The Financial Conduct Authority has published its final Policy Statement on AIFMD (known as PS13/5). The document sets out the FCA’s rules for implementing the Alternative Investment Fund Managers Directive and provides its response to the two consultation papers.
The PS includes a last minute reduction in the level of regulatory capital required by firms wishing to perform depositary-lite duties in order to encourage a competitive market, and introduces a number of changes to previous Perimeter Guidance (PERG) on marketing including the ability for AIFMs to generally rely on a confirmation from an investor that they approached the AIFM (therefore reverse solicitation) rather than being marketed to by the manager.
In the February 2013 edition of the Hedge Fund Journal, INDOS Financial wrote an article “Depositary-Lite: Simple as the theory sounds?”. The article (which can be found by clicking here) explained the so-called ‘depositary-lite’ regime of the AIFMD, and the issues which the industry could face in seeking to comply with the new requirements. Since February, there have been a number of positive developments which have been summarised below.
To recap, following the introduction of the AIFMD, UK and other EU hedge fund managers that wish to market their non-EU, offshore hedge funds to EU investors through private placement will need to comply with the depositary-lite regime. This requires one or more firms to be appointed to perform the depositary duties of safe keeping of assets, cash flow monitoring and oversight (principally the oversight of the valuation process, subscriptions and redemptions, compliance with laws and regulations, investment restrictions and leverage).
Many of the AIFMD requirements for depositaries go beyond the custodian/ trustee requirements which apply to EU funds today. The cash flow monitoring procedures, in particular, require a daily reconciliation and monitoring of unusual cash flows, whilst the oversight requirements are an entirely new requirement for offshore hedge funds. The good news is that the depositary-lite requirements do not apply to non-EU Alternative Investment Fund Managers (AIFMs) at all, and the strict liability for loss of assets which will apply to depositaries of EU funds, and the potential increase in costs to the funds which may result, does not apply.
In February we noted that the UK was proposing to ‘gold plate’ the depositary-lite area of the directive by requiring, in certain situations, a single UK depositary to perform all the duties. This would most likely have resulted in additional cost to funds, a more complex implementation and on-going operating model for existing service providers and managers alike. Much to the relief of the industry, this gold plating has now been removed in the UK’s amended AIFMD Regulations which are due to become law on 22 July 2013. Instead, the Financial Conduct Authority (FCA) will require that any UK firm performing the duties will need to hold an ‘Article 36 Custodian’ regulatory authorisation. It is not however necessary for a UK firm to be appointed to perform any of the duties but, unlike in the UK, the precise regulatory framework which will apply to firms performing these duties that are domiciled in other fund centres such as Ireland and Luxembourg remains unclear.
Given the AIFMD, and now the UK, will allow one or more firms to perform the duties, many still believe the most efficient and lowest cost, and therefore preferred, model would be for prime brokers and custodians to continue to perform the safe keeping duties, the fund administrator to perform the cash flow monitoring duties and a trustee/ depositary business to perform the oversight duties. An alternative model may emerge whereby certain depositaries may only accept appointment where they perform all three depositary-lite duties – for risk management and other reasons, they want to operate broadly consistent processes regardless of whether they are acting for an EU or non-EU fund. We would expect this model to be more expensive than the multiple-firm approach.
Another positive development is the transitional approach to AIFMD which some countries, such as the UK, will apply. These may allow managers to continue to market their funds until the earlier of their date of authorisation as an AIFM or July 2014 before they are required to comply in full with the new rules. Managers that plan to market through private placement will, however, need to notify the FCA of their chosen depositary-lite providers in their AIFMD ‘variation of permission’ application. We expect the FCA will want to see that appropriately regulated firms are proposed and will independently check with those firms that they are prepared to act. We anticipate the FCA will also focus on the suitability of non-UK firms appointed to perform the depositary-lite duties.
The primary focus of prime brokers and depositaries remains, at present, to agree the single depositary model for EU funds. However, we expect UK-based prime brokers will seek to obtain the necessary Article 36 custodian authorisation in order to perform the depositary-lite safe keeping of assets duties, and administrators are considering how to adapt their existing reconciliation procedures to comply with the cash flow monitoring requirements. As reported in the February article, it is still widely expected most existing trustee businesses will only be willing to perform the oversight duties where an affiliated entity already performs fund administration. Firms that are willing to perform any depositary-lite duties where an affiliate does not also perform fund administration are likely to only do so for significant accounts which could leave small to medium-sized managers – and those that need to market via private placement the most to attract and grow assets – in a difficult position.
