The European Directive of 8 June 2011 on Alternative Investment Fund Managers (AIFMD) has been transposed in the local laws of the various member states of the European Community. Some of them, like Italy, have been late in implementing the directive, which has added to the current confusion generated by its introduction in a largely unregulated space.
Today, most participants in the European alternative investments fund management industry, including fund managers, custodians, prime brokers and administrators, are evolving their strategy to adapt to a complex, time and resource-consuming revolution of their businesses.
So what does this directive entail that will change the European landscape so radically?
Post the 2008 crisis, the AIFM Directive was initiated and designed to achieve different goals. These may be categorised as follows:
• The first one is to monitor the amount of leverage stemming from alternative investment funds (AIFs) in the financial system. This is meant to mitigate the occurrence of systemic risk. Under the AIFM Directive, all AIFs will have to report the amount of leverage they use to regulators on a regular basis. Data will be compiled and consolidated, allowing them to monitor and potentially decide jointly upon concrete actions to be taken to limit the global amount of leverage in the system.
• The second goal is to reinforce the level of protection of European investors through the creation of a harmonised regulated framework for managing non-UCITS funds in Europe. To mitigate the risk of fraud, misvaluation, misrepresentation or misappropriation, cases of which have often made the headlines, the AIFMD imposes that managers provide minimum standards of transparency and security, as well as a stronger alignment of interest with their investors.
Among the defined measures, Alternative Investment Fund Managers (AIFMs) will have to increase the level of regulatory capital by a minimum of one basis point of the assets under management of the AIFs they manage. These represent more or less all European domiciled investment funds other than UCITS vehicles. This additional capital is meant to compensate for losses or damages resulting from any negligence by the asset manager in the handling of their duties.
Managers will have to report on a regular basis to investors and regulators. Reports to regulators in particular will be extremely detailed, and include information relative to the fund’s assets and liabilities, liquidity management, stress test scenarios, value at risk and leverage calculations etc. They will be delivered with a frequency varying between quarterly and yearly based on the funds’ AUMs.
On top of transparency, the AIFM Directive enforces additional security measures like the compulsory appointment of a unique custodian, who bears responsibility for the safekeeping of the fund’s assets, the supervision of the flows of cash and securities, the monitoring of financial and operational solidity of various parties to the fund like prime and executing brokers, the oversight over re-hypothecation of assets.
The AIFMD also strengthens the fund’s valuation process, via the introduction of a set of provisions. One introduces the responsibility of the manager over the fund valuation and the necessity to: (1) either appoint an external recognised expert; or (2) have valuation tasks carried out by an independent internal team, separated from portfolio management.
On a more global note, any delegation to a third party has to be justified and does not exempt the fund managers from their responsibilities vis-à-vis investors. Pass-through vehicles are therefore clearly banned under the AIFMD.
A strong emphasis has also been placed on liquidity management, with the obligation for AIFMs to monitor the liquidity of assets with respect to their contractual liabilities vis-à-vis the fund holders. It is compulsory for them to set up specific liquidity management tools and procedures for monitoring purposes, and to ensure equal treatment of investors.
Last but not least, the question of excessive risk being taken by fund managers has been addressed through a series of measures aimed at aligning interests between portfolio managers and key decision makers within the firm on the one hand, and investors on the other. They include among others the existence of a documented policy on issues including compensations and conflicts of interests.
As far as compensations is concerned, a remuneration committee should be put in place by the AIFM. Variable individual compensations should be based on collective as well as individual performance, and be subject to a minimum of 40% deferral. Variable amounts should also be paid for at least 50% in the relevant AIFs or other similar instruments.
• The last goal of the AIFMD is to create a level playing field across Europe for asset managers willing to distribute their unconstrained strategies and products – as opposed to UCITS – to institutions or more broadly to professional investors under the definition of the MiFI Directive. Obtaining a licence and conforming to the AIFM Directive enables managers to distribute their funds to professional investors outside their home country through a simple harmonised passporting process. Similar to the passporting of UCITS, AIFs incorporated in one European country will be authorised for commercialisation in another country. Deadlines should in theory not exceed 20 business days following the demand of the home regulator of the manager.
The directive also makes it possible for managers with an AIFM licence to manage AIFs outside their home jurisdiction. A UK asset manager could for instance manage a Luxembourg AIF from the UK, without having to establish any presence in Luxembourg, as was the case before.
The AIFMD therefore creates a harmonised market for European asset managers to manage and distribute their AIFs to institutions without any technical barriers in Europe, in the same way as the successive UCITS Directives have in their time.
So what do we concretely observe at the moment? Do we see any effect of the new regulation today?
