The Alternative Investment Fund Managers Directive (AIFMD) aims to provide a common regulatory regime for firms running Alternative Investment Funds (AIFs), thereby creating a single European market in this area.
An AIF is essentially a fund that does not require authorization under the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive. It includes hedge funds, as well as those investing in private equity and real estate.
The manager is defined as the organisation that is capable of providing and that takes responsibility for the investment management functions including the portfolio and risk management. Ancillary services can be delivered in-house or outsourced.
There are new reporting requirements to ensure that investors and regulators are kept fully up to date. The Directive also imposes various other rules governing the authorization and ongoing operations that will have a big impact on the way some of the funds are run. These have the effect of harmonizing investor protection across the EU.
The AIFMD stipulates that an internally managed AIF must have at least €300,000 of initial capital. For an externally appointed AIFM the figure is €125,000, although they must also have additional own funds of 0.02% of the amount by which the total value of their AIFs exceed €250m, subject to a cap of €10m.
Each European member state has the power to allow AIFMs to provide up to half of their additional own funds via a guarantee or insurance undertaking from a credit institution such as a bank, as long as it has a registered office somewhere in the EU or in a country with equivalent acceptable regulations. The remainder must be invested in liquid assets or securities than can be quickly converted into cash and that are not held for speculative purposes.
The AIFM’s own funds must be greater than a quarter of the previous year’s fixed overheads. This is to provide a measure of comfort that the firm is adequately capitalized and has enough money to continue in business for a few months even if it is forced to suspend operations. There should also be additional own funds or professional indemnity insurance to cover any potential claims for negligence.
One of the main aims of the Directive is to improve investor protection. A key element of this is that AIFMs are required to appoint a depository for each alternative fund that is managed or marketed in the EU. The depository is responsible for: monitoring the cash flows, the safe-keeping and record keeping of assets, and overseeing certain operational functions. They are expected to act independently on behalf of the fund and its investors and to be responsible for the loss of any financial instruments.
The idea behind monitoring the AIF’s cash flows is to ensure that all payments and receipts are properly recorded and that there are daily reconciliations. With regards to the safe-keeping of assets, the general principle is to ensure that the securities are held in segregated accounts in the name of the AIF. Where this is not possible, such as with a commercial property, the depository is required to verify the fund’s ownership.
The various oversight duties include: monitoring the valuation of the AIF, checking the treatment of investor subscriptions and redemptions, and ensuring compliance with the relevant laws and regulations.
Transparency and other requirements
In the past, hedge funds and other AIFs have been criticized for a lack of transparency, but the new legislation aims to overcome this by strengthening the reporting requirements. The Directive lists the content and format of the annual report for each fund and specifies that they have to comply with local accounting standards. It also defines what needs to be covered by the manager’s report.
Another key area of the legislation is the risk management. Each AIFM is required to ensure that the risk management function is kept separate from the investment operations and that there are controls in place to measure and contain all the risks that each AIF is exposed to. These should be recorded in a policy document with limits for each type of risk.
Many AIFs invest in illiquid assets that may be impossible to sell at short notice. This can affect the ability of investors to redeem their holdings. To guard against the possibility of not being able to raise enough cash, each AIF is required to maintain an appropriate level of liquidity to meet its redemption policy. The AIFM is responsible for monitoring and stress testing the associated liquidity risk under all market conditions.
The Directive stipulates that there has to be proper procedures in place to value each fund’s assets. This can either be done internally by the AIFM or externally, although the depositary is not allowed to act in this capacity so as to avoid any potential conflict of interest. There must also be a maximum leverage limit for the fund that is disclosed in the offer document.
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