21 December 2012
The long awaited Delegated Act supplementing the Alternative Investment Fund Manager Directive (AIFMD) was released on 19 December 2012, providing an extensive set of detailed implementing measures and technical rules on a wide range of business areas.
We have summarized the most important aspects of the “Level 2 Measures” and what they will mean for our clients and industry players.
Key highlights include:
- The act takes the form of a regulation and does not need any national transposition but will be directly applicable in all EU Member States. However, European Parliament and Council have a period of 3 months, which may be extended to 6 months, to object to this act. If there are no objections, the Delegated Regulation will be applicable from 22 July 2013.
- The Regulation specifies the delegation rules of the AIFMD and, in particular, sets out the definition of a letter-box entity. This may have a significant impact on the business and/or operating models of some alternative fund managers.
- The duties of the depositary and the liability regime are defined in a strict manner. This may impact operating and business models of some depositaries and lead to different fee structures.
- The rules set out by the Commission diverge on some key points from ESMA’s technical advice from November 2011.
Finally, KPMG Luxembourg’s Georges Bock and Charles Muller discuss the substantial strategic impacts on asset managers of the AIFMD “Level 2” implementing measures that were released by the EU Commission on 19 December 2012. Click here to view the video on KPMG TV.
We hope you find this insight valuable. We would be pleased to offer any additional information and answer any questions.
Feel free to contact us anytime.
Georges Bock Ravi Beegun Charles Muller
1. Commission adopts Delegated Regulation
The European Commission finally adopted the long awaited AIFMD Delegated Regulation (so-called ‘Level 2 measures’) on 19 December 2012, providing a very extensive set of detailed implementing measures and technical rules on a wide range of topics in the Alternative Investment Fund Managers Directive (AIFMD). The range of topics include delegation of AIFM functions, clarification of the depositary’s duties and liability, calculation of assets under management, risk and liquidity management, methods for calculating leverage, detailed reporting and transparency requirements, clarification of certain operating conditions and organizational requirements, and rules related to third countries.
In terms of the legislative process powers were delegated to the Commission to adopt the Delegated Regulation. The European Parliament and Council now have a period of 3 months, that may be extended to 6 months, to object to the delegated act. The Regulation shall apply from 22 July 2013 if neither the Parliament or Council object to it within this period. The Regulation will be binding in its entirety and directly applicable in all Member States and does not need any national transposition.
The European Securities and Markets Authority (ESMA) also published two consultation papers on 19 December: one on draft regulatory technical standards on types of AIFMs and the other on guidelines on key concepts of the AIFMD. The consultation period closes on 1 February 2013. Furthermore, final guidelines on remuneration policies and practices expected from ESMA in Q1 2013.
In this Alert we provide you with a synopsis of the most important aspects of the Delegated Regulation.
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2. Delegation of AIFM functions (Articles 75-82)
The Regulation specifies the meaning of a ‘letter-box entity’ to any one of four situations. The first is where the AIFM delegates the performance of investment management functions to an extent that exceeds by a substantial margin the investment management functions performed by the AIFM itself.
The AIFM’s supervisory authority will assess the delegation model based on eight criteria including the assets managed under delegation; the types of assets, and importance of assets managed under delegation to risk/reward profile of the AIF; the importance of the assets managed under delegation for achievement of investment goals; the geographical and sector spread of investments; risk profile of the AIF; types of investment strategies; types of tasks delegated in relation to those retained; configuration of delegates and their sub-delegates, geographical sphere of operation and their corporate structure including whether the delegation is conferred on an entity belonging to the same corporate group as the AIFM.
In line with ESMA’s advice a ‘letter box entity’ would also arise in a second situation where the AIFM no longer retains necessary expertise and resources to supervise the delegated tasks effectively and manage the risks associated with the delegation and thirdly where the AIFM no longer has the power to take decisions in key areas.
