On Wednesday the European Commission adopted “level 2” implementing measures for the controversial Alternative Investment Fund Managers Directive that have confirmed GPs’ fears that parts of the regulation would be difficult to interpret or make sense in practice.
Over the course of the year the buyout industry has been in talks with the European Securities and Market Authority (ESMA) – the pan EU regulator responsible for enforcing the directive when it goes into effect in July – and policymakers over sensitive areas including delegation rights and depository requirements.
In late 2011, ESMA provided the Commission welcomed technical advice on how the Directive should be fine-tuned; however, in certain areas that advice has been ignored.
Despite originally planning to release final measures over the summer, the Commission has not used the additional time to write clear-cut rules on delegation – which are intended to prevent GPs from significantly outsourcing fund operations to other countries. The text provides some qualitative factors GPs can use to determine when too much delegation has occurred, but these factors do not clearly distinguish “risk management” from “portfolio management”, which elsewhere in the directive are viewed as separate elements, said Gregg Beechey of London-based law firm SJ Berwin.
EU Commission: unclear on
“In private equity, risk management and portfolio management are usually handled by the same team; and so without a clear separation in terminology the asset class will have a difficult time understanding exactly what can be delegated to a third party entity,” Beechey said.
The regulation also defines when a GP is labeled a “letter-box entity”, a term denoting an entity whereby a fund manager is registered in one jurisdiction but delegates the majority of fund operations to outside jurisdictions. A firm would earn such a designation if a significant amount of “investment management functions” are delegated to any other entity (such as an offshore fund outside the directive’s scope).
Some speculate the confusion could lead EU-based GPs with offshore operations to fully migrate funds onshore to avoid the letter-box label, and vice versa, GPs with little EU activity to fully migrate offshore for similar compliance-related reasons.
The Commission said it will review the delegation rules in two years, but in the meantime allow ESMA to issue its own guidance “to ensure a consistent assessment of delegation structures” across the EU, which Beechey describes as a “Herculean task” for ESMA.
LOSS FOR DEPOSITORIES
On level 2 measures related to depositories, the Commission did not stray far from draft proposals circulated in April that the industry criticised as ambiguous. Legal sources tell PE Manager the Commission has for some time signaled it would not require private equity assets to be held in custody by a depository (such as a bank), but the measures could be interpreted differently from that effect. However, sources don’t suspect GPs bypassing the custody requirement to face much legal opposition from EU regulators who understand the intent of the provision.
In similar fashion the Commission did not provide depositories any additional wiggle room in escaping liability for lost assets held in their custody – which banks and other entities had hoped for. To escape liability, a depository must prove that the loss was caused by an event outside its control, and that it had taken sufficient precautions and comprehensive due diligence to protect the asset. The directive will also prohibit depositories from delegating these liability risks to any direct or indirect sub-custodian.
In their relationships with GPs, depositories will have significant oversight functions. Aside from safekeeping GPs’ assets, depositories will police fund activity to make sure cash accounts are kept honest and ensure that fund managers are keeping true to the limited partnership agreement and other governing documents. Crucially a depository that suspects a fund leaned against its investment mandate or constitutional guidelines can retroactively stymie a deal found in breach, which could lead to some complications in practice if a deal was too far along in the acquisition process.
While the heavily anticipated implementing measures were welcomed by the industry, some sources have told PEM that they were disappointed with its lack of clarity in crucial areas. A client memo from SJ Berwin noted the measures were still not entirely clear on the meaning of the terms “AIF” and “AIFM”.
All together the rules give EU firms a much better sense of their obligations under the pan-EU marketing and regulatory framework, however leaves GPs “perilously short of time to prepare” for the July 2013 effective date, said in a statement John Everett, of financial services regulatory consultancy Bovill.
Nearly half of private fund managers have not taken any concrete steps to analyse the impact of the directive on their firm, nor have made changes to their operations in anticipation of its implementation, according to a KPMG poll of some 70 fund managers – most of whom said they were waiting for the implementation measures before making significant preparations. The directive will impose new rules on general partners’ pay, fund transparency, restrictions on asset stripping and also governs which non-EU funds will be permitted marketing rights across the 27-member bloc.
Non-EU managers hoping to access EU markets will need their local governments to sign a cooperation agreement with EU authorities. Under the level 2 text, the agreements must establish an information exchange and put in place “mechanisms, instruments and procedures” for non-EU regulators to assist with on-site inspections and enforcement actions with respect to non-EU firms. Critics have described the provision as a territorial overreach of EU power.
As EU sovereigns continue implementing the rules into national frameworks, there exists a risk that some will go above and beyond what the directive requires, warned Dörte Höppner, head of industry trade body the European Private Equity and Venture Capital Association. Already Germany has raised concerns that some EU states would interpret the directive in a way that could harm Europe’s €2.2 trillion alternative assets industry. In contrast, the UK is positioning itself as an “enlightened regulator” on AIFM.
The European Parliament and Council now have a three month window to study the directive and raise any objections before it becomes law. However sources expect no objections will be made on account of extensive backroom negotiations before publication of the implementing measures.