A secure and stable financial system requires that all significant financial market actors are subject to appropriate regulation and supervision.
Alternative Investment Fund Managers ('AIFMs') have grown to become very significant actors in the European financial system, managing a large quantity of assets on behalf of pension funds and other investors; accounting for a significant proportion of trading activity in financial markets; and constituting an important source of counterparty risk for other market participants. AIFMs have also contributed to the build-up of leverage in the financial system, the consequences of which for the stability of financial markets became apparent when leverage in the hedge fund sector was rapidly unwound during the crisis.
In this context, it is essential that the risks that AIFMs pose to their investors, the financial markets and the companies in which they invest are rigorously monitored and controlled. The crisis exposed a number of deficiencies in this regard, notably a lack of transparency, deficiencies in the risk management and asset-safekeeping arrangements, and weaknesses in due diligence.
By responding to these risks, the Alternative Investment Management Directive [Directive 2011/61/EU hereinafter referred to as the 'AIFMD' or the 'Directive'] and the related Commission Delegated Regulation [Commission Delegated Regulation (EU) No 231/2013, hereinafter referred to as the 'Level II Regulation'] are therefore a key part of the European Commission's drive to lay the regulatory foundations for a secure financial system that supports and stimulates the real economy.
On the 24th June 2014, a Delegated Regulation [Commission Delegated Regulation (EU) No 694/2014, hereinafter referred to as the 'Regulatory Technical Standards' or the 'RTSs'] supplementing the Directive was published in the Official Journal of the European Union. The RTSs determine the types of AIFMs managing AIFs, providing detail on the circumstances when an AIFM will be considered to be managing open-ended AIFs or, alternatively, closed-ended AIFs. Under the AIFMD, AIFMs have to follow specific rules depending on whether or not they are AIFMs of open-ended and/or closed-ended AIFs. Therefore, it is important to foresee detailed rules determining whether an AIFM is managing open-ended and/or closed-ended AIF(s).
How are open-ended and closed-ended AIF(s) defined?
The distinguishing factor in determining whether an AIFM is managing AIF(s) of the open-ended type should be the fact that an open-ended AIF repurchases or redeems its shares or units with its investors, at the request of any of its shareholders or unitholders, prior to the commencement of its liquidation phase or wind down and does so according to the procedures and frequency set out in its rules or instruments of incorporation, prospectus or offering documents.
However, a decrease in the capital of the AIF in connection with distributions according to the rules or instruments of incorporation of the AIF, its prospectus or offering documents, including one that has been authorised by a resolution of the shareholders or unitholders passed in accordance with those rules or instruments of incorporation, prospectus or offering documents of the AIF, should not be taken into account for the purpose of determining whether or not the AIF is of the open-ended type.
Thus, the repurchases or redemptions which should be relevant for determining whether an AIFM is managing AIFs of the open-ended or closed-ended type should only be the ones made out of the assets of the AIF. Therefore, whether an AIF's shares or units can be negotiated on the secondary market and are not repurchased or redeemed by the AIF should not be taken into account for the purpose of determining whether or not the AIF is of the open-ended type.
On the other hand, an AIFM of a closed-ended AIF is then an AIFM which manages an AIF other an open-ended AIF. Hence, the RTSs do not give a definition of what constitutes a closed-ended AIF but they are only defined to the exclusion of an open-ended one.
Can an open-ended AIF convert into a closed-ended one (and vice versa)?
Recital 6 of the RTSs holds that '[a]ny change in the redemption policy of an AIF implying that the AIF may be considered no longer as being an AIF of the open-ended type or an AIF of the closed-ended type, should lead the AIFM to cease to apply the rules relating to the old-redemption policy of the AIF it manages and to apply the rules relating to the new redemption policy of such AIF.'
However, the RTS is silent as to how such change is to be recognized and registered.
Why is it important to know whether one is managing an open-ended or a closed-ended AIF?
In particular, it is important to differentiate between the management of open-ended or closed-ended AIFs to apply correctly the rules on liquidity management, the valuation procedures and the transitional provisions of the AIFMD.
