Most people working in the private equity sector in Europe will be well aware that the Alternative Investment Fund Managers Directive will become effective this year, and many will have noticed that the long awaited and much needed "Level 2" regulation – which prescribes many of the detailed rules – was published just before Christmas. This regulation is very important, but unfortunately it does not make easy reading. And the unnecessary delay in its publication leaves some firms with very little time to prepare for implementation.
There is in fact very little change in the final version of the Level 2 regulation since earlier unofficial versions were widely "leaked" last year. For instance, there has been no significant change on the critical depositary responsibility and liability issues. Nevertheless the final version of these depositary requirements will be welcomed by the private equity sector: a lighter regime is provided for instruments which "in accordance with national law are only directly registered in the name of the AIF with the issuer or its agent". Although this is an undesirably restrictive formulation, it is intended to give firms an opportunity to exclude private company shares and limited partnership interests from the full rigours of the depositary liability rules. Further, whilst the depositary's supervisory and cash management responsibilities are extensive, they are limited to post-transaction review – which is what the private equity industry had argued for, and will be much easier to manage than the pre-approval controls which were widely discussed at an earlier stage.
The cause of the most recent delay in the publication of the Level 2 requirements was a dispute about the extent to which an asset manager is allowed to delegate functions before it becomes a "letter box entity", and therefore no longer the manager for Directive purposes. But instead of resolving the problem the Commission has just deferred it, a strategy which the institutions of the EU might be said to over-use. The Commission did not bow to pressure to remove its unclear additional test for identifying a "letter box entity" – that its delegation of the performance of investment management functions exceeds "by a substantial margin" the investment management functions it performs itself. Instead there is an obligation to review this definition in two years, and to give the European Securities Markets Authority, the pan-European regulator, powers to produce guidance to ensure a "harmonized interpretation" is adopted by national regulators. Whilst most delegation models used in the private equity sector are likely to continue to work under this formulation (in some cases with modifications), some structures will need to be changed to ensure that they do not fall foul of the "letter box" test. Reviewing structures in light of the Level 2 requirements is a sensible first step for any fund manager which delegates significant parts of its management responsibility, including those where the manager is outside the EU.
The Directive's strict rules will only apply to managers with "assets under management" in excess of €100m, or €500m where the funds are "unleveraged" and do not offer redemption rights to investors, unless managers choose to opt in. AUM will be (broadly) the net asset value of the portfolio (and will not include undrawn commitments). But the definition of leverage raises many questions, and managers of funds with any borrowings, hedging, or portfolio company guarantees may find that they need to apply the lower threshold. The Level 2 requirements do make it clear that where the core investment policy of an AIF is to acquire control of portfolio companies, leverage at the portfolio company level does not have to be included provided that the AIF does not have to bear potential losses beyond its investment in the portfolio company. Borrowing of a "temporary nature" that is fully covered by capital commitments from the AIF's investors should not be treated as leverage, in line with ESMA's earlier advice, although a confusing recital says that revolving credit facilities are not to be regarded as "temporary".
An extra cost for many managers will be the requirement to have specified levels of professional indemnity insurance, or to hold additional capital to cover the risks arising from professional negligence. PII must be held with a third party EU insurer or another insurer authorised to provide insurance in the relevant Member State with a per claim limit of at least 0.7% of assets under management and an aggregate per year limit of at least 0.9% AUM. Any exclusions in the PII policy will have to be covered by additional capital. In practice, it is going to be very hard to get the insurance required because, whilst there have been some welcome modifications to the list of risks to be covered originally proposed by ESMA, it remains very broad. And even more difficult is the fact that the risks of loss or damage to be covered by PII or additional capital include negligent performance of activities by a "relevant person". The term "relevant person" includes not only the AIFM's own personnel but also others who are providing delegated services to the AIFM in relation to its collective portfolio management. It may be particularly difficult to obtain cover for the negligence of people not directly controlled by the AIFM or a group member.
For many firms it is therefore likely to be more relevant to know what level of capital they have to hold as an alternative to taking out Directive compliant insurance. The regulation sets this by reference to variable assets under management (0.01% of AUM, taken as the sum of the absolute value of all assets including those acquired by way of leverage but valuing derivatives at their market value). An option is given to national regulators to reduce this percentage from 0.01% to 0.008% of the value of the portfolio but it is not likely that many will do so (and the UK has already indicated that it will not). Further, there remains an apparently open-ended power for national regulators to increase a manager's additional capital requirements if it does not consider them adequate to cover liability risks. These provisions will disappoint those in the private equity industry and elsewhere who argued for them to be removed.
(For a more detailed analysis of the European Commission's Level 2 regulation, please read our technical briefing note.)
For the really avid AIFMD watcher in the UK, the new year provided some further reading material: the UK government published a consultation paper on key policy decisions for implementing the Directive, including draft implementing regulations. Issues covered in the paper include: the scope of the regime for AIFMs who fall below the Directive threshold; conditions for marketing AIFs to retail investors; the operation of the UK private placement regime and the meaning of an AIF. The Paper begins with a general commitment to copying out the Directive requirements, which is for the most part honoured, although there are a few examples of "gold-plating" (some of which may be unintentional). In general, though, there are a number of helpful clarifications - most strikingly in relation to the one year grace period which managers will have before they need to comply with the new rules. It seems clear that the government is trying to ensure that the UK retains its competitive advantage as a home for private equity and venture capital fund managers, including those below the Directive's threshold, although the industry will have some important points to raise during the consultation period to ensure that this objective is achieved. A second consultation is expected shortly to address Directive scoping issues, the European legislative proposals for venture capital and social entrepreneurship funds, marketing of EEA retails funds and third country funds, the application of the FSA approved persons regime to internally managed funds, and the application of the Financial Services Compensation Scheme and the Financial Ombudsman Service to AIFMs. Market participants have until 27 February 2013 to comment on this latest consultation paper.
Simon Witney, Partner
Simon is a partner in SJ Berwin's market leading Private Funds team and can be reached at Simon.Witney@sjberwin.comFull Bio
SJ Berwin LLP
SJ Berwin is an international law firm with more than 160 partners and 350 other lawyers based in 12 offices in Europe, East Asia and the Middle East. The firm’s clients are sophisticated buyers of legal services, principally multi-national and entrepreneurial companies and financial institutions, which are advised on a comprehensive range of matters including corporate finance, private equity, commercial, real estate, finance, reconstruction and insolvency, financial services and regulation, intellectual property, investment funds, litigation and dispute resolution, employment and pensions, EU and competition and tax. More information on SJ Berwin can be found at www.sjberwin.com.
Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from SJ Berwin LLP. This work reflects the law at the time of writing 18 January 2013.