In the four years since it was introduced, the Alternative Investment Fund Managers Directive has played a major role in regulating the investment sector. What are the latest developments – and what lies ahead post-Brexit?
The Alternative Investment Fund Managers Directive (AIFMD) is a regulatory framework for alternative investment fund managers (AIFMs). Implemented on 22 July 2013, the AIFMD covers the management, administration and marketing of alternative investment funds (AIFs), with a focus on the regulation of the AIFM rather than AIF.
An AIF is defined as a 'collective investment undertaking' that is not subject to the Undertakings for the Collective Investment of Transferable Securities (UCITS) regime, including hedge funds, private equity funds, retail investment funds, investment companies and real estate funds, among others.
The AIFMD establishes an EU-wide harmonised framework for monitoring and supervising risks posed by AIFMs and the AIFs they manage, and for strengthening the internal market in alternative funds.
The AIFMD was introduced in response to the credit crisis. The original intention was to regulate the hedge fund sector, but it now captures any type of collective investment vehicle that is not a UCITS. Its principle aim was to establish common requirements governing the authorisation and supervision of AIFMs, providing a coherent approach to the risks potentially spread or amplified through the financial system by the activities of AIFMs, and so reduce the impact on investors and markets.
The AIFMD brought with it enhanced transparency through rules on disclosure to investors and mandatory regular reporting to regulators (including conflicts of interest, remuneration, risk management, valuation, fund assets and exposures). It also strengthened cross-border competition thanks to the deregulation of inequitable nationwide barriers.
The AIFMD requires AIFMs to be authorised and to comply with all its requirements (“full scope” AIFMs) or, where the AIFM’s total AIF assets under management are below certain thresholds, to be registered and subject only to a reporting regime. If these ‘sub-threshold’ AIFMs wish to benefit from the AIFMD's marketing and management passports, they can opt-up to full AIFMD authorisation.
The AIFMD does not include any limits on hedging or leverage, but it allows European Securities and Markets Authority (ESMA) or national regulators to do so. Regulators already had in place or have introduced measures for AIFs sold to retail investors but, to date, most professional funds are not subject to such limitations.
The greatest impact of the AIFMD in the private equity/venture capital sector has been through its asset stripping rules. These were designed to restrict the ability of Private Equity Funds to extract funds in the first two years of ownership, following an AIF taking control of an unlisted company (control for these purposes being holding at least 51% of a company) in certain circumstances. Specifically, the rules are:
The rules apply to restrict distributions of pre-acquisition profits – in other words, to avoid reducing a company’s value by asset stripping. Where a fund is subject to the AIFMD asset stripping restrictions, it is imperative to confirm that any planned extractions of funds are permitted under the rules. The obvious circumstances in which this may apply are:
At the start of 2017, the FCA published amendments to its rules and guidance on Annex IV reporting under the AIFMD. The amendments came into force on 29 June 2017.
The reporting requirements have now been extended to include fund managers established outside the European Economic Area (non-EEA AIFMs) and which market feeder AIFs in the UK under the AIFMD national private placement regime, as well as submitting Annex IV reports for these feeder AIFs on a quarterly basis. These non-EEA AIFMs are now required also to report quarterly information on the feeder AIF's master AIF, even where the master AIF has not been registered for marketing in the UK. However, if the AIFM of the feeder AIF differs from the master AIF, the additional reporting requirement will not apply, even if the AIFMs of the respective feeder and master are affiliated.
The FCA has contacted those non-EEA AIFMs affected by the changes, with the first quarterly Annex IV reports due to have been submitted to the FCA by 31 July 2017. AIFMs affected by the new requirements should already have taken appropriate steps to ensure that the required information will be reported within the correct time frames.
The changes now bring the UK’s rules and guidance on Annex IV reporting in line with existing ESMA guidance.
The changes to the rules are of most relevance to non-EEA AIFMs that market feeder AIFs in the UK under the AIFMD national private placement regime and who therefore need to ask whether the FCA's reporting requirements apply to their master-feeder.
Brexit is likely to change the landscape dramatically for the UK’s alternative managers.
Top of the list will be the loss of the marketing passport, which currently allows the distribution of AIFs around Europe to professional investors, provided both the AIF and the AIFM are in the EU/EEA. The non-EU passports in the Directive have still not been activated, although they were intended to be launched by July 2016, meaning that UK AIFMs and UK AIFs will have to comply with the national private placements regimes (NPPR). Not all member States have such regimes and those that do exist tend to be more restrictive than the UK’s NPPR.
Although ESMA has already reported to the European Commission that a number of non-EEA jurisdictions meet the AIFMD “third country” requirements, the European Commission has not yet introduced passports for those jurisdictions and ESMA would have to undertake a separate assessment on the UK. A loss of passporting rights would put UK AIFMs and AIFs in the same position as US managers and others outside the EEA.
This may drive demand for the set-up of a legal presence and funds in alternative jurisdictions such as Luxembourg or Dublin. However, the requirements for adequate substance and minimum capital may cause UK AIFMs to think twice about such a move. It is likely that some AIFMs will look to third-party management companies – as US managers have done. That could serve as an intermediary solution allowing access to the EU, although even this may be a less attractive option going forward. ESMA has called for delegation practices to be reviewed, including the extent to which key functions are delegated outside the EEA.
We recommend that developments around Brexit are monitored and we will provide updates as the situation develops.
The rules should not restrict distributions of pre-acquisition profits where sufficient distributable reserves exist. Nor should they restrict the payment of service or management charges or interest. These payments may be used as an alternative to distributions to upstream cash. Payments for group relief surrenders should also be permitted. Introducing leverage into the target as part of the acquisition, for example, by refinancing existing debt in the target company, can provide a future route to upstream cash to service acquisition debt. This emphasises the need to ensure any debt pushdown exercise also considers future repatriation.
It may also be possible to make upstream loans, in order to either service debt or distribute cash to the shareholders. However, local financial assistance rules would need to be considered to ensure this is possible. If the company making the loan is a UK close company, the loans to participator rules should also be considered. Care will need to be taken, where an upstream loan is made and proceeds are ultimately passed to shareholders, that the relevant tax implications of such loans are considered well in advance of any such transaction.
Where regular cash extraction is expected or required, further consideration may be needed when structuring an investment. As well as the making of upstream loans, the rules do not apply to the repayment of loans. This may be of interest to infrastructure funds, which normally expect to receive regular distributions. To the extent that the need to make payments in the first two years is greater than the profits forecast, the initial acquisition could be funded with debt, sufficient that the debt can be repaid as required to return cash. However, note that distributions out of post-acquisition profits should still be allowed. In this case, there may be timing issues to consider as to when those profits can legally be distributed.
One particular circumstance that may be restricted by the rules is the ability to make part disposals in the initial two-year period following an acquisition, where that disposal may result in a distribution of cash to shareholders. If this part disposal is known or expected in advance (e.g. if a division is due to be sold on), part of the funding could be structured as a shareholder loan to be repaid with the cash from the disposal. However, where there is an unplanned disposal, it may be harder to repatriate the funds whilst leaving the group with the desired capital structure going forward.
Overall, the possibility of making distributions in the first two years of ownership, either to service debt or extract cash, may be limited in certain circumstances for firms subject to the AIFMD. Firms should, therefore, at the time of acquisition, focus on their future plans for the business and consider the impact of the rules, adapting their structures (where possible) to minimise the impact.
For further information please contact:
Julie Patterson - Director
Zeeshan Arshed - Assistant Manager