745
POLICY, REGULATION, AND PRIVATE EQUITY
Sally Gibson and Simon Witney1
Introduction
Until a few years ago, private equity (PE) fund manager regulation in Europe was a matter for national governments, and the EU’s “hands-off” approach gave rise to a variety of policy responses. On the one hand, many European countries judged PE to be a relatively low priority for regulators, given its mainly institutional and sophisticated investor base and perceived lack of systemic risk. In a number of EU jurisdictions (including, for example, Germany), that meant virtually no industry-specific regulation at all,2 while in others (most notably the UK) fund managers were regulated, but in a relatively “light touch” way and mainly on the basis of “principles-based” standards. On the other hand, a few countries (France being the most important example) opted to put prescriptive rules in place, designed mainly to protect investors. Whether these regulatory choices had any significant impact on the development of national PE and venture capital industries is an interesting question in itself, but one that became moot when, following the financial crisis, EU regulators decided that pan-European rules were needed3 – a decision that culminated, in 2011, in the Alternative Investment Fund Managers Directive4 (the “AIFMD” or “the Directive”5). The Directive mainly regulates hedge fund and larger private equity fund managers, and had an implementation date of 2013, with transitional provisions expiring in 2014.6
Some practitioners7 and academics8 have argued that the AIFMD represents poor regulation, even if most acknowledge that the final version of the Directive was manageable and not as burdensome or restrictive as it might have been. It is certainly arguable that the Directive is an ill-conceived response that failed properly to identify the problems that it was seeking to address, and suffers from some ambiguous and anomalous drafting. However, with the rules now fully implemented and with the first review of the AIFMD underway at the time of writing,9 there is an opportunity to take stock and to seek some empirical evidence on the impact of the AIFMD on the industry, both in terms of consequential changes to the operations of fund managers and the funds they manage and the impact of the new regulatory regime on European institutional (or professional) investors. Not only is that an important exercise for the EU regulators, but it will also be of great interest to the Financial Conduct Authority (the “FCA,” the relevant UK regulator) as it decides how to regulate the fund management sector in a post-Brexit world.
75This chapter will briefly review the main regulatory objectives of the AIFMD, insofar as they are capable of being discerned, and suggest an implied research agenda.
Scope of the Directive and the costs of opting in
The Directive seeks to regulate all alternative investment fund managers (each an AIFM)10 operating or marketing funds in the EU,11 but with a registration-only requirement for fund managers with assets under management (“AUM”) falling below a certain size threshold. Fund managers with AUM below the threshold are, in fact, exempt from almost all of the Directive’s requirements because they are “unlikely to have individually significant consequences for financial stability,”12 An EU-based AIFM that is above the threshold must be authorized under the Directive (even if it does not wish to benefit from its passporting provisions), and its home state regulator must assess its ability to comply with the Directive’s requirements. Its regulator will also assess the suitability of those running the business of the EU-based AIFM and its substantial shareholders. Certain provisions of the Directive (for example, those relating to controlled European portfolio companies and regulatory reporting) also apply to AIFMs established outside the EU if they have actively marketed their fund within the EU under national fund marketing rules.
The thresholds themselves differ according to the characteristics of the funds managed by the fund manager but, unfortunately, because of the uncertainty relating to the definition of “leverage” in the Directive (see further later), it is not always entirely clear which of the thresholds applies. The basic threshold is AUM of €100 million, with a higher value of €500 million set for managers of funds that are “unleveraged” and that offer no redemption rights exercisable for the first five years after initial closing. It seems clear that the higher threshold was intended to cover PE and venture capital funds, but adoption of the concept of leverage as a distinguishing feature of such funds is not entirely satisfactory.
The definition of AUM excludes undrawn commitments from investors, which means that when a fund is first raised it is likely to remain below the threshold and only exceed it as investments are made and/or increase in value. A manager must aggregate the AUM of all of the funds that it manages in order to determine whether it has exceeded the relevant threshold, although some transitional grandfathering provisions allow older funds to be excluded.
