As July draws ever-closer and we approach the final AIFMD deadline, how should the alternative investment fund management (AIFM) industry continue to make the most of its period of transition?

The experts at Baronsmead, an independent specialist
brokerage for the investment management industry, discusses the
implementation of the Alternative Investment Fund Managers Directive,
and notably its insurance requirements and what these mean from a
compliance perspective.

As July draws ever-closer and we approach the final
AIFMD deadline, the alternative investment fund management (AIFM)
industry continues to make the most of its period of transition.
Since the directive was passed last year, the investment community
has undergone a period of significant change, as managers and
directors adjust their offerings to align them with the new
regulatory measures.

As the legislation is still not in force, the full
effect of the AIFMD remains to be seen, with asset and hedge fund
managers divided on the directive’s likely effect. However, the
number of managers that have successfully obtained, or are currently
applying for, AIFM authorisation, suggests that the industry is
prepared for considerable change. At its most basic, the AIFMD hopes
to reduce systemic risk and give investors more protection against
sharp practice than before, while the European Union hopes to create
a more level playing field. It will become clear over time whether
these goals are achievable, but we can be certain that firms will
find themselves in a new environment once the deadline passes in
July. An increase in regulation, and the guidelines that precede it,
brings many considerations to the fore, and will have implications
for the hedge fund sector.

At each hedge fund, compliance and risk management
staff must analyse their entire operation from a regulatory, legal,
compliance, operational and commercial perspective. With the emphasis
on change and understanding, as well as implementation, it is
apparent that compliance and risk management is set to have a key
role in the restructuring of AIFMs.

Insurance requirements: malpractice in the
spotlight?

Perhaps one important aspect of the AIFMD that has
not been very widely addressed is the change to insurance
requirements. This is an aspect of regulation the directive addresses
in detail, with clear and specific instructions for AIFMs which
mandate insurance.

The changes put forward by the AIFMD require managers
to hold appropriate additional 'own funds' or professional indemnity
insurance. This is primarily to cover the risk that liability will
arise from professional negligence. Professional liability can be an
all-encompassing term, however. As far as an AIFM is concerned, it
includes damage or loss caused by persons who are directly performing
activities for which the AIFM has legal responsibility, such as the
AIFM’s directors, officers or staff, and persons performing
activities under a delegation arrangement with the AIFM.

The most significant insurance change outlined in the
directive, as far as compliance and risk management people are
concerned, is featured in articles 12 and 15. Article 12 states that
AIFMs must hold 'own funds' or professional indemnity insurance to
cover their professional liabilities. The liability of the AIFM in
question will not be affected by delegation or sub-delegation and the
AIFM should provide adequate coverage for professional risks related
to such third parties for whom it is legally liable. Article 12 goes
on to suggest the types of risk that should be covered as the result
of various activities the AIFMs may carry out, including the
following:

• loss of documents evidencing title of assets of
  the AIF;

• misrepresentations or misleading statements made
  to the AIF or its investors;

• acts, errors or omissions resulting in a breach
  of legal and regulatory obligations;

• duty of skill and care towards the AIF and its
  investors;

• fiduciary duties;

• obligations of confidentiality;

• AIF rules or instruments of incorporation;

• terms of appointment of the AIFM by the AIF;

• failure to establish, implement and maintain
  appropriate procedures to prevent dishonest, fraudulent or malicious
  acts;

• improperly carried-out valuations of assets or
  calculations of unit/share prices; and

• losses arising from business disruption, system
  failures and failures in the processing of transactions or the
  management of processes.

Under Article 15 the cover is required to have an
initial term of one year at a minimum, with a notice period for
cancellation by insurers of not less than 90 days. It is worth noting
that some smaller AIFs are exempt from such requirements under the
AIFMD. These are AIFs with assets under management (including debt or
'leverage') that do not exceed €100 million, or do not exceed €500
million when the portfolio is not 'leveraged'. Smaller AIFs also need
have no redemption rights during a period of five years following the
date of initial investment to be exempted.

Potentially disruptive issues

At a superficial level, there is a conflict between
what the AIFMD requires and the practice amongst some alternative
investment managers of agreeing to a higher ‘gross negligence’
standard with the fund in the terms of their contracts. This is
something compliance and risk management folk should bear in mind.

