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Setting up an AIF in Europe

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By James Williams – 1. Choosing the Fund’s European Domicile: One of the hardest decisions for any start-up or established manager wishing to launch a European Alternative Investment Fund is picking the most suitable jurisdiction. Europe has multiple fund centres, including Luxembourg, Ireland, Malta and The Netherlands, each of which offers something slightly different. Due care and consideration of all the options is therefore vital before the manager engages with legal counsel to commence the fund set-up phase. 

Europe’s largest onshore funds domicile is Luxembourg, home to approximately 14,400 funds, including sub-funds, representing just short of EUR4 trillion in AUM, of which one third are held in alternative assets. 

In terms of legal vehicles, since 2004 Luxembourg has offered the SICAR, the Société d’investissement en capital à risqué (SICAR), which has primarily been used as a vehicle to support private equity and venture capital investments. Up until 2013, Luxembourg operated quite an antiquated limited partnership regime – the société en commandite simple (SCS), which was based on the 1915 company law. 

Cognisant of this, in 2013, at the time the AIFM Directive was introduced, Luxembourg’s authorities created the Luxembourg Limited Partnership Regime, allowing for Luxembourg AIFs to be treated as Luxembourg limited partnerships, which are not necessarily subject to direct supervision by the CSSF. 

At the same time, a new structure in the form of a Special Limited Partnership (SCSp) was introduced. This takes the best elements of the Anglo Saxon limited partnership. Both the SCS and SCSp can be used for regulated and unregulated partnerships. 

Since 2013, more than 1,400 limited partnerships have been established. 

Ireland’s reputation as a leading funds domicile has gone from strength to strength over the years. There were approximately 6,470 funds domiciled in Ireland through 2016 – 2,000 of which are alternative funds – with around EUR2.1 trillion in AUM. 

The two primary legal structures in Ireland are the Irish investment company (Irish Plc) – which can be used for open-ended or closed-ended funds – and the Irish Collective Asset Management Vehicle, or ICAV. Up until March 2015, the Irish Plc, also known as a Part XIII Company, was the most popular vehicle. 

This has since been superseded by the hugely popular Irish Collective Asset Management Vehicle (ICAV). This is a bespoke regime and has been quite successful since it was introduced in March 2015. At the end of April 2017, there were 314 ICAVs registered with the Central Bank of Ireland.

The ICAV is a bespoke piece of funds legislation so general Irish Company Law doesn’t apply. In addition, the ICAV is a corporate `check-the-box’ entity, which is beneficial for those wishing to market to US taxable investors and umbrella ICAVs can prepare separate audited financial statements for individual sub-funds. From a marketing and tax point of view, the ICAV is an enhanced version of the Irish Plc.

Key features of the ICAV:

• Authorisation and supervision by the Central Bank;

• Establishment as a UCITS fund or an AIF;

• If established as an AIF, it may be structured as open-ended, closed ended or with limited liquidity;

• Possible establishment as an umbrella fund with segregated liability between sub‑funds;

• Multiple share classes;

• The assets of the ICAV must be entrusted to a depositary;

• Registered office in Ireland;

• Board of directors and a minimum of two directors.

Unlike the Irish Plc structure, if the manager wants to change the memorandum and articles of association they don’t need a shareholder vote. They can also dispense of their AGM on 60 days notice and, unlike the investment company, there is no legislative requirement to spread investment risk within the ICAV. 

Malta has been a leading jurisdiction of choice for smaller fund managers over the last 10 years. The island’s regulator, the MFSA, is very approachable to small start-ups and offers appropriate guidance where necessary to make sure everything with the fund is properly up and running. 

The island offers a number of options with respect to the legal structure of the fund: the investment company with variable share capital (SICAV), the investment company with fixed share capital, limited partnerships that can be divided into shares or not divided into shares, unit trusts and the common contractual fund. The SICAV is the most common legal structure and can be used for single fund structures and umbrella fund structures, depending on the manager’s preference. 

And then there is the Netherlands, which operates a light regime under AIFMD, making attractive to start-up managers based inside or outside the Netherlands, due to the lower costs involved. In case of a foreign manager, a management company should be incorporated in the Netherlands which will act as the Dutch AIFM. 

One is able to choose between corporate and non-corporate entities. A corporate entity takes the form of either private limited liability company (BV) or a public limited company (NV). A non-corporate entity takes the form of a limited partnership called a CV structure (commanditaire vennootschap), or a fund for joint accounts (FGR). 

