Operating Conditions

AIFMs which are fully authorised under AIFMD are subject to detailed rules regarding operating conditions (including with respect to conduct of business, managing conflicts of interest, risk management and liquidity management) and with respect to their internal organisation.

Conduct of business: general principles

The AIFMD contains a broad set of general principles (in Article 12) that an authorised AIFM must comply with, including the requirement to act honestly and fairly and in the best interests of the relevant AIF (or its investors) and the integrity of the market when conducting its business activities and to take reasonable steps to avoid conflicts of interests and treat all investors fairly (which entails that no investor in an AIF may get preferential treatment unless disclosed in the AIF’s rules/instrument of incorporation).

Chapter III of the Level 2 Regulations provides a much greater level of detail in respect of the procedures, policies and internal structures (for example separation of personnel carrying out risk functions with the operating units of the AIFM) an authorised AIFM will need to introduce / maintain to comply with the above general principles. The Level 2 Regulations stipulate the frequency with which an authorised AIFM must review such procedures and policies and when the senior management of an authorised AIFM should be involved in such decision making. The Level 2 Regulations also contain lists of the factors that an authorised AIFM must take into account when carrying out certain functions as well as detailing the specific information that must be recorded for various transactions.

Some key points to note are as follows:

• in respect of an authorised AIFM permitted to carry out discretionary portfolio management, such AIFM is required to gain the prior approval of its client before investing all or part of the client’s portfolio in units or shares of an AIF it manages;
• authorised AIFMs are required to ensure that investors in the AIFs they manage are not charged undue costs;
• authorised AIFMs are required to apply a high standard of diligence in the selection and monitoring of investments;
• in respect of all assets, an authorised AIFM must implement, review and update written due diligence procedures. Special due diligence requirements are in place when investing in assets of limited liquidity – authorised AIFMs are required to prepare, update and monitor compliance with a business plan consistent with the duration of the AIF and market conditions, and assess the transaction relating to such asset in light of all relevant legal, tax, and financial considerations, including consideration of any exit strategies relating to such assets. The AIFMs must retain records relating to such assessments for a period of five years;
• authorised AIFMs must exercise due skill, care and diligence in the selection and appointment of prime brokers and the terms of such appointment shall be set out in a written contract. The written contract must make note of any possibility of transfer and reuse of AIF assets and require the depositary to be informed of the existence of the contract. In addition, when entering into any agreements with prime brokers or counterparties in over-the-counter derivatives transactions, securities lending transactions or repurchase agreements, authorised AIFMs must ensure such parties are subject to ongoing supervision by a public authority, are financially sound (taking into account whether they are subject to prudential regulation such as capital requirements) and have the necessary organisational structure and resources for performing the services for which they are engaged;
• as part of the duty of an authorised AIFM to act honestly, fairly and with due skills, competent authorities may assess whether the members of the governing body of an authorised AIFM commit sufficient time to perform their functions and whether adequate resources are devoted to the training of such members;
• the decision-making procedures and organisational structure of an authorised AIFM should ensure fair treatment of investors. Any preferential treatment accorded by an authorised AIFM to one or more investors should not result in an overall material disadvantage to other investors;
• as part of the duty of an authorised AIFM to act honestly, fairly and in accordance with the best interests of the AIFs it manages, such AIFM should ensure that when carrying out its functions, it is not paid any fee, commission or non-monetary benefit other than (i) from the AIF; (ii) where the nature, existence or amount of such fee, commission or non-monetary benefit is disclosed to investors and the provision of such fee, commission or non-monetary benefit is designed to enhance the quality of the relevant service being provided; or (iii) the provision of such fee, commission or non-monetary benefit is necessary for the provision of the relevant services, including custody, settlement, regulatory levies or legal fees; and
• in respect of a subscription or redemption, authorised AIFMs must ensure that investors are promptly provided, by means of a durable medium, with the essential information concerning the execution of that order or the acceptance of the subscription offer, as the case may be.

The following sections provide an overview of the topics covered in AIFMD and the Level 2 Regulations.

