AIFM: Round two

Since the European Commission first began work on the Alternative Investment Fund Managers (AIFM) directive in 2009, fund managers have been left sweating over its effects on the private equity industry. 

In April, those concerns were heightened when the Commission published a draft text that caused many private fund managers to question why, in some respects, industry-favoured technical advice submitted by the European Securities and Markets Authority (ESMA) was being ignored. In one swoop, the Commission had rehashed some of the old wounds the industry suffered during initial rulemaking.

More specifically, concerns around third country provisions, depositories, leverage and the calculation of assets under management, appear to be areas where ground has been lost for the industry in the latest text. GPs have expressed frustration that politicians are applying uniform rules for a diverse set of asset classes which might leave certain fund managers worse off than others.

On a broader level, the latest text demonstrates the Commission’s desire to get the ball rolling on the second phase (or level II) rulemaking. The Commission wants the AIFM changes to be enacted as a Regulation, a legal vehicle which enters into national law much quicker than a Directive.

However, a speedier implementation into law under a Regulation approach leaves EU sovereigns less flexibility in rulemaking, potentially removing a way for some jurisdictions to address industry concerns, says Imogen Garner, a senior associate at law firm Norton Rose. The advantage in using a Regulation structure would be (in theory at least) greater certainty as to how the rules are to be interpreted, adds Garner.


Perhaps the biggest concern for fund managers is the ‘third country issue’, which relates to how managers who operate in areas not under EU jurisdiction can access EU-based LPs.

“There is definitely a chance that US fund managers will be discouraged from seeking EU investors given the additional regulatory burden they could face,” says Priya Kumar, senior associate at law firm Baker & McKenzie. “You may get a situation where EU investors have to actively seek out US funds.”

Garner adds this is an area where it seems that Level II – which will fine-tune the directive’s core provisions –has taken a step backwards from points that were seemingly won at level I (which make up the Directive’s bare bones).

The European Commission’s update contemplates the use of legally binding cooperation agreements with foreign governments. In practice that may be problematic as regulators around the world would in effect be asked to enforce EU law on their home territories. Unless the Commission takes a less stringent stance in final rulemaking, some non-EU jurisdictions fear a shutout from EU investors.

“The terminology used at Level I was quite sensitive to the idea that cooperation arrangements aren’t expected to be legally binding,” says Garner. 

ESMA’s advice was to centralise the cooperation agreement process and have itself act as a negotiator on behalf of EU member-state authorities. The pan-EU regulator had also developed guidelines on the content of the cooperation agreements to act as a memorandum of understanding that could serve as a starting point in negotiations.


Fund managers are also unclear on the definition and treatment of leverage, which is proving to be a sticking point during AIFM rulemaking. 

Garner said leverage was a strong point of contention when Level I rules were being finalised. The fear expressed by fund managers was that debt held by portfolio companies would be, for whatever reason, accounted for at the fund level.

ESMA in its advice said portfolio company debt should be separate from the fund level so long as the two entities were not tied to each other in the event of insolvency, which is the case with most limited liability partnerships in the private equity universe. 

However, the fear now is rulemakers will ignore that advice in a bid to keep hedge funds from using the ESMA definition to create holding companies that park fund-level debt.

“We thought we had successfully achieved a situation where leverage at the level of investee companies was not captured but it is less clear now whether that will always be the case,” says Garner. “This is a problem for private equity, not least because much of the beneficial tailoring built into the Level I text contemplates that private equity is unleveraged.”

Another area unsettling fund managers is depositories – which secure funds’ financial assets, track cash flows and monitor funds’ compliance with their own governing documents. Garner says the costs of these services are likely to increase if depositories are required to take on additional duties and potentially higher liability.

Kumar agrees and said this extra layer of expense is not considered relevant by the private equity industry. “You don’t trade assets on a regular basis so you don’t really have a situation where a depository is adding an additional layer of protection to investors.”

As a corollary to this, the rules’ imposition of additional liabilities on depositories may result in fewer, albeit larger, depositaries in the market creating a potentially dangerous level of concentration. “With fewer larger entities you may actually end up increasing risk in the depository world,” says Garner.


A major cause of uncertainty moving forward is the scope of the directive. “It’s almost hard to believe that this far down the process we have a directive that is settled and finalised in terms of provisions but we still don’t have certainty on exactly who is subject to it,” Garner adds.

This will make it difficult for private equity firms to move forward and begin adapting to life under the new regulations, say sources.

Kumar was concerned the directive creates another barrier to entry in a market that is already difficult to join. “The compliance burden that will be placed on funds, especially new entrants, is likely to be a significant adverse consequence of the impact of the directive.”

Kumar adds: “Private equity has historically had many small teams coming out of the bigger players and setting up new funds. This provided competition in the market and brought innovative ideas into the industry which this directive may discourage.”

Nonetheless one positive aspect of AIFM rulemaking has been the demonstration of effective lobbying by the industry. Sources say what started out as a horror story has been pushed towards a much more reasonable bill of law. Of course a number of problem spots exist, as detailed above, but the situation could have been far worse than it is today without a strong voice able to communicate GPs’ concerns. In round two of rulemaking, the industry will be hoping that voice only grows louder.