However, having excluded smaller fund managers from the scope of the Directive, a decision was also taken to exclude such managers from the EU’s single market.13 It is not entirely clear why the EU’s institutions decided that exclusion from the AIFMD on the grounds that smaller fund managers and their funds did not pose risks for financial stability also entailed excluding them from the benefit of the EU-wide passport that was made available to AIFMD authorized fund managers (see later). As a consequence of the implementation of the Directive into the national laws of the EU jurisdictions, the national private placement rules were revisited and redefined and, in a number of jurisdictions, no real consideration was given to the position of EU-based smaller fund managers. The Directive does allow smaller fund managers to opt into the Directive, accepting all of its obligations in return for the passport, and – to the extent that managers feel obliged to do so in order to benefit from the single market’s advantages – this would seem to impose de facto burdens and costs on fund managers (and ultimately their investors) that were not deemed to be necessary by the regulators. It would be interesting to identify the extent to which smaller fund managers have in fact voluntarily opted in to the Directive in this way and the burdens that it entails.
76Prevention of fraud or malpractice: the value of a depositary
Those who framed the AIFMD were clearly concerned by the risk of fraud or malpractice or dissipation of fund assets. Perhaps conscious of some high-profile cases involving hedge funds, including the Madoff fraud and the collapse of Lehman Brothers, various provisions of the AIFMD provide for significant regulatory oversight of fund managers and their operations. The most significant way in which the Directive seeks to achieve these objectives is through the fund manager’s obligation to engage a depository for each of its funds. Investors (who negotiate bespoke partnership agreements and insist on a wide range of investor protections) had typically required some outside financial oversight over the fund manager and the fund by an auditor (even if the domestic law did not require that), but had not typically required an outside custodian or a third party with a broader oversight function. However, the Directive imposes an obligatory gatekeeper role on an independent outsider, whose responsibilities extend significantly beyond safekeeping of assets.14
A depositary is generally required to be an EEA credit institution, an investment firm authorized under the Markets in Financial Instruments Directive (MiFID) that is subject to the same capital requirements as a credit institution, or a prudentially regulated and supervised institution that is eligible to be a depositary under the Undertakings for Collective Investment in Transferable Securities (UCITS) IV Directive. However, recognizing that such a strict set of eligibility requirements might be unnecessary for funds that do not have redemption rights within their first five years and do not generally invest in assets that require safekeeping (most notably PE funds), it is possible to appoint an alternative depositary, regulated in its own right. Many new entrants have ensured that there is a competitive market for alternative depositary services, and a significant number of PE funds have opted for such a solution.
The depositary is required to monitor fund cash flows, ensure that investor subscriptions and all funds are held in appropriately segregated accounts with an EU credit institution or similar institution, hold certain assets in custody and verify the ownership of “non-custody assets,” ensure compliance with certain of the fund’s rules, and perform certain other oversight tasks. The depositary has significant potential liability to investors in the event that these obligations are not complied with, although other than in relation to safekeeping of custody assets, liability only arises from intentional or negligent failures.
The requirement to appoint a depositary was one of the Directive’s most controversial provisions,15 particularly for UK-based managers who, unlike many in France and Luxembourg, were not familiar with such a requirement. There was a widespread view that the depositary would add cost and bureaucracy without significant additional protection for investors. A study that sought to measure the costs and benefits of the depositary function for PE fund managers, and the settled reaction of investors (who largely bear the costs) and fund managers, would make a helpful contribution to the evidence base.
Protecting investors: conduct of business rules
Apparently taking the view that investors in PE (and hedge) funds are not capable of negotiating appropriate terms in the bespoke partnership agreements that typically regulate their contract with the fund manager, the AIFMD seeks to regulate, through AIFMD-mandated standards of behaviors and conduct of business rules, certain aspects of the contractual bargain. No evidence was produced during the legislative process preceding the Directive to demonstrate a failure of contracting, and the requirements for optimal contractual bargaining would appear to be present.16
77The standards of behavior and conduct of business rules included in the AIFMD effectively supplement the content of the fund’s limited partnership agreement itself and are presumably intended to offer additional protection to investors.17 For example, the AIFM must “act honestly, with due skill, care and diligence and fairly in conducting their activities”; ensure that its governing body has appropriate skill and expertise, act in the best interests of the funds or their investors; establish policies and procedures to prevent malpractice; operate due diligence policies and practices; and manage conflicts of interests and treat investors fairly. Investors can only be given preferential treatment if this is fully disclosed, but the Directive goes further and actually prohibits certain terms even if they are contractually agreed: any “preferential treatment” given to one investor must not result in an “overall material disadvantage to other investors”18 (whatever that may mean). There are requirements to maintain a segregated risk management process;19 to undertake specified levels of due diligence before investment and to keep certain records;20 to develop and implement strategies on the exercise of voting rights;21 and to maintain and apply an appropriate best execution policy.22
The AIFMD also regulates the fees that may be earned by the fund manager and, once again, goes beyond establishing a default rule: it expressly prohibits certain practices even if disclosed to and agreed by investors. In particular, fees received from any third party are prohibited unless (among other things) they are “designed to enhance the quality of the … service” provided to the fund.23
Remuneration
The AIFMD also includes restrictions on the way in which senior fund management employees24 can be paid, largely following the content of rules originally drafted for the banking sector and now included in the Capital Requirements Directive.25 The purpose of the rules is to ensure that remuneration practices “are consistent with and promote sound and effective risk management and do not encourage risk-taking which is inconsistent with the risk profiles, rules or instruments of incorporation of the AIFs they manage”;26 in other words, to align the interests of the senior staff and the fund’s investors. There are no restrictions on the level of risk that can be taken by the fund manager in respect of its fund (subject to agreement with, and appropriate disclosure to, investors), so the need for prescriptive rules regulating, for example, the proportion of remuneration that can be paid as a bonus – rules that cannot be varied with investor consent – could restrict the ability of the fund manager and its senior staff to contractually agree appropriate remuneration policies.
