AIFMD alert: The impact for Real Estate Funds
ESMA's final advice
The European Securities and Markets Authority (ESMA) published its final advice to the European Commission on the detailed rules that will be applicable to fund managers within the scope of the Alternative Investment Fund Managers Directive (AIFMD) on 16 November 2011.
Our AIFMD Alert provides a short briefing on ESMA's final advice and contains a summary and analysis. In addition to the AIFMD Alert, the note below draws out the key impacts for the real estate funds industry
Impact for the Real Estate Funds Industry
There has been clarification, albeit limited, of the rules proposed around the risk management activities of the AIFM and the depositary’s duties. However, ESMA has not answered a number of questions relating to the Directive’s scope, including the application to REITS, the definition of “joint ventures”, the impact of borrowings for AIFM that would otherwise be below the de minimis thresholds, and whether a fund should be viewed as a consolidated group.
- Risk management provisions and independence
- Depositary functions
- Scope of application - REITs
- Scope of application - Joint Ventures
- Identity of the AIFM - Substance
- Definition of an AIF - implications for leverage calculations and the application of EMIR
The ESMA advice sets out further details on risk management activities and responsibilities and also the extent to which the function needs to be independent. These rules are based on those currently applicable to retail funds under the UCITS Directive and may be difficult to implement in practice.
The risk management function is required to be functionally and hierarchically separate from the operating units, including the portfolio management function, which may present a significant challenge for many real estate fund managers where there is little scope for effective separation of responsibilities and significant overlap between management of the firm and management of its fund(s). ESMA’s final advice acknowledged that this would be difficult in practice for many fund managers and has reiterated that the competent authorities responsible for reviewing the separation of the risk management function should apply the principle of proportionality, having regard to the operational structure of the AIFM and the corporate governance arrangements of the AIFM / AIF. ESMA’s advice requires the implementation of mandatory safeguards if these independence requirements cannot be satisfied, one of these being an independent review.
The AIFM must also ensure that the risk management function is appropriately resourced and that a permanent risk management function is established, which may again present practical difficulties and have cost implications.
The requirement for a depositary will be new for many unregulated UK real estate funds. The liability provisions of the Directive, which shape the risk profile of the depositary, remain in sharp focus and this is likely to lead to higher fees, increasing contractual complexities, and depositaries challenging AIFMs on key risk areas.
IIt appears that ESMA intend holding structures to be 'look-through' for the purposes of determining the assets for which the depositary will have strict liability. Since the intention appears to be to include real estate assets in the remit of the depositary's scope, the 'look-through' provision makes sense because assets are often held indirectly by an AIF, through asset-owning SPVs. This does, however, greatly extend the scope of the depositary's role and its risk profile, which in turn is likely to have a cost impact.
The role of the depositary has been clarified in the ESMA advice, and importantly it confirms that a controls based approach to cash monitoring and the oversight function will apply, emphasising the importance of a robust risk management framework of controls.
Despite lobbying and the presentation of a number of arguments for their exclusion, the specific issue of the scope of the Directive in relation to REITs has not been addressed in the final advice and as a result, it appears that they continue to fall within the scope of the Directive.
The final implementation guidance is expected around July 2012, which may provide further clarity, but otherwise it may be left to relevant competent authorities to interpret at the national level how the rules will be applied to REITs.
The Level 1 Directive contained a recital that excluded certain joint venture arrangements (after lobbying from UK Treasury on this matter), however the Directive is silent as to the definition of a joint venture for this purpose. ESMA has not addressed this point and the exact scope of the exemption remains uncertain.
For many private equity style real estate funds there remains a very significant uncertainty about whether the GP of a partnership would be treated as the AIFM, or whether the investment manager or adviser entity would take the AIFM role. Much depends on the functions and risks housed in the GP and whether this should be considered purely a ‘letterbox’ entity. Currently the interpretation of the rules could vary case by case and for consistency we would expect that the FSA needs to provide further guidance.
Real estate AIFMs can only make use of the €500m threshold exemption where they do not use leverage. Following the publication of the Level 1 Directive, it was widely understood that leverage within asset-owning SPVs and other entities held by the fund vehicle was not intended to be included for the purpose of calculating assets under management and concluding upon whether the AIFM falls within the scope of the Directive.
ESMA has, however, cast some doubt on this conclusion and unfortunately this remains another area where further guidance is required. If leverage within entities held by the fund vehicle is included this may mean that ESMA considers the AIF to include the entire legal structure of a fund rather than just the top fund vehicle. When considering this alongside the European regulations on derivative clearing (EMIR), which make use of the AIFM definitions for their application, we understand that the knock-on implications could be that all derivatives within asset-owning SPVs as well as fund vehicle entities would need to be subject to a clearing obligation.
With these significant changes on the horizon for the real estate funds industry, managers should be aiming to ensure that the investment in operational and fiduciary functions required to comply, and the additional cost burden which arises there-from, is carefully scoped, planned, communicated with investors and executed over the next 12-24 months.