The European Commission adopted a Regulation supplementing the Alternative Investment Fund Managers Directive. With the AIFMD, all investment funds in the EU fall into one of the following two categories: They are either UCITS (undertakings for collective investment in transferable securities) or hedge funds and other types of alternative investment funds. UCITS funds are governed by the UCITS Directive (2009/65/EC) and are authorized for sale to the retail market.
Following its implementation, the AIFMD will introduce authorization and regulation requirements for hedge funds and private equity funds and regulatory standards for depositaries and administrators; minimum capital requirements related to portfolio size, governance and risk management requirements for fund managers. The Directive will also allow EU-wide marketing of hedge funds through a passport scheme, initially for EU fund managers only, and then to be extended to non-EU based fund managers two years later. EU Member States must transcribe the AIFMD into their respective national laws by July 22, 2013.
The Regulation clarifies the general duty of hedge fund managers and other alternative investment fund managers to act in the best interests of the fund and fund investors and the integrity of the market. It clarifies the scope of due diligence in general and the scope of due diligence which should be applied if investments are made in assets of limited liquidity and where fund managers are selecting and appointing counterparties and prime brokers. The Regulation sets out rules on inducements and handling of orders, including reporting obligations in respect of execution of subscription and redemption orders, and rules on placing orders to deal on behalf of hedge and private equity funds with other entities for execution and aggregation and allocation of orders.
The Regulation specifies the types of conflicts of interest that may arise and sets out a conflict of interests policy which includes procedures and arrangements that fund managers are expected to implement and apply in order to identify, prevent, manage, monitor and disclose conflicts of interest.
The Regulation lays down rules concerning the risk management system that should be established and applied by fund managers. The system comprises the organizational structure, policies and procedures for managing the risks relevant to each fund’s investment strategy and the processes and techniques used to measure and manage those risks. The Regulation requires a permanent risk management function to be established and entrusts it with specific tasks, including the implementation of the risk management policy, risk monitoring and measuring the risk level and ensuring that it complies with the fund’s risk profile. The Regulation also requires the functional and hierarchical separation of the risk management function from operating units and specifies safeguards against conflicts of interest which should ensure that the risk management activities are carried out independently.
The fund manager must ensure that, for each fund it manages, appropriate and consistent procedures are established so that an independent valuation of the fund’s assets can be performed in accordance with Article 19 of the AIFMD and the applicable national rules. The Regulation requires the fund manager to establish and implement for each fund policies and procedures for the valuation of assets, and lays down the main features of such valuation policies and procedures. Specific rules are adopted for the use of models for valuing asset. There must be periodic review of valuation policies and procedures, as well as a review of individual values of assets, the calculation of the net asset value per unit or share, and the professional guarantees to be provided.
Under the Regulation, in calculating total assets under management, the preference is to use the value of all assets managed by the fund manager without deducting liabilities and valuing financial derivative instruments at the value of an equivalent position in the underlying assets. Valuing financial derivative instruments as if the underlying assets were acquired by the fund reflects the fund’s exposure to these assets.
With regard to the calculation of leverage, the preferred option is to combine the so-called gross and the commitment methods, The leverage ratios that result from applying the gross method are consistent with the objective to monitor macro-prudential risks. The commitment method is well established and recognized in the asset management sector. Its results can be easily compared with those for UCITS funds. It provides, in particular when combined with the gross method, a good insight into the investment strategies and exposure of hedge funds and private equity funds relevant for both investors and supervisors.
In case of proven necessity for an additional method to better apprehend systemic risk, the precise parameters of such an advanced method should be established by EMSA. This method would then be adopted by modifying the delegated act. Recourse to an advanced method must not obviate the calculation of leverage according to the gross and commitment method, noted the Commission, both remain obligatory for all hedge fund and other alternative fund managers.
All financial instruments which can be registered in a financial instruments account, essentially, transferable securities, money market instruments units in collective investment undertakings, and which belong to a hedge fund or private equity fund must be held in custody. Alternative investment funds may not be excluded from the scope of custody simply because they are the subject of a security interest collateral arrangement. Therefore, should a hedge fund provide its assets as collateral to a collateral taker, the AIFMD requires that these assets remain in custody, except if the fund transfers ownership of the collateralized assets to the collateral taker.
Custody of the collateralized fund assets can be ensured in three ways: (1) the collateral taker is appointed custodian over the collateralized fund’s assets; (2) the fund’s depositary appoints a sub-custodian that acts for the collateral taker or (3) the collateralized assets remain with the fund’s depositary and are earmarked in favor of the collateral taker. All of the above custody arrangements reflect industry practice to ensure that the depositary is not liable for the return of assets that are beyond its control. In addition, the proposed approach, in line with the AIFMD, does not require that a central counterparty become a sub-custodian.