In PE funds, it is typical for fund managers to receive a share of the profits of the fund, usually after the investors have received back their investment and an appropriate “preferred” return, which is known as “carried interest.” It is clear from the Guidelines issued by the European regulator,27 ESMA, that carried interest is, for AIFMD purposes, to be treated as “remuneration” and is therefore subject to the rules – although if the carried interest complies with specified criteria it will be deemed to fulfill certain of the requirements that would normally apply to variable remuneration.28 In addition, the UK’s FCA guidance on the application of the remuneration rules allows many fund managers to dis-apply certain rules applicable to variable remuneration on proportionality grounds.29 Nevertheless, the fact that certain aspects of the remuneration structure are fixed even if the investors and the manager wish to negotiate an alternative arrangement constrains contractual flexibility and could lead to suboptimal outcomes in certain circumstances. In practice, given the provisions relating to carried interest and the flexibility to dis-apply certain requirements on proportionality 78grounds, it seems unlikely that the rules have heralded any significant changes to practice, although research on the impact of the rules on remuneration practices would be valuable.
Valuation
PE fund managers typically value their portfolio companies periodically and report those values to their investors. Such valuation is clearly not straightforward, given that there may be no readily available market price for the underlying assets, and industry guidelines have been developed to assist valuers.30 Even though such valuations are rarely used to determine payouts to managers (because carried interest is paid only when profits are realized), the AIFMD adds its own requirements to those that are mandated by contractual agreement with the fund’s investors. In particular, the valuation and the portfolio management function must be independent of each other, with appropriate rules to mitigate conflicts of interest, or an external valuer must be used. It seems unlikely that many PE firms would have appointed an external valuer, or that they would have made any significant changes to internal valuation procedures, but it would be useful to see what impact the Directive has had in this regard.
Delegation
The Directive restricts the extent to which an EU-based AIFM is able to delegate its functions to a third party.31 The rules differ according to whether the manager is delegating one of its two core functions – risk management and portfolio management – or whether it is delegating other, non-core, services such as fund administration. For any delegation, the AIFM remains liable to the fund for adequate performance of the delegated matters and will need to notify its regulator and investors. In addition, the delegation must be objectively justifiable, undertaken after appropriate due diligence and the AIFM must retain oversight of the delegate. Specifically for risk or portfolio management, the EU-based AIFM cannot delegate to a depositary and can generally only delegate to regulated entities within the EU or those outside the EU where the relevant regulators have entered into a co-operation agreement.
General
Overall, whether investors draw additional comfort from these provisions, whether it has any discernible effect on their willingness to invest in PE funds, and whether any additional comfort that they do take is justified by the actual protection provided by the regulation, would be interesting research questions. It is plausible that the regulation encourages certain (less sophisticated) investors, relying on the regulated status of the manager, to invest in the asset class when they otherwise would not have done so and/or to negotiate weaker contractual protections than they otherwise might have done. If that is the case, there is a question as to whether any such reliance on the regulation is justified.
