In April 2009, the European Commission issued a controversial proposal to regulate private equity in the European Union. Managers of private equity funds, hedge funds and other alternative funds are confronted with substantial proposed new regulation under the European Commission’s proposed Directive on Alternative Investment Fund Managers.
This article focuses on a number of the frequently asked questions that have arisen about the proposed Directive.
Question 1: Who would be impacted by the Directive?
Under the proposed Directive, every alternative investment fund manager “established and operating in the EU” and which provides “managing and administrative services” to AIFs will need to obtain authorisation within one year after its home Member State implements the final Directive. Once authorised by its home Member State, an AIF manager established in the EU will be able to perform managing and administrative services to AIFs and market AIFs that are domiciled in the EU cross-border within the EU via a passporting regime.
AIF managers established outside the EU cannot provide “managing and administrative services” to EU AIFs but will be able to market AIFs in the EU if they are authorised to do so. There is an extended three-year deadline for non-EU AIF Managers to obtain authorsation to market AIFs in the EU. Requirements for qualifying non-EU AIFs for sale in the EU are also covered by the Proposed Directive. For details, see Questions 8, 9 and 10.
The earliest the Directive would come into force would likely be 2010. The deadline for Member State implementation has not been set, but it probably will not be before mid-2012.
Question 2: What types of alternative investment funds are covered?
AIFs include vehicles for pooled investment that are not regulated under the Directive for Collective Investment in Transferable Securities or UCITs. AIFs include hedge funds, private equity funds, funds of hedge funds, real estate funds, infrastructure funds and commodity funds. It does not matter how the AIF is organised, whether it is open-ended or closed-ended, or where it is domiciled. Certain exceptions are described in Question 7.
Question 3: What are “managing and administrative services”?
This is a crucial interpretive issue for AIF managers. Unfortunately, because the terms “managing” and “administrative services” are not defined in the proposed Directive or discussed in any of the associated legislative commentary, there is no certain answer to this question.
Question 4: How can an AIF Manager become authorized? How burdensome are the requirements?
In order to be authorised, an AIF Manager must be established in the EU and apply for authorisation with the competent authority in its home Member State (the country where its registered office is located). The AIF manager will have to provide detailed information about its owners, governance, planned activities, the identity and characteristics of AIFs it manages, information about any plans for delegation of management services, the arrangements for valuation and safe-keeping of assets, and its auditors and regulatory reporting systems.
As proposed, a non-EU AIF manager cannot be authorised to perform managing and administrative services for an EU AIF, although it can be authorised to market them.
As proposed, the minimum capital requirement for obtaining an authorisation as an EU AIF Manager is €125,000. The industry has pointed out that there could be substantial additional capital required if the value of the assets under management exceeds €250 million.
Question 5: Will there be other obligations and costs associated with being authorised as an EU AIF Manager?
Yes. Under the proposed Directive, EU AIF managers can be authorised to provide services in the EU only if they comply with numerous business conduct regulations, including conflict of interest policies as well as risk management and liquidity management policies, procedures and systems.
The proposed Directive would also require that AIFs must have independent valuators and depositories to hold AIF assets in segregated accounts. This proposal has been heavily criticised as misguided in light of the manner in which private equity funds invest and operate.
AIF managers will also be subject to new annual AIF reporting requirements to investors and regulators, additional offering memorandum disclosure requirements, and regulatory reporting about assets in which AIFs are invested, liquidity and risk profiles, and the use of short-selling. These requirements would substantially increase compliance costs of many AIF Managers.
Question 6: Are special disclosures required if an AIF Manager acquires a controlling influence over portfolio companies?
The proposed Directive contains controversial disclosure requirements that apply to an AIF manager managing AIFs “in a position to exercise” 30 percent or more of the voting rights of any unlisted issuer domiciled in the EU. Once the AIF manager “acquires” 30 percent or more of the voting rights in a listed or unlisted company, the AIF manager has an obligation to provide detailed information to the company, its shareholders and employee representatives. For a non-listed company, the AIF manager has to disclose its “development plan” for the company and policies for dealing with conflicts of interest. There is a limited exception to these requirements for a non-listed small or medium enterprise.
Question 7: What exemptions from regulation under the Directive would be available for AIF managers?
Under the Proposed Directive, there are four possible exemptions available for AIF managers:
(1) €100 million threshold An AIF manager would be exempt if it manages, directly or indirectly, with its controlled or controlling affiliates, AIFs with assets under management (including assets acquired through leverage) not exceeding €100 million. Any AIF manager that manages AIFs with assets under management of more than €100 million and which utilizes leverage will not be eligible for any exemption. It is estimated that 90 percent of the hedge fund assets under management in the EU will be covered by the proposed Directive.
(2) €500 million threshold An AIF manager is exempt if it manages, directly or indirectly, AIFs with assets under management not exceeding €500 million as long as the AIFs both do not use leverage and have a five-year lock-up period. .