The CV structure is most commonly used for closed-ended private equity and real estate vehicles, whereas the FGR is most commonly used for daily trading open-ended investment vehicles. An FGR can either be tax transparent, where there’s full look-through and no Dutch tax concerns on investors, or, if necessary, it can be tax opaque. In this case, it is not subject to corporate, income or dividend withholding tax. 

Fund structuring options

Ireland and Luxembourg both have well-established regulated fund vehicles, referred to as Qualified Investor Alternative Investment Funds (QIAIFs) and Specialised Investment Funds (SIFs) respectively. 

There are no investment restrictions on the QIAIF, no leverage limits and no diversification limits. It’s a broad structure that can be used by most alternative strategies. Speed to market is one of the key attractions. In order to get a QIAIF authorised, it takes two to three months but each application will be approved within 24 hours, once all the accompanying documentation is submitted to the Central Bank of Ireland. 

A loan origination QIAIF is also available in Ireland. It can issue loans, participate in loans, participate in lending and it can also hold debt and equity securities, which are issued by the entities it is lending to. 

Luxembourg offers both regulated products – namely the SIF and the société d’investissement de capital à risqué (`SICAR’) as well as unregulated products – Luxembourg limited partnerships (SCS or SCSp) and the Reserved AIF (`RAIF’). 

The Reserved AIF can be managed by an authorised EU AIFM. It can be created in the form of a company or a contractual common fund (FCP). If it is established as an investment company with variable capital it will be called a SICAV. There, it can choose to operate as a partnership (SCS or SCSp), a limited liability company, or a limited company form; whatever suits the manager best. 

In addition, there is the SOPARFI (Société de Participations Financières). This is still used for 60 to 70 per cent of private equity vehicles. It is a fully taxable Luxembourg company and can benefit from double taxation treaties signed by Luxembourg. 

In Malta, the most popular choices are the Professional Investor Fund (PIF), the AIF and like Luxembourg, it has also introduced an unregulated fund: in this case the Notified AIF, where the AIFM is responsible for the running of said vehicle.

2. Regulation and Compliance: Understanding one’s regulatory obligations can be a minefield. Knowing what counts as regulated activities, or not, is vital if one is to stay out of trouble with the FCA. 

One of the most common misconceptions among start-ups is that they think just because they are operating with a small AUM – say EUR5 million or less – they somehow fall outside of the purview of the FCA. This is not true. Even if the manager starts off with a managed account running his own capital, the moment they start promoting what they are doing to friends and family, for example, this is technically viewed as providing investment advise. 

As soon as someone does this, they have to be a regulated entity; either directly, or by using a MiFID regulatory platform and operating as an Appointed Representative. This is the easiest way to operate within the FCA’s rules. As long as one is on a regulatory platform, one can invite as many people as they want into the managed account, allowing them to build their track record before potentially spinning off to set up a standalone fund structure.

To clarify, MiFID (Markets in Financial Instruments Directive) applies to those who advise on trades in managed accounts or single investor accounts, whereas AIFMD applies to those who manage commingled funds with more than one investor. 

Of course, one can opt to become directly FCA authorised. It is, however, important to take into account the costs of using legal advisers, FCA fees, putting up regulatory capital and also possibly having to make use of external compliance consultants. So it can be a costly route. 

Three platforms

There are potentially three platform considerations for any new manager to consider under AIFMD – these relate to the AIFM, to the investment advisor and the fund.

As mentioned, a MiFID hosted solution allows a new manager to trade freely under FCA rules as an Appointed Representative to the platform, while they wait to become FCA authorised. Nowadays there are well funded, high quality fund managers using hosted regulatory umbrellas and, importantly, they are becoming accepted by institutional investors. 

The MiFID hosted platform means that managers can focus 100 per cent on their investment strategy, while the platform has sole responsibility for compliance and the regulated activities of the fund. 

It’s worth speaking to three or four different platforms to work out the potential long-term costs. How will they implement trade reporting under MiFID II – will it be an additional cost? Will implemented rules on data protection under GDPR result in an extra cost? 

Have a clear understanding of the fixed costs before making a final decision.

