On 26 October 2010, the European Parliament and Ecofin reached an agreement on the Alternative Investment Fund Managers Directive (AIFM Directive), which will introduce European regulation for AIFMs. The directive is part of the extensive European Commission (Commission) reform programme aimed at extending regulation to all activities that may carry significant market risks. It was introduced as a regulatory post-crisis response in line with the G20's commitments to global action to build a strong supervisory and regulatory framework for the financial sector. The directive aims to establish a harmonised framework to monitor and supervise the risks posed by the AIF industry to different financial market participants and to financial stability as a whole. Following the initial proposal of the directive by the Commission on 30 April 2009, strong criticism and fierce resistance by the industry and member states, as well as divergence of opinions between the Commission and the Parliament, led to delay in voting on the directive and to 18 redrafts of the proposal.

The AIFM Directive has a very broad scope and will apply to all AIFMs managing or marketing investment funds that do not require authorisation in the EU under Council Directive 85/611/EEC on UCITS (UCITS Directive). The directive not only covers managers of hedge funds and private equity funds but also managers of real estate funds, infrastructure funds, commodity funds and funds of funds. An AIFM can either be an external manager that provides portfolio management or risk management services to a fund, or the AIF itself, in the case of a self-managed AIF.

The directive gives a number of exemptions including, among other things, holding companies, national and international governmental institutions, and employee participation schemes. Additionally the AIFM Directive has de minimis exemptions for:

An internally managed AIF must have an initial capital of at least EUR300,000. Where an AIFM is appointed as external manager, it must have an initial capital of at least EUR125,000. AIFMs whose portfolio value exceeds EUR250 million have an additional minimum capital requirement of 0.02% of the excess amount, up to an aggregate EUR10 million cap.

AIFMs must have remuneration policies and practices for staff whose professional activities have a material impact on the risk profiles of the AIF they manage, including:

Annex II of the directive sets out the principles that an AIFM must comply with when establishing and applying remuneration policies. To ensure that the assessment process is based on longer-term performance, the AIFM Directive requires performance assessments to be based on a longer-term framework appropriate to the life-cycle of the AIF. Guaranteed variable pay will become exceptional and will be limited only to new staff in their first year. In addition, a substantial portion of the variable remuneration component (at least 40% and in some cases at least 60%) will have to be deferred over an appropriate period.

The directive requires AIFMs to periodically (and at least annually) value the net assets of the funds they manage. Open-ended funds must carry out valuations at a frequency that is appropriate to the assets held and the issuance and redemption frequency. For closed-ended funds, valuations must be undertaken when there is an increase or decrease of its capital. Valuations can be conducted by an external independent valuer or the fund manager itself (if this can be done on a functional level that is separate from its management and remuneration tasks).

In the initial debates on the AIFM Directives' depositary functions, the main focus was on the question of who can act as a depositary. The problematic provision was adjusted to allow the following entities to act as a depositary:

Controversially, the provisions still give a strict liability regime for depositaries. The directive stresses that the depositary is liable to the AIF, or the AIF's investors, for the loss of financial instruments held in custody, although there are a number of rules under which the depositary is exempted from liability.

An AIFM managing one or more AIF employing substantial leverage must disclose to the competent authorities of its home member state for each AIF it manages information on the:

Member states may impose further additional reporting requirements and impose limits on the level of leverage that an AIFM can employ to ensure the stability and integrity of the financial system. These requirements also apply to non-EU AIFMs in relation to any EU AIFs managed and non-EU AIFs marketed by them in the EU.

Despite strong opposition by the private equity industry, private equity funds will become subject to a series of additional disclosure requirements under the directive. Except for small or medium enterprises or real estate special purpose vehicles, when an AIF acquires shares in a non-listed company passing through the 10%, 20%, 30%, 50% and 75% voting right levels, the AIFMs must notify their home-state regulator, the company and its shareholders.

If the AIFs control 50% or more of voting rights of a non-listed company, their AIFM must make a number of disclosures, including disclosing to the company, its shareholders and its employees its future intentions regarding the company and the likely consequences for employment. AIFMs must also ensure that that the AIFs' annual reports include disclosures on the controlled company and that the board provides this information to the company's investors and employee representatives.

The industry will face new rules against asset stripping. The directive contains provisions that apply to the acquisition of control of non-listed companies or issuers. For 24 months following an acquisition, an AIFM must refrain from facilitating, supporting or instructing, and in any event use its best efforts to prevent, distribution, capital reduction, share redemption and any acquisitions of own shares when:

The most hotly contested and highly politicised issue is that of the treatment of non-EU AIFs/AIFMs. While France strongly opposed allowing non-EU funds to receive an EU passport, the US Treasury Secretary stated that it would be discriminatory and contrary to prior assurances to refuse a passport to these funds, and the UK advocated the necessity of the passport in the context of an increasingly global industry.

While under the initial proposals non-EU AIFMs could only market in the EU under the national private placement regimes, the final text of the directive grants them a passport right. This enables them to market to investors across the EU without first having to seek permission from each member state and comply with different national laws. The passport will only be granted to AIFMs that are duly authorised and comply with, among other things, all requirements and obligations set out in the directive and whose home-state meets minimum regulatory standards and allows information sharing based on agreements with member states.

