By James Tinworth (pictured), partner in the hedge funds practice at Stephenson Harwood – As the name suggests, the EU’s directive on alternative investment fund managers (AIFMD) applies to “AIFMs”, namely “legal persons” whose regular business is “managing” one or more “AIFs” (essentially, funds that are not UCITS).
One would hope therefore that it would be easy to spot an AIFM in a fund structure. This task is complicated, however, by four aspects of the AIFMD:
1 Each AIF managed within the scope of the AIFMD has a single AIFM, which shall be responsible for ensuring compliance with the AIFMD
2 An AIF itself could be the AIFM
3 The AIFMD defines “managing” AIFs as performing either portfolio management or risk management functions for one or more AIFs
4 If an AIFM delegates its functions to the extent that it becomes a “letter-box entity” then it can no longer be considered to be the AIFM
“Managing AIFs” – portfolio management or risk management?
The AIFMD’s definition of “managing AIFs” means that an entity performing either portfolio management or risk management for an AIF could be the AIFM unless the performance of either function is done under a delegation arrangement with the AIFM in accordance with the
The first task would therefore be to list all the entities in the structure that are responsible for performing either of these functions. The AIF itself may need to be included in this list.
Internally managed AIFs
The AIFMD provides that the AIFM shall be either an external manager, which is the legal person appointed by the AIF or on behalf of the AIF and which through this appointment is responsible for managing the AIF (an “external AIFM”), or, where the legal form of the AIF permits an internal management and where the AIF’s governing body chooses not to appoint an external AIFM, the AIF itself (an “internally managed AIF”).
The first point to make is that only a “legal person” can be an “AIFM”. The AIFMD does not define the term “legal person” – it is only used in contrast to the term “natural person”. The term “legal person” may, however, refer only to an entity with its own legal personality.
It may therefore be possible for only some legal forms of AIF to be internally managed AIFs. For example, and in accordance with early FSA views, an AIF structured as:
- a corporate vehicle could be internally or externally managed
- a unit trust or a contractual fund would be more likely to be externally managed
- a limited partnership with its own legal personality could be internally or externally managed
- a limited partnership without its own legal personality (such as an English limited partnership) would be more likely to be externally managed (e.g. by its general partner or a managed appointed by its general partner)
The second task would therefore be to determine whether or not the AIF can be an internally managed AIF.
Delegation and letter-box entities
The final task would be to review the delegation arrangements in the structure relating to management functions.
Whilst an AIFM is permitted to delegate to third parties the task of carrying out functions on its behalf, an AIFM is not permitted to delegate its functions to the extent that, in essence, it can no longer be considered to be the AIFM and to the extent that it becomes a “letter-box entity”.
When playing the game of spot the AIFM, therefore, a potential suspect can be discounted if it is in fact a “letterbox entity”.
The EU Commission will define “letter-box entity” in its Level 2 measures later this year and, for the moment, there are only indications as to how this fundamental term will be defined.
In its February 2012 discussion paper ESMA, which is advising the Commission, wrote that an AIFM may delegate the two functions (i.e. portfolio management or risk management) either in whole or in part, in the understanding that an AIFM may not delegate both functions in whole at the same time. This would infer that a potential AIFM in an existing fund structure that has delegated both functions cannot be the AIFM for the relevant AIF as it has become a letter-box entity.
This is hopefully a mistake, however, as it conflicts with ESMA’s final advice to the Commission in November 2011 that an AIFM would become a letter-box entity and could no longer be considered to be the manager of the AIF where:
1. the AIFM no longer retains the necessary expertise and resources to supervise the delegated tasks effectively and manage the risks associated with the delegation; or
2. the AIFM no longer has the power to take decisions in key areas which fall under the responsibility of the senior management or no longer has the power to perform “senior management functions”, in particular in relation to implementation of the general investment policy and investment strategies.
According to ESMA, “senior management functions” would include:
- responsibility for the AIFM’s compliance with its obligations under the AIFMD
- assessing and periodically reviewing the effectiveness of the policies, arrangements and procedures put in place to comply with the obligations in the AIFMD and taking appropriate measures to address any deficiencies
- responsibility for the implementation of the general investment policy for the relevant AIF
- oversight of the approval of the investment strategies for the AIF
- responsibility for ensuring that valuation procedures according to Article 19 of the AIFMD are established
- responsibility for ensuring that the AIFM has a permanent and effective compliance function, even if this function is performed by a third party
- ensuring and verifying on a periodic basis that the general investment policy, the investment strategies and the risk limits of the relevant AIF are properly and effectively implemented and complied with, even if the risk management function is performed by third parties
- approving and reviewing on a periodic basis the adequacy of the internal procedures for undertaking investment decisions for the relevant AIF, so as to ensure that such decisions are consistent with the approved investment strategies
- approving and reviewing on a periodic basis the risk management policy and arrangements, processes and techniques for implementing that policy including the risk limit system for the relevant AIF
- responsibility for establishing and applying a remuneration policy in line with Annex II of the AIFMD
In the leaked draft of its Level 2 measures, the Commission followed ESMA’s advice, although it added two further circumstances where an AIFM would become a letter-box entity, namely where:
3 The AIFM loses its contractual rights to inquire, inspect, have access or give instructions to its delegates or the exercise of such rights becomes practically impossible; or
4 the totality of the individually delegated tasks substantially exceeds the tasks remaining with the AIFM.
The last circumstance (a quantitative test, which may be impossible to assess) is causing the most concern.
Any delegation by any of the entities identified in the first two tasks (which may or may not include the AIF itself) would therefore need to be reviewed in order to establish whether the relevant entity is a “letter-box entity” rather than the AIFM.
Why is it so important to identify the AIFM?
In the end there can be only one AIFM in a fund structure. Unlike the movie Highlander, however, there may not be much of a Prize.
It is vitally important to spot the AIFM because:
- the AIFMD applies to the AIFM
- the AIFM may have to be authorised under the AIFMD
- where there is more than one potential AIFM, the question of whether the AIFM is an “EU AIFM” or a “non-EU AIFM” could significantly impact on the extent to which the AIF can be managed and/or marketed in the EU
- existing fund structures may have to be re-structured or could be voluntarily re-structured in order to benefit from opportunities, or avoid challenges, presented by the AIFMD
James Tinworth is a partner in the hedge funds practice at Stephenson Harwood.