Linklaters' Elizabeth Ward answers our questions on disclosure requirements, leverage restrictions and ‘third country’ rules in the differing AIFM drafts being negotiated.

The directive looks like it will have some significant additional disclosure requirements. Which version is more favourable to private equity?

On disclosure, the Parliament text is not as favourable to private equity as the Council’s, ECOFIN Committee text. In the Council text there is an exemption for SME’s – small- and medium- size companies. The exemption basically excludes companies that meet at least 2 out of the following 3 requirements: – employ fewer than 250 people in the EU, have an annual turnover of less than €50 million, or a balance sheet total of not more than €43 million. The Parliament position just includes a very small exemption, for companies that employ less than 50 people. That really is extremely low, and it’s quite a big concern for venture capital-owned portfolio companies, who will still be caught, but who won’t have the same resources to do the same reporting that larger companies will be able to do. Some of the disclosures include items such as research and development efforts, which is something that you wouldn’t normally have to disclose. For some companies, disclosing information like that could be quite damaging.

The next difference between the Parliament and Council text is in relation to what constitutes a controlling influence in a company – as the additional disclosures apply where a controlling influence is acquired. In the Council text, controlling influence is defined as acquiring more than a 50 percent interest in a company, which obviously is what people normally would understand to be a controlling influence. But the Parliament text defines a controlling influence basically as anything from 10 percent. So if you acquire 10 percent of a company you will have all of these additional reporting requirements, which include reporting on your planned significant divestments of assets, the people who are responsible for business strategy and employment policy, and all the additional disclosures that you need to make in annual reports.

How easily could this information become public?

Disclosure on acquisition of a controlling influence requires disclosure to the company, the shareholders, and also employee representatives. If there aren’t any employee representatives, then the company must make the disclosures to the employees themselves. Both the Parliament and Council texts provide that the employee representatives aren’t allowed to reveal to employees or third parties anything which would breach a legitimate confidentiality undertaking. Also, member states can provide that an employer is not required to disclose information to an employee representative if it would seriously harm the company.  There are certain confidentiality restrictions built in, but they’re by no means failsafe.

There are other disclosures as well that the fund manager needs to make about the fund to its investors. There are also disclosures that they need to make to the member state regulators – although, private equity is excluded from this requirement the Parliament text. In the Council text, disclosure to investors is on the most part what you would normally disclose to LPs. But in the Parliament text there is quite a bit more disclosure required and with some of the disclosure, you can’t really see how they would help private equity investors. For example you need to disclose information about the correlation of the applied investment approach of the fund compared with traditional investment strategies.

There are also disclosure requirements in relation to remuneration – in the Parliament text this extends to disclosure of carried interest. Both the Council and Parliament texts also include certain remuneration policies and practices which need to be followed by the fund manager.

Are the costs of this additional reporting manageable for GPs?

For the very large buyout houses, the costs are manageable. But for the very small houses they’ll be difficult to deal with, so it’s quite unfair that the smaller funds and their portfolio companies are caught by the Directive.

Would a US firm that owned a portfolio company in the EU be subject to these requirements?

If the US firm did not opt into the Directive to be able to market its funds in Europe, then the rules which would apply to the EU portfolio company would just be those of the particular member state where the portfolio company was located.

What sort of leverage restrictions are in the current versions of the Directive?

In the Council text, it is clear that leverage restrictions operate at the fund level. In the Parliament text, it’s more unclear as in the context of a clause which deals with leverage at the fund level, the Parliament text specifically mentions that in the case of a private equity fund the various factors that the member state regulators have to take into account in ensuring that the leverage limits set by a fund are reasonable are – “the ratio of financial debt used for the acquisition to EBITDA”. That clearly looks like they’re talking about leverage at the portfolio level. What this will mean is that each member state will have the discretion to look at leverage levels used in private equity deals.

What do the lawmakers mean when they suggest that leverage restrictions could prevent “asset stripping”?