The Commission includes a fourth situation where the AIFM loses its contractual right to inquire, inspect, have access or give instructions to its delegates or the exercise of such rights becomes practically impossible. The Commission shall monitor the application of the letter box entity provision in the light of market developments, review the situation after two years and take, if necessary, appropriate measures to further specify this term. Furthermore, ESMA may issue guidelines to ensure a consistent assessment of the delegation structures across the EU.
The Regulation provides a number of criteria to assess whether delegation is based on an ‘objective reason’ including cost saving, optimization of business functions, expertise and access to global trading capabilities. It also requires the management of any conflicts on interest in the delegation model.
The entities to whom risk management or portfolio management may be delegated is limited to authorized UCITS Management Companies, MiFID investment firms, credit institutions, external AIFM and authorized third country asset managers where a cooperation agreement exists between the supervisory authorities. The cooperation agreement must satisfy a number of conditions that are set out in the Regulation.
The Regulation also reiterates that the AIFM remains at all times fully responsible for the proper performance of the delegated tasks and compliance with the AIFMD and the implementing measures. The AIFM will have to ensure that the delegate carries out the delegated functions effectively and in compliance with applicable laws and also establish procedures for reviewing the services provided by each delegate on an on-going basis.
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3. Depositary (Articles 82-102)
The Regulation defines that those transferable securities, money market instruments and fund units that can be registered or held in an account directly or indirectly in the name of the depositary or can be physically delivered to the depositary are to be considered as instruments held in custody. Only an outright transfer of ownership would put the financial instruments outside the scope of custody. Assets subject to collateral arrangements with no title transfer cannot be excluded from the scope of custody.
The ‘loss of a financial instrument held in custody’ is deemed to take place in three situations: 1) where the ownership right no longer exists or never existed; 2) where the financial instrument exists but the AIF has definitively lost its ownership right; and 3) where the AIF has the ownership right but cannot dispose of it on a permanent basis. An external event beyond reasonable control that would delineate liability is limited to natural events, acts of government, war, riots or major upheavals.
The strict liability regime covers cases of fraud, accounting errors, operational failure and failure to segregate assets held in custody by the depositary or by a third party to whom custody has been delegated. The Regulation also specifies the ‘objective reason’ which is necessary for the contractual discharge of liability by the depositary. The depositary needs to demonstrate that it had no other option but to delegate its custody duties to a third party. In particular, this shall be the case if: a) the law of the third country requires that certain financial instruments are held in custody by a local entity and local entities exist that satisfy the delegation criteria of the AIFMD or b) the AIFM insists on maintaining an investment in a particular jurisdiction despite warnings by the depositary as to the increased risk this presents.
In terms of cash-monitoring duties the depositary will become the hub for cash-flows with the Regulation requiring the depositary to perform daily reconciliations of all AIF cash flows on an ex-post basis. There is the flexibility to perform less frequent reconciliation as and when cash flows occur. The depositary will also be required to identify significant cash-flows that are inconsistent with the AIF normal activity.
In terms of safe-keeping duties and ownership verification the Regulation requires the depositary to apply a ‘look-though basis’ to assets held by financial or legal structures controlled directly or indirectly by the AIF/AIFM, but exempts Fund of Funds and Master-Feeder structures provided that they have a depositary. The Regulation details the reporting requirements for Prime Brokers to the depositary, describes the oversight functions, describes the due diligence process for the selection of delegates including the monitoring of the segregation obligation, and sets out the contractual particulars for the appointment of a depositary. In the case of appointment of a third country depositary the criteria for assessing the ‘prudential regulation and supervision’ of the depositary are given.
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4. Calculation of assets under management (Articles 2-5)
The Regulation specifies the method for calculating the total value of Assets under Management (AuM), which is a key point in defining whether an AIFM is in scope of the AIFMD. The AuM must be calculated based on the values of all assets managed by the AIFM without deducting liabilities and is not based on the NAV of the AIFs. In order to take the leverage embedded in derivatives fully into account the AIFM will have to value derivatives at the equivalent position in the underlying assets, and not at the mark-to-market value.