In common with a number of other areas of the AIFMD, solutions are starting to emerge. In anticipation of the challenges some firms may face complying with the depositary-lite regime, INDOS Financial was established in late 2012 with the sole purpose to develop a pragmatic and flexible depositary oversight solution for offshore hedge funds. Unlike almost all trustee/ depositary businesses today, INDOS is 100% independent, and will work with most leading fund administrators leaving managers free to use their existing service providers. INDOS has recently submitted an application to the FCA for authorisation as an Article 36 Custodian/ Depositary.
AIFMD Countdown – June 2013
There is now just one month to go until the 22 July 2013 AIFMD implementation date. Whilst there have been several positive developments since the last update, it looks increasingly likely several EU countries will not be ready to implement the directive by the July go-live date. For UK managers currently authorised by the Financial Conduct Authority (FCA), the picture is now clearer than it was a couple of months ago, notwithstanding uncertainty still remains in a number of areas including how the UK will implement the AIFMD remuneration guidelines.
The main developments over the past month are as follows:
Following Ireland’s lead in May, the FCA published draft application forms enabling existing UK authorised managers to apply to vary their permission (VoP) to become an Alternative Investment Fund Manager (AIFM). We understand the FCA will prioritise VoP applications from managers that completed their March 2013 AIFMD survey and will seek to process applications within one month of receipt. In addition, Luxembourg has now published its AIFM application forms.
ESMA announced it has approved co-operation agreements with 34 global regulators. Amongst the countries included are the Cayman Islands, British Virgin Islands, Bermuda, Jersey, Guernsey, and the USA in addition to Switzerland and Brazil noted in our previous updates. Negotiations continue with further countries. Whilst ESMA has negotiated these agreements centrally each EU member state needs to enter into a bi-lateral agreement with each non-EU regulator. Luxembourg recently announced that it will sign the co-operation agreements and the FCA has commented on its website it expects to do the same. The ESMA announcement was welcomed since concern had been growing that the co-operation agreements, which are a key component of the AIFMD and required in order for non-EU managers or non-EU funds to access EU markets, or perform fund management by delegation from EU managers, may not be in place by 22 July.
The FCA published a draft of the variation of permission form for depositaries of Alternative Investment Fund (AIFs). Transitional provisions exist in the UK for firms already authorised to undertake trustee/ depositary business (i.e. they have until July 2014 to obtain the necessary AIFMD authorisation), but they nevertheless need to ensure the services they provide comply with the requirements of the directive. Firms wishing to enter the depositary market that are not currently authorised may apply to the FCA using the draft VoP application forms.
The FCA has also confirmed it believes that an AIFM authorised to provide MiFID services should be able to exercise its single market rights by passporting those services, and not just AIFM management services, to other European States. The FCA recognises this is contrary to the position taken by the European Commission and is attempting to reach a common understanding with the Commission and other European regulators on the issue.
The UK’s amended Alternative Investment Fund Managers Directive Regulations 2013, which were published in May and reported in the last AIFMD Countdown, have now been laid before Parliament and will come into force on 22 July 2013.
ESMA published a long awaited consultation on guidelines on reporting obligations required of AIFMs in respect of the portfolio of the AIFs they manage or market in the EU. This is definitely worth a read in conjunction with the reporting template that was set out in the AIFMD level 2 text to assess whether the reporting requirements will present particular challenges – something that several commentators believe could be the case.
ESMA also published a final report containing guidelines applying to AIFMs and national regulators on key concepts of the AIFMD which had previously been subject to consultation.
Over the coming month, we expect the FCA to publish their final AIFMD Policy Statement and many are hopeful the FCA will also issue the AIFMD remuneration consultation although this is likely to be later in Q3. It will also be interesting to see how prime brokers and depositaries conclude negotiations of the ‘Day One’ AIFMD depositary model for EU AIFs which, to our knowledge currently remains unresolved.
INDOS Financial announces plans to enter AIFMD Depositary Market
INDOS Financial Limited (INDOS) has announced it has submitted an application to the Financial Conduct Authority for authorisation as a Depositary. INDOS plans to provide independent depositary oversight services to hedge fund managers seeking to comply with the long-awaited Alternative Investment Fund Managers Directive (AIFMD) which becomes law on 22 July 2013.