Asset-stripping is not mentioned in the Council text, but is mentioned in the Parliament text in a clause called “capital adequacy in target companies”. This clause requires the net assets of a target company controlled by the fund to comply with the provisions on capital adequacy in the Second Company Law Directive. The Second Company Law Directive includes a restriction on a company giving financial assistance for the purchase of its own shares and it’s not clear whether this part would be included in the AIFM Directive. If this clause was included in the final text, then it would need to be made clear that it didn’t extend to the financial assistance restrictions as otherwise; it would make leveraged acquisitions in some EU countries by private equity investors much more difficult to do. 

The financial assistance restrictions go much further than company law in some of the member states. So you’ve got a situation where portfolio companies which are owned by private equity funds covered by the Directive will be subject to more rigorous restrictions than non-private equity owned companies. This point extends to the disclosure requirements as well – private equity owned portfolio companies will be required to disclose more information than their non private equity owned competitors. Both the EU Parliament and Council have said that they’ll review EU company law to ensure that there is a level playing field between private equity owned companies on the one hand and non private equity owned companies on the other, however, when the Directive is implemented, there isn’t going to be a level playing field at all initially and it could take a long period of time to introduce any changes.

Are there any other significant differences among the versions of the directive now being debated?

In the Parliament text there is a partial exemption for private equity, which means that private equity is only subject to some of the provisions in the Directive and not all of them. In the Parliament text private equity is not subject to the capital requirements – the requirement to have a certain amount of capital at the fund manager level. But they will still be subject to individual member state rules on capital requirements. The depositary requirements don’t apply to private equity either and neither does the annual reporting to regulators as I mentioned before.

What is the status of the “third country” regulations?

In both the Parliament and Council texts, the manager of a third-country fund can only market that fund in the EU if they comply with certain conditions. Those conditions are different under the Parliament and Council texts – the Parliament text is much more restrictive. If the third country fund is managed by a non EU manager, under the Parliament text, marketing is only permitted to professional investors if a cooperation agreement exists between the home state regulator of the member state where the fund is being marketed and the regulator of the third-country where the fund is established. The Commission must also have made a decision that the third country meets certain anti-money laundering requirements. There also need to be agreements in place between the member states where the fund is marketed and the third country where the fund is established in relation to tax conventions and exchange of information on tax matters. The third country needs to be subject to a decision from the Commission on reciprocity, which means the Commission must recognise that the third country grants reciprocal access to marketing of EU funds on that third country’s territory. And the third country must also recognise and enforce judgments given in the EU on any matters connected to the Directive. In addition to those requirements, the non-EU fund manager must agree to comply with the directive and the regulator of the third country in which the fund manager is based must sign an agreement with the European Securities and Markets Authority, which is called ESMA, to enforce the powers of ESMA under the directive against the fund manager if necessary.

So basically to be able to market in the EU, a non EU fund would have to comply with a number of factors, and the fund manager would also have to comply with the rest of the Directive.
The Council text on the other hand basically allows national private placement regimes to continue provided that the third country fund manager complies with some of the Directive and cooperation agreements are in place between the home regulator and the regulator of the third country where the fund’s established.

Which version is more likely to become law?

It’s very unclear. When the Council’s ECOFIN committee voted on their version of the text they did acknowledge that certain countries did have reservations about the third country positions, and that would be something that would be looked at very carefully during the trilogues negotiations – which is the stage we’re at now, where the EU Council, Parliament and Commission negotiate to agree a final text which can then be voted on and implemented.

What is the biggest concern for foreign fund managers at the moment?

If you’re a US fund manager, then you would, under the Parliament text, need to go through a number of requirements and the outcome might not be the same for you in each country in the EU. Some countries regulators might recognize equivalence, whereas others may not so willingly. Another concern is the uncertainty at the moment. We have different texts of the directive on the table, and you can’t really advise funds on what will happen because there isn’t enough certainty.

As a general point, regulation to a degree is helpful, but there is a risk that if the EU gets this regulation wrong, certainly in relation to the third country issue, it will be cutting Europe off from access to external funds, which is not desirable.

Elizabeth Ward is a counsel at law firm Linklaters and has been part of an industry working group on the AIFM directive.