The European Securities and Markets Authority has published on February 23 a discussion paper on key concepts of the Alternative Investment Fund Managers Directive and types of alternative fund manager to initiate a consultation process aimed at finalising its policy approach.
Esma says that in the light of responses to the discussion paper, it will draw up a consultation paper during the second quarter of this year setting out formal proposals for draft regulatory technical standards under Article 4(4) of the directive, “to determine types of AIFMs, where relevant in the application of this directive, and to ensure uniform conditions of application of this directive”.
The authority says it will use the results of the public consultation to finalising the draft regulatory technical standards, which it will submit to the European Commission for endorsement by the end of 2012. Comments must be received by March 23.
Esma seeks to align supervisory practices among European national regulators in the interpretation of certain key concepts of the AIFMD as part of its efforts to achieve a harmonised application of the directive, and may consider developing additional convergence tools for this purpose in future.
Definition of an alternative investment fund manager
Esma notes that Article 4(1)(w) defines the activity of managing alternative funds as performing at least portfolio management or risk management functions, and argues that therefore an entity performing either of the two functions should be considered as managing a fund. Such an entity must therefore seek authorisation as an alternative fund manager under Article 6 of the directive.
No authorisation is required where either portfolio or risk management is carried out under a delegation arrangement with an alternative manager. Article 20 requires that any entity to which portfolio or risk management functions are delegated is authorised or registered for the purpose of asset management and subject to supervision, otherwise prior approved is required from the manager’s home regulator.
According to Esma, Article 6(5)(d) should be interpreted as requiring a manager to be capable of providing, and take responsibility for, both portfolio management and risk management functions in order to be authorised under the AIFMD. However, it may choose to outsource either or both of these functions according to the delegation rules set out in Article 20 of the directive and the Level 2 measures to be announced by the European Commission later this year.
The manager’s liability is not affected by delegation (or further sub-delegation) of portfolio and/or risk management functions to a third-party entity. Esma emphasises that these functions may not be delegated to such an extent as to make the manager effectively a letterbox entity that can no longer be considered as manager of the fund in question. Subject to these requirements, Esma says that a manager may delegate both portfolio and risk management in whole or in part, but it may not delegate both functions in whole simultaneously.
Esma says this also means the manager of an alternative fund does not have to perform the additional functions set out in Annex 1 of the directive, comprising administration, marketing and services relating to fund assets. However, if it does not, these functions should be considered to be delegated to a third party, leaving the manager responsible for their performance under the directive’s rules on liability for delegation liability and responsibility for compliance.
Definition of an alternative investment fund
Regarding the definition of what constitutes an alternative investment fund, Esma acknowledges that the scope of the directive is extremely broad, embracing both funds that invest in traditional assets and those that invest in non-traditional asset classes including shipping, forestry and wine.
Article 2(3) of the directive lists various entities that fall outside its scope, including holding companies. This is defined as a company with shareholdings in one or more other companies through which it carries out a business strategy or strategies. It must either operate on its own account and be listed on a regulated EU market, or alternatively its annual report or other official documents must make clear that it has not been established for the main purpose of generating returns for its investors through divestment of its subsidiaries or associated companies. However, Esma cautions that the holding company exemption should not be used as a means of circumventing the provisions of the directive.
Article 3 lists entities that would fall under the scope of the directive were they not exempted. These include managers of one or more funds whose only investors are the manager itself, its parent or subsidiaries, or other affiliated companies within the same group that are not themselves funds. Family office and similar private investment vehicles that do not raise external capital should not be considered as alternative investment funds, while insurance contracts and joint ventures are also excluded.
Esma is calling for feedback from stakeholders on whether they see merit in further clarification of the notion of family office vehicles and what “investing the private wealth of investors without raising external capital” should cover. It also asks whether “insurance contracts” and “joint ventures” need further clarification, whether further detail of the characteristics of holding companies is required, and whether any of the other exclusions or exemptions need further clarification.
Through a ‘mapping exercise’ surveying EU regulators, Esma has identified six categories of alternative fund: funds that invest in similar assets as Ucits funds but do not meet Ucits diversification or leverage rules; funds that invest in assets not eligible for Ucits; private equity funds; venture capital funds; real estate funds; and ‘alternative alternatives’ vehicles including commodity funds.
Esma has concluded that concentrating on asset classes or on investment strategies are not the best methods of determining what constitutes an alternative investment fund under the directive.
