AIFMs which are fully authorised under AIFMD are subject to detailed rules regarding delegation of their functions, which are set out in Article 20 of AIFMD and Articles 75 to 82 of the Level 2 Regulations.
ESMA has gone further in its ESMA Q&A guidance, indicating that when a third party performs any of the functions stated in Annex I of AIFMD, then those functions should be deemed to have been delegated by the AIFM to the third party, and the AIFM is therefore responsible for compliance with the AIFMD delegation rules in relation to that appointment. This implies that service providers such as administrators should be appointed by the AIFM rather than directly by the AIF, and that the AIFM should retain responsibility for the performance of their functions. In practice, regulators have taken differing approaches to the application of this guidance.
Requirements applicable to delegation generally
The AIFM's liability towards the AIF and its investors will not be affected by the fact that the AIFM has delegated functions to a third party, or by any further sub-delegation.
The home regulator of the AIFM must be notified before any delegation or sub-delegation arrangements become effective. This also applies to the intended delegation of administration, marketing or activities related to the assets of the AIF for which the AIFM is responsible. In addition, the AIFM’s prior consent is required in respect of any further sub-delegation arrangements.
Article 75 of the Level 2 Regulations sets out some general principles with which AIFMs must comply when delegating. In particular, the Level 2 Regulations require that the delegation arrangement takes the form of a written agreement between the AIFM and the delegate. The agreement must set out:
- rights of the AIFM: the AIFM’s right to information and of inspection, admission and access, as well as its instruction and monitoring rights against the delegate. The respective rights and obligations of the AIFM and the delegate must be clearly allocated and set out in the agreement. In particular, the AIFM’s termination rights, its rights to information, and its right to inspect and access books and premises should be set out in the agreement; and
- sub-delegation: the agreement must ensure that sub-delegation can only take place with the consent of the AIFM. Such consent shall be provided by the AIFM in writing – a general consent given in advance is not sufficient for these purposes.
The conditions to delegation (or any sub-delegation) are as follows:
- the AIFM must be able to justify its entire delegation structure with objective reasons. The following criteria must be considered: (a) optimisation of business functions and processes; (b) cost saving; (c) expertise of the delegate in administration or in specific markets or investments; and (d) access of the delegate to global trading capabilities, and the AIFM may be required by competent authorities to provide further explanations and provide documents proving that the entire delegation structure is based on objective reasons;
- the delegate must have sufficient resources to perform the delegated tasks and the persons who effectively conduct the business of the delegate must be of sufficiently good repute and sufficient experience. The Level 2 Regulations provide additional detail, noting that, unless there is evidence to the contrary, persons shall be considered to be of sufficiently good repute if they are regulated in respect of their professional services in the EU and the relevant supervisory authority reviewed the “good repute” criterion in its authorisation procedure. However, persons will not be deemed of sufficiently good repute if they have “any” negative records relevant for the assessment of good repute and the performance of the delegated tasks, or if there is other relevant information affecting their good reputation. For these purposes, special attention is given to any offences related to financial activities, such as those relating to money laundering, dishonesty, fraud or financial crime, bankruptcy or insolvency. Other relevant information includes information that indicates the person is not trustworthy or honest. The delegate must have an appropriate organisational structure to support the performance of the delegated tasks;
- the delegation must not prevent the effectiveness of supervision by the AIFM. This will be deemed not to be the case where:
- the AIFM, its auditors and the competent authorities do not have effective access to data related to the delegated functions and to the business premises of the delegate, or the competent authorities are not able to exercise those rights of access;
- the delegate does not co-operate with the competent authorities of the AIFM in connection with the delegated functions; or
- the AIFM does not make available on request to the competent authorities all information necessary to enable authorities to supervise the compliance of the performance of the delegated functions with the requirements of AIFMD and its implementing measures;
- the delegation must not prevent the AIFM from acting, or the AIF from being managed, in the best interests of the AIF or its investors. Article 80 of the Level 2 Regulations sets out the position on conflicts of interest on delegation in detail;
- the AIFM must be able to demonstrate that the delegate is qualified and capable, it selected the delegate with all due care, it can effectively monitor the delegate, give further instructions to the delegate at any time and can withdraw the delegation with immediate effect when this is in the interests of investors; and
- in order to ensure continuity of delegation functions, the AIFM is required to ensure that the delegate establishes, implements and maintains a contingency plan for disaster recovery and periodic testing of backup facilities while taking into account the types of delegated functions. Further, in the event of termination of the delegation, the AIFM must ensure the continuity and quality of the delegation functions either by transferring the delegated functions or the delegated task of carrying out functions to another third party or by performing them itself.