Next, once the manager is ready to establish an AIF, they must decide on whether to become their own AIFM or use a delegated model. The latter is most common, for managers of all sizes, who do not want the operational and compliance burden of complying with AIFMD. There are now multiple third party AIFMs in Luxembourg, Dublin, and the UK, for managers to consider.

The management company (AIFM) is charged with overseeing the proper management of the AIF from a risk and compliance perspective.

If, however, someone wants to become their own AIFM, firms like Laven Partners in London can handle all the operational due diligence and ongoing compliance functions on the manager’s behalf. 

Once the AIFM has been appointed, the last consideration is whether to run a standalone fund or to use a fund platform, which most third party AIFMs will offer by using a multi-cell SICAV or ICAV. In this arrangement, although the manager effectively operates as a sub-advisor to the fund, they fully own the fund and can market it with their own branding. 

While the combined outsourced fund and AIFM platform option is highly cost-effective, most managers choose to have their own standalone fund and appoint an outsourced AIFM. 

In this arrangement, they remain in regulatory compliance using a hosted MiFID platform for investment advisory activities, and take comfort knowing that the third party AIFM appointed to the fund can handle all AIFMD-related requirements, such as risk management, filing Annex IV reports, providing the regulatory capital, etc.

The final step on the journey is for the investment manager to become an FCA-authorised MiFID regulated entity, or a fully authorised AIFM. 

3. Self-managed AIFM versus outsourced AIFM: Anyone that wishes to market their alternative investment fund (AIF) in Europe, regardless of whether it is an EU AIF or a Cayman AIF, must have an AIFM in place. 

The third party AIFM will typically be involved in doing risk management and overseeing portfolio management, as well as delegating the day-to-day management of the fund to the investment manager. 

One needs to allow at least a month to put together an AIFM application. The FCA is then likely to take an extended period of time reviewing it (nine months or more). Given the time involved to become a self-managed AIFM, oftentimes investment managers will appoint an outsourced AIFM to act in their interests. This is especially important for managers with seed capital in place from a cornerstone investor who needs to get to market quickly.

In this instance, the third party AIFM provides an ideal `stopgap’, while they wait for their FCA authorisation to come through. 

There is no shortage of AIFMs to consider in Europe. In Ireland, for example, since AIFMD was introduced in 2013, the number of AIFM providers has grown from a handful to in excess of 30. 

Key functions of the ManCo include delegated portfolio management, post-trade risk management, supervision of the AIF’s service providers, and maintaining valuation, compliance and liquidity policies. The quality of risk management expertise varies greatly. Some AIFMs have the technological capabilities to analyse clients’ portfolios and generate the necessary risk analytics required under AIFMD such as: liquidity analysis, VaR analysis, stress testing, etc.

Others will outsource it or ask the investment manager to provide the reports. 

The initial capital requirements for an AIFM in Ireland are EUR125,000, as stipulated by the CBI. 

Once the net asset value of the collective investment schemes under management exceed EUR250 million, the AIFM is required to set aside 0.02 per cent of the amount by which the net asset value exceeds EUR250 million. 

Managing these capital requirements is an important function of the AIFM. If investment managers become victims of their own success and raise a lot of capital, the risk is that the AIFM suddenly finds itself unable to meet those additional capital requirements and goes out of business. 

Therefore, before selecting an outsourced AIFM, see what other managers are on the platform. If there are a number of smaller managers, this is likely to present less of a risk than if there are one or two larger managers who have a greater chance of raising significant assets from investors. 

Finally, the AIFM’s substance is key. Do they have general expertise in all areas to bring the various functions together that are required to support AIFs? What is the governance framework used by the AIFM? Do they have people within the management company that are capable of asking the right questions of investment managers?

If one decides to become an AIFM, it needs to be a full commitment. One cannot approach it half-heartedly or look to cut corners. Be realistic about the long-term prospects of the business. Are you hiring people? Are you looking for office space to grow into? Do you have the regulatory capital needed to operate as a standalone AIFM? 

If not, and if it is likely to create bumps in the road, then going the outsourced AIFM route is likely to be the best option. 

4. Selecting the AIF’s service providers: There are lots of factors involved in selecting the AIF’s service providers, which this report cannot detail in full, suffice to say that any service provider selected has to fully understand one’s business offering. People setting up hedge funds or private equity funds in the early stages experience ups and downs; investors committing capital and then pulling out for example. 