Cross-holdings in other AIFs are excluded from the calculation as well as any UCITS managed by the AIFM. The AIFM will be required to monitor the AuM on an ongoing basis and should the AuM exceed thresholds for more than 3 months the AIFM must submit an application for authorization of the AIFM to its competent authority within 30 days.
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5. Methods to calculate leverage (Articles 6-11)
The Regulation adopts two mandatory methods for calculating the leverage of each AIF managed which are the ‘Gross’ and the ‘Commitment’ methods and provides detailed calculation methodologies, including conversion methods for financial derivative instruments and duration netting rules. There is no option to use any ‘Advanced Method’ as foreseen by ESMA in its technical advice. The Commission undertakes to review these calculation methods by 21 July 2015 and may develop an additional method if the ‘Gross’ and ‘Commitment’ methods are considered inappropriate for all AIFs.
The level of leverage that will trigger additional reporting requirements to the AIFMs local competent authorities has been set at 3 x NAV (based on the commitment calculation) although ESMA had proposed 2 x NAV in its advice. The Regulation also provides a framework for competent authorities to exercise their power to impose leverage limits or other restrictions on the AIFM.
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6. Additional own funds and professional indemnity insurance (Articles 12-15)
The Regulation defines a non-exhaustive list of professional liability risks including loss of documents evidencing title of assets, misrepresentations made to the AIF or investors, improper valuation of assets or NAV, breach of legal or contractual obligations or failure to establish procedures to prevent fraud. It also clarifies that professional liability risks can be covered either by additional own funds or professional indemnity insurance (PII) with no possibility to combine approaches as proposed by ESMA.
Additional own funds must equal 0.01% of the value of the portfolios of AIFs managed, valuing derivatives at market value. The AIFMs competent authority may be able to lower this to 0.008% on the basis of historical loss data for a 3 year period, or may increase this amount if it is not satisfied that the AIFM has sufficient additional own funds to cover professional liability risks.
Professional indemnity insurance needs to cover 0.9 % of the value of the portfolios of AIFs managed for claims in aggregate per year, and 0.7 % of the value of the portfolios of AIFs managed per individual claim. These thresholds are higher than ESMA’s advice and there is no maximum cap as proposed by ESMA.
The Regulation requires AIFMs to establish policies and procedures for operational risk management, to be reviewed at least on an annual basis.
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7. Valuation (Articles 67-74)
The regulation provides a detailed valuation framework, including requirements for a detailed valuation policy and procedures to be applied consistently across all AIF, and subject to periodic review. The Regulation requires competence and independence for personnel performing valuation. The valuation policy must set out a review process for assets where a material risk of inappropriate valuation exists and describe the checks and controls used in this review process, as well as escalation procedures.
Where the AIFM uses models to value assets, the model must be sufficiently documented and subject to validation by a person with sufficient expertise who has not been involved in building the model. The model must also be subject to senior management approval.
The NAV calculation frequency needs to match the frequency of investor activity and the calculation procedures and methodologies used must be subject to regular verification by the AIFM. Valuation of other assets must be on an annual basis, and financial instruments must be valued on each NAV calculation date. The AIFM will also need to ensure remedial actions in case of NAV error.
The ‘professional guarantees’ required from external valuers shall be written documents proving sufficient personnel, technical resources, procedures, knowledge and experience. Any registered valuer must include the name of the relevant authority and the relevant rules of professional conduct.
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8. Risk management (Articles 39-46)
The Regulation outlines the role and responsibilities of the AIFMs permanent risk management function and defines the conditions to be satisfied in order to ensure the functional and hierarchical separation risk management. These include that the persons in risk management should not be supervised by the head of operating units, including portfolio management, and that they should not perform activities within the operating units. The basis for calculating their remuneration should be independent of the performance of the operating units.
