AIFMD – The time to act is fast approaching

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As part of our professional network, we have the benefit of receiving valuable industry updates from various firms and individuals. Bill Prew, a former Hedge Fund COO and founder of Indos Financial Limited, has prepared a useful briefing which we believe will be of interest to you:

Faced with other priorities and, until recently, in the absence of the 'Level 2' regulation, most hedge fund managers have been pragmatic and not yet fully considered AIFMD. The Directive takes effect on 22 July 2013; however the FSA will give existing managers until July 2014 to apply to vary their permission to become an 'AIFM'. Following this publication of the Level 2 regulation in December many managers will now prioritise AIFMD in the New Year, so it may be helpful to share some thoughts on AIFMD particularly as it relates to UK managers.

Who is the AIFM? Clarity is still required to determine who needs to be the AIFM. I expect managers performing the majority of their portfolio management in the UK will have little choice but to become an 'EU AIFM'. UK managers within a group, where management is also undertaken outside the EU, may have flexibility to define an overseas office as a non EU AIFM thereby avoiding many elements of the directive.

Regulatory Capital: An AIFM is required to hold a minimum of €125,000 plus the greater of one quarter of annual expenditure or 0.02% of gross AUM in excess of €250m. In addition, capital or professional indemnity insurance equivalent to 0.01% of AUM is required. Capital requirements are therefore likely to increase for many managers.

Depositary liability: Managers of Alternative Investment Funds ('AIF') registered in the EU ('EU AIFs') are concerned about costs resulting from the appointment of a depositary taking on strict liability for loss of financial instruments held in custody by it or a delegate. I expect competitive forces will keep the costs in check and they will be significantly less than the 1-1.5% suggested. Costs for EU AIFs will however be greater than non EU AIFs so many managers may retain their offshore funds at the expense of not being able to access the EU marketing 'passport' until 2015.

Marketing: An EU AIFM of a non EU AIF must comply with AIFMD except for Article 21 – Depositaries. Where non EU funds are marketed to EU investors through national private placement regimes the EU AIFM must ensure one or more firms (or possibly just one under the recent FSA consultation paper) perform certain depositary functions: custody, cash flow monitoring, and oversight of subscriptions/redemptions and NAV processes. Managers may rely on reverse solicitation and avoid these requirements. Private placement regimes may also become more restrictive. Regardless of the route taken, managers will need to review compliance procedures around marketing since it seems inevitable there will be increased regulatory focus in this area.

Valuation: Since administrators are unlikely to be the 'external valuer', most AIFMs will perform this function (albeit functionally and hierarchically separate from the front office). The AIFM, not the administrator, will be liable to the AIF for valuation errors. Many will therefore view this aspect of AIFMD as a backward step. An agreement between the AIFM, AIF and administrator could ensure the administrator is liable (to the AIFM) for valuation errors.

Remuneration: AIFMD will have a greater impact on the approach firms take to remuneration than the existing FSA remuneration code. AIFMD will apply to a broader set of individuals whose activities could have a material impact on the AIF and not just the manager. Questions remain but it may be necessary to defer at least 40% of variable remuneration over 3-5 years including a portion in non-cash form such as AIF units, implement claw back adjustments and provide remuneration disclosure to investors. The treatment of limited liability partnership profit also remains unclear.

Operating and organisational requirements: Managers are familiar with FSA principles such as acting in the best interests of investors and managing conflicts of interest which also form part of AIFMD. Compliance in this area should therefore be relatively straight forward. One area to watch will be the final requirements to disclose the existence of material side letter terms, including fee arrangements, in the prospectus.

Risk and Liquidity Management: EU AIFMs must maintain an independent risk function which manages market, credit, liquidity, counterparty and operational risk. Maximum leverage limits must be set for each AIF managed by an EU AIFM, and portfolio liquidity limits defined and regularly stress tested. Many firms may require additional resource in this area.

Reporting and Disclosure: The increase in regulatory reporting will continue. Financial statements must include, inter alia, an overview of performance, remuneration and risk management. Offering documents will be expanded, in many cases constitutional documents amended (thereby potentially requiring investor general meetings) and there will be additional disclosure to investors and regulators (at least half yearly). There will be overlap with the current bi-annual FSA survey, SEC Form PF and other reporting but, as we have come to expect, there will no doubt be differences. Many managers already recognise the need to focus on data management to enable efficient and accurate reporting.

In conclusion, there are no doubt significant implementation challenges ahead. It's easy to focus on the negatives of AIFMD but, in time, I hope it will be regarded in some ways as being positive for the industry and the effort will be rewarded. What‟s clear is that the time to act is fast approaching.

December 2012

Should you have any questions relating to the above, please do not hesitate to contact Bill at  

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