Regulatory capital
The Directive mandates fairly substantial capital requirements for fund managers,32 with an initial capital requirement of €300,000 for AIFMs of internally managed AIFs and €125,000 for AIFMs of externally managed AIFs. It is not clear why such high levels of capital are required for firms with little exposure on their balance sheet and whose activities 79are comparable to firms benefiting from lower capital requirements under MiFID (such as the €50,000 requirement for firms that do not hold client money or securities and do not deal on own account or underwrite on a firm commitment basis). If the capital requirement is designed to enable the orderly wind-down of a failed firm, the requirements imposed by the AIFMD would seem to be excessive, given that it is typical for the manager to have a regular income stream from the underlying fund that will generally be sufficient to fund its ongoing operating expenses and enable orderly wind-down should the firm fail. In the UK, before the AIFMD (and still for firms that are outside the scope of the AIFMD),33 the relevant capital requirement could be as low as £5,000, and the additional amount mandated by the Directive adds a significant cost to operating an authorized manager and could deter new entrants, especially since the requirement is to hold much of the capital in liquid assets. To give some idea of the extent of the ongoing requirement, an AIFMD-authorized manager of externally managed AIFs with assets under management of €1 billion could be required to hold liquid assets (which it could not use for the purposes of its own working capital) of around €325,000.34
Protecting the financial system
A desire to protect the financial system is evident in a number of the Directive’s provisions. There was a view among the legislators at the time the Directive was being discussed that, although they did not cause the financial crisis, hedge funds had amplified its severity and were a source of systemic risk. On the other hand, while it was clear that such charges could not be leveled at the PE industry, some argued that leverage at the level of a PE-backed portfolio company and a lack of transparency might pose a threat to financial stability in the future.35 For example, the ECB concluded that: “All in all, while the likelihood of LBO activity posing systemic risks for the banking sector appears remote at the EU level, the survey results underlined the fact that behind recent rapid growth in the market some pockets of vulnerability could be developing.”36
However, if these concerns about systemic risk did motivate the legislators, it is far from clear how effectively the final version of the Directive addresses them, which perhaps reflects the fact that the concerns were not well supported by evidence, and indeed were strongly disputed by the PE industry.37
The Directive does impose a certain level of disclosure (both to regulators38 and to investors39) on fund managers in relation to the amount and type of “leverage” employed by its funds, especially those that employ leverage on a substantial basis,40 although it does not directly limit the amount of leverage that a fund can take on. Instead, the fund manager must set and declare its own leverage limit,41 and the supervisors are therefore theoretically able to monitor the build-up of leverage in the system. National regulators are empowered to impose leverage limits when that is deemed necessary, and ESMA is given powers to “advise” national supervisors in that regard.42
However, the Directive itself left open the precise definition of leverage,43 which is dealt with in the Level 2 rules,44 and the resulting definition seems to disregard leverage taken on by a company owned by the fund, provided that there is no recourse to the fund for that debt.45 Such a position is entirely logical, because the other assets of the fund are not put at risk by a default on the part of the underlying company, and would appear to acknowledge the industry’s argument that the PE leverage model is not a source of systemic risk in itself.
This definition of leverage, and the exclusion of debt incurred by an underlying portfolio company, is important not just because it determines whether additional disclosures 80are required and the methods of calculating the ratios to be disclosed, but also because, if a fund is “unleveraged,” the manager may be able to benefit from the higher AUM thresholds referred to above. Unfortunately, there appear to be a number of other problems with the methods of calculation mandated by the Commission that may confound the apparent intention of the draftsperson. A rigorous analysis of these calculation methodologies and their implications for funds would be useful, and may help regulators to make sense of the information they receive in respect of leveraged funds.
In addition to rules relating to leverage reporting, the Directive also includes requirements for an AIFM to report regularly to national regulators on a range of other matters. In general, the frequency of such reporting depends upon the AUM of the AIFM, but AIFMs that only manage unleveraged funds investing in non-listed companies (intended as a proxy for PE funds) need only report annually. Regulator reporting is quite a burdensome process – the reporting template is quite detailed, including (for example) information on investments made, the strategies of the fund, and the markets on which it trades.
Protecting employees and stakeholders more generally
Legislators expressed some concerns during discussions about the AIFMD that PE-backed companies could have their capital depleted by the PE fund, weakening the company’s own long-term prospects,46 and the lack of disclosure required from these large companies had also given rise to concerns that, in the UK, the industry had addressed this voluntarily through the Walker Guidelines on Disclosure and Transparency in Private Equity.47 In fact, these concerns, rather than concerns about systemic risk, appear to have been more prevalent in the debates about PE (as opposed to hedge funds) and were taken up by a number of European trade unions and politicians.