Does the service provider have the flexibility and the willingness to work with you over the long term? If not, it can lead to problems and unnecessary costs further down the line if one has to change their fund administrator or prime broker. 

Get a good understanding of what procedures each service provider has in place. Do they have good checks and balances internally? Are all the relevant procedures being followed and are people doing what they should be doing? 

Getting the chemistry right is critical so during the fund set-up phase, ask to meet with the people that will be supporting the fund on a daily basis. Do you fit their business objectives? Equally, do they understand your strategy properly – for example, does your preferred fund administrator have experience in handling Level 3 illiquid assets? There’s nothing worse than a service provider who says, `Sorry, I can’t do that’.

Hedge fund start-ups often assume they have to have a blue chip prime broker in place to impress investors. While there is an obvious prestige to having Goldman Sachs appointed, the reality is that unless having formerly worked at the bank, or one is launching with EUR500 million in day one capital, they simply will not entertain the idea of doing business. 

Moreover, courting a big name can lead to unintended consequences. If a tier one prime reviews the fund and decides not to proceed, word will quickly spread. Other brokers will find out and will start to wonder why the fund wasn’t taken on. This can also unsettle seed investors.

The message here is, `be careful what you wish for’. Also, if one is looking to get on to a distribution platform, be careful of strategy bias. The funds industry is very cyclical. Strategies fall in and out of favour with investors. It is important to be aware of this before paying to appoint a distribution partner. 

5. Fundraising & Distribution: Based on Preqin data, private capital funds (private equity, real estate and infrastructure) secured USD669 billion as of June 2016, the latest data available, which shows that institutional demand for alternatives remains robust. Indeed, this is playing into the hands of smaller GPs. Large groups are oversubscribed and this has made it easier for first time funds to get to market as LPs are forced to look beyond the upper quartile of top performing fund managers. 

However, start-up managers bringing regulated AIFs to the European market need a healthy dose of reality; no matter what the calibre of the manager, or the efficacy of the investment strategy, if they do not have a clearly thought out marketing and distribution strategy, it will count for nothing if they approach the wrong type of investor. 

In Europe, an increasing number of bank-owned and independent fund platforms are emerging to host funds and provide active and passive distribution support, whilst placement agents and distribution partners can prove highly effective at introducing managers to the right investors.

Broadly speaking, successful managers are those who have a clear understanding of what investors are looking for, where the appetite is, and work backwards to build a strategy; a kind of reverse engineering process. 

The following steps can help one to develop an effective approach to raising assets and building brand reputation: 

Firstly, try and secure cornerstone investors. You’re not going to get a first-time fund off the ground unless you’ve got a backer. If they can give you seed capital, this could be used to make investments and build an early track record. 

Secondly, get the timing right. You don’t want to launch too early because you might find that during the first round of fund raising your fund lingers in the market. That can reduce momentum in the fund raising process. Check that other similar products are not already being presented to institutions. If not, they will find it difficult to tell the difference between one strategy and the next. 

Thirdly, good news is great for fund raising. If you are an existing manager about to embark on launching your first onshore regulated AIF, communicate any successful exits in previous fund vintages, any updates in the deal pipeline, your overall track record. 

Fourth, try, if possible, to create scarcity around the fund raising process – i.e. if investors don’t allocate now they might miss out; that can also be an effective tool within the marketing strategy.

And finally, do your research. Can you compete? And if so, where can you compete and how? If you can’t compete on performance, for example, maybe you can compete on price. 

Indeed, one area that managers typically trip up on is appropriate pricing. It’s all well and good having the right fund structure but it means nothing if the wrong price tag in on the product with respect to fees. This is something that investors will look at through a microscope so. 

Will you offer a founder share class? Will you offer a seeder share class, and if so will this be offered without a management fee? Will you increase the fee structure once you go beyond, for example, EUR150 million? Don’t put boots on the ground and then think about how you are going to sell your product. Think about who is likely going to buy your product; in which geographies are they likely to be located? 

Whether one is to run a fully compliant AIFMD fund and avail of passporting, or simply target a handful of EU Member States using national private placement regimes, it is important to plan ahead and try to put together a roadshow three to six months before the expected launch date.

This will go some way towards identifying potential seed investors and validate the price tag on the fund’s different share classes. Knowing one’s investors is the lynchpin to any successful distribution strategy. The more preparation and planning there is the greater level of potential assets one can attract into the fund. 

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