Specific requirements for delegation of portfolio management and risk management
Where the delegation concerns portfolio management or risk management:
- if the delegate is an entity that is not authorised for asset management and subject to supervision, prior approval from the AIFM’s home regulator is required. Entities that are deemed to be authorised or registered for these purposes are:
- management companies authorised under the UCITS Directive;
- investment firms and credit institutions (authorised under CRD IV) authorised to perform portfolio management functions under MiFID II;
- external AIFMs authorised under AIFMD; and
- non-EU entities authorised or registered for the purposes of asset management and effectively supervised by a competent authority in such country;
- if the delegate is a non-EU entity, a written co-operation arrangement must be in place between the AIFM’s home state regulator and the supervisory authorities of the delegate, which satisfies the requirements set out in the Level 2 Regulations; and
- the ESMA Remuneration Guidelines state that where an AIFM delegates portfolio management or risk management activities, it must ensure that:
- the delegate is subject to regulatory requirements on remuneration that are equally effective as those applicable under the guidelines; or
- appropriate contractual arrangements are put in place to ensure that the delegate undertakes to comply with AIFMD-equivalent remuneration requirements
Click here for more information in relation to the rules and guidance relation to remuneration under AIFMD.
The portfolio management and risk management functions cannot be delegated to the depositary or a delegate of the depositary of the AIF in question.
The portfolio management and risk management functions cannot be delegated to any other entity whose interests conflict with those of the AIFM or the investors, unless such entity has functionally and hierarchically separated the performance of the portfolio management and risk management from its other potentially conflicting tasks and potential conflicts of interest are properly identified, managed, monitored and disclosed to investors. Article 80 of the Level 2 Regulations describes the conditions for establishing that portfolio management and risk management functions are functionally and hierarchically separated.
As a consequence of the United Kingdom’s withdrawal from the European Union, the United Kingdom is now a “third country” for purposes of AIFMD. Accordingly, if an EU AIFM wishes to delegate portfolio management or risk management functions to a UK entity, the AIFM must comply with the requirements for delegation to non-EU entities summarised above. See here for more details.
AIFMs are prohibited from delegating their functions to the extent that, in essence, they can no longer be considered to be the manager of the AIF in question and become a “letter-box entity”. The Level 2 Regulations contain detailed rules regarding where an AIFM will be deemed to be a “letter-box entity” and hence no longer considered to be the manager of the AIF as a result of delegation. This will occur if:
- the AIFM no longer retains the necessary expertise and resources to supervise the delegated tasks effectively and manage the risks associated with the delegation;
- the AIFM no longer has the power to take decisions in key areas which fall under the responsibility of the senior management or no longer has the power to perform senior management functions in particular in relation to the implementation of the general investment policy and investment strategies;
- the AIFM loses its contractual rights to inquire, inspect, have access or give instructions to its delegates or the exercise of such rights becomes impossible in practice; or
- the AIFM delegates the performance of investment management functions to an extent that exceeds the investment management functions performed by the AIFM itself by a substantial margin. When assessing the extent of delegation, competent authorities will assess the entire delegation structure taking into account not only the assets managed under delegation but also the following qualitative criteria:
- the types of assets the AIF or the AIFM acting on behalf of the AIF is invested in, and the importance of the assets managed under delegation for the risk and return profile of the AIF;
- the importance of the assets under delegation for the achievement of the investment goals of the AIF;
- the geographical and sectoral spread of the AIF's investments;
- the risk profile of the AIF;
- the type of investment strategies pursued by the AIF or the AIFM acting on behalf of the AIF;
- the types of tasks delegated in relation to those retained; and
- the configuration of delegates and their sub-delegates, their geographical sphere of operation and their corporate structure, including whether the delegation is conferred on an entity belonging to the same corporate group as the AIFM.
Where an AIFM manages multiple AIFs, when assessing whether the AIFM is a “letter-box entity”, the assessment should be carried out at the level of each individual AIF and not in relation to a group of AIFs.
It is worth noting that Article 82(1) of the Level 2 Regulations does not state that an AIFM will only constitute a letterbox entity where it has delegated portfolio management and/or risk management. This suggests that an AIFM may become a letterbox entity even where it has retained the performance of both of these functions, for example where, as a result of the delegation, it no longer has the power to take decisions in key areas which fall under the responsibility of the senior management.