As a result, although the Directive does not directly regulate PE-backed companies, it does impose various obligations on an EU-based AIFM in relation to EU-based companies controlled by a fund or funds that it manages (either alone or jointly with another fund).48 With exclusions for SMEs,49 the fund manager is required to disclose its stake in an EU-based portfolio company when it reaches certain ownership thresholds, and must make additional disclosures to an unlisted company and its shareholders, and the regulator, when the fund owns more than 50% (or 30% for a listed company).50 In addition, on the acquisition of control of an EU-based company (listed or unlisted), the AIFM must disclose its policy for preventing and managing conflicts of interest and “the policy for external and internal communication relating to the company in particular as regards employees”; for private companies, the intentions for the business and likely repercussions on employment must also be given. The AIFM is obliged to make efforts to ensure that these communications are passed to employees or their representatives, and (for a private company) is also required to give information on the financing of the acquisition to the AIFM’s regulator and the fund investors.
There are also continuing obligations: an affected unlisted company’s annual report, or that of the fund manager, must include a fair review of the development of the company’s business, details of important events since the end of the financial year, and information relating to share buybacks and the company’s likely future development. Again, efforts must be made to make this information available to employees and to the fund’s investors.
It might be doubted that these requirements have had any meaningful impact on the relationships among a fund manager, a portfolio company acquired by its fund, and the company’s shareholders and employees, or whether they have improved the quality of information relayed to the fund investors, but research on that question would be valuable.
81Another impact of the Directive for an EU-based AIFM was the introduction of new rules restricting certain distributions to shareholders of European portfolio companies controlled by one of its funds. Again, the regulation affects the AIFM rather than the underlying company, and mandates the manager to vote against, or otherwise take steps to prevent, certain distributions, capital reductions, share redemptions, or share buybacks for a period of two years after the initial acquisition of control unless (in the case of a distribution) the proposed distribution does not cause net assets to fall below the subscribed capital and is made from net profit. The rules are poorly drafted and include a number of ambiguities that make their application hard to understand in many situations and give rise to potentially perverse effects. However, they appear to aim to prevent a situation that was in any case rather rare and so may not have had any significant effect on behavior.
The passport
As we have seen, the Directive imposes considerable additional regulation on an EU-based AIFM. However, in return, such a fund manager receives a significant benefit: the right to manage and market its funds freely across the EU, without requiring any separate authorization in any other member state.51 In reality, the passport has proved less seamless than might have been hoped, with a number of member states imposing fees on AIFMs that make use of the marketing passport in their territory. However, the alternative – a patchwork of national regulations that enable AIFs to be marketed to domestic investors to varying degrees – is generally more costly to navigate when a manager wishes to raise money from investors in a variety of EU countries and, consequently, an EU-based AIFM generally is able to market to investors more easily than an out-of-scope fund manager (unless such fund manager opts in or qualifies for a passport under separate regimes applicable to venture capital and social entrepreneurship funds)52 or one that is based in a non-EU country. Whether this benefit outweighs the costs of the Directive for the fund manager concerned would be an interesting research question, and an analysis of the fund managers that are outside the scope of the Directive but that have chosen to opt in could be a valuable way to analyze it.
As mentioned earlier, it remains unclear why smaller buyout fund managers, whose lack of systemic importance is acknowledged by the Directive, are not able to benefit from access to the single market on a passported basis, but, despite some proposed reforms to the venture capital and social entrepreneurship regulations, there do not seem to be any immediate plans to bring forward a more generalized passport for EU firms that pose no risk to financial stability and that are therefore excluded from pan-European regulation. If the costs of that were better understood, the data could help persuade the EU institutions to alter their current approach.
