November 2010 Welcome Background Timeline and next steps Expected industry impact – selection of some key aspects Client impact

Welcome

Natalie Westerbarkey
Vice President, EMEA Client and Sales Management
Global Transaction Services, Citi

This Regulatory Spotlight will address the latest update on the AIFMD – Alternative Investment Fund Managers Directive.
Regulatory reform is a continuous process; hence, our Regulatory Spotlights provide no more than snapshots of some key aspects. It does not purport to be comprehensive or to provide legal or other advice, but is aimed at generating discussion with clients on regulatory change and we would be delighted to get your thoughts on any issues that this regulation raises for you.

Background

AIFMD was first proposed in April 2009 by the European Commission with the aim to create a comprehensive pan-European regulatory framework for Alternative Investment Fund Managers (AIFMs). The objective is to establish some common EU rules regarding the authorisation and supervision of AIFMs, their operating conditions including transparency, marketing, passporting and business continuity applicable primarily to alternative investment funds (AIFs), such as hedge funds and private equity funds. It also addresses a broader range of organisational topics such as the management of conflicts of interest, capital requirements, rights of delegation and remuneration. The new rules are designed to achieve greater investor protection and ensure the stability of financial markets, but over time the agenda of legislators has also taken on wider themes such as who should be accountable for different types of risk within the investment chain.

The political negotiations over the last 18 months with the industry and through a complex trialogue procedure – a consensus finding process between the European Council, European Commission and European Parliament – evolved around the following key contentious aspects:

• Third country rule and passport – the marketing and distribution rules for non-EU AIFs
• Depositary liability – the stricter liability rules for depositaries of AIFs; the reversal of the burden of proof
• Private equity provisions – asset striping rules requiring AIFs to adopt a more long-term strategy

A consensus on this law was finally reached on 26 October 2010 and a formal adoption is expected by end 2010.

Timeline and next steps

Expected industry impact – selection of some key aspects

Scope
AIFs are very broadly defined as any collective investment undertaking that is not caught by the UCITS Directive and which raises capital from a number of investors.

This means that the new law applies to:

• all EU managers of AIFs;
• all non-EU managers of EU AIFs;
• all non-EU managers who market AIFs in the EU.

The AIFMD will fully impact managers with more than € 500 million assets under management (AUM), with a much lighter regulatory regime applicable to managers with less than € 100 million AUM or who manage unleveraged funds with less than € 500 million AUM. There are also some exceptions to the scope. The AIFMD will for example not apply to funds managed by public sector entities supporting social security or pension system, such as certain Sovereign Wealth Funds, or family office vehicles that invest without raising external capital.

Passport and third country rule
The long-standing debate surrounding passport rights for non-EU AIFs has been resolved by allowing passporting rights in principle. Once the fund is registered in one EU jurisdiction, the AIFMD enables third country funds and managers to market their funds across the EU without the need to seek prior permission from each Member State. These passporting rights are only available, however, if the non-EU country of origin has a co-operation agreement and tax treaty in place with the EU Member State where the fund is to be marketed. Although AIFMD awards passporting rights for the marketing of non-EU AIFs in Europe, managers will only be able to use these passporting rights 2 years after the implementation of the AIFMD at the earliest. Until that time, non-EU country funds and managers will need to market a fund through existing national private placement regimes only, which will potentially be phased out after 2018. Substantial oversight and regulatory powers in this context will be granted to ESMA.

Nevertheless, the debate is not yet closed. Detailed technical discussions around this issue will likely continue during the design of Level 2 legislative measures throughout 2011, in particular with regards to the authorisation process and criteria for the AIFM passport.

Functional segregation – depositary, prime broker, counterparty, valuer
In order to avoid conflicts of interests, a manager cannot act as depositary of the funds under its management. Furthermore, a prime broker acting as counterparty to an AIF cannot act as a depositary, unless it functionally and hierarchically separates out the roles of the depositary from those of the prime broker. The AIFM must ensure an independent valuation of assets either through an external valuer, the manager itself or its depositary, provided that the two latter have also functionally and hierarchically separated their roles, and have disclosed their dual roles to the investors in the fund.

Depositary provisions and liability
An AIFM must ensure that for each AIF under its management a single depositary is appointed, so all funds caught by the Directive will have to get familiar with the presence of a depositary.

There is likely to be an increased, almost strict liability in relation to a literal “loss” of financial instruments that they safe-keep for funds, although other losses will be subject to performance standards. Depositaries will face restrictions on delegating to sub-custodians, especially in exotic markets that do not have regulation standards equivalent to the EU. Furthermore, depositaries will be subject to duties in relation to the oversight of cash and the designation of cash accounts with themselves or third parties.

This combination of factors is likely to increase depositaries’ risk based capital requirements and to concentrate risk within depositaries.

Client impact

The AIFMD is expected to result in greater transparency and robustness of alternative investment funds and their managers. However, these benefits will come at a certain cost, given that the industry will need to increase controls, compliance and train or employ competent resources who understand and can apply the new rules.

Furthermore, the stricter liability rules for depositaries will change risk profiles for depositaries themselves, but also will have a knock on effect on how funds and their managers behave and interact, what types of investments they make and where they invest.

AIFs, most notably private equity firms, will also need to comply with certain provisions that prevent asset stripping. For 24 months after acquiring control in a non-listed company or issuer, an AIF shall not participate in any distribution, capital reduction, share redemption and/or acquisition of own shares by this company. The rationale is to deter private equity investors to acquire control of a company for the sole purpose of a quick profit, and instead urge them to develop longer-term strategies for target companies.

To discuss the matter, please contact your client executive or Natalie Westerbarkey, Vice President, EMEA Client and Sales Management, Global Transaction Services, Citi at +44 (20) 7500-0965.