WR Asset Management: When does a company qualify as an alternative investment fund? A particular focus on project financing

Below we discuss the criteria for when a company is defined as an AIF, with particular focus on project finance companies.

Project financing

There is no legal definition of project finance companies or project finance as such. Project financing is a form of financing with long-standing traditions in the Norwegian market, particularly in the shipping and real estate sectors, and will in practice have many similarities with a typical AIF. In brief, project finance is a collective term for various investment structures in which one or more investors join together to acquire one or more assets in an investment object - typically a single asset, such as a real estate or a ship. This form of investment is characterised by experienced investors being invited - by a facilitator (normally an investment firm) - to invest in projects, often on short notice. After the relevant investors have subscribed, the management responsibility typically shifts to the investors, usually through the board, while the facilitator withdraws. Key functions related to day-to-day operations are often outsourced to service providers associated with the facilitator. 

Investment in commercial real estate and shipping projects through syndication has historically been a popular form of investment in Norway. Returns have been consistently strong, especially in commercial real estate. Project financing in shipping is normally characterised by higher market volatility, but demand for shipping projects in this segment has also been relatively high in recent times. 

The definition of alternative investment funds 

The Norwegian Act on the Management of Alternative Investment Funds (the "AIFM Act") section 1-2 (1) (a) defines an AIF as a:

1. collective investment undertaking, that
2. is not a UCITS, cf. § 1-2 (1) no. 4, which
3. raises capital 
4. from a number of investors
5. with a view to investing that capital for the benefit of those investors in accordance with a defined investment strategy

A company must meet all five conditions to qualify as an AIF. This status triggers a number of requirements and obligations for the manager (whether the management is external or internally managed by its board). You can read more about this here.

In 2019, FSAN published a circular on the definition of alternative investment funds and project finance companies (Norwegian) (the "Circular"). In the Circular, FSAN goes a long way in claiming that project finance companies often must be considered as AIFs. At the same time, FSAN emphasised that the assessment of whether there is an AIF or not must be based on the guidelines of the European Securities and Markets Authority (ESMA), in accordance with their Guidelines on the Key Concepts of the AIFMD (2013/600). 

Normally, conditions (ii) to (v) are met by most project finance companies. We summarise these below, before discussing in more detail the condition that is most often the question in doubt - namely whether the project finance company is a "collective investment undertaking".

Exclusion of UCITS

An AIF is distinctly not a UCITS. In brief, UCITS funds are a type of mutual funds that satisfies common European rules under the UCITS Directive. UCITS are subject to extensive requirements regarding, among other things, risk diversification, what the fund can invest in and frequent access for unitholders to redeem their units. Ordinary project finance companies are inherently non-UCITS. 

Raising capital

According to ESMA's guidelines, the condition of raising capital will be fulfilled if the company or someone acting on behalf of the company takes direct or indirect steps to obtain a transfer or commitment of capital. It is irrelevant whether this activity takes place only once, several times or on an ongoing basis, and it is irrelevant whether the transfer or commitment is in the form of cash or a non-monetary contribution. The decisive factor is whether the company raises external capital that is not already in the company. Traditional project finance companies will typically fulfil this requirement. 

Raising capital from a number of investors

AIF status also requires that the capital is raised from a number of investors. In its guidelines, ESMA states that the condition will be met if the company is not legally prevented from raising capital from more than one investor. In other words, a theoretical possibility that a company can raise capital from more than one investor is in generally sufficient. The condition may thus be fulfilled despite the fact that there is de facto only one investor in the company.

ESMA emphasises that so-called master/feeder funds, fund-of-funds and nominee structures must be regarded as circumvention, and that the condition that capital is raised from a number of investors must also be regarded as fulfilled in relation to such structures. Traditional project finance companies will normally fulfil the condition of raising capital from a number of investors.

Defined investment strategy for the benefit of investors 

An AIF invests capital raised in accordance with a defined investment strategy for the benefit of the investors. In the Circular, FSAN states that the condition normally will be met if the other conditions in the AIF definition are met. The type of investment object, or whether investments are to be made accordance with one or more objects, is irrelevant to the assessment of whether there is a defined investment strategy for the benefit of the investors. FSAN states that there is a presumption against investors committing to an investment without there being a framework or mandate for how the invested capital is to be managed.