One important, unresolved issue arising from the AIFMD is the availability of a marketing passport for non-EU-based fund managers (and for EU-based fund managers who wish to market a non-EU AIF). According to the terms of the Directive,53 such a passport should have been made available under delegated acts following positive advice from ESMA, which was to be delivered by July 2015. In fact, ESMA did provide some advice in accordance with those provisions in relation to six countries, but the Commission opted to defer the passport while ESMA expanded its analysis.54 In September 2016 ESMA issued revised advice,55 the substance of which was that there are no significant barriers to an extension of the passport to a number of non-EU countries, including Switzerland and the Channel Islands. However, notwithstanding that advice and the provisions of the Directive, which would appear to require the Commission to draft a delegated act, the third country passport has so far not 82been made available.56 There is some speculation that the delay is a reaction to Brexit, on the basis that it would be very difficult to deny the passport to UK-based managers after the UK leaves the EU if it has been made available to fund managers in other non-EU countries. A recent speech by Steven Maijoor, Chairman of ESMA,57 also suggests that the EU may take a more restrictive stance towards equivalence and be less willing to grant equivalence decisions to third country jurisdictions that enable firms from those jurisdictions to provide services in the EU on a cross-border basis without a license. Although the comments were made in the context of the equivalence regime for central counterparty clearinghouses, they could equally apply to the other equivalence regimes contained in recent financial services legislation.
The impact of the lack of a passport for non-EU fund managers, combined with the difficulties in accessing European investors under the patchwork of national private placement rules that are now in place, may be having a significant impact on the level of access European-based investors have to non-EU fund managers and their funds. While it is clear that some non-EU fund managers might be willing to navigate the domestic rules in some EU countries (especially those that have a relatively high number of prospective investors and relatively straightforward marketing rules, like the UK), it seems plausible that many will simply avoid marketing to European investors in some jurisdictions (or perhaps in most or all jurisdictions) given the costs associated with doing so. On the other hand, the costs of accessing the passport – if it were to be made available – would also be significant, and might be prohibitive for a fund manager raising capital for its fund largely from non-EU investors. Implementing a passport and then closing down national private placement rules, as envisaged by the Directive,58 could therefore make the position worse for EU investors. Research on the likely impact of the continuing delay in implementing the third country passport could help to shed light on this question, and might also inform the approach that is taken to the arrangements between the EU and the UK in a post-Brexit world.
Conclusions
The Directive sought to achieve multiple, unrelated objectives within a single piece of legislation. Although the primary aim was to harmonize regulation of private funds at a pan-European level and provide a passport in respect of private funds where none existed before, the Directive also sought to achieve additional objectives related to investor protection, financial stability, and portfolio company governance. It is questionable whether such unrelated objectives have been satisfactorily addressed in the Directive or whether it would have been better to confine the Directive to a narrower set of objectives. The EU has developed a sophisticated framework for financial stability, with the European Systemic Risk Board working together with the European Supervisory Authorities to monitor risks to financial stability and adopt measures that are more suitable for addressing financial stability and macro-prudential concerns than the hard-wired requirements in the AIFMD. Corporate governance regulation is also evolving in the EU, and it is far from clear that inflexible requirements in a Directive principally aimed at imposing authorization and business conduct requirements for private fund managers are the best way to achieve protection for investee companies and their stakeholders. It is particularly difficult to see why such protection, if necessary at all, should be triggered by the fact that the relevant fund is subject to the AIFMD.
83Notes
1 The authors are grateful to Aatif Ahmad, International Counsel, Debevoise & Plimpton for his assistance in the preparation of this chapter.
2 Although there was an absence of targeted, industry-specific regulation, many activities of PE fund managers were, of course, subject to regulation, and it would perhaps be misleading to say that they were “unregulated” – see Duncan et al. (2011).
3 It was not only EU regulators that came to this conclusion: The Dodd-Frank Act, passed in the US in 2010, also regulates PE fund managers, and because many European PE managers raise significant funds from US investors, some aspects of the US regulations cover some European managers as well as those based in the US.
4 Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers.
5 The AIFMD is supplemented by Level 2 Regulations (Commission Delegated Regulation (EU) No 231/2013 of 19 December 2012), hereafter “Level 2,” and was implemented in the UK by The Alternative Investment Fund Managers Regulations 2013 (SI 2013 / 1773) and the rules and guidance of the FCA (as set out principally in the FUND sourcebook of the FCA Handbook).
6 See Article 66 (setting a deadline for transposition by member states of 22 July 2013) and Article 61 (providing for a one-year period after transposition for managers to become authorised).
7 See, for example, Funds flee offshore to evade ‘bad’ regulation, Financial Times, October 16, 2011, available at: www.ft.com/content/60642840-f5b4-11e0-be8c-00144feab49a.
