Four months (give or take) have now elapsed since the majority of alternative investment fund managers (“AIFMs”) became authorised under the Alternative Investment Fund Managers Directive (“AIFMD”). This is still a brief period in comparison to the three years or more that the industry has been thinking and preparing for this brave new world. However, there is nothing like the cold water of reality to concentrate minds and translate general concepts into specific actions. Compliance consultants can play a pivotal role in this process as the common approach of two or three quickly snowballs into industry best practice. Is it too early to start making generalisations about how AIFMD is working in practice? In this article, as we move from the possibilities of theory to the reality of implementation, we stick our necks out to offer a hit parade of critical issues and some typical responses:
1. Reverse solicitation is not the answer. A year ago this was seen by many as a viable option which would allow many non-EEA advisers to side-step AIFMD all together, or UK based advisers to avoid the depositary-lite requirements. We detect a change of opinion in recent months. The key to this lies in the definition of reverse solicitation: “marketing at the initiative of the investor” and difficulty of positively evidencing this for all but the largest or higher profile or unique managers. “Cap-intro” events sponsored by the prime brokers, that have been restructured with the advent of AIFM, may help support this audit trail, but do not solve the fundamental problem which needs to be considered on a case by case basis. At the same time, uneven interpretation of reverse solicitation by different EEA jurisdictions is adding another layer of complexity.
At first sight the FCA’s perimeter guidance is helpful: “A confirmation from the investor … should normally be sufficient to demonstrate that this is the case, provided this is obtained before the offer or placement takes place”. However, the very next sentence undermines this certainty: “AIFMs and investment firms should not be able to rely upon such confirmation if this has been obtained to circumvent the requirements of AIFMD.” Where does this leave managers? Many have changed their view on the viability of reverse solicitation not just because of the attendant regulatory risk but also the potential lethal threat of compensation claims for mis-selling down the line – the so-called “free put” scenario. Business development teams need to, well, develop the business and compliance officers need to sleep at night. Reverse solicitation is not a marketing strategy.
2. Registration in multiple jurisdictions is both costly and complicated – choose wisely. In principle, any EEA manager can continue to market their Cayman (or similar, non EEA) fund across Europe through the so-called National Private Placement Regime (“NPPR”). Managers must submit a prior “Article 36” notification prior to marketing commencing (Article 36 refers to the section of the original Directive which introduced this requirement). Although this is relatively straightforward in the UK, you need to make this notification in each EEA state you want to market the AIF in.
Unfortunately, no standard notification exists and each country can vary in regard to procedure, level of detail required and conditions to be met (thus meaning that hiring local counsel may be necessary). Bear in mind also, that a direct passport for non-EEA funds may be available from next year rendering such investment worthless.
Consider carefully with your marketing team which are key European jurisdictions for them to have access to and that will give an order of priority. There can also be no more spontaneous road shows round Europe – the necessary registration needs to be complete beforehand.
3. Did we really say that? Delivering the promises of your Variation of Permission application. The authorisation process for would-be AIFMs includes committing to a substantial extension of their compliance framework, including valuation, depositary and risk management (often grouped together with liquidity management). In most cases, the grunt work of drafting new policies is now largely complete. Now comes the hard part of monitoring that the day to day practice meets these often ambitiously high standards. Risk management is a typically problematic area where new monitoring and intervention powers are granted to a risk management function which must be functionally and hierarchically separate from portfolio management. This typically cuts right across existing culture and governance, particularly in smaller AIFMs.
Across the board, therefore, AIFMs now have some work to do to make sure that all those policies and procedures are firmly embedded in the business. Reviewing your AIFMD Variation of Permission is an excellent place to startand making sure the necessary updates are reflected in the compliance monitoring programme.
4. Annex IV reporting: harder than you might think. Under the transparency requirements of AIFMD all EEA AIFMs must make an Annex IV report to its home member state regulator. Non EEA AIFMs which market into the EEA via Article 42 notifications are obliged to report separately to each member state in which they are able to market. Annex IV reports are based on a central template released by European Securities and Markets Authority (“ESMA”, the European central regulator). The templates cover four sections, each of which require different information specific to both the AIFM and the AIF, and running to several hundred data and text fields in total. The superficial similarities with Form PF (the SEC equivalent) are misleading as there are often minor differences in definitions as well as completely new fields. For most newly-authorised AIFMs, the first reports are due by the end of January 2015. Although self-reporting is a possibility, we expect the majority of managers to go with a third party solution.
A plan of action should be determined well before the report due date. This is not a ‘compliance report’ – it needs data from around the business including operations, fund accounting teams, investor relations teams. Questions to answer include: Who will prepare the report? Where will the data come from? Do you have the necessary technology? Make sure your plan includes time for a dummy run of the report.
5. Remuneration: hold on that move to Switzerland. Lastly, an issue where some are now wondering what all the fuss was about. There are two main aspects to this: first, the introduction by the FCA of proportionality thresholds that permit disapplication of some of the more arduous requirements around the pay-out process rules (deferral, payment in AIF units and performance adjustment). Thus, AIFs with assets under management of less than £1 billion have a working presumption of avoidance, although this can be challenged by the FCA on the grounds of size (i.e. number of personnel), internal organisation or the nature, scope or complexity of activities. Second, the remuneration disclosure that is now required in the annual report of each AIF may be provided at an aggregated level (a key concern, particularly for many US advisers), so there is no need to individually disclose what your highly-paid CIO earns.
As you prepare for the first disclosure of remuneration in the AIF’s annual report consider the options that AIFMD offers in how that data is presented. And prepare the business for the disclosure – despite being on an aggregated basis, any disclosure on such matters is always sensitive.
More broadly, we expect the FCA’s relative silence on AIFMD implementation in recent months to end in 2015, with particular focus on areas such as delegation arrangements, risk management and leverage. AIFMs should be prepared to discuss their fully implemented AIFMD compliance programmes with the FCA next year.
Also coming up towards the end of the year is an ESMA-led review of the operation of the marketing passport and whether to extend this option to non-EEA domiciled AIFs and to non-EEA AIFMs.
Martin Lovick and Adam Palmer are, respectively, Compliance Consultant and Managing Director with ACA Compliance (Europe) Ltd, the compliance consultancy firm for wholesale financial services companies with a client focus on hedge fund managers, private equity managers and institutional brokers. The views expressed are their own.