In response to the perceived risk to investors and to the stability of the European financial market, the activities of alternative investment fund managers are being more strictly regulated. The EU Directive on Alternative Investment Fund Managers (“AIFMD”) aims to create a harmonised regulatory framework for managers of alternative investment funds within the European Union. Impacted investment managers are currently grappling with the implementation of the new regulatory regime, in large part because of the ambiguity of the Directive, the continued room for interpretation afforded by the AIFMD Delegated Regulation of the European Commission (the so-called “Legal 2 Regulations”) and the lack of clarity provided by the Financial Conduct Authority.
The Directive entered into force in Europe in June 2011, and by virtue of national legislation was implemented by the UK in July 2013. The UK Regulations come fully into force on 22 July 2014.
Scope of the AIFMD
The new AIFMD regime introduces a new regulated activity: managing an alternative investment fund (“AIF”). An AIF is broadly speaking any “collective investment undertaking”, potentially covering all alternative sectors such as hedge funds, real estate, private equity and other funds that are not UCITS funds (Undertakings for Collective Investments in Transferable Securities under EU Directive 2001/107/EC and 2001/108/EC), including art funds.
Prima facie, any manager that manages an AIF is potentially in scope for the Directive. In practice however, the Directive does not apply to managers outside the European Economic Area (“EEA”) managing non-EEA AIFs who market outside the EEA, or who market inside the EEA under the Private Placement Regime. Otherwise, the Directive will apply, either in whole or in part. The Private Placement Regime is the existing European marketing regime, which will continue to co-exist alongside the AIFMD marketing regime (see below).
‘Lite’ regime or full regime?
The extent to which the Directive impacts the manager of an art fund will depend on the size of the fund.
Managers of small funds may be able to fall within the Directive’s ‘lite’ regime. To determine whether a manager can utilise the lite regime, it must calculate the total aggregate value of assets under its management, across all funds it manages, in accordance with the asset valuation rules set out under the Level 2 Regulations. The manager will be able to take advantage of the lite regime if such assets do not exceed either (i) EUR100 million or (ii) EUR500 million when the portfolios of an AIF consisting of other AIF that are not leveraged and have no redemption rights exercisable during a period of five years following the date of initial investment in the relevant AIF. If a manager’s assets under management exceed these de minimis thresholds, the Directive will apply to the manager in full.
Most European art funds are currently thought to fall below the EUR100 million mark, but some of the bigger funds operate several funds, and if these are managed by the same manager, it may well find that it cannot take advantage of the lite regime.
If a manager does fall within the lite regime, it has the option to opt-in to full compliance. A manager may consider doing this if, for example, it considers it attractive to investors to be fully regulated, or because it would like to benefit from the new marketing regime introduced by the Directive (see below).
If an art fund manager does seek to rely on the lite regime, it must ensure it has procedures in place to monitor its total assets under management on an on going basis to ensure it remains eligible for the regime. In the UK, any breach of the de minimis thresholds for a period of more than three months would require the manager to seek a variation of permission (from registration under the lite regime, to authorisation under the full regime) from the Financial Conduct Authority within 30 days.
What is the lite regime, and its impact on art fund managers?
Firstly, a manager subject to the lite regime must register itself with its home regulator. For a UK manager this means submitting the appropriate form to the Financial Conduct Authority, identifying both itself as the manager and the fund(s) under its management.
Secondly, at the time of registering, managers must provide certain information relating to the fund, including: total assets under management; the fund’s trading strategies; the main instruments it is trading (i.e. art in the case of art funds); geographical coverage of the fund; principal market data; and investor concentration information. UK managers submit this information to the Financial Conduct Authority via a pro-forma template. This information must be updated and provided to the Financial Conduct Authority on an annual basis.
What is the full regime, and its impact on art fund managers?
