMD can only be known once the time comes for it to be tested

A Summary of AIFMD and How it Affects Hedge Funds

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