What does the recent ESMA decision on the AIFMD Passport extension mean for non-EU hedge fund managers?
Since ESMA recommended extending the AIFMD passport to Switzerland, Jersey, and Guernsey last year, the hedge fund industry has been wondering if the AIFMD passport would ever be extended to a non-European domicile. Now we know the answer: Sort of but not really.
On 19 July, ESMA released its recommendations for extending the AIFMD passport to nine other non-EU domiciles. It reevaluated three jurisdictions it had originally deferred in 2015, the United States, Hong Kong, Singapore, along with six new jurisdictions, Australia, Bermuda, Canada, Cayman Islands, Isle of Man, and Japan.
Each jurisdiction was evaluated for eligibility based on four key criteria:
- Investor protection: Are the rules around the safekeeping of assets and the function of the depositary in place?
- Market disruption: To what extent will granting the passport undermine the activity of existing EU AIFMs? And is it likely to lead managers to circumvent of AIFMD?
- Competition: Is there a level playing field for EU funds and managers, in terms of market access to the non-EU markets?
- Monitoring of systemic risk: Is there tangible evidence of adequate regulatory surveillance of potential or actual systemic risks?
The result of ESMA’s assessment was a bit of a mixed bag. Canada and Japan were given unqualified recommendations; joining Switzerland, Jersey, and Guernsey in that category. For Australia and the United States, ESMA provided qualified recommendations. However, while not deal breakers, it noted a few issues with both jurisdictions. For Hong Kong and Singapore, ESMA recommended that funds from these jurisdictions be granted access to the passport but not managers. ESMA deferred making a decision on both Bermuda and the Cayman Islands because both jurisdictions are in the process of implementing new regulatory regimes and felt it was too early to judge their effectiveness. Finally, ESMA found that the absence of an AIFMD-like regime in the Isle of Man meant ESMA could not recommend granting it access to the passport.
So, what does this all mean? Well, that depends on who you ask. Most headlines have focused on how ESMA has supported opening the AIFMD to a number of countries and, specifically, that US hedge fund managers gaining access to the AIFMD passport. However, the news is probably less significant than it appears at first blush and doesn’t really change the current dynamic.
Rather that focusing on what ESMA did, the bigger headline should be what decision ESMA did not make. ESMA delayed making a recommendation on Cayman until some unidentified point in the future. This is an issue because Cayman is the preferred domicile for US hedge fund managers, particularly for those selling to non-US investors. In fact, the Cayman Islands Monetary Authority estimates 75% of the assets in Cayman funds are managed by US firms. Effectively, ESMA’s decision means that US managers actually won’t have access to the passport because they cannot use it to sell their Cayman funds across the EU.
Another mitigating factor to ESMA’s decision is that the AIFMD passport is really more of a theory than a reality. As you would expect, there have been some problems with the introduction of the AIFMD passport. In a report in July 2015, even ESMA has noted that there are a number of issues with the AIFMD passport including: divergent approaches by local regulators towards