Whilst the transparency requirements of the Alternative Investment Fund Managers Directive will be helpful for investors, it could be argued that investors should continue to negotiate additional information rights.
The Alternative Investment Fund Managers Directive (AIFMD) will soon become law in EU member states. One of the stated aims of the AIFMD is to enhance the transparency to investors (and regulators) of fund managers and the funds they manage. In the context of transparency in relation to open-ended funds like hedge funds, this article examines whether investors can rely solely on the transparency requirements of the AIFMD or whether investors should continue to negotiate additional information rights.
The AIFMD and its secondary measures have been one of the most controversial and heavily debated pieces of financial regulation to emerge from the European Union (EU). The AIFMD seeks to regulate fund managers (AIFMs) of alternative investment funds (AIFs) in the non-UCITS fund sector.
AIFs include hedge funds and private equity funds. Investors in AIFs are typically institutional investors like pension funds, sovereign wealth funds, fund-of-funds, insurance companies and family offices. Unlike UCITS funds which have always been heavily regulated, light touch regulation has been traditionally applied to the AIF sector. This will change with the AIFMD, which will be implemented into national laws of the EU member states by 22 July 2013.
The location of the AIFM and the AIF (i.e. whether or not it is located in the EU) will have a considerable impact on the effect of the AIFMD. Unless an exemption applies, the AIFMD will apply to the following fund managers:
- EU AIFMs which manage EU or non-EU AIFs (regardless of whether or not they market them in the EU);
- non-EU AIFMs which manage EU AIFs; and
- non-EU AIFMs which market their AIFs in the EU.
Accordingly, a non-EU AIFM marketing outside of the EU and a non-EU AIF which invests in EU equities will not come within the scope of the AIFMD.
AIFMs will need to be authorised and be subject to compliance requirements (including with respect to capital, delegation, valuation, depositories, leverage, risk management, liquidity management and remuneration of staff). AIFMs will also be subject to transparency requirements, whereby they will have specific reporting and disclosure obligations to investors and regulators.
Open-ended AIFs and redemption rights
Open-ended investment funds permit investors to redeem their investment in the fund at their option over the life of the fund. The exit route through redemption is an important feature for investors seeking or requiring liquidity in their investments. In the AIF world, hedge funds are typically structured as open-ended AIFs. Understanding the redemption rights and liquidity profile of the AIF is crucial for investors in such AIFs. Another area of paramount importance for investors in open-ended AIFs is the timely disclosure by AIFMs of certain information that can influence investors’ decisions to exit the investment by exercising their redemptions rights.
Transparency requirements under the AIFMD
The AIFMD imposes requirements for information to be given to investors and regulators, both in the marketing process and on an on-going basis.
Under the AIFMD, audited annual reports must be made available by an AIFM for each EU AIF it manages within six months following the end of the financial year. The annual report must be provided to investors on request and made available to the member state regulator. Interestingly, there is no obligation on the AIF to provide the annual report to investors unless requested, so investors should ensure that this information request is made upfront upon subscription.
The AIFMD lists out certain items that must be included in the annual report. This includes any material changes that occurred during the financial year in respect of the information which needs to be disclosed to investors before they invest in the AIF.
Such information would typically be set out in the AIF’s offering memorandum, and includes:
- a description of the investment strategy and objectives of the AIF;
- any delegated management or depositary function and any associated conflicts of interest;
- the AIF’s valuation procedure and pricing methodology;
- the AIF’s liquidity risk management (including redemption rights);
- any preferential treatment received by an investor (e.g. by way of a side letter); and
- prime brokerage arrangements.
Material changes to such information may be significant for investors in terms of their continued investment in the AIF. The AIFMD, however, requires such material changes only to be included in the annual report rather than requiring prompt disclosure at the time of the material change. Clearly, some changes may require investor consent, in which case the investors would receive prior notice of such change. However, with respect to changes that are not subject to investor consent, it could actually be several months from the date of change before it comes to the attention of the investor. This is especially so as the deadline to make the annual return available to investors is six months after the AIF’s financial year-end. All this leaves the investor in an unsatisfactory position.
Rather than solely relying on the AIFMD obligations, it would be prudent for investors to negotiate a prompt notification by the AIFM of certain material changes that can influence their exit decisions e.g. changes in investment strategy and objectives, managers, prime brokers, depositories, valuation policies, and preferential redemption rights granted to other investors.
Periodic disclosure to investors
The AIFMD also requires that each AIFM must periodically disclose the following information to investors:
- the percentage of assets which are subject to special arrangements arising from their illiquid nature;
- any new arrangements for managing the liquidity of the AIF;
- the current risk profile of the AIF and risk management systems employed by the AIFM; and
- certain leverage information (regular disclosures).
As liquidity is crucial for investors in open-ended AIFs, the AIFMD requirement for the disclosure of such items on a periodic basis is welcome. However, the timing of the periodic disclosures should be carefully reviewed against redemption time-frames to ensure that investors are not disadvantaged.
Investors should also note that the AIFMD does not specifically address the prompt disclosure of a number of other critical events that can also influence investors’ decisions to exit the investment. For instance, events like key person departures, change of control of the AIFM, and litigation against the AIF or AIFM should be promptly notified to investors. Other areas where transparency may be desirable for investors are plans to close the AIF to new subscriptions and the receipt of a large amount of redemption requests with respect to a particular redemption day.
Transparency beyond the AIFMD
The AIFMD is a welcome piece of legislation for investors in open-ended AIFs, but investors would be ill-advised to rely solely on its transparency requirements. In circumstances where the AIFMD does not apply (e.g. a non-EU AIFM marketing outside of the EU), investors may certainly be disadvantaged. However, as described above, even where the AIFMD does apply, the information disclosures required under the AIFMD may either come too late or be inadequate for investors. In either case, it is paramount that investors proposing to make investments in open-ended AIFs do their due diligence on the fund terms and negotiate appropriate information rights.
For more information on this matter, please place an inquiry with a member of the team on 020 3319 3700.
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.