8 See, for example, Payne (2011), who argues (p. 585) that PE was swept into a regulatory agenda which will add costs and put it at a competitive disadvantage, even though “the justifications for the regulation of PE at EU level are much weaker than in relation to hedge funds.” For further discussion of the background to and the reasons for regulating the PE and hedge fund industries, as well as a comprehensive analysis of the AIFMD’s main provisions, see Ferran (2011). For a review of the legislative process, see James (2014).
9 AIFMD Article 69, which reads: “By 22 July 2017, the Commission shall, on the basis of public consultation and in the light of the discussions with competent authorities, start a review on the application and the scope of this Directive. That review shall analyse the experience acquired in applying this Directive, its impact on investors, AIFs or AIFMs, in the Union and in third countries, and the degree to which the objectives of this Directive have been achieved.”
10 Some of the critical definitions in the AIFMD, including that of an “alternative investment fund” (or AIF), are notoriously difficult to apply at the margins. In broad terms, the AIFMD Article 4(1) (a) defines an AIF as a collective investment undertaking that raises capital from a number of investors, invests in accordance with a defined investment policy, and is not regulated under the UCITS Directive (2009/65/EC), and an AIFM is a manager of such a fund.
11 Technically, the territorial scope of the AIFMD is the EEA, which is the EU plus Norway, Iceland, and Lichtenstein. However, the terms of the implementation of the Directive in some EU countries, and the delayed implementation in some EEA states, has made the position rather complicated, and for the purposes of this chapter we have referred to the territorial scope as “the EU.”
12 AIFMD Recital 17 and Article 3.
13 Unless the fund manager falls within the regimes applicable to venture capital funds and social entrepreneurship funds; see footnote 53 below.
14 AIFMD Article 21.
15 See Ernst & Young (2012: 22).
16 Various academic analyses of venture capital and PE limited partnerships suggest that sophisticated and bespoke contracting does take place – see, for example, Gompers and Lerner (1996) and Metrick and Yasuda (2010). See, however, Phalippou et al. (2015) for evidence that regulatory intervention has altered the negotiated outcome in relation to fees charged and retained by PE managers.
17 AIFMD Article 12.
18 Level 2 Article 23.
19 AIFMD Article 15.
20 Level 2 Articles 18 and 19.
21 Level 2 Article 37.
22 Level 2 Article 27.
8423 Level 2 Article 24.
24 The rules apply to staff of the AIFM whose activities have a material impact on the risk profile of the fund manager and the funds it manages.
25 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013.
26 AIFMD Article 13.
27 ESMA, Guidelines on sound remuneration policies under the AIFMD, available at: www.esma.europa.eu/sites/default/files/library/2015/11/2013-232_aifmd_guidelines_on_remuneration_-_en.pdf.
28 ESMA, Guidelines on sound remuneration policies under the AIFMD, ibid., at paragraph 159 on p. 32.
29 FCA, General guidance on the AIFM Remuneration Code (SYSC 19B), available at www.fca.org.uk/publication/finalised-guidance/fg14-02.pdf.
30 See International Private Equity and Venture Capital Valuation Guidelines, December 2015, available at www.privateequityvaluation.com/download/i/mark_dl/u/4012990401/4625734325/151222%20IPEV%20Valuation%20Guidelines%20December%202015%20Final.pdf.
31 AIFMD Article 20.
32 The capital requirements are set out in Article 9 of the AIFMD.
33 The capital requirements for a “small authorised UK AIFM” are set by the Financial Conduct Authority and set out in the relevant rulebook: IPRU-INV 5.4.
34 See Invest Europe’s Guide to the AIFMD, AIFMD Essentials, published July 2013 and available at: www.investeurope.eu/policy/evca-publications/#i, p. 30. This calculation assumes that one-quarter of fixed overheads would be €225,000 and that the AIFM would choose to hold additional capital instead of maintaining professional indemnity insurance to meet the Directive’s requirements.
35 See, for example, the influential report produced by the PSE (Socialist Group in the European Parliament), Hedge Funds and Private Equity – A Critical Analysis, available at: www.socialistsanddemocrats.eu/sites/default/files/2239_EN_publication_hedge_funds_1.pdf; Draft Report of the European Parliament (Committee on Economic and Monetary Affairs) with recommendations to the Commission on hedge funds and private equity (2007/2238(INI)), April 2008, available at www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//NONSGML+COMPARL+PE-404.764+01+DOC+PDF+V0//EN&language=EN, p. 14; Ferran (2011: 382–385) and, more recently, the Bank of England’s Quarterly Bulletin 2013 Q, Private equity and financial stability, available at www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2013/qb130104.pdf.
