Many members of the private equity industry spent their summer months pouring over crucial follow-up details to the highly anticipated Alternative Investment Fund Managers (AIFM) directive.
In July, the European Securities and Markets Authority (ESMA) – the body responsible for providing European policymakers with technical advice on the directive – unveiled a number of new proposals, the second of four phases that detail the core provisions of AIFM agreed last year.
Working on a tight timeline, ESMA provided stakeholders a two-month window to submit feedback on its daunting 438-page consultation paper. The EU regulator, in turn, must digest the responses, which were accepted until 13 September, and submit its final proposals by 16 November.
The consultation paper provided important clues to ESMA’s thinking of how regulators might supervise private funds. Sister publication PE Manager graded how well some of their proposals reflect the ins and outs of the private equity model.
New pay disclosure rules under the AIFM directive will require a firm’s senior management and key staff members to provide a breakdown of their fixed and variable remuneration. Moreover, at least 40 percent of a GP’s variable pay must be deferred for at least three to five years (depending on a fund’s lifecycle).
Some of the rules are arguably redundant in an investment model where long-term performance incentives already are built into compensation arrangements. Indeed, a major gripe for private equity managers revolves around how carried interest should be reported, or whether it should be reported at all.
ESMA provided some insight in the consultation paper, expressing their view that carried interest payable by the fund should be treated as part of the total variable remuneration to be reported. Yet, “this itself leads to a question of exactly how to report carry – as a contingent interest in the fund or only at the point actual payments are received upon investment realizations,” says Michael Newell of law firm Norton Rose.
Overall, however, ESMA provided little clarity on a subject many GPs have been left sweating over. A prime example of this is the lack of details around remuneration committees, which large firms will need to create as part of the directive.
The proposals demonstrate ESMA has been receptive to industry concerns over the definition of leverage. Fund managers feared portfolio company debt would be counted as leverage at the fund level. “It seems that the current thinking would exclude such debt from the definition of leverage if there is no recourse to the fund,” says Tamasin Little of law firm SJ Berwin.
However, the provision still is the subject of ongoing debate among EU regulators, who fear hedge funds may use this definition to their advantage by creating holding companies to park their debt.
ASSETS UNDER MANAGEMENT: B-
How the directive determines assets under management is one hazy topic GPs still await clarity upon. Funds with aggregate assets under management no greater than €100 million will be exempt. Likewise, unleveraged funds under the €500 million mark also will be out of the directive’s scope.
The good news is the proposals recognize that closed-ended funds may need their own definition. For these funds, a net asset value of the portfolio approach may not be relevant or calculated with sufficient frequency and perhaps other methods could be used, such as acquisition cost of assets held or commitments less realisations at cost for private equity and venture funds.
Importantly, ESMA stressed in its proposals the need to exempt firms that may yo-yo in and out of the directive’s scope. For instance, if a firm temporarily breaks the €500 million threshold (ESMA suggests no more than three months), it would not suddenly be caught by the directive.
RISK MANAGEMENT: F
The AIFM directive will require firms to implement a risk management system and keep it separate from the firm’s portfolio management team. The intent behind the rule is to create a Chinese wall between those responsible for monitoring and mitigating risk and the fund managers, who are compensated based on the success of their investments and thus incentivised to seek higher risk-return payouts.
However, in the private equity industry, the two roles are virtually one in the same, says one London-based lawyer. The private equity industry earlier this year argued an independent risk management team could in no way monitor portfolio company risks as well as those fund managers actually responsible for overseeing the company’s growth. Doing so would in effect be a duplication of roles, contends the European Private Equity and Venture Capital Association (EVCA).
CAPITAL REQUIREMENTS: D
During level I measures, it was agreed by EU policymakers that alternative investment firms would need to hold capital equal to at least one-quarter of their annual fixed costs for liquidity purposes. Firms also must have at least €125,000 in capital and large firms (exceeding €250 million in assets under management) must tack on an additional .02 percent of their portfolio totals, subject to a €10 million cap.
Furthermore, firms are required to purchase professional indemnity insurance or use their own funds to cover risks arising from professional negligence. The private equity industry has argued this type of insurance has to be carefully calibrated or it can be an exorbitant cost or unavailable during economic turmoil.
ESMA has ramped up this industry concern by proposing criteria for the required insurance that appear to be well beyond market norms, says SJ Berwin’s Little. For instance, the insurance would have to cover not just the negligence of the GP but also the activities of third-party delegates, fraud, business disruption and systems failures, she explains.
“ESMA seems to want managers’ capital, held in liquid form, to insure investors against everything except some aspects of poor investment performance and depositary failure,” Little says.
One potential area of relief for private equity managers has been the extent of their depositary liabilities. It appears unlisted shares will potentially fall under a more light-touch approach relative to listed securities.
Other risks, however, have been introduced by ESMA with respect to depositaries, which are responsible for safekeeping a fund’s financial assets, monitoring cash flows and ensuring the fund complies with its governing documents. If a depositary suspects a fund leaned against its investment mandate or constitutional guidelines, ESMA indicated the depositary might be able to retroactively stymie a deal found in breach, a concept which would be difficult or impossible to apply in the private equity context.
Troublingly, this leads on to an indication by ESMA that a depositary would be entitled to apply a pre-transaction clearance process in situations where it thought it appropriate (including in private equity deals), says Little.
THIRD-COUNTRY ENTITIES: C
One of the directive’s more controversial areas, relating to “third-country” rules, came out as a separate consultation paper in late August. The proposals would dictate how non-EU fund managers raise capital within the EU and establish an extensive framework to collaborate efforts between ESMA and other regulatory agencies in sniffing out market abuse and systematic risk.
One big question is a proposal to allow ESMA to conduct on-site inspections of funds domiciled outside European borders. It is unclear whether this requires them to go to the home state of the manager first, explains Jonathan Herbst of Norton Rose.
Another industry concern relates to how EU regulators will test the regulation quality of managers outside their jurisdiction. The proposals say third-country managers should be regulated based on criteria equivalent to those established under EU legislation, says Edward Devenport of law firm Mourant Ozannes.
Looking at ESMA’s other released technical guidance, an “equivalence test” should not be taken to mean third-country regulators would need to adopt exactly the same criteria set out in the AIFM directive, according to James Mulholland of law firm Carey Olsen.
“If that was the case, and given the US Securities and Exchange Commission’s approach to regulating funds, US managers would struggle to achieve AIFM equivalency,” Mulholland says. “A degree of pragmatism inevitably will be required since there will be discrepancies between EU member states in interpreting the directive.”
FINAL GRADE: Incomplete
At this stage in the game, ESMA is only releasing preliminary proposals and its final advice has yet to be written. With the EVCA and other stakeholders expected to spotlight industry concerns in their consultation responses, ESMA will have time to chew over industry concerns when finalising its proposals.
All things considered, the regulator approached the task with significantly more understanding and flexibility towards private equity than did EU politicians during level I negotiations, according to a number of market sources. ESMA is, after all, the body responsible for enforcing the directive. A list of regulations that make little sense for private equity managers or are met with fierce criticism would only make its job more difficult.
For ESMA, the next big test comes due 16 November, when final proposals are to be submitted.