AIFMs which are fully authorised under the Directive are subject to detailed rules regarding operating conditions (including with respect to conduct of business, managing conflicts of interest, risk management, liquidity management and investing in securitisation positions) and with respect to their internal organisation.
Conduct of business: general principles
The Directive contains a broad set of general principles that an authorised AIFM must comply with, including the requirement to act honestly and fairly and in the best interests of the relevant AIF (or its investors) and the integrity of the market when conducting its business activities and to take reasonable steps to avoid conflicts of interests and treat all investors fairly (which entails that no investor in an AIF may get preferential treatment unless disclosed in the AIF’s rules/instrument of incorporation).
Chapter III of the Level 2 Regulations provides a much greater level of detail in respect of the procedures, policies and internal structures (for example separation of personnel carrying out risk functions with the operating units of the AIFM) an authorised AIFM will need to introduce / maintain to comply with the above general principles. The Level 2 Regulations stipulate the frequency with which an authorised AIFM must review such procedures and policies and when the senior management of an authorised AIFM should be involved in such decision making. The Level 2 Regulations also contain lists of the factors that an authorised AIFM must take into account when carrying out certain functions as well as detailing the specific information that must be recorded for various transactions.
Some key points to note are as follows:
in respect of an authorised AIFM permitted to carry out discretionary portfolio management, such AIFM is required to gain the prior approval of its client before investing all or part of the client’s portfolio in units or shares of an AIF it manages;
authorised AIFMs are required to ensure that investors in the AIFs they manage are not charged undue costs;
authorised AIFMs are required to apply a high standard of diligence in the selection and monitoring of investments;
in respect of all assets, an authorised AIFM must implement, review and update written due diligence procedures. Special due diligence requirements are in place when investing in assets of limited liquidity - authorised AIFMs are required to prepare, update and monitor compliance with a business plan consistent with the duration of the AIF and market conditions, and assess the transaction relating to such asset in light of all relevant legal, tax, and financial considerations, including consideration of any exit strategies relating to such assets. The AIFMs must retain records relating to such assessments for a period of five years;
authorised AIFMs must exercise due skill, care and diligence in the selection and appointment of prime brokers and the terms of such appointment shall be set out in a written contract. The written contract must make note of any possibility of transfer and reuse of AIF assets and require the depositary to be informed of the existence of the contract. In addition, when entering into any agreements with prime brokers or counterparties in over-the-counter derivatives transactions, securities lending transactions or repurchase agreements, authorised AIFMs must ensure such parties are subject to ongoing supervision by a public authority (and are subject to prudential regulation), are financially sound and have the necessary organisational structure and resources for performing the services for which they are engaged;
as part of the duty of an authorised AIFM to act honestly, fairly and with due skills, competent authorities may assess whether the members of the governing body of an authorised AIFM commit sufficient time to perform their functions and whether adequate resources are devoted to the training of such members;
the decision making procedures and organisational structure of an authorised AIFM should ensure fair treatment of investors. Any preferential treatment accorded by an authorised AIFM to one or more investors should not result in an overall material disadvantage to other investors; and
as part of the duty of an authorised AIFM to act honestly, fairly and with due skills, such AIFM should ensure that when carrying out their functions, they are not paid any fee, commission or non-monetary benefit other than (i) from the AIF; (ii) where the nature, existence or amount of such fee, commission or non-monetary benefit is disclosed to investors and the provision of such fee, commission or non-monetary benefit is designed to enhance the quality of the relevant service being provided; or (iii) the provision of such fee, commission or non-monetary benefit as is necessary for the provision of the relevant services, including custody, settlement, regulatory levies or legal fees.
In respect of a subscription or redemption, authorised AIFMs must ensure that investors are promptly provided, by means of a durable medium, with the essential information concerning the execution of that order or the acceptance of the subscription offer, as the case may be. The following sections provide an overview of the topics covered in the Directive and the Level 2 Regulations.