- With regard to the liquidity management, Article 16(1) of the AIFMD holds that:
'AIFMs shall, for each AIF that they manage which is not an unleveraged closed-ended AIF, employ an appropriate liquidity management system and adopt procedures which enable them to monitor the liquidity risk of the AIF and to ensure that the liquidity profile of the investments of the AIF complies with its underlying obligations(…)'
Moreover, '[f]or any new arrangements for managing the liquidity of the AIF in accordance with point (b) of Article 23(4) of Directive 2011/61/EU AIFMs shall:
(a) for each AIF that they manage which is not an unleveraged closed-ended AIF, notify to investors whenever they make changes to the liquidity management systems and procedures referred to in Article 16(1) of Directive 2011/61/EU which are material in accordance with Article 106(1).
In addition to this, Recital 60 of the Level II Regulation holds that:
'The requirement to monitor the liquidity management of underlying collective investment undertakings in which AIFs invest, along with the requirements to put in place tools and arrangements to manage liquidity risk and identify, manage and monitor conflicts of interest between investors should not apply to AIFMs managing AIFs of the closed-ended type regardless of whether they are deemed to be employing leverage. The exemption from those redemption-related liquidity management requirements should reflect the differences in the general redemption terms of investors in a closed- ended AIF compared to those in an open-ended AIF.'
- With regard to the valuation procedures, Article 19(3) of the AIFMD applies different requirements in relation to the frequency of valuation for open-ended and closed-ended AIFs:
'AIFMs shall also ensure that the net asset value per unit or share of AIFs is calculated and disclosed to the investors in accordance with this Article, the applicable national law and the AIF rules or instruments of incorporation.
The valuation procedures used shall ensure that the assets are valued and the net asset value per unit or share is calculated at least once a year.
If the AIF is of the open-ended type, such valuations and calculations shall also be carried out at a frequency which is both appropriate to the assets held by the AIF and its issuance and redemption frequency.
If the AIF is of the closed-ended type, such valuations and calculations shall also be carried out in case of an increase or decrease of the capital by the relevant AIF.
Taking into account the fact that no harmonized definition of closed-ended AIFs existed in the EU prior to the AIFMD, the RTS clarifies that AIFMs can benefit from the transitional periods in Articles 61(3) and (4) of the AIFMD.
Article 61(3) and (4) of the Directive provide for transitional periods during which existing AIFMs, in so far as they manage closed-ended AIFs that are in an advanced or financial stage of their investment after 22nd July 2013, can continue to manage such AIFs without authorization or without having to comply with a significant part of the Directive. Consequently, in order to preserve the scope of those provisions as intended in light of this objective and the above-mentioned background, it should be also considered to be an AIFM of a closed-ended AIF for the purposes of Article 61(3) and (4) of the Directive, each AIFM in so far it manages AIFs whose share or units are repurchased or redeemed after an initial period of at least 5 years during which redemption rights are not exercisable.
Therefore, it is important to distinguish between open-ended and closed-ended AIFs wherever this distinction is relevant for the application of the AIFMD.
An open-ended fund is generally considered to be one which provides redemption facilities to investors, while a closed-ended fund does not provide such right. If no consideration is given to AIFs which are only nominally open-ended (i.e. they provide redemption facilities at very infrequent intervals, such as less than annually or after a period of five years), such funds will be subject, for instance, to the liquidity management requirements of Article 16 and the future implementing measures. In order to avoid taking a disproportionate approach, there may be grounds for considering such AIFs as closed-ended for the purposes of the AIFMD. Proportionality needs to be applied to all articles and not only some, as proportionality is a general principle of law and regulation.
Therefore, the European Securities and Markets Authority ('ESMA') is of the view that open-ended funds are those funds the units/shares of which may be, at the holder's request, repurchased or redeemed without any limitation, directly or indirectly out of the assets of these undertakings at least annually.
This document does not purport to give legal, financial or tax advice. Should you require further information or legal assistance, please do not hesitate to contact Dr. Katya Tua or Dr. Nicholas Micallef.