The most recent holiday period may not have been as festive as years past for private equity compliance professionals in Europe. That’s because in late December the European Commission released highly anticipated “level 2” implementing measures for its controversial Alternative Investment Fund Managers (AIFM) directive that creates for the first time a pan-EU funds marketing and legal regime.
The measures, released after months of delay and speculation, confirmed GPs’ fears that certain aspects of the directive will be difficult to interpret, while some areas such as remuneration are still awaiting further clarity.
Nonetheless GPs have until 22 July to comply with the directive, leaving little choice but to begin meaningful preparations now despite the lingering uncertainties.
DEFINING DELEGATION
Despite originally intending to release level 2 text over the summer, the Commission stalled with many in the industry attributing the delay to difficulties in defining certain provisions. More specifically, rules on delegation – written to prevent GPs from significantly outsourcing fund operations to other countries – were cited as the most time-consuming for policymakers by industry sources.
The measures define when a GP is labeled a “letter-box entity”, a term denoting a fund manager who is registered in one locale but delegates the majority of fund operations to outside jurisdictions. The follow-up rules describe a letter-box entity as one that “exceeds by a substantial margin the investment management functions performed” by the fund manager, which according to private equity lawyers speaking with PE Manager, leaves plenty of room for interpretation.
The Commission, perhaps well aware of the ambiguity, says it will review how its letter-box test is being applied after the market has had some time to develop best practices – leaving open the possibility for additional measures that clarify delegation rules if no standards have been established.
“What is unsatisfactory is that the Commission knows that it has made a mess of this point,” comments Tamasin Little, a partner at law firm SJ Berwin. “The Commission said it can come back to the letter-box test in two years time, at which point it may revise its criteria, but in the meantime allow the European Securities and Markets Authority (ESMA) to issue its own guidance. That means it is going to be very hard to build up accepted procedures and reach stable conclusions because they are reserving the right to come back and change everything.”
Nonetheless firms (with the help of their lawyers) will use what guidelines are available to structure funds in a way that aims to avoid any suspicion of being a letter-box entity.
“EU managers will need to document why they have delegated each function and give decent reasons for it,” advises Little. “There is a wide range of permitted reasons, including things like optimizing business functions, reducing cost and the need for specific expertise; so it’s not particularly restrictive, but it is more paperwork which people need to start putting together now.”
Helpfully the text provides some qualitative factors GPs can use to determine when too much delegation has occurred, but (in another area of concern) these factors do not clearly distinguish “risk management” from “portfolio management”, which elsewhere in the directive are viewed as separate elements, says Gregg Beechey of London-based law firm SJ Berwin.
“In private equity, risk management and portfolio management are usually handled by the same team; and so without a clear separation in terminology the asset class will have a difficult time understanding exactly what can be delegated to a third party entity,” explains Beechey.
Proskauer partner Peter McGowan adds the issue will be notably problematic for smaller private equity firms that may not have enough partners to begin splitting their team between risk supervisors and portfolio managers. “Firms may have to employ more people and replace internal structures throughout the organization to demonstrate the separation. Individual countries are, however, able to apply the separation principle in a proportionate way, so there may be further relaxation of the rule for smaller firms.”
Remuneration rules may prevent countries from relaxing the rules too far. At minimum GPs must be able to demonstrate that risk-focused partners are not remunerated in a way that is tied to portfolio performance, which would result in a conflict of interests under the bill. That reduces hope a partner may be able to serve both functions at some capacity.
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One firm’s general counsel, speaking on the condition of anonymity, says delegation may in fact be the solution to the splitting of duties challenge. Assuming enough final control is preserved with the parent firm, a delegated function can effectively separate a portfolio manager (for example a Nordic specialist under the firm’s control) from a risk supervisor (under the same example, the firm’s senior management based in the UK). More firms may adopt this advisory model approach, the general counsel predicted, adding those that do will need to write careful policies and procedures demonstrating how sufficient control is retained by the delegating GP.
