As well as complying with general Governance guidelines, what additional factors should the Board of an investment vehicle defined as an Alternative Investment Fund (AIF) consider when appointing and monitoring a regulated Alternative Investment Fund Manager (AIFM)?
Most large real estate investment vehicles need to be managed by regulated managers or AIFMs. Although INREV’s guidelines apply equally to regulated and unregulated managers, there are additional specific considerations concerning regulated managers in order to comply with the applicable regulation. This scenario may typically occur where an AIF within the scope of the AIFMD appoints an external AIFM as its manager. In this case, there are a number of important activities which the Board of the AIF delegates to the manager, but which it must monitor in order to ensure that the AIFM is performing such tasks reasonably and in compliance with legal and regulatory requirements.
Important tasks delegated to the AIFM must include portfolio management and risk management and will often also include administration and marketing. The AIFM may also, for example, provide support to the Board of the AIF in the performance of its duties. In addition, the AIFM commonly identifies and manages key service provider relationships on behalf of the AIF, such as depositories and auditors, and under the AIFMD has a responsibility to manage the valuation of the AIF’s assets and liabilities on behalf of the AIF to which it has been appointed. Clearly, the Board of the AIF has to be comfortable with the competencies and performance of the AIFM and will normally perform a degree of due diligence on the AIFM pursuant to this goal.
There are two key elements to this due diligence role:
- Initial due diligence
- Ongoing due diligence
Both initial and ongoing due diligence should be documented.
Initial due diligence
Before appointing an AIFM, the Board of the AIF should perform initial due diligence. The initial due diligence should, among other things, assess the ability of the proposed AIFM to perform the tasks to be delegated to it, and its ability to comply with the requirements of the AIFMD.
One of the key indicators for the Board of the AIF will be authorisation and supervision by the relevant supervisory authorities. Other typical factors which the Board of the AIF may consider may include:
- Scope of activities and experience of the AIFM;
- Knowledge, skills, experience and reputation of the Board, senior management and key staff, including the portfolio manager and risk manager;
- Organisation of the AIFM, including human and technical infrastructure, and the control arrangements of the risk management, compliance and internal audit functions;
- Delegation arrangements, and ability of the AIFM to perform adequate due diligence and ongoing monitoring;
- The identity and nature of the shareholders of the AIFM;
- Values statement or code of conduct, and how they are implemented in practice;
- Segregation of risk and portfolio management functions;
- Independence of the internal/external valuer.
From a practical perspective, the AIFM could provide the Board of the AIF with part or all of its application for authorisation to the supervisory authorities, and/or its handbook describing its organisational structure, policies and procedures, to assist the Board of the AIF in its assessment of the ability of the AIFM to comply with the requirements of the AIFMD.
Ongoing due diligence
The Board of the AIF should perform ongoing due diligence to assess whether the AIFM continues to have the ability to perform the tasks which have been delegated to it and to comply with AIFMD requirements. From an ongoing compliance perspective, the AIFM should provide the Board of the AIF with one or more reports covering:
- Risk management, including, among other items, KPIs on compliance with the risk limits and the risk profile of the AIF as disclosed to investors;
- Compliance with the regulatory requirements, including in particular KPIs on the compliance of the AIF;
- Internal audit reports, providing, among other items, an evaluation on whether risk management, control, and governance systems are functioning as intended.
Typically, each of these reports would be AIF-specific. In each case, the report should also cover remedial action to correct any deficiencies identified in the current or previous reports. The Board of the AIF should receive these reports at a frequency which is appropriate to the activities of the AIF, and at least annually.
In addition, when the AIF is appointing key service providers such as auditors and depositories, or providing representations to them, and when approving reports and accounts of the AIF, they are relying on the output of many of the key functions of the AIFM. Such reliance may be formally constituted in the form of reports and representations from the AIFM to the AIF.
How is confidentiality considered in the INREV Governance module and how to respond to the conflict between protecting sensitive information about your investors and being transparent?
The INREV standards refer to confidentiality in certain key areas:
- The Governance Module: principle number 5 refers to confidentiality in the context of transparency.
- The INREV Due Diligence Questionnaires (DDQs) refer to confidentiality in the assessment process.
- INREV provides a standard Non-Disclosure Agreement (NDA) with the purpose of providing a standardised alternative to the wide variety of NDAs currently being used in the industry.
The Governance Module is built upon seven principles. Principle 5 refers to being transparent while respecting confidentiality considerations. In general, it promotes free information flow between all involved parties in an investment vehicle to enable investors to understand the performance of the vehicle and its compliance with the vehicle strategy. The best practices in the module go as far as to disclose the terms of side letter agreements to all investors to create full transparency among all investors.
At the same time, Principle 5 also stresses the need for confidentiality. These provisions are mainly focused on the treatment of commercially sensitive information such as the identity of individual investors or information which would be advantageous to competitors. This information should be kept confidential and not made publicly available.
As referred to in the Governance guidelines, the general provisions covering confidentiality requirements and information to be disclosed to investors should be included in the constitutional documents. However, a significant amount of practical judgment needs to be applied during the lifetime of the investment vehicle to balance the information needs of investors whilst protecting the confidentiality requirements of both investors and the investment managers.
Given the wide variety of investment vehicle types, investment strategies, number and nature of investments it is difficult to be prescriptive on how to strike the right balance between transparency and confidentiality. There are many potential situations in the lifecycle of a vehicle that need to be considered when applying these basic principles. These may include but are not limited to:
- The risk that investors acquire commercially sensitive information from a specific vehicle and use this information inappropriately in other transactions or relationships;
- Investors wishing to waive the right to anonymity in order to collaborate with other investors;
- Investment managers using the identity and information regarding the position of existing investors in a vehicle to inappropriately promote their own interests;
- Investment managers entering into agreements with individual investors outside the normal terms of the vehicle, which modify the relevant investors engagement in the vehicle (side letters) without the knowledge of other investors;
- The risk that investment managers inappropriately withhold information about key events that impact the performance of an investment vehicle on the grounds of confidentiality;
- The risk that investment managers inappropriately use confidential information about a specific investment vehicle to promote interests in other non-related investment vehicles managed by the same investment manager;
- The risk that potential investors do not disclose all relevant information in relation to their qualification for admission to an investment vehicle (minimum net worth tests, tax position, etc).
In exercising practical judgment, investment managers and investors should always prioritise transparency over confidentiality while putting the best interests of all investors in the vehicle first and respecting the relevant constitutional terms.
In order to promote understanding and protect the confidentiality requirements of the parties involved, non-disclosure agreements are commonly used in the industry. To facilitate and standardise this understanding between the parties, INREV provides a non-disclosure agreement (NDA) template. For example, this may be used when providing information to potential new investors looking to buy interests in the vehicle through primary or secondary trades (INREV Liquidity Guidelines).
In addition, the INREV DDQs also include specific questions to help investors understand the scope of confidentiality requirements the manager and investors need to comply with regarding the disclosure of certain information about the vehicle and interests in it.