There is not a specific stipulation in the AIFMD that
suggests that legal liability cannot be avoided in this way. However,
the regulation indicates that the European Commission will be
concerned if the AIFM can bypass some of the rules by contracting out
of its responsibilities for negligence. This is particularly likely
in view of the FCA’s recent public comments about the reservations
it has about negligence clauses.

This does not necessarily mean that contractual
responsibilities toward funds are an area likely to require review by
alternative investment fund managers. However, there is potential for
conflicts of interest between asset managers and their
fund-customers.

The changes brought on by the directive will not only
be regulatory, but also come from investor demands. Already,
investors seem to be paying more and more attention to the
responsibility of investment fund managers for ‘negligent’ trade
errors. This has led insured investment fund managers to take a
greater interest in the ways in which their PII policies might
respond.

Options for the future

The outlined changes leave UK managers with two
primary options:

• Buy Professional Indemnity Insurance (PII).
  This will amount to 0.7% of the total asset value of the AIF for
  individual claims, and 0.9% of the total asset value of the AIF in
  aggregate per year.

• Hold additional 'own funds' to cover losses.
  In February this year the FCA provided 'guidance' which described
  how to value assets under management (AuM) and announced that it
  would permit AIFMs to value derivatives positions at market value
  for the purposes of determining their capital requirements under the
  directive.

Potential solutions

There is no blanket solution, given the huge
variances in size and scale between AIFMs. Purely from a compliance
perspective, it seems clear that a combination of both options is the
best way to reduce overall risk, as well as being a much sounder
strategy from a financial perspective. It is debatable whether the
AIFMD’s capital allocation approach is an appropriate direct
replacement for insurance and it is fair to say that investors are
unlikely to consider it so.

A large percentage of investment managers already
purchase PII. It is very unlikely that such managers will cancel
existing PII to rely on additional own funds alone. One of the main
driving forces behind PII, is often pressure from investors who
demand a ‘safety net’ and the type of assurance that additional
own funds simply cannot offer. The purchase is also popular amongst
corporate governance and operational risk departments, which may have
a preference for an insurance policy to cover operational risks.
These risks include an over-reliance on capital amounts.

The logic behind using a lower value of additional
own funds is that coverage through PII is widely viewed as less
certain than coverage provided through additional own funds. For
obvious reasons, this is of particular concern to compliance
departments. Because of this, different percentages should apply to
the two different instruments used for covering professional
liability risk. Although this is an understandable position to take,
it is questionable whether it is a feasible long-term strategy, given
the levels of uncertainty, particularly the amount of funds that must
be available to cover losses resulting from professional liability
risks.

It is apparent that the adequacy of the 'additional
own funds' approach is questionable, especially when one is trying to
achieve the objective of protecting investors and paying for
professional liability losses and particularly when compared with the
limit of indemnity required under the AIFMD, or indeed the PII limit
of indemnity that many AIFMs already purchase. For example, one
insurer’s own assessment relating to the hedge fund sector, which
it has based on its predominantly EU-based customer portfolio,
indicates that the average limit of indemnity of their insured firms
when compared with assets under management is 2.39%.

As it stands, the 'own funds' requirements outlined
in the AIFMD may not offer investors the necessary levels of
protection, particularly when smaller firms serve them. Compliance
departments in the UK will have to reconsider whether the appointed
AIFM is protecting investors from sharp practice well enough, or if
further investment is necessary. Professional indemnity risk transfer
products will no doubt form part of this consideration, either
alongside the 'own funds' they hold or in place of them.

Although it will be necessary for AIFMs to make
further policy amendments to comply totally, an AIFM who chooses the
insurance route should at least find this section of the AIFMD
relatively easy to grasp and implement across the business.

The use of 'own funds' may initially seem appealing
from a compliance and risk management perspective when the firm in
question is large enough to cover the costs and produce the necessary
capital. However, as at smaller firms, this will not be enough by
itself. Larger firms that wish to use 'own funds' for compliance
purposes will still benefit from the additional security of PII. This
can also contribute to a strong risk management strategy built on a
combination of the two options. An insurance programme purchased in
accordance with perceived risk exposure as opposed to a strict
adherence to prescriptive limits is likely to be the most practical
approach.

Baronsmead, whose senior partner is Robert Kelly,
has offices in the City of London and can be reached on +44 (0) 20
7529 2305.