ENGAGE DEPOSITORIES
On level 2 measures related to depositories, the Commission did not stray far from draft proposals circulated in April that the industry criticized as ambiguous. Legal sources tell PEM the Commission has for some time signaled it would not require private equity assets to be held in custody by a depository (such as a bank), but the measures could be interpreted differently from that effect. However, sources don’t suspect GPs bypassing the custody requirement to face much legal opposition from EU regulators who understand the intent of the provision.
In their relationships with GPs, depositories will have significant oversight functions. Aside from safekeeping GPs’ assets, depositories will police fund activity to make sure cash accounts are kept honest and ensure that fund managers are keeping true to the limited partnership agreement and other governing documents. Crucially a depository that suspects a fund leaned against its investment mandate or constitutional guidelines can retroactively stymie a deal found in breach, which could lead to some complications in practice if a deal was too far along in the acquisition process.
In similar fashion the Commission did not provide depositories any additional wiggle room in escaping liability for lost assets held in their custody – which banks and other entities had hoped for. To escape liability, a depository must prove that the loss was caused by an event outside its control, and that it had taken sufficient precautions and comprehensive due diligence to protect the asset. The directive will also prohibit depositories from delegating these liability risks to any direct or indirect sub-custodian.
GPs in need of a depository should begin the search process now, warn lawyers, who add the fund’s governing documents should make clear how depository costs will be paid for (presumably by the fund itself).
TURNING THE PAGE
With release of heavily anticipated level 2 implementing measures, one could be forgiven for thinking the long running saga that is the AIFM directive was nearing its end. Unfortunately, many firms have not yet begun significant preparations for the bill, and the aforementioned uncertainties in some of the directive’s key provisions is sure to leave compliance officers feeling tested.
Indeed nearly half of private fund managers have not taken any concrete steps to analyze the impact of the directive on their firm, nor have made changes to their operations in anticipation of its implementation, according to a KPMG poll of some 70 fund managers in mid-December – most of whom said they were waiting for the level 2 text before beginning any major compliance work. The directive, as PEM has been reporting, will impose new rules on general partners’ pay, fund transparency, restrictions on asset stripping and also governs which non-EU funds will be permitted marketing rights across the 27-member bloc.
On reporting, many firms are already gathering data needed to comply with the directive’s reporting rules. However, no concrete reporting systems can yet be put into place as draft reporting forms were dropped from the directive. Moreover GPs must identify a member state of reference under the directive, but here too no templates or final rules have been provided by officials.
On remuneration, ESMA will be providing further guidance sometime in the first quarter that will detail how firms must report their partners’ and employees’ compensation packages under the directive.
ESMA, led by Steven Maijoor, will also be kept busy negotiating with non-EU governments over cooperation agreements that will permit non-EU managers access to EU markets. Currently Switzerland is the only third-country to have signed a deal – which creates an information exchange and puts in place “mechanisms, instruments and procedures” for non-EU regulators to assist with on-site inspections and enforcement actions with respect to non-EU firms (which critics have described as a territorial overreach of EU power).
Worryingly for the industry, sources have said that negotiations with the US are not progressing as well as hoped. “My understanding is that ESMA is asking US managers to encourage the SEC [Securities and Exchange Commission] to be responsive which suggests it might not be going quite so smoothly,” said one funds lawyer.
Individual EU member states are also under pressure. They now have six months to continue implementing the directive into their national legislative frameworks. Dörte Höppner, head of industry trade body the European Private Equity and Venture Capital Association, fears some sovereigns will go above and beyond what is required by the directive. Germany raised concerns with what many called a “strict” draft bill, that has since been somewhat toned down.
But for all the toing and froing it seems that the Commission has its mind pretty well made-up. And for the industry it is a matter of knuckling down and getting on with it. “When it arrives you deal with it,” said one firm’s general counsel. And for private equity now is the time to deal with it.
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