Conflicts of interest
An authorised AIFM must take all reasonable steps to identify conflicts of interest between (i) itself and the AIF it manages (or the investors in the AIF), (ii) two AIFs that it manages (or investors in the AIFs), (iii) an AIF that it manages (or investors in the AIF) and another client of the AIFM, (iv) the AIF (or investors in the AIF) and a UCITS managed by the AIFM (or investors in the UCITS) and (v) two of the AIFM’s clients.
An authorised AIFM must maintain and operate organisational and administrative arrangements with a view to taking all reasonable steps designed to identify, prevent, manage and monitor conflicts of interest in order to prevent conflicts from adversely affecting the interests of the AIF and the investors in it. Authorised AIFMs must segregate, within their own operating environment, tasks and responsibilities that may be regarded as incompatible with each other or which may potentially generate systemic conflicts of interest.
Where arrangements are not sufficient to ensure, with reasonable confidence, that the risk of damage to investors will be prevented, an authorised AIFM must clearly disclose the conflicts to the investors before undertaking business on their behalf, and develop appropriate policies and procedures. The Level 2 Regulations specify that an authorised AIFM must have and maintain a written conflicts of interest policy, which must identify the circumstances which constitute or may give rise to a conflict of interest as well as procedures to be followed to prevent, manage and monitor such conflicts. An authorised AIFM will need to ensure that the persons responsible for managing conflicts of interest are independent from the rest of the AIFM, including how such persons are supervised, remunerated and influenced. Authorised AIFMs are required to record the types of activities in which a conflict of interest has arisen or may arise, and the senior management of an authorised AIFM is required to review such records frequently and at least once a year.
- types of conflicts of interest;
- conflicts of interest policy;
- conflicts of interest related to the redemption of investments;
- procedures and measures preventing or managing conflicts of interest;
- managing conflicts of interest;
- monitoring conflicts of interest;
- disclosure of conflicts of interest; and
- strategies for the exercise of voting rights.
The Directive requires the risk management function of an authorised AIFM to be functionally and hierarchically separate from the operating units and portfolio management functions. An authorised AIFM must have adequate risk management systems in place which must be reviewed at least annually.
The Level 2 Regulations state that each authorised AIFM must have a permanent risk management function which must implement effective risk management policies and procedures in order to identify, manage and monitor on an ongoing basis all risks relevant to each AIF’s investment strategy to which each AIF is or may be exposed. Each authorised AIFM is required to have an adequate and documented risk management policy. An authorised AIFM is required to periodically review and update its policy and systems and to carry out reviews on the basis of internal and external events as well as material changes to the investment strategy of an AIF managed by the AIFM. Further, an authorised AIFM must establish and implement quantitative or qualitative risk limits (if an AIFM elects to only provide qualitative risk limits it must be able to justify this approach) for each AIF it manages, which must cover at least the following risks: market, credit, liquidity, counterparty and operational.
- risk management systems;
- permanent risk management function;
- risk management policy;
- assessment, monitoring and review of the risk management systems;
- functional and hierarchical separation of the risk management function;
- safeguards against conflicts of interest;
- risk limits; and
- risk measurement and management.
For each AIF it manages (other than any AIF which is an unleveraged closed-ended AIF) an authorised AIFM must employ an appropriate liquidity management system and adopt procedures which enable it to monitor the liquidity risk of the AIF and to ensure the liquidity profile of the AIF’s investments complies with its underlying obligations.
Each authorised AIFM must also conduct regular stress tests to assess the AIF’s liquidity risk and ensure that the AIF’s investment strategy, liquidity profile and redemption policy are consistent.
The Level 2 Regulations provide that an authorised AIFM must document its liquidity management policies and procedures, which must be reviewed at least annually and include suitable escalation measures to address actual or anticipated liquidity shortages or other distressed situations of the AIF. The stress tests referred to above must be carried out under normal and exceptional liquidity conditions and should be conducted on the basis of reliable and up-to-date information in quantitative terms (where possible), simulate a shortage of liquidity of the assets in the AIF and atypical redemption requests (where appropriate) and account for valuation sensitivities under stressed conditions.
