Thursday, May 2, 2013

EU AIFM Directive – Rationale, scope, and consequences of application

AIFM is a shortcut for “alternative investment funds manager”. The EU regulation, which shall be adopted by national European governments this summer, therefore addresses fund managers, not funds themselves. For example, structure and portfolio composition of AIF will remain regulated on a national level. This is, at least, what the directive explicitly promises. However, as you can imagine, the limits are blurry. For example, when the directive sets maximum levels of leverage for alternative investment funds (AIF) managed by AIFM, it also regulates indirectly AIF.

Following my recent post about UCITS, I will look, from an AIFM directive perspective, at three questions – Why does the EU regulate? (Rationale), When does the directive apply? (Scope of application), and What do you have to respect? (Consequences of application).


The AIFM directive pursues a triple rationale:

  • establish common requirements for AIFM and create an internal market for AIFM;
  • ban risks for financial markets in the EU;
  • ensure investor protection.

Scope of application

The AIFM directive will apply if AIFM manage AIF.

First, what is an alternative investment funds (AIF)?
Basically, the notion of AIF wants to cover any fund that is not covered by the EU UCITS directive. More specifically, your fund must answer two cumulative conditions: collective investment undertaking (A vehicle with a unique investor is not covered.) and defined investment policy. In other words, the AIFM directive will apply to you if you raise capital from a number of people to invest it for their benefit, applying a defined investment policy.
Pension funds, social security funds, employee participation or savings schemes, and securitization special purpose vehicles are, nevertheless, explicitly excluded from the directive's scope of application.
Some criteria explicitly don’t matter: The directive applies to both open-ended and closed-ended funds, to any legal form, and to listed and not listed funds.

Second, what is an alternative investment fund manager (AIFM)?
The notion refers to any entity managing AIF on a regular basis and which is not a supranational institution, national central bank, or national government. In addition, the fund manager must have some relationship with the EU: It can be an EU-AIFM, manage EU-AIF, or market AIF in the EU.

Consequences of application

Authorization of AIFM

To be authorized under the directive, an AIFM must have sufficient initial and subsequent capital from suitable shareholders, hire experienced employees to conducts its business, and either have its head office or be registered in an EU member state.

Once authorized in an EU member state, an AIFM can do business in any EU member state. This is called the harmonized passport system for EU and non-EU AIFM.

Operating Conditions for AIFM

Operating conditions for AIFM is a core regulation of the directive. They include general requirements, organizational requirements, delegation of AIFM functions, and depositary requirements.

General requirements can be seen as guidelines when interpreting other provisions of the directive.
For example, AIFM must
  • act honestly and with due skill, care, and diligence;
  • act in the best interest of investors and market integrity;
  • avoid or, if not avoidable, manage conflicts of interest;
  • treat all AIF investors fairly.
Risk management and operating activities must be carried out in different functions and hierarchies. In the same vein, AIFM are bound to set maximum levels of leverage for each AIF.
Finally, appropriate liquidity management systems must be in place and regular stress tests be conducted.

Organizational requirements refer to appropriate human an technical resources and proper and independent annual valuation of assets. The valuation function must be independent from portfolio management. Under specific conditions, it can be outsourced.

AIFM functions can be delegated and sub-delegated. However, this should not lead to “a de facto circumvention of the AIFM directive” or “turn the AIFM into a letter-box entity”. Even though an AIFM delegates some of its functions, it remains ultimately liable for the management of AIF.

Asset safe-keeping and asset management functions must be separated. This is where the depositary comes into play: He holds financial assets in custody, manages cash flows, ensures any sale, issue, re-purchase, redemption, and cancellation of AIF units or shares, ensures proper valuation of AIF units or shares, and applies AIF income. Depositary functions are usually exercised by a credit institution or investment firm. Exceptionally, other professionals such as notaries and lawyers might also be chosen. The depositary must belong to the EU member state of the AIF or, in case of a non-EU AIF, to the country of the AIFM. He can delegate his functions to a suitable third party if he remains ultimately liable.

Transparency Requirements

Transparency requirements ask AIFM to
  • disclose information on the leverage employed by an AIF if it is substantial;
  • pass special information to employees of companies controlled by an AIF;
  • prepare annual reports for each AIF;
  • communicate with potential investors on elements such as AIF investment strategy, liquidity risk management, fee structure, and depositary function;
  • report to administrative authorities.

Marketing of funds

Reading this section of the AIFM directive is definitely not funny. To guide you through the detailed stipulations, the following schema might help you:

A common trait of these marketing possibilities is the distinction between professional and retail investor. As a general rule, the directive allows distributing AIF units to professional investors only. However, individual EU member states can still admit marketing all or certain types of AIF to retail investors within their territory, provided the conditions for such distribution are stricter than those fixed by the AIFM directive for professional investors.