Conflicts of interest

An authorised AIFM must take all reasonable steps to identify conflicts of interest between (i) the AIFM itself, including the AIFM’s managers, employees and persons linked to it by control, and the AIF it manages (or the investors in the AIF), (ii) two AIFs that it manages (or investors in the AIFs), (iii) an AIF that it manages (or investors in the AIF) and another client of the AIFM, (iv) the AIF (or investors in the AIF) and a UCITS managed by the AIFM (or investors in the UCITS) and (v) two of the AIFM’s clients.

An authorised AIFM must maintain and operate organisational and administrative arrangements with a view to taking all reasonable steps designed to identify, prevent, manage and monitor conflicts of interest in order to prevent conflicts from adversely affecting the interests of the AIF and the investors in it. Authorised AIFMs must segregate, within their own operating environment, tasks and responsibilities that may be regarded as incompatible with each other or which may potentially generate systematic conflicts of interest.

Where arrangements are not sufficient to ensure, with reasonable confidence, that the risk of damage to investors will be prevented, an authorised AIFM must clearly disclose the conflicts to the investors before undertaking business on their behalf, and develop appropriate policies and procedures. The Level 2 Regulations specify that an authorised AIFM must have and maintain a written conflicts of interest policy, which must identify the circumstances which constitute or may give rise to a conflict of interest as well as procedures to be followed to prevent, manage and monitor such conflicts. An authorised AIFM will need to ensure that the persons engaged in business activities involving a risk of conflict of interest have a degree of independence which is appropriate to the size and activities of the AIFM and its group, and the materiality of the risk of damage to the AIF and its investors, including with respect to the manner in which such persons are supervised, remunerated and influenced. Authorised AIFMs are required to record the types of activities in which a conflict of interest has arisen or may arise, and the senior management of an authorised AIFM is required to review such records frequently and at least once a year.

The provisions dealing with conflicts of interest are contained in Chapter III, Section 2 of the Level 2 Regulations and can be found here. The topics covered are:

• types of conflicts of interest that an AIFM must take into account;
• the AIFM’s conflicts of interest policy;
• conflicts of interest related to the redemption of investments;
• procedures and measures preventing or managing conflicts of interest;
• managing conflicts of interest where the AIFM’s procedures may be insufficient;
• monitoring conflicts of interest;
• disclosure of conflicts of interest; and
• strategies for the exercise of voting rights.

Risk management

The AIFMD requires the risk management function of an authorised AIFM to be functionally and hierarchically separate from the operating units and portfolio management functions. An authorised AIFM must have adequate risk management systems in place which must be reviewed at least annually.

The Level 2 Regulations state that each authorised AIFM must have a permanent risk management function which must implement effective risk management policies and procedures in order to identify, manage and monitor on an ongoing basis all risks relevant to each AIF’s investment strategy to which each AIF is or may be exposed. Each authorised AIFM is required to have an adequate and documented risk management policy. An authorised AIFM is required to periodically, and at least annually, review and update its policy and systems and to carry out additional reviews if required as a result of internal and external events or if there are material changes to the investment strategy of an AIF managed by the AIFM. Further, an authorised AIFM must establish and implement quantitative or qualitative risk limits (if an AIFM elects to only provide qualitative risk limits it must be able to justify this approach) for each AIF it manages, which must cover at least the following risks: market, credit, liquidity, counterparty and operational (as well as, in the near future, sustainability).

The provisions dealing with Risk Management contained in Chapter III, Section 3 of the Level 2 Regulations can be found here. The topics covered are:

• risk management systems;
• the requirement for a permanent risk management function;
• the requirement for a risk management policy;
• assessment, monitoring and review of the risk management systems;
• functional and hierarchical separation of the risk management function;
• safeguards against conflicts of interest in relation to the risk management function;
• the requirement to implement risk limits; and
• risk measurement and management.

Liquidity management

For each AIF it manages (other than any AIF which is an unleveraged closed-ended AIF) an authorised AIFM must employ an appropriate liquidity management system and adopt procedures which enable it to monitor the liquidity risk of the AIF and to ensure the liquidity profile of the AIF’s investments complies with its underlying obligations.

