The impact of the EU’s Alternative Investment Fund Managers Directive (AIFMD) on structures established in Luxembourg: What steps must be taken to comply with the Directive?

With the focus on ESG, AIFMD II and ELTIF 2.0, anyone reading the title may say “surely the market knows what is required? Have we not moved past this question?”

However, non-EU Sponsors and startups looking to raise capital in the EU, find the AIFMD a bit of a minefield. Emerging managers still look to structures that may fall outside the scope of the AIFMD, as the on-going costs of the top tier structure offered under the AIFMD require sufficient levels of assets to justify the costs, which may exclude startups.

Luxembourg pooling structures, regardless of legal form and underlying assets, should be analysed against the definition of an AIF to determine whether they are in or out of scope of the AIFMD. The definition of an AIF is very broad and covers any type of vehicle established for the purpose of raising capital from a number of different investors, with the aim of investing these funds into assets to generate returns and which does not qualify as a UCITS.

The AIFMD does not regulate the AIF directly as it is a managers’ directive, requiring the appointment of an AIFM by the AIF, or the AIF seeking itself to be treated as internally managed and thereby required to comply with the AIFMD.

The ability to fall outside the definition of an AIF is limited, hinging primarily on the structure not meeting all the elements of the definition of an AIF. For example, a JV or family fund, invests their own money and therefore do not raise capital. There are other examples, such as managed accounts or securitisation structures, which in certain circumstances also fall outside the scope of the AIFMD. Explicit exemptions under the AIFMD are narrow, including the group exemption and the partial (de minimis exemption) available to small AIFMs.

Option 1 – Partial exemption

To meet the requirements of the partial exemption, small Luxembourg AIFMs must manage: - AIFs which are not leveraged and offer no redemption rights for a period of five years, and with aggregate AuM below €500 million. - AIFs whose AuM, including any assets acquired through the use of leverage, do not exceed €100 million.

Small AIFMs are required to register with the national competent authority, the CSSF (Commission de Surveillance du Secteur Financier) and have to comply with very few requirements of the AIFM Law as they are not supervised by the CSSF for asset management purposes (limited reporting to the CSSF). Alternatively, these below-threshold AIFMs can opt-in by applying for a licence as an above-threshold AIFM which benefits from a management and marketing passport across the EU/European Economic Area.

There is an on-going debate in the Luxembourg market as to whether the partial exemption is a useful option for startup managers. The argument is that the costs of running a full-blown structure, does not vary that much from the running costs of a sub-threshold structure if one considers the limitations of the partial exemption option. A substantial portion of the costs of the smaller AIFM are linked to its obligations to comply with the Luxembourg AML law as they are subject to the CSSF supervision for AML purposes.

It is true that smaller AIFMs do not benefit from the marketing passport under the AIFMD but the sponsor does retain control over the investment management process and has limited interference from a third party which is often important for startup managers.

Each project should be assessed on its own merits to determine whether or not the partial exemption is useful, remembering that the marketing passport under the full AIFMD structure is only available to professional investors and not semi-professionals.

Some startup managers may wish to have their own employees in Luxembourg and delink their business from third party service providers as they grow their own team and business.

Option 2 – Setting up an authorised AIFMD

Before starting business, the new Luxembourg AIFM entity must be authorised by the CSSF.

CSSF Circular 18/698 of 23 August 2018 on the authorisation and organisation of Luxembourg investment fund managers provides good guidance on the requirements together with the “Application questionnaire for the setup of a fully licensed alternative investment fund manager”.

Specific requirements are applicable with respect to the members of the management body as well as the senior managers (conducting officers) in terms of the number of persons, skill, residency, and ability to travel to Luxembourg and number of mandates. This may change slightly under AIFMD II particularly with respect to independence at the management body level.

The application will include a programme of activity outlining the organisational structure of the AIFM and how it intends to comply with its obligations under the AIFMD. A number of policies and procedures will also be filed as part of the application including but not limited to delegation and the remuneration policy. A number of supporting documents are also included, such as rental agreements, professional indemnity cover, corporate documents, information on controlling shareholders and information on the initial AIF to which AIFM services will be provided.

A large portion of the application will also focus on the distribution channels and how Luxembourg AML requirements (depending on the distribution model) will be complied with.

With respect to timing, the CSSF must determine if authorisation will be granted, within a period of three months from the date from which it receives the complete application. This may be extended by an additional three months.

It should be noted that the CSSF authorisation is not a blanket authorisation to manage all types of alternative investment funds. Authorisation is granted in respect of the alternative strategy disclosed in the application. For example, a licence would need to be extended to accommodate crypto as it would fall within the category of other investment strategies.

Embarking on a business in a new jurisdiction is not taken lightly by sponsors and often option 3 is the preferred route.

Option 3: Compliance through the appointment of a third party AIFM/Host AIFM

There are a number of third party AIFMs selling their services to sponsors, where they undertake to assume the regulatory and compliance burden of the AIFMD. The true benefit of the third party AIFM option, is that access to the marketing passport is granted, without the cost of running a new business.

Although, there is concern, particularly from non-EU sponsors about losing control over the investment decision making process. The extent to which the host AIFM will control the investment decision making process will be dependent on the model adopted by the sponsor, which is either the delegation of portfolio management or the retention of this function by the Host AIFM with the sponsor providing investment advice only.

Delegation

Authorised AIFM may delegate one of the components making up the investment management function, typically portfolio management to an eligible third party, while retaining risk management.

The third party is required to be an entity authorised for asset management and subject to supervision. If the delegate is a non-EU entity, a written co-operation arrangement must be in place between the AIFM’s home state regulator and the supervisory authorities of the delegate, which satisfies the requirements set out in the Level 2 Regulations of the AIFMD.

Under the delegation model, the sponsor should understand which AIFMD obligations the AIFM wishes to impose contractually, and which obligations are inescapable under the AIFMD and are “non-negotiable”. One of the points of using a host AIFM, is to allow the sponsor to concentrate on what it does best. The sponsor should understand that the AIFM has an obligation to act in the best interests of investors and its liability towards the AIFs investors will not be affected by the fact that the AIFM has delegated functions to a third party, or by any further sub-delegation.

Advisory

Under the advisory model, the AIFM retains both risk and portfolio management and the third party sponsor provides investment advice.

Each one of the above options has advantages and disadvantages and the commercial requirements of each project will determine which of the options is most suitable and appropriate.

The sub-threshold option could be used as an interim measure, until the assets under management justify appointing a thirdparty AIFM or seeking full authorisation itself under the AIFMD.

The beauty of the single market is that the authorised AIFM is not required to be a Luxembourg entity. Other EU AIFMs may passport into Luxembourg to manage a Luxembourg Fund, this opens other options for sponsors.

This article was originally published by AGEFI Luxembourg.