Time is running out for alternative fund managers to submit their applications under the new AIFMD legislation, says Nick Sudbury. But the confusion just keeps on coming
It’s been a long process, but Europe’s shiny new Alternative Investment Fund Managers Directive (AIFMD) will soon be fully operational. Yes, it all kicks off on 22nd July. And yes, you may never have even heard of it.
Even more incredibly, the need to regulate this critical area of the market was first raised as long ago as 2008, and yet the complexity of these products combined with powerful lobbying has meant that we’re only just lining up the starting blocks.
What’s an AIFMD? Good question. Broadly speaking, an Alternative Investment Fund (AIF) is one that does not require authorisation under the UCITS Directive. It includes hedge funds, as well as those that invest in private equity and real estate, some of which have until now been completely unregulated.
So it’s a big field. And the new legislation covers the authorisation, ongoing operation and transparency of the fund managers that manage or market AIFs in the EU. It provides a framework for monitoring and supervising the risks, while allowing compliant providers to passport their products across the region.
Addressing the Failings
Some of these products − the hedge funds in particular − have been criticised for a lack of transparency and excessive remuneration, with the ‘2 and 20’ model (where fees are set at a flat 2% of total asset value plus 20% of any profits) being pretty typical across the industry.
The AIFMD aims to address these issues by increasing the levels of disclosure and governance. There is also a slew of regulations covering the capital adequacy and risk management.
The rules require an internally managed AIF to have at least €300,000 of initial capital, with the figure for an externally appointed AIFM being €125,000. They must also have additional own funds where the total value of their AIFs exceed €250m, part of which can be in the form of a bank or insurance guarantee.
Another key aspect of the Directive is that fund managers will have to appoint an independent depositary for each of their AIFs that is managed or marketed in the EU. These organisations are expected to act on behalf of the fund and its investors and are responsible for: monitoring and reconciling the cash flows; the safe-keeping of the underlying assets; and for overseeing some of the critical back office operations.
Risk Management and Liquidity
Potentially, the area of the legislation that could have the biggest impact on fund managers relates to risk management. The AIFMD stipulates that this needs to be kept separate from the investment activities, and that those responsible should not be supervised by the heads of the operating units. This is to avoid the sort of failings that we have seen in many of the investment banks that contributed to the financial crisis.
Private equity and real estate funds typically invest in illiquid assets that cannot be sold at short notice. These sorts of holdings can create problems when large numbers of investors want to redeem their units – as was the case with certain open-ended property companies at the start of the credit crunch.
To counter the risk of a similar event occurring in the future, the legislation requires each AIF to maintain sufficient liquidity to meet its redemption policy. It is the duty of the AIFM to stress test this area to ensure that it is adequate in all market conditions.
The Directive and its associated regulations go into detail about the type of information that has to be disclosed in the original offer document, as well as what needs to be included in the annual accounts. It also provides more information on the content of the investment manager’s report.
One of the most controversial aspects is the remuneration guidelines. The AIFMD requires fund managers to have remuneration policies that promote sound and effective risk management. These should apply to senior staff, the risk takers and those in the control functions, with the aim of discouraging them from taking inappropriate risks to boost their bonuses.
The AIFMD came into force on 21 July 2011, with Member States given two years to transpose the ‘Level 1’ framework into national law. The more detailed regulations governing the implementation of the legislation − the so-called Level 2 measures − became effective in December 2012.
There is a 12-month transitional period for fund managers to complete and send in the 35 page application form for authorisation, although new firms have to be compliant from day one. Unfortunately, the evidence suggests that a lot of organisations are struggling to meet that 22nd July 2014 deadline.
A survey conducted in January by BNY Mellon, one of the largest fund administrators, found that only 19% of AIFs had submitted their application. And it can take months to actually secure the authorisation – although the FCA has said that firms based in the UK can continue without it as long as they get their applications in before the deadline.
On a more positive note, nearly 60% of respondents told BNY Mellon that they had appointed an AIFMD compliant depositary service and that the risk management improvements were also well advanced.
It certainly seems as though the momentum is picking up. In January the FCA received 214 AIFMD applications – which represented just over a quarter of the total that it is expecting.
AIFs that are based elsewhere but marketed in the EU must operate under jurisdictions that meet AIFMD compliance standards. And a number of countries with large hedge fund industries, including the Bahamas and the Cayman Islands, have yet to sign up with all of the European Union Member States. This could stop them from taking advantage of the Private Placement Regime (PPR) to market their funds within these countries.
There are lots of questions still to be resolved about PPR and the third country agreements. Some believe that the confusion could lead to the creation of AIFMD II, the sequel, to address these issues. Pessimists think it could be a lot worse and point to the fact that it has taken almost 20 years to make the UCITS Directive workable.
The data suggests that the average cost of compliance with AIFMD will be $300,000 with further one-off costs of at least $100,000 per institution. Around a quarter of firms have said they will pass some of this onto the funds, with a further 46% saying that they were still considering their options.
A report by the Alternative Investment Management Association released last October concluded that the average cost of compliance by hedge fund managers was at least $700,000 for small firms, rising to $14m for larger institutions. The AIFMD was one of the most expensive areas of legislation for them to deal with, it said, because of the complexity.
Yawn, What’s the Hurry?
Despite the high cost, a survey by Northern Trust has found that the majority of fund managers think that investors won’t engage in AIFMD considerations until after 2015. Two-thirds of the respondents thought that the Directive was mainly a compliance exercise, with less than 15% believing that it offers a strategically important opportunity to passport their products across the European Union.
AIFMD certainly brings more funds into the scope of the EU’s regulatory regime and shines a light into corners of the market that have hidden behind a wall of secrecy. It remains to be seen how effective it will be and how much difference the legislation will make to IFAs when it comes to recommending these products to their more sophisticated clients.