Instead it proposes various criteria: capital-raising that involves at least some kind of communication between the entity seeking capital or its representatives and prospective investors that results in the transfer of cash or assets to the fund; collective investment seeking to generate a return from pooling investors’ capital; the absence of any rule limiting the sale of shares or units to a single investor; a fixed and defined investment policy that is communicated to investors; the fund rather than the investors owns underlying assets; and the manager has responsibility for the management of those assets.
The application of various articles of the directive depends on different factors such as whether they are open-ended or closed-ended, internally or externally managed, whether they employ substantial leverage and or whether or not they use a prime broker. In addition, Esma’s Level 2 advice to the Commission notes that the principle of proportionality should be followed in some (but not all) areas.
Esma suggests that open-ended funds be defined as those whose units or shares may, at the holder’s request, be repurchased or redeemed without any limitation, directly or indirectly, at least annually. It proposes to tackle the question of what constitutes an alternative fund “of significant size” in drawing up guidelines on sound remuneration policies.
Appointment of an alternative investment fund manager
Article 5 of the directive requires each alternative fund to have a single manager responsible for compliance with the directive. However, depending on the fund’s structure, more than one entity could be capable of being designated – for instance the fund itself, where internal management is legally possible, or another entity responsible for the portfolio and risk management functions.
The directive itself does not set conditions or criteria for the appointment or selection of a manager – it can be any legal entity authorised as an alternative investment fund manager under the directive.
Treatment of Ucits management companies
Article 6(2) allows an authorised alternative manager also to act as a Ucits management company provided it is authorised as such. After the AIFMD enters into force, a Ucits management company that already manages alternative funds must seek separate authorisation under the directive.
Esma says a Ucits management company will be able to provide services including investment management to an alternative fund even where it cannot be the appointed manager, for example because the fund is internally managed. In such a case the Ucits management company’s activities will continue to be authorised under the Ucits Directive and it will not need separate authorisation under the AIFMD. A single entity will be able to obtain authorisation under both directives.
Treatment of MiFID firms and credit institutions
Investment firms authorised under MiFID and credit institutions authorised under the Banking Consolidation Directive are not required to obtain authorisation under the AIFMD to provide investment services such as individual portfolio management to alternative funds. They may continue to provide services to funds under the rules governing delegation arrangements.
Although Article 6(2) of the AIFMD says no external alternative fund manager may engage in activities other than those referred to in Annex I or the management of Ucits, Article 6(4) permits a manager to provide portfolio management services to clients including funds where it is not the appointed manager, as well as non-core services such as investment advice, safekeeping and administration, and receipt and transmission of orders.
Esma therefore argues that a firm authorised under MiFID or the Banking Consolidation Directive cannot be the appointed manager of an alternative fund nor obtain authorisation under the AIFMD, but they may provide investment services such as individual portfolio management in respect of alternative funds.

The European Securities and Market Authority’s 500 pages of technical advice to the European Commission on Level 2 measures implementing the Alternative Investment Fund Managers Directive have helped to bring greater certainty to the global fund industry on what it can expect in July 2013 and thereafter.
Nevertheless, until the Commission comes up with the final rulebook and all primary and secondary AIFMD-related legislation is adopted into the national law of European Union member states, questions will remain about the overall impact of the directive, especially as it affects managers, funds or service providers located in jurisdictions outside the EU.
‘Equivalence’ dropped
For industry members, one of the most important aspects of the final advice document sent to the Commission on November 16 is the removal of reference to the ‘equivalence’ of third-country jurisdictions, which had already been dropped from the legislative text finally agreed by the European Council and Parliament in November 2010.
The concept of equivalence was re-introduced in Esma’s consultation paper on possible implementing measures relating to supervision and third countries, published in August 2011. With regard to the delegation of investment management or depositary functions to entities outside the EU, the requirement for equivalence was regarded as a potential barrier to investment by funds in non-EU jurisdictions, as well as creating the probably impossible task of assessing the equivalence or otherwise of dozens of jurisdictions before the directive came into force.
Regulatory co-operation approach
Esma’s advice to the Commission tackles the issue of regulatory co-operation between third countries where funds or managers are domiciled and EU member states by proposing an approach based on Iosco’s Multilateral Memorandum of Understanding Concerning Consultation and Co-operation and the Exchange of Information.