Under the AIFMD UK hedge fund managers marketing offshore hedge funds to European investors are required to comply with the so-called ‘depositary-lite’ regime. These new rules require funds to appoint a firm such as INDOS to perform oversight over fund valuation, subscriptions and redemptions, compliance with laws, regulations and investment guidelines.
Bill Prew, Founder of INDOS, said “Many hedge funds will face a challenge appointing an AIFMD depositary and they are looking for firms such as INDOS to provide a pragmatic and flexible solution. We aim to become the only UK regulated independent depositary specialising in hedge funds and, unlike other depositary businesses today, we will work with most leading fund administrators and perform 100% arms-length oversight.”
Andrew Shrimpton, Member, Kinetic Partners, said “With the introduction of AIFMD this year, much of the hedge fund industry is looking for independent depositary oversight solutions to achieve compliance with the directive. The changes made by HMT as part of the UK investment management strategy has encouraged new business models to enter the market; we are pleased to be able to support INDOS with their application to become authorized with the FCA.”
— ENDS —
AIFMD – How Prepared Are You? (AIMA Journal)
INDOS Financial’s article “Countdown to AIFMD – How Prepared Are You?” was published recently in the Alternative Investment Management Association (AIMA) Q2 Journal. The article is reproduced below. The full AIMA journal – which includes other useful information about AIFMD – can be downloaded by clicking here.
There is now less than a month to go before the Alternative Investment Fund Managers Directive (AIFMD) becomes law across the EU. It has been a long journey since AIFMD was first announced over four years ago. We have all needed to become accustomed to working through the uncertainty which surrounds AIFMD and which still remains in a number of areas today.
In the UK at least, where most hedge fund managers manage non-European hedge funds domiciled in the Cayman Islands, there are signs that many managers plan to make use of the UK’s flexible interpretation of AIFMD’s one year transitional provision. Managers appear to accept that this might be at the expense of not being able to market their funds through private placement to certain non-UK, EU professional investors for several months. In return, it will allow managers more time to implement the directive, let others learn from being a ‘first mover’, and avoid the remuneration provisions until 2014.
Yet, despite the uncertainty which still remains, and irrespective of whether managers are planning to delay authorisation as an AIFM until 2014, there are a number of questions or strategic decisions that UK hedge fund managers should have considered by now and started to develop and commence AIFMD implementation plans.
Is your firm within scope of AIFMD?
The answer for most hedge fund managers is likely to be yes, given the low threshold which determines whether your firm is in scope. If you manage alternative investment funds with gross assets, including leverage, of greater than €100m, then you are within scope of AIFMD.
Have you identified the Alternative Investment Fund Manager (AIFM)?
For many UK based managers managing offshore hedge funds, this is likely to be a simple question. The answer will most likely be your existing UK MiFID management entity. You will apply to the FCA to vary your permission and your existing entity will become the AIFM. Even if you have an offshore, say Cayman Islands, management entity you will probably be unlikely to meet the substance, or so called ‘letterbox’ requirements of the AIFMD.
This question can clearly be more complex, for example, if you form part of a broader group with overseas entities which could become the AIFM or non-EU AIFM. Most managers in this situation should, by now, have a good feel for where they plan to end up strategically and understand the advantages and disadvantages of being an EU or non-EU AIFM.
Have you identified and classified your Alternative Investment Funds (AIF)
By now, it should be clear which entities under your management are AIFs and whether they are EU or non-EEA AIFs. The question can become more challenging in relation to managed accounts where it is important to agree the identity of the AIFM with the sponsor of the account. Generally speaking, it is preferable to avoid being the AIFM in order to avoid taking on all of the AIFMD responsibilities in relation to the account and that, in many respects, you are unable in influence.
Have you considered whether you plan to delegate portfolio or risk management?
The AIFMD allows firms to delegate portfolio management or risk management but not to the extent that the AIFM becomes a ‘letterbox’, which broadly means a firm has not delegated substantially more of these activities than it retains. In the majority of cases I expect most UK managers will retain both functions and develop their risk management policies and procedures to become AIFMD compliant. In some cases, managers may opt to delegate risk management to a specialist firm, several of whom are now marketing their services in this regard.
When do you plan to become an authorised AIFM?