The AIFM will need to have an adequately documented risk management policy covering all risks faced by the AIFs and will need to set quantitative or qualitative risk limits for each AIF covering market, credit, liquidity, counterparty and operational risks. Risk measurement includes requirements for back-testing, stress testing and scenario analyses and the rules also require remedial actions for breaches of limits. The risk management systems should be subject to an annual review by the senior management.
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9. Liquidity management (Articles 47-50)
In terms of AIF liquidity management the Regulation specifies that each AIF needs to maintain an appropriate level of liquidity taking into account investor profile, size of investments and redemption terms. The AIFM will need to monitor the liquidity risk of the AIF portfolios and set liquidity limits where appropriate to be monitored on an ongoing basis. There are requirements for the AIFM to regularly conduct a range of stress tests under normal and exceptional liquidity conditions.
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10. Organizational requirements (Articles 57-66)
In terms of organizational requirements the Regulation sets out detailed requirements for general business organization, administration procedures and internal controls that are largely inspired from the UCITS and MiFID frameworks, including requirements for a separate and independent compliance function and internal audit function. The regulation also defines the role and responsibilities of senior management, requires accounting procedures for each AIF, and sets out detailed 5 year record keeping requirements covering portfolio transactions, AIF sub/red activity and personal transactions. AIFMs will be required to ensure business continuity and have data protection systems in place.
The Regulation allows for proportionality in terms of organization requirements allowing AIFMs to calibrate their organizational structure to the nature, scale and complexity of their business.
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11. Operating conditions - general principles and conflicts of interest (Articles 16-38)
The Regulation imposes substantial operating requirements which are largely inspired by the UCITS regime and on which competent authorities will assess the AIFM. These include a formalized and documented due diligence procedure for the selection and on-going monitoring of investments, with additional requirements for less liquid assets. The Regulation also imposes due diligence requirements on the selection and appointment of prime brokers and counterparties which are limited to financially sound, and properly resourced supervised entities. The prime brokers selected must be subject to approval by the AIFM’s senior management.
The Regulation also contains detailed rules on inducements, order handling, investor reporting obligations for subscriptions/redemptions, best execution requirements, and trading orders aggregation and allocation. The AIFM board of directors will need to have sufficient skills, experience and knowledge to understand the risks of the AIFM activities, and commit sufficient time to perform their functions and receive training.
In relation to conflicts of interest the Regulation gives indications on how to identify types of conflicts of interest and describes the requirements for a written conflict of interest policy, as well as procedures and measures to prevent, monitor, manage and disclose conflicts of interest. The AIFM will be required to determine a strategy for the exercise of voting rights, to be disclosed to investors on request.
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12. Transparency requirements (Article 103 – 112)
The Regulation sets out the content and format of the annual report for each AIF that will also need to comply with local accounting standards. It also defines the content of the Managers report and provides more detail on the remuneration disclosure. The frequency of reporting to competent authorities is defined in terms of AuM. AIFM with AuM under €1bn will need to report on a semi-annual basis, and on a quarterly basis for any AIF over €500mn. AIFMs that manage in excess of €1bn are subject to quarterly reporting. AIFMs are required to report annually in respect of unleveraged PE/VC AIF. However national competent authorities are permitted to impose more frequent reporting. The Annex contains all the relevant templates for reporting to competent authorities.
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13. Investment in securisation positions (Articles 50-56)
The section on investments in securitisation positions provides a list of scenarios that qualify as ‘retention of a material net economic interest of not less than 5% by the issuer’. It also contains a list of qualitative requirements that the AIFM will have to assess regarding the sponsors and originators of securitizations that will have to be respected for new securitizations issued from 1 January 2011. There is an additional list of detailed qualitative requirements for the AIFMs regarding their investment due diligence process, risk and liquidity management, internal reporting and disclosure of securitization positions to investors.
The Regulation provides for a grandfathering clause for existing securitizations up until 31 December 2014. After that date the new framework will apply where new underlying exposures are added or substituted.
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14. Rules related to third countries (Articles 113-115)
The Regulation also specifies the scope, form and objectives of cooperation arrangements between supervisory authorities.
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