36 The European Central Bank, Large banks and private equity-sponsored leveraged buyouts in the EU, April 2007, available at: www.ecb.europa.eu/pub/pdf/other/largebanksandprivateequity200704en.pdf.
37 See EVCA, Private equity and venture capital in the European economy – An industry response to the European Parliament and the European Commission, February 2009, available at: www.investeurope.eu/uploadedfiles/news1/news_items/evca_submission_to_ec_and_ep_fullpaper.pdf. Many argued that, if there were concerns that banks were over-exposed to the debt of PE-backed companies, that concern should be dealt with by banking regulation and not at the borrower level.
38 AIFMD Article 24.
39 AIFMD Article 23.
40 Level 2 Article 111 stipulates that leverage employed on a substantial basis arises where the exposure of the AIF exceeds three times its net asset value.
41 AIFMD Article 15(4).
42 AIFMD Article 25.
43 AIFMD Article 4(v) defines leverage as “any method by which the AIFM increases the exposure of an AIF it manages whether through borrowing of cash or securities, or leverage embedded in derivative positions or by any other means,” and Article 4(3) mandates delegated acts to further specify the methods of calculating leverage, including “any financial and/or legal structures involving third parties controlled by the relevant AIF.”
44 Level 2 Section 2.
45 Level 2 Article 6(3) says: “For AIFs whose core investment policy is to acquire control of non-listed companies or issuers, the AIFM shall not include in the calculation of the leverage any exposure that exists at the level of those non-listed companies and issuers provided that the AIF or the AIFM acting on behalf of the AIF does not have to bear potential losses beyond its investment in the respective company or issuer.” ESMA’s Q&A on the AIFMD, Section VII: Calculation of leverage, updated in May 2015 (available at www.esma.europa.eu/file/20454/download?token=hLXnqKCi, confirms that interpretation.
46 See, for example, PSE (Socialist Group in the European Parliament), Hedge Funds and Private Equity – A Critical Analysis, available at: www.socialistsanddemocrats.eu/sites/default/files/2239_EN_publication_hedge_funds_1.pdf; Draft Report of the European Parliament (Committee on Economic and Monetary Affairs) with recommendations to the Commission on hedge funds and private equity (2007/2238(INI)), April 2008, available at www.europarl.europa.eu/sides/getDoc.do?pubRef=-//EP//NONSGML+COMPARL+PE-404.764+01+DOC+PDF+V0//EN&language=EN, p. 14. See also Ferran (2011: 386–387).
47 See http://privateequityreportinggroup.co.uk/.
48 AIFMD Articles 26–30.
49 SMEs are as defined in Article 2(1) of the Annex to Commission Recommendation 2003/361/EC of 6 May 2003 concerning the definition of micro, small and medium-sized enterprises and, broadly, are companies with less than 250 employees and either turnover equal to or less than €50 million or a balance sheet total equal to or less than €43 million.
50 In fact, the threshold for a listed company will vary from country to country, as these are specified by the member state under Article 5(3) of the Takeover Directive (Directive 2004/25/EC). In the UK, the relevant threshold is 30%.
51 AIFMD Articles 32 and 33.
52 Regulation (EU) No 345/2013 of the European Parliament and of the Council of 17 April 2013 on European venture capital funds and Regulation (EU) No 346/2013 of the European Parliament and of the Council of 17 April 2013 on European social entrepreneurship funds.
53 AIFMD Article 67.
54 www.esma.europa.eu/sites/default/files/library/eu_commission_letter_aifmd_passport.pdf.
55 www.esma.europa.eu/press-news/esma-news/esma-advises-extension-funds-passport-12-noneu-countries. The original advice was issued in July 2016, but updated in September.
56 While the Commission appears to be obliged to adopt the delegated act extending the passport once it receives positive advice, ESMA left the door open for the Commission to delay the delegated act by stating in its advice that the Commission may “wish to consider whether to wait until ESMA has delivered positive advice on a sufficient number of non-EU countries before triggering the legislative procedures [to adopt the delegated act].”
57 See www.esma.europa.eu/press-news/esma-news/steven-maijoors-address-alde-seminar-review-european-supervisory-authorities.
58 AIFMD Article 68.
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