Each authorised AIFM must also conduct regular stress tests to assess the AIF’s liquidity risk and ensure that the AIF’s investment strategy, liquidity profile and redemption policy are consistent.

The Level 2 Regulations provide that an authorised AIFM must document its liquidity management policies and procedures, which must be reviewed at least annually and include suitable escalation measures to address actual or anticipated liquidity shortages or other distressed situations of the AIF. The stress tests referred to above must be carried out under normal and exceptional liquidity conditions and should be conducted on the basis of reliable and up-to-date information in quantitative terms (where possible), simulate a shortage of liquidity of the assets in the AIF and atypical redemption requests (where appropriate) and account for valuation sensitivities under stressed conditions.

The provisions dealing with Liquidity Management contained in Chapter III, Section 4 of the Level 2 Regulations can be found here. The topics covered are:

• liquidity management system and procedures;
• monitoring and managing liquidity risk;
• liquidity management limits and stress tests; and
• alignment of investment strategy, liquidity profile and redemption policy.

Organisational requirements

Authorised AIFMs are required at all times to use adequate and appropriate human and technical resources that are necessary for the proper management of AIFs, in the near future including for the effective integration of sustainability risks. AIFMD also provides that an authorised AIFM must have sound administrative and accounting procedures, control and safeguard arrangements for electronic data processing and adequate internal control mechanisms, including, in particular, rules for personal transactions by its employees or for the holding or management of investments in order to invest on its own account.

The Level 2 Regulations contain detailed provisions setting out the organisational requirements that an authorised AIFM must have in place. Generally, an authorised AIFM is required to establish, implement and maintain: (i) an organisational structure which allocates functions and ensures the relevant persons are aware of the procedures to be followed, (ii) decision-making procedures, (iii) internal control mechanisms, (iv) confidentiality procedures, (v) an adequate business continuity policy, (vi) accounting policies and valuation rules and (vii) orderly records of its business and internal organisation. When complying with these requirements, authorised AIFMs will in the near future also be required to take into account sustainability risks.

Authorised AIFMs are required to keep detailed records with respect to portfolio transactions and must also record information regarding subscription offers and redemption orders. Records of this nature must be retained by the AIFM for a period of at least five years.

Chapter III, Section 6 of the Level 2 Regulations provides further detail on each of these requirements. The topics covered are:

• electronic data processing;
• accounting procedures;
• control by the governing body, senior management and supervisory function;
• the requirement for a permanent compliance function;
• the requirement for a permanent internal audit function;
• personal transactions and associated conflicts of interest;
• recording portfolio transactions and the information required;
• recording subscription and redemption orders and the information required; and
• general recordkeeping requirements.

See also the provisions in relation to delegation of functions by the AIFM, which are summarised here.

Investment in securitisation positions

The rules applicable to investment by AIFs in securitisation positions apply differently depending on whether the relevant securities were issued on or after 1 January 2019. The Securitisation Regulation replaces the rules in AIFMD and the Level 2 Regulation with respect to investing in securitisation positions for securitisations the securities of which are issued on or after 1 January 2019).

Securities issued prior to 1 January 2019

For securitisations the securities of which are issued prior to 1 January 2019, the provisions in the Level 2 Regulations with respect to investments by AIFMs in securitisation positions continue to apply. The relevant articles are contained in Chapter III, Section 5 of the Level 2 Regulations, which can be found here. These provisions only apply to authorised AIFMs, and not to sub-threshold AIFMs and non-EU AIFMs which manage and/or market AIFs into the EU.

The topics covered are:

• requirements for retained interest;
• qualitative requirements concerning sponsors and originators;
• qualitative requirements concerning authorised AIFMs exposed to securitisations; and
• corrective action.

Securities issued on or after 1 January 2019

For securitisations the securities of which are issued on or after 1 January 2019, the Securitisation Regulation sets out certain verification, due diligence and on-going monitoring obligations which apply to AIFMs.