(3) AIF managers neither managing nor marketing AlFs in the EU Any AIF manager is exempt, even if it is established in the EU, as long as it neither provides management services to EU AIFs nor markets any AIFs within the EU.
(4) Other exemptions Managers of pension funds and non-pooled investments (such as endowments, sovereign wealth funds or assets held for their own account by credit institutions, insurance or reinsurance undertakings) are also exempted under the proposed Directive. In addition, actively managed investments in the form of securities, such as certificates whose performance is linked to a pool of assets, managed futures, or index-linked bonds are apparently not treated as AIFs under the proposed Directive. For various reasons, the alternative fund industry criticises these exemptions for tilting the playing field toward unregulated derivatives.
Question 8: Can AIF managers continue to market AIFs in the EU? What constitutes “marketing”?
Under the proposed Directive:
(1) Marketing means any “general offering or placement of units or shares” in an AIF with investors domiciled in the EU, regardless of at whose initiative the offer or placement takes place.
(2) The general rule is that an AIF manager established in the EU can market EU AIFs only to “professional investors/professional clients” (as defined by the Markets in Financial Instruments Directive) in the Member State in which the AIF Manager is authorised and other Member States subject to compliance with a passporting regime. If effective as proposed, the Directive is expected to make it difficult to market AIFs throughout the EU to high net worth individuals and other non-professional investors as is currently permitted in some EU jurisdictions.
(3) An individual Member State can decide to adopt regulations to allow an AIF manager authorised by the Member State to market AIFs to retail investors within the Member State’s territory (but not elsewhere in the EU).
(4) There is an exception to obtain authorisation for marketing AIFs to EU investors for non-EU AIF managers for a three year grace period after the date the Directive is adopted by Member States which will likely not start before 2012. After the end of the grace period, a non-EU AIF manager will be required to be authorised under the Directive in a Member State in order to market AIFs in the EU. Marketing will be limited to professional investors. As proposed, non-EU AIF managers will not be eligible for any passporting regime. For more details, see the answers to Questions 9 and 10.
Question 9: Are there restrictions on the ability to market a non-EU AIF to investors in the EU?
Under the proposed Directive, an EU AIF Manager, once authorised in its home Member State under the Directive, can market non-EU AIFs to professional investors but only if the country where the non-EU AIF is domiciled agrees to comply with Article 26 of the OECD Model Tax Convention and “ensures the exchange of information on tax matters.” .
During the grace period, a non-EU AIF manager can continue to market to EU investors AIFs, wherever they are organised or domiciled, as long as local laws are observed. After the end of the grace period, a non-EU AIF manager will be required to be authorised under the Directive in a Member State to market AIFs to investors in that Member State. In order to be authorised, the non-EU AIF manager must meet the requirements described below in Question 10. An authorised non-EU AIF manager will be able to market only those non-EU AIFs that meet the tax transparency requirements described in the paragraph above.
Question 10: Are there restrictions on the ability of non-EU AIF Managers to become authorised to market to EU investors?
After the end of the grace period, a non-EU AIF manager may be authorised by a Member State to market non-EU AIFs to investors in that Member State but only if the European Commission has determined that the country where the non-EU AIF manager is established has equivalent regulation, supervision and enforcement, provides effective comparable market access, agrees to cooperate in the exchange of information about AIF Managers, and has signed an agreement with the Member State to comply with Article 26 of the OECD Model Tax Convention. Qualification in one Member State cannot be passported into another Member State.
It has been pointed out that the intersection of the requirements described in Question 9 and in this Question 10 would have a substantial negative impact on the activities of AIF Managers domiciled in many countries outside the EU.
Question 11: Can services be delegated to third parties?
Under the Proposed Directive, an authorised AIF manager can delegate one or more of its functions to third parties with the prior authorisation of the competent authority of its home Member State. Unlike the practice in several European jurisdictions today, the proposed Directive would limit delegation of portfolio management or risk management only to an authorised AIF Manager and no sub-delegation is permitted Delegation of administrative or depository functions to an entity in a non-EU country is possible, subject to demonstration of necessary safeguards.
Question 12: Will AIFs be regulated?
Most AIFs are not regulated under the proposed Directive. As is the case now, AIFs are subject to the laws of the country of their respective organisation and fund documentation.
Many aspects of the proposed Directive are highly unpopular with the private equity and hedge fund communities, and even with some influential European investors. It is certain that the proposed Directive will go through substantial revision. Nonetheless, anticipating the enhanced regulatory environment is important, as is ensuring that the regulations are shaped to focus on significant and demonstrated risk-based commercial rather than political issues.
Marcia MacHarg is a partner, Philipp von Holst is international counsel and Ina Maria von Raven is an associate in the Frankfurt office of Debevoise & Plimpton. Anthony McWhirter is a partner in the firm’s London office. A version of this article originally appeared in the Spring issue of the Debevoise & Plimpton Private Equity Report.