EU AIFMs that manage non-EU AIFs can also market them throughout the EU if a set of conditions are met, including among other things, compliance with all the requirements of the directive and arrangements for the exchange of supervisory information between the member state and the third country.

The passport system will be phased in over the next five years, granting a passport for European funds in 2013 and non-European funds in 2015. In the first two years following adoption of the directive, the private placement regime will remain in force subject to certain conditions. For the following five years, the passport regime and the private placement regime will exist side-by-side. Five years after the transposition of the directive, the Commission will fully abolish the private placement regime, if it deems appropriate after issuing an opinion on both the private placement and the passport regimes.

Under the AIFM Directive, the Commission has the power to adopt measures to specify different directive provisions by means of delegated acts, for a period of four years following the entry into force of the directive. This enables the Commission to draw up the rules on a wide variety of matters, including:

The regulation of AIFs and AIFMs will change significantly under the AIFM Directive. While currently subject to light regulation or different exemptions, AIFMs will have to operate under much closer scrutiny and oversight by the incoming European Securities and Markets Authority (ESMA). Although both the industry and the member states stress that the directive was substantially improved from the initial draft, there remains criticism towards certain directive provisions. The following concerns have been expressed regarding the final text:

Following the approvals by the Parliament during their plenary session on 11 November and the formal approval of the text by the Council, the text will come into force in December or early 2011, requiring implementation of the directive by the 27 member states by early 2013.

There are a number of current developments in the US that could directly affect AIFs. On 18 March 2010 the Foreign Account Tax Compliance Act (FATCA) was enacted, which places a significant burden on private equity funds and their tax directors, and which is likely to make additional resources and technology necessary. FATCA has significant implications for all financial services institutions (including asset managers) that have US citizen clients or receive US source income.

Previously, payments on synthetic instruments (such as swaps and repurchase transactions on US equities) were generally paid without any withholding tax. A significant provision in this law re-characterises these payments as dividends, with the result that they are subject to 30% US withholding tax.

The pending US International Tax Competitiveness Act of 2010 is a proposal to amend the Internal Revenue Code to, among other things, treat foreign corporations that are managed, directly or indirectly, within the US as domestic corporations for US tax purposes. Under the Stop Tax Haven Abuse Act, the "managed and controlled" portion was targeted at offshore hedge funds and private equity funds. However, the current version is not so limited. Many countries establish residency for taxpayers on an effective management basis and, to that extent, are far less formalistic than the US. The concept is not completely new in the US, as can be seen from US tax treaties (for example, the limitation on benefits provisions of the US - Netherlands tax treaty).

Nonetheless, if the various tests are met, this provision could have the effect of bringing corporations from anywhere in the world into the US tax jurisdiction. It is expected that taxpayers will plan around these measures in an attempt to avoid falling under the scope of the provision.

On 24 June 2010, the US Senate held another procedural vote on increasing carried interest tax. This vote failed and as a result, carried interest will continue to be treated as capital gains for tax purposes, if structured properly.

On 12 July 2010, the Canadian government brought into force changes to the Income Tax Act aimed at easing the tax and administrative burdens for non-residents that invest in Canadian companies, in an effort to stimulate foreign investment. These may provide opportunities for non-resident investors to simplify existing investment structures.

In the past, non-residents have generally been subject to Canadian taxation on gains arising from the disposition of taxable Canadian property (subject to relief under an applicable tax treaty). Taxable Canadian property previously included a broad range of property with a direct link to Canada (for example, shares of private Canadian companies). As a result of this legislation the foreign investor was obliged to file a detailed compliance regime. The wide definition of taxable Canadian property, and the complex compliance burden discouraged numerous foreign investors.

The amendments have narrowed the definition of taxable Canadian property in the Tax Act. In effect, the amendments will generally exempt non-resident investors (regardless of their entitlement to claim tax treaty relief) from Canadian federal income taxes in respect of capital gains realised on the disposition of shares of many types of private Canadian corporations.

Investments into Asia continue to grow. From an investment perspective, the region has historically been difficult to navigate, as an investor's tax treatment tends to be based on complex tax legislation and administrative practices.

One of the main developing trends seen in China, Indonesia, Australia, Japan, Korea and India is for local tax authorities to challenge treaty-based tax avoidance structures. In most cases this involved holding structures that took advantage of tax treaties while having little or no substance at the level of the holding vehicle.

For example, at the end of 2009 Australia denied a Dutch holding company owned by an AIF treaty benefits during the disposal of an Australian company in an initial public offering. In May 2010, Indonesia stated that only beneficial owners of income can claim treaty protection under their respective tax treaties. Recently, the Lone Star case and the Vodafone case (in Korea and India, respectively) have also addressed the substance issue.

With increased investment interest in the Asia Pacific region, countries such as Singapore and Hong Kong have introduced safe harbour rules to attract fund managers. These give tax exemptions for funds managed in the country (generally offshore funds with a focus on offshore investors). The exemption is usually subject to a list of conditions and to a list of qualifying investments and income.