The verification and due diligence obligations applying to AIFMs under the Securitisation Regulation vary depending on the nature of the relevant originator, sponsor or original lender (including whether it is either a credit institution or an investment firm, and whether it is established in the EU). Generally, however, prior to holding a securitisation position, an AIFM must:

• verify that the originator, sponsor or original lender:
• retains on an ongoing basis a material net economic interest of not less than 5%;
• has disclosed such risk retention to the AIFM;
• grants all the credits giving rise to the underlying exposures on the basis of sound and well-defined criteria and clearly established processes for approving, amending, renewing and financing those credits; and
• has effective systems in place to apply those criteria and processes to ensure that credit-granting is based on a thorough assessment of the obligor’s creditworthiness; and
• carry out a due diligence assessment which enables it to assess the risks involved, including considering at least all of the following:
• the risk characteristics of the individual securitisation position and the underlying exposures;
• all the structural features of the securitisation that can materially impact the performance of the securitisation position, including the contractual priorities of payment and priority of payment-related triggers, credit enhancements, liquidity enhancements, market value triggers, and transaction-specific definitions of default; and
• where a securitisation has been notified as a simple, transparent and standardised (“STS”) securitisation, the transaction complies with the criteria for STS securitisations set out in the Securitisation Regulation. AIFMs may rely to an appropriate extent on the STS notification and the information disclosed by the originator, sponsor or securitisation special purpose entity on the compliance with the STS requirements, provided that the AIFM does not do so “solely or mechanistically”. The articles dealing with the STS requirements contained in Chapter 4 of the Securitisation Regulation can be found here.

For so long as the AIFM holds the securitisation position, it must also:

• establish appropriate written procedures that are proportionate to the risk profile of the securitisation position in order to monitor performance of the securitisation position and of the underlying exposures.
  
  Where relevant with respect to the securitisation and the underlying exposures, those written procedures shall include monitoring of the exposure type, the percentage of loans more than 30, 60 and 90 days past due, default rates, prepayment rates, loans in foreclosure, recovery rates, repurchases, loan modifications, payment holidays, collateral type and occupancy, and frequency distribution of credit scores or other measures of credit worthiness across underlying exposures, industry and geographical diversification, frequency distribution of loan to value ratios with band widths that facilitate adequate sensitivity analysis. Where the underlying exposures are themselves securitisation positions, the AIFM must also monitor the exposures underlying those positions;
• regularly perform stress tests on the cash flows and collateral values supporting the underlying exposures or (where relevant) the solvency and liquidity of the sponsor;
• ensure internal reporting to the AIFM’s management body so that the management body is aware of the material risks arising from the securitisation position and so that those risks are adequately managed; and
• be able to demonstrate to the AIFM’s competent authorities, upon request, that:
• it has a comprehensive and thorough understanding of the securitisation position and its underlying exposures;
• it has implemented written policies and procedures for the risk management of the securitisation position and for maintaining records of the verifications and due diligence performed; and
• where relevant, it has a comprehensive and thorough understanding of the credit quality of the sponsor and of the terms of the liquidity facility provided.

Where an authorised AIFM is exposed to a securitisation that no longer meets the requirements of the Securitisation Regulation, it must take such corrective action (if appropriate) as is in the best interests of the investors in the relevant AIF.

Scope of Securitisation Requirements – non-EU AIFMs and small AIFMs

These Securitisation Regulation requirements are expressed apply to an AIFM that manages or markets alternative investment funds in the EU.

On a literal reading, as well as full-scope authorised EU AIFMs, the requirements also apply to both non-EU AIFMs which only market AIFs in the EU under NPPR and small, sub-threshold AIFMs There has been some uncertainty in the market as to whether this was intended. The Joint Committee of European Supervisory Agencies issued an opinion on 26 March 2021 in relation to the jurisdictional scope of the Securitisation Regulation, to the effect that the relevant legislation should be amended to make clear that due diligence requirements apply to non-EU AIFMs with respect to AIFs they manage and/or market in the Union (i.e. including under NPPR), and to identify how these requirements will be supervised and enforced. The ESAs did not provide a definitive opinion in relation to the application of these requirements to small AIFMs, except to advise that the position should be clarified in the legislation, noting that the regulation and supervision of small AIFMs is generally under review in connection with the ongoing AIFMD review.