AIFMD: Minimizing legal risks on transactions

The EU Alternative Investment Fund Managers Directive (AIFMD) has created significant regulatory challenges for private equity, real estate and infrastructure transactions. Whilst much attention has been given to the issues that AIFMD creates when fundraising, its impact on transaction structuring and execution is only beginning to be fully understood. Often, it may affect the way in which transactions are structured and executed. In all cases, a new approach to transaction compliance may be helpful.

A reasonable number of funds subject to AIFMD have now been raised and many have made a number of investments subject to its rules as well. But fundraising cycles and avoidance strategies mean that some managers are yet to make their first investments in a fully-
AIFMD compliant world.

The key areas that both groups of managers need to consider are as follows:

  • Does the transaction structure inadvertently create any Alternative Investment Funds (AIFs)?
  • Which target companies are subject to the AIFMD portfolio company rules?
  • Do the asset stripping restrictions result in any cash being unexpectedly trapped in the target group?
  • Have all portfolio company disclosures been properly made?
  • Have the newly-minted AIFMD compliance policies and procedures been correctly applied to the transaction?

Let’s review each in further detail.

Have any AIFs been formed?

A critical step in assessing AIFMD transaction compliance should now include a review to understand which companies, partnerships or other entities in the holding or target structures could fall within the wide AIF definition. AIFs are defined as any collective investment undertaking (other than a UCITS fund) that raises capital from a number of investors, with a view to investing it in accordance with a defined investment policy, for the benefit of those investors.

Notably, the definition of an AIF has potentially greater reach than the UK’s definition of a collective investment scheme, in particular as it does not exclude any vehicle set up in the form of a company.

Furthermore, there is no exception for vehicles that only hold or invest in a single asset and so any holding or co-investment vehicles with more than one passive investor are at serious risk of being treated as AIFs. There is a formal exclusion for holding companies and guidance to the effect that joint ventures are not intended to be caught, but these exclusions and guidance are not easy to apply and may be too narrow for many vehicles that would never have been thought to be “funds” previously.

If an entity is wrongly assumed not to be an AIF then it is likely to have accepted its “investors” in breach of law, agreements may be unenforceable and executives may face criminal consequences.

Application of portfolio company rules

Where an acquisition of a European company is being made by a fund subject to AIFMD (including a non-European fund that has been privately placed into Europe), then the manager needs to consider the “portfolio company rules.” These include (i) asset stripping restrictions and (ii) portfolio company disclosures. Each set of rules is discussed further below.

However the key technical step prior to the application of these rules is to make a decision as to which companies the rules apply to. This has caused considerable discussion amongst practitioners and the uncertainty could create significant legal and compliance risks. Broadly, there are two possible views: that the rules only apply to the top European company of the target group or to every European company in the target group. It is important to consider this issue carefully as it could have significant commercial and compliance implications with varying effects across different transactions. If it has not already been subject to strategic consideration when fundraising, an approach should be developed as early as possible.

Asset stripping provisions

The Directive places a restriction on making distributions (including dividends and interest on shares), capital reductions, share redemptions or purchases of own shares by EEA-incorporated portfolio companies over the course of the first two years following the acquisition of control by an AIF. While the rules are similar to existing Companies Act principles that already apply to public (but not necessarily private) companies, the key additional restriction is that they do not permit distributions to be based upon interim accounts. This can result in cash being unexpectedly trapped within group structures, particularly if one takes the cautious view that the portfolio company rules must be applied to all target group companies.

The restriction was aimed at leveraged recapitalizations; but it is having wider effects and causing concern on deals without significant re-financings where managers would otherwise want to move cash around a group.

There are a number of other ways the impact of the rules can be minimized. If spotted early enough, it may be possible to implement pre-completion planning measures. Similarly, as the provisions do not relate to debt, one may structure intra-group debt arrangements that serve as a form of dividend stream (although it will of course be important to work closely with tax advisers to understand the impact of this).

 

Portfolio company disclosure obligations

A disclosure regime applies to Alternative Investment Fund Managers (AIFMs) when a fund acquires an interest in an EEA Company. They require notifications when stake-building (including when taking minority positions in unlisted companies) and then further detailed disclosures when actually acquiring control. Further disclosures are required on an ongoing basis.

Detailed disclosures include:

  • A conflicts of interest policy which includes information on arms-length safeguards between an AIFM, its AIFs and the EEA Company;
  • A communications policy, in particular relating to employee communications;
  • Intentions as to future business and effects on employment; and,
  • Information on how the acquisition is to be financed.

These disclosures are to be made to a range of stakeholders, including regulators, other company shareholders, investors and employee representatives.

Managers are wrestling with the content of these disclosures. At present market practice is to make relatively short-form disclosures, but there is clearly a concern that these need to be robust enough to demonstrate reasonable compliance with the spirit of the new rules. Whilst to some extent it is a compliance exercise, these disclosures could clearly create commercial, legal and regulatory risks if mishandled and should be considered carefully as part of any transaction structuring.

A new approach to transaction compliance

These issues are creating some additional cost pressure on transaction and compliance budgets and may in some circumstances have timing impacts on a transaction. Where circumstances do not allow for the issues to be properly addressed legal and compliance risks may be quietly building within the industry.

We think a new approach to compliance may be helpful. Not based upon top-down compliance systems – dictated by ambiguous legislation copied into policies and procedures that are expensively assembled, but not always properly implemented or understood. Top-down compliance may make sense for funds with frequent trading activity, but it is fundamentally the wrong approach for closed-ended funds that make a small number of significant investments within complex structures.

Aside from the costs of assembling the policies, managers face further costs in making sure that deal teams understand and implement the policies correctly and consistently. Managers should consider appointing private fund regulatory specialists on a deal-by-deal basis to report on two simple questions: does this transaction comply with AIFMD? How can we demonstrate that to our regulators and other stakeholders?

James Gee and Shimon Simon are executive director and legal advisor respectively within the London-based Financial Services Legal practice at professional services firm EY.