- liquidity management system and procedures;
- monitoring and managing liquidity risk;
- liquidity management limits and stress tests; and
- alignment of investment strategy, liquidity profile and redemption policy.
Investment in securitisation positions
The Commission has adopted implementing measures setting out the requirements that need to be met by (i) the originator, sponsor or original lender (including that the originator, sponsor or original lender retains a 5% net economic interest) and (ii) the AIFM.
The Level 2 Regulations confirm that an authorised AIFM can only assume exposure to the credit risk of a securitisation on behalf of one or more AIFs it manages if the originator, sponsor or original lender has explicitly disclosed to the AIFM that it retains, on an ongoing basis, a material net economic interest, which in any event cannot be less than 5%. The Level 2 Regulations specify the factors an authorised AIFM must consider in respect of the originator or sponsor before assuming exposure to the credit risk of a securitisation, including, that such parties operate effective systems to manage their credit risk-bearing portfolios, that they adequately diversity each credit portfolio and that they have a written policy on credit risk. Authorised AIFMs must also be able to demonstrate to the competent authorities for each of their individual securitisation positions that they have a comprehensive and thorough understanding of those positions and have implemented formal policies and procedures appropriate to the risk profile of the relevant AIF’s investments in securitised positions.
In addition, authorised AIFMs must establish formal monitoring procedures in line with the principles laid down in the Directive in relation to the credit risk of a securitisation position. Such information must include the exposure type, the percentage of loans more than 30, 60 and 90 days past due, default rates, prepayment rates, loans in foreclosure, collateral type and occupancy, frequency distribution of credit scores or other measures of credit worthiness across underlying exposures, industry and geographical diversification and frequency distribution of loan to value ratios with bandwidths that facilitate adequate sensitivity analysis. Where the underlying exposures are themselves securitised positions, authorised AIFMs must have the information set out in this subparagraph not only on the underlying securitisation tranches, such as the issuer name and credit quality, but also on the characteristics and performance of the pools underlying those securitisation tranches.
- requirements for retained interest;
- qualitative requirements concerning sponsors and originators;
- qualitative requirements concerning authorised AIFMs exposed to securitisations; and
- corrective action.
Authorised AIFMs are required at all times to use adequate and appropriate human and technical resources that are necessary for the proper management of AIFs. The Directive also provides that an authorised AIFM must have sound administrative and accounting procedures, control and safeguard arrangements for electronic data processing and adequate internal control mechanisms, including, in particular, rules for personal transactions by its employees or for the holding or management of investments in order to invest on its own account.
The Level 2 Regulations contain detailed provisions setting out the organisational requirements that an authorised AIFM must have in place. Generally, an authorised AIFM is required to establish, implement and maintain: (i) an organisational structure which allocates functions and ensures the relevant persons are aware of the procedures to be followed, (ii) decision-making procedures, (iii) internal control mechanisms, (iv) confidentiality procedures, (v) an adequate business continuity policy, (vi) accounting policies and valuation rules and (vii) orderly records of its business and internal organisation.
Authorised AIFMs are required to keep detailed records with respect to portfolio transactions and must also record information regarding subscription offers and redemption orders. Records of this nature must be retained by the AIFM for a period of at least five years.
Section 6 of the Level 2 Regulations provides further detail on each of these requirements. The topics covered are:
- electronic data processing;
- accounting procedures;
- control by the governing body, senior management and supervisory function;
- the requirement for a permanent compliance function;
- the requirement for a permanent internal audit function;
- personal transactions and associated conflicts of interest;
- recording portfolio transactions and the information required;
- recording subscription and redemption orders and the information required; and
- general recordkeeping requirements.
See also the provisions in relation to delegation which are summarised here.
In the UK, the provisions relating to operating conditions and organisational requirements in the Directive have been implemented in different sections of the FCA Handbook, including in the Conduct of Business Sourcebook (COBS), the Principles for Businesses (PRIN), the Senior management Arrangements, Systems and Controls (SYSC), the Compensation rules (COMP) and the Investment Funds Sourcebook (FUND). For a table showing the transposition of the relevant provisions of the Directive into the FCA Rules, please click here.