It proposes that an MMoU be centrally negotiated by Esma to avoid the need for third-country regulators to conclude multiple bilateral co-operation arrangements, ensuring a level playing field by removing the opportunity for regulatory arbitrage. However, details what this would mean in practice and how co-operation agreements should be concluded may not be announced before mid-2012.
Article 20 of the directive provides that where portfolio or risk management functions are delegated by an EU-based manager (or sub-delegated) to an entity located outside the union, regulatory co-operation arrangements should be in place between the manager’s home regulator and the third-country supervisor of the entity to which the functions are delegated.
The regulatory co-operation arrangements should be based on written agreements and enable the manager’s home regulator to obtain on request information required for its supervisory duties under the AIFMD, obtain documents held in the third country and conduct on-site inspections of the entity to which portfolio or risk management functions have been delegated (either directly, by the third-country regulator, or jointly).
The co-operation arrangements should also ensure notification by the third-country regulator of any breach of the directive’s requirements and the ability to perform “sufficiently dissuasive” enforcement actions in such a case.
The third-country entity will be deemed to meet the AIFMD’s requirements for delegation if it is authorised or registered to carry out asset management based on local criteria and is effectively supervised by an independent regulator. Independence in this case means compliance with the criteria and methodology set out in Part II of the Iosco Objectives and Principles for Securities Regulation and the Basel Committee Core Principles.
The EU manager’s home regulator must approve in advance the delegation of portfolio or risk management to a third-country entity that is not authorised as an asset manager, as it would also have to do if such an entity was based in the EU.
Framework for depositaries
As with the criteria for delegation of portfolio or risk management, the concept of equivalence of third-country regulation has been removed from the advice on assessing the prudential regulation and supervision of non-EU depositaries to alternative funds.
Instead Esma says the depository should be authorised and supervised by an independent regulator with adequate resources to fulfil its tasks. The local regulatory framework should set out eligibility criteria for depositaries “that have the same effect” as those applicable to credit institutions or investment firms within the EU.
The minimum capital requirements and operating conditions applicable to the depositary should have the same effect as those applicable within the EU, depending on whether it is a bank or an investment firm, while the local requirements regarding performance of the depositary’s duties should have the same effect as those set out in the AIFMD. Esma advises that the third-country legislation should be assessed by comparing eligibility criteria and operating conditions with EU requirements.
The local regulatory framework should provide for the application of enforcement action in the event of breaches of the directive’s requirements, and ensure that the liability of the depositary to investors in the event of loss of assets should be capable of being invoked either directly or indirectly through the manager, depending on the nature of the investment structure. If the depositary is supervised to more than one regulatory authority, all of them should meet the requirements.
Under Article 21 of the directive, if the criteria are met, the Commission should adopt implementing acts stating that the prudential regulation and supervision of a particular third country have the same effect as EU law and are effectively enforced.
Private placement rules
Regarding co-operation between EU and third-country regulators for the marketing of non-EU funds within the EU under national private placement arrangements – and subsequently the marketing of non-EU funds or EU funds run by non-EU managers under a passport – Esma says the agreements should cover exchange of information for supervisory, enforcement and other regulatory purposes, as well as the ability of the EU regulator to carry out on-site inspections directly or jointly with the non-EU regulator.
The latter should co-operate in the event or breach of either EU or local regulation, and assist the EU regulator by providing information required for systemic risk oversight. Co-operation agreements should allow information provided to the EU regulator to be passed on to its counterparts in other member states, to Esma itself or to the European Systemic Risk Board.
This part of the Esma advice, as well as that regarding depositaries, stresses that managers, funds or service providers should not benefit from more lenient regulatory treatment as a result of being based in a non-EU jurisdiction, and that regulatory co-operation arrangements should take this into account.
Determining the member state of reference
Finally, the Esma advice proposes more detailed guidelines for determination of the member state of reference that will supervise non-EU managers taking advantage of the AIFMD passport in or after July 2015.
In the event of a dispute over the designation of the member state of reference, the decision should take into account in which EU member state the manager intends to develop effective marketing to investors for most of its funds, either through direct relationships or third-party distributors. The criteria should include the domicile of most targeted investors, the language of the offering and promotional documents, and the member states where advertisements are “most visible and frequent”.
EU regulators identified by the manager as being potentially its member state of reference should contact each other and Esma. Following consultation or receipt of relevant documentation, they should exchange views within a week and subsequently take a joint decision on the designation. The Level 1 text of the directive provides that where the regulators cannot agree, Esma will decide.