In the UK, managers must comply with AIFMD and apply for authorisation no later than 22 July 2014. I expect most managers will want to be authorised as an AIFM by this deadline rather than run the risk their application is rejected after July 2014. Working back from this date therefore, you need to allow at least 3 months to submit your variation of permission application to the FCA. Bearing in mind it seems inevitable the FCA will receive a very large number of applications at the same time, it will face a real challenge to process all applications within 3 months. Managers probably want to allow 4 to 5 months to be safe which means being in a position to submit their application by the end of January 2014.
Will your existing capital and insurance requirements be adequate to meet the AIFMD requirements?
For many managers AIFMD ought not to have a material impact on the amount of capital they are required to hold. A quick analysis should confirm whether this is the case. At the time of writing, there is still uncertainty as to whether the base capital requirements are based on gross or net assets so it is worthwhile calculating on both measures.
Insurance brokers are reviewing the wording of their hedge fund professional indemnity insurance (PII) policies and liaising with the insurers. Most hedge fund managers already have PII cover therefore, it is worth checking whether existing cover will cover the optional PII requirements of the directive, as an alternative to maintaining additional own funds. Engage with your broker and be prepared to articulate how the AIFMD impacts your firm and why you don’t believe your operational risk profile will be impacted, in order to limit or negate any impact AIFMD may have on premiums.
Do you plan to market a non-EEA AIF to EU professional investors through private placement or seek to rely on reverse solicitation?
Firms marketing through private placement are required to comply with a number of provisions of the AIFMD. These include certain disclosure and reporting requirements and the so-called ‘depositary-lite’ regime. Reliance on, and compliance with, reverse solicitation (i.e. at the initiative of the investor) will avoid a number of these requirements altogether. Those wanting to market through private placement will need to monitor the private placement rules in the countries they are targeting, many of which are still unknown. Those relying on reverse solicitation will require clearly defined procedures, as well as enhanced compliance monitoring and oversight, to ensure that they do not undertake marketing.
Will your administrator be prepared to act as External Valuer for some or all of your portfolio?
Fund administrators will still calculate the net asset value of the AIF in much the same way as they do today. Despite this, under AIFMD the AIFM is responsible for valuation. Some administrators have now confirmed they are willing to act as External Valuer (EV) for certain types of assets. Do you know your administrator’s position with respect to your funds?
Despite the fact the manager remains responsible for valuation even where an EV is appointed, it should be worthwhile engaging the administrator as an EV. This is because the EV is required to contract to a negligence standard of care. For some administrators this will be a lower standard than at present, whether this is gross negligence or an outright liability cap.
Have you identified and started discussions with a depositary?
This will be a priority for UK managers of EU funds where it will be mandatory to ensure a single depositary is appointed. Early engagement with your prime brokers and potential depositaries is essential here. Hopefully by the time this article is published, depositaries and prime brokers will have resolved how they will work together, including how depositaries will mitigate their risk from taking on strict liability for loss of assets.
For the larger number of UK managers of offshore funds, you only need to be concerned about depositaries if you market to EU investors through private placement. If you do, then you must comply with the ‘depositary-lite’ regime which requires that one or more firms is appointed to perform the depositary duties of safe keeping of assets, daily cash flow monitoring and oversight.
The signs are that the prime brokers will perform the safe keeping of assets, much as they do today and administrators will perform the cash flow monitoring, again, much as they do today particularly if they already perform daily reconciliations. You will need to identify a depositary to perform the traditional trustee duties of oversight of the fund valuation, subscriptions and redemptions, compliance with laws and regulations and monitoring of compliance with investment guidelines and leverage. Your starting point will be to ask your administrator with whom they plan to work to perform these duties. Some administrators may introduce you to an affiliated trustee, however it is also sensible to consider whether an independent firm could offer a genuine arms-length service.
Have you reviewed the Annex IV regulatory reporting requirements to identify any significant issues in deriving and reporting the data?
For those managers that have completed the FCA’s six monthly hedge fund manager survey, the AIFMD reporting requirements will be very familiar and indeed you may already have a system or process in place for maintaining and reporting the necessary data. For others, it is sensible to review the requirements early in order to start putting processes in place to enable you to report the data. The indications are, reporting by UK managers will not commence until you become an authorised AIFM, however the level of work which may be required to prepare for the commencement of reporting should not be underestimated.