Regulation: Another level of worry

In December, the European Commission finally released the ‘Level 2’ implementation measures for the AIFM directive. The industry was underwhelmed, writes Thomas Duffell

On December 19, the European Commission ruined the Christmas of private equity compliance professionals across Europe by releasing its long-awaited ‘Level 2’ implementing measures for the controversial Alternative Investment Fund Managers Directive.

Unfortunately, the measures did nothing to dispel GPs’ fears that certain aspects of the pan-European regulation will be fiendishly difficult to interpret in practice. Here are three areas of the directive still in desperate need of greater clarity:


When the Commission failed to publish these measures last summer, as promised, many in the industry assumed it needed extra time to clarify certain rules. One particular source of debate has been the rules concerning delegation, which are intended to prevent GPs from substantially outsourcing fund operations to other countries.

The measures define when a GP is a “letter-box entity” (i.e. registered in one jurisdiction but delegating the majority of fund operations to outside jurisdictions). But the Level 2 text describes a letter-box entity as one that “exceeds by a substantial margin the investment management functions performed” by the fund manager – which lawyers say is clearly open to interpretation.

The Commission, perhaps recognising this ambiguity, says it will review the directive in two years. But in some ways, that’s almost worse. “You can’t build up an accepted way of doing things, because they are reserving the right to come back in two years and change things,” complains one UK-based fund lawyer.


Level 2 also requires firms to split risk and portfolio management in a “functional and hierarchical” manner, while still conforming to the delegation provisions. Helpfully, the text does provide 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’.

“In private equity, risk management and portfolio management are usually handled by the same team – 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,” says Gregg Beechey of London-based law firm SJ Berwin.


The industry has been up in arms about the directive’s depositary requirement since the initial drafts. The major concern was initially cost – and this fear has not been eased by the Level 2 measures, as the Commission did not provide depositories any additional wiggle room to escape liability for lost assets held in their custody (as banks and other entities had hoped).

However, it is equally important to discuss with depositaries what their restrictions and procedures are going to be. The depositary has obligations of oversight, cash monitoring, policing fund activity and so on. The industry will be worried that a less-than-bureaucratic approach by the depositary could be the difference between efficient investment procedures and a spanner in the works. This could be the difference between doing a deal and not, according to the UK-based fund lawyer.

It’s clear that there’s still much to be done following the publication of the Level 2 measures. ESMA will be providing further guidance to the remuneration code, which will detail how firms should report their employees’ pay packets in the first quarter. The new measures have also provided national regulators with the impetus to press forward with implementing the directive within their respective laws. For GPs, the real work starts here.