The UCITS IV directive will dramatically alter the European fund management scene. It is intended that UCITS IV will lead to consolidation of a fragmented European investment fund industry, both at the fund and service provider level. The aim is that this consolidation will lower costs and therefore boost competitiveness. Although UCITS IV does not describe any tax matters, the directive could potentially have significant tax consequences for management companies and funds, including tax leakage or other tax inefficiencies.

Some new opportunities derived from UCITS IV are the:

UCITS IV will oblige all EU member states to allow cross-border mergers. However, the tax treatment of fund mergers will remain different in almost every country. Some countries allow tax neutrality for domestic mergers but most tax foreign and cross-border fund reorganisations either at the level of the fund or/and at the level of the investor. Transformations of existing UCITS into feeder funds will be at market value. As a result, unrealised gains at the level of the investor could become taxable in certain countries (such as Germany).

Another important tax-related decision is selecting the jurisdiction of establishment of the European management company. Tax considerations include the corporate income tax rate, computation of the taxable basis of the management company, transfer pricing rules, VAT and so on, but above all the taxation of the fund itself.

Despite certain perceived downsides from a tax perspective, UCITS IV offers many opportunities. Therefore, a careful analysis of the different tax options is advisable.

Market terms over the past year remain heavily in investors' favour. AIFMs must now expect to deal with terms relating to:

AIFMs have also seen heavily negotiated or less than generous terms in relation to:

AIFMs have also seen the scope their discretion under attack with investors increasingly examining reinvestments, investment strategies, borrowings, and guarantees and standards of corporate governance. They may also wish to specify decisions that must taken with the approval of an investor body such as the supervisory board, rather than at the AIFM's discretion.

In addition, the publication by the Institutional Limited Partners Association (ILPA) of recommended best practices (ILPA Principles) aims to bring the starting point of the negotiations to a place where the terms balance the interest of both the AIFM and the investors. However, there are areas where the ILPA Principles differ significantly from pre-2009 market norms, including:

The ILPA Principles are commonly mentioned at the negotiations stage, with investors asking AIFMs to point out areas where the fund terms diverge from the ILPA Principles, signalling that the ILPA Principles may very well represent the new private equity business model. From that starting point, investors often further negotiate terms in their favour.

Institutional investors have demonstrated an increasing preference for onshore jurisdictions in the past 12 months. Often, there is more than one workable jurisdiction for a potential fund from a legal and tax perspective, and the choice of jurisdiction can be heavily influenced by the investors' aims. With the recent actions against tax havens taken by governments around the world, institutional investors are increasingly asking for funds to be located onshore. While this may have the effect of giving an AIF a clean stamp, for AIFMs who are accustomed to using certain jurisdictions and have built up contacts in such jurisdictions, these demands can be troublesome. It is important for AIFMs to involve their potential key investors at the early structuring stage to assess the investors' comfort level with the proposed structure and jurisdiction of the AIF.

A surprising aspect of the shift towards investor-friendly terms is the level of detail in which investors now negotiate terms. If one looks back at AIF documentation dating back four to five years, the level of detail is markedly lower than that seen in today's documentation. Most of the concessions are seen in non-financial terms, such as the examples given above, but also increasingly in the AIF's commercial terms. The principle behind investing in an AIF is that the investor trusts the commercial expertise of the AIFM. However, this has not stopped institutional investors from extending their traditional role and giving their input on the investment strategy and aims. If an AIFM wants to diverge from an established strategy, it must get the approval of an investor committee such as an advisory board. It is interesting to see that AIFMs' discretion to use their business judgement has decreased in the past two years, when it is something investors presumably trust if they are investing in the AIFMs' funds.

However, these trends will perhaps not greatly affect established players. Many investors doubt that the pendulum has shifted significantly towards investors who are investing in AIFs that are over-subscribed. Rather, they see the shift as causing problems for new AIFMs and AIFs that have trouble raising capital, who will try to implement more investor-friendly terms in the first instance to secure certain investors. However, even the largest and most successful funds have made concessions to their most important investors by trimming management and other fees.

Developments in fund terms are going to make the next few years very interesting for practitioners. It will be increasingly important to stay at the cutting edge of new developments in market standards since the AIFMs will want their advisers to be able to help them position their terms as accurately and reasonably as possible and be able to ascertain when investors' demands can be met and when an AIFM should stand firm. Deep knowledge, broad experience and negotiation skills, as well as good contacts with key investors, will cause AIFMs to appoint one adviser over another.

However, in turn, those practitioners must be able not only to follow the market but to lead it, suggesting creative new structures and provisions to meet new investor concerns, while also ensuring that AIFMs continue to have a viable and well-protected business. Practitioners also increasingly need to be able to answer the question of why it makes sense for certain fees to be covered by investors or why certain commercial terms should be left up to the discretion of the AIFMs. In essence, the interests of the AIFMs and the investors are aligned in the sense that all parties to the AIF want to see good results.