ESMA states in its guidelines that whether there is a defined investment strategy must be assessed on a case-by-case basis, and that it will be relevant to consider whether the investment strategy is sufficiently defined at the time investors' participation becomes legally binding, and whether it is laid down in or is mentioned in the company's articles of association or founding documents. Furthermore, it is relevant whether the investment strategy specifies that (i) certain categories of assets are to be invested in, (ii) a certain strategy is to be followed, (iii) investments are to be made in certain geographical areas, (iv) a certain loan-to-value ratio is to be adhered to, (v) there is a certain minimum investment period, and finally (vi) other restrictions to reduce risk are to be pursued.

As mentioned in the introduction, the four conditions mentioned above will typically be met by project finance companies.

Collective investment undertaking

The crucial point in the assessment of whether or not there is an AIF is often whether a specific company can be considered as a so-called collective investment undertaking.

If a project finance company is initially considered as a collective investment undertaking, it will typically also qualify as an AIF, because the other conditions mentioned in the relevant section in the AIFM Act typically are met.

According to ESMA's guidelines the following three sub-conditions must be met in order for a company to be considered as a collective investment undertaking:

1. The company does not conduct ordinary business activities
2. The company raises capital from investors with the intention of investing the capital to generate a total return for the investors, and
3. Investors do not have continuous control or influence. 

Traditional project finance companies will normally fulfil condition (ii) that the company raises capital from investors with the intention of investing the capital to generate a total return for the investors. 

The core of the assessment will therefore be sub-conditions (i) whether the company does not conduct ordinary business activities, and (iii) whether the investors do not have ongoing control or influence.

Exclusion of ordinary business activities

A project finance company engaged in general business activities cannot qualify as an AIF. For certain project finance companies it will be unclear whether the company conducts investment activities or general business activities. The question relates in particular to project finance companies that have a financial purpose, but where commercial or industrial activities are also included in the business. This typically applies to project finance companies that lease out property or ships on long-term contracts, but where the expected gain for the investors is also linked to expectations of a potential sale of underlying assets. In such a situation, a specific assessment must be made of whether the company is predominantly engaged in investment activities or general business activities. 

In the specific assessment of whether a company is engaged in investment activities or general business activities, the FSAN places particular emphasis on the following factors:

• Organisation/competence internally to manage operations and outsourcing: General manager or board member(s) with relevant expertise can indicate a commercial/industrial purpose.
• Investment horizon: Long and indefinite time horizon can indicate a commercial/industrial purpose.
• The degree of commercial operation: The duration of lease contracts coinciding with the expected lifespan of the structure, along with few/long-term contracts requiring minimal follow-up, may suggest that the company has a financial rather than a commercial/industrial purpose.
• Dividend policy: Fixed dividend policy indicates that the purpose is financial.

This is in line with the assessment factors that the Danish Financial Supervisory Authority and the UK Financial Conduct Authority (FCA) have emphasised in similar contexts.

Exclusion of companies where investors have ongoing influence or control

A company where the investors – as a group – have ongoing influence (i.e. making the most important decisions or control day-to-day operations) will not be considered as an AIF according to ESMA's guidelines and the Circular. 

According to ESMA's guidelines, the key issue is whether the authority to influence extends "substantially further" than the ordinary ownership authority that follows from being a shareholder. 

This will typically be the case if all the investors are represented in, or given the right to engage in, the company's board of directors, or where the articles of association or shareholders' agreements give investors the necessary influence or control over ongoing operational decisions, extended access to information from the company, etc. 

The fact that shareholders are free to elect board members, who in turn are responsible for the day-to-day management, will, in FSAN's view, not be sufficient to fulfil the AIF definition. Nor is it sufficient to have clauses in the articles of association that give the right to realisation in the event of approval from a limited percentage, unless the clause also gives the minority shareholders the same opportunity to activate such a clause in practice.

In the specific assessment of whether the investors in a company have ongoing influence or control, FSAN places particular emphasis on whether there is a decision-making authority that goes significantly further than which follows from the investors' general shareholder/owner rights. This can typically be ensured by all investors being represented on, or given the right to sit on, the company's board of directors, or through articles of association/shareholder's agreements that give the investors the necessary influence regarding ongoing operational decisions, extended access to information from the company, etc.

Co-author: Poria Khosravi