The requirements imposed on a manager by the full regime are much more extensive. Broadly speaking it covers: manager authorisation; portfolio management; risk and liquidity management; general operating principals of the manager; marketing; use of depositaries; capital requirements; remuneration; valuation; transparency (to investors and regulators); and leverage. In this article we will focus on (i) manager authorisation, (ii) the use of a depository and (ii) marketing.
A manager subject to the full regime must obtain authorisation from its home regulator by 22 July 2014. As part of the application procedure, managers need to provide fairly extensive information relating to both itself and the fund(s) it manages. This information is provided to the regulator by way of a pro-forma reporting template, which must be updated and provided to the regulator on an annual basis.
Use of third party depositaries
The Directive requires managers to appoint a single independent depositary in respect of each AIF it manages. The duties of such a depositary are extensive and complex and vary according to the type of assets under management, but generally relate to custody and safekeeping duties. In the case of an art fund, amongst other things, a depositary is required to safe keep cash (i.e. subscription monies which are not invested in art) and monitor cash flows including subscriptions and redemptions. The depositary is not required to hold in custody the art assets of the fund (as would be the case of certain types of financial instrument assets typical of financial investment funds), rather, it is required to verify that the fund or the manager on behalf of the fund is the owner of the art, and maintains records and has procedures in place to record and monitor such ownership. The depositary must also take all necessary steps to ensure that there are appropriate valuation procedures in place to value the art.
Such depository services do not come cheap and will certainly add to the costly administration of art funds.
The Directive introduces a new marketing regime – the marketing passport. Obtaining a marketing passport allows managers to market AIFs to professional investors in all EU member states, without having to seek individual approval from each member state it wishes to market in. By contrast, marketing under the Private Placement Regime requires managers to obtain a separate marketing authorisation for each member state it markets in. The passport regime could therefore result in significant cost and time savings for managers who want to market in several European markets, which is arguably one of the major upsides of the full AIFMD regime.
Art fund managers qualifying for the lite regime will want to consider the benefits of opting-in (including having a pan-European marketing passport), versus the cost of opting-in and having to implement the Directive in full (including the cost of appointing a depositary).
Opting-in allows managers to benefit from the marketing passport. For now at least, managers taking advantage of the lite regime must market in Europe via the Private Placement Regime, which means having to apply to the regulator of each country you want to market in. Plus, managers marketing via the Private Placement Regime must comply with any jurisdiction specific marketing rules applicable to marketing under the Private Placement Regime – it is not a level playing field (as it is if you use the marketing passport) and this can be costly to manage (see below). However, at the time of writing, it is strongly expected that the Private Placement Regime will be abolished perhaps as early as the end of 2015, leaving the pan-European passport as the only regime under which a manager can market funds in Europe. If so, one of the advantages of ‘opting-in’ will be removed.
Since the implementation of the Directive, certain key European countries (e.g. Germany and France) have been ‘gold-plating’ their marketing rules under their existing national Private Placement Regime. This presents an additional challenge and cost to managers relying on this regime as they must check, on an on-going basis, what approach each jurisdiction is taking to such ‘gold plating’, which frequently means imposing additional obligations on managers when marketing in those jurisdictions.
Fast approaching deadline to be fully compliant with AIFMD
The deadline for compliance with the Directive (whether under the lite or full regime) is 22 July 2014. Market data as at the end of January 2014 suggested that approximately 80% of in scope managers had yet to submit their application for full regime authorisation to the Financial Conduct Authority. There are concerns that with time to full implementation running out, the backlog of applications that the Financial Conduct Authority will undoubtedly face will be extremely challenging. The Financial Conduct Authority has confirmed that legally it is bound to process and determine applications within a three-month turn around (exceptionally 6 months) so managers must submit their applications by 22 April 2014 at the very latest. It may be the case that lite regime applications can be processed more quickly but this is not clear. Managers are advised to submit their applications as soon as possible.
Link to Delegated Regulations: http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:083:0001:0095:en:PDF