The first reaction of most managers in July 2013 when the directive went live was largely a ‘wait and see’ attitude. The level of complexity of the multiple changes forced by the directive upon AIFMs has led them to take a cautious stance and use the one-year grace period allowed by the directive until 22 July 2014 to reflect before making the relevant strategic choices and adapting their structures accordingly, before the deadline.
The remuneration clause in particular generated some concern and setbacks within the firms. All of them reached out for legal advice to identify potential ways to go around the most cumbersome parts of the AIFM Directive. Differences in interpretation by the different member states have been closely watched. Structuring routes including feeder structures of offshore master funds have also been investigated in an attempt to find ways to bypass the directive.
As of today, at least in the hedge fund industry, it seems as though managers are embarking in the following directions:
• SINGLE-MANAGER HEDGE FUNDS face various challenges. European-based managers traditionally have a significant proportion of their investments from European institutions. Managing only UCITS and mandates is probably not the best route for them, so we expect them to apply for a licence with their home regulator. Knowing that the directive and the ESMA guidelines are relatively unambiguous, the risk of having different member states adopting fundamentally different interpretations of the European Directive seems remote. The challenge remains for them to adapt to the dispositions of the directive and provide the necessary additional resources to comply with it without necessarily having an immediate return on their investments.
• For US HEDGE FUND MANAGERS, the situation looks more complex. First of all, unless they opt for a local presence as a regulated fund manager based in Europe, none of them will have the capacity to either manage or distribute AIFs until 2015 at the earliest, when a system of equivalence will be introduced for non-European asset managers. With Europe representing only a fraction of their AUMs, a large number of these managers will either be tempted to stay away and limit their activity to the few remaining private placement regimes, or to launch and distribute UCITS products – out of scope from the directive – or eventually find indirect distribution channels. These could encompass funds of hedge funds – which can invest into offshore hedge funds under the AIFMD – or consultants, who can receive direct mandates from their clients.
Another interesting route will probably reside in the various managed account platforms available in Europe. They will be able to provide AIF infrastructure to these managers and delegate part of their investment duties to them, provided they bring adequate representations of existing remuneration policies in place at the firm and alignment – in spirit if not by the letter – with AIFM requirements.
• FUNDS OF HEDGE FUNDS will probably follow the same path. While European players will probably try to leverage quickly on the marketing opportunities provided by the directive to gain first-mover advantage, US firms with no or limited local presence may be tempted to stay away and focus on consultants, mandates and advisory services to make their way to the institutional clients before 2015.
US firms might therefore be generally at a slight disadvantage compared to their European counterparts in the coming months. Approaching institutions and presenting them with products and real track records will become more difficult for them under AIFM – at least until the end of 2015 – as past tolerance regarding the interpretation of reverse enquiry is fading away.
More fundamentally, institutional clients in Europe are likely to welcome the directive positively in the coming months. Most know surprisingly little about it today, but some are already asking for AIFs when launching request for proposals for new dedicated allocations to alternatives. The combined attraction of transparency, increased operational security and onshore regulated vehicles responds to the needs of European institutions.
Some of them who have refrained from investing until now because of the lack of regulated vehicles might well boost demand for alternatives. In that regard, the directive seems to complement nicely the UCITS framework in place for traditional long-only investments.
The negative impact of the AIFMD for them could possibly lie in an additional fee layer resulting from the increased workload and responsibilities on the side of service providers (custodians in particular), which could logically translate into higher costs charged to the funds.
The reality seems to be more nuanced. The lack of appetite from investors for alternatives since 2008 has changed the balance of power to the demand side. Neither the fund managers nor the service providers have the real power to force a price increase on investors. In Europe, the fund of funds industry and second-tier hedge funds have suffered continuous fee compression.
All in all, if smaller funds and asset managers might be impacted in their negotiations with their service providers, large ones are unlikely to suffer materially and might even take the opportunity to renegotiate prices to more favourable levels.
Overall, even though the introduction of a regulated framework comes second to performance and diversification in the investment decisions of institutions, a positive factor in the development of alternatives in Europe can reasonably be expected in the coming years as a consequence of the introduction of the directive.
Once perceived as inappropriate because of their offshore, uncontrolled, sometimes opaque features, alternatives may more easily find their way into institutional portfolios thanks to the framework and related credibility provided by the AIFM Directive. And in much the same way as the UCITS model, the AIFMD could eventually export itself beyond European borders.
Christophe Baurand is the head of alternative investments at Lyxor Asset Management. He is also the global head of business development, overseeing the sales and marketing efforts of Lyxor’s investment solutions worldwide. Baurand is a graduate of ESCP and holds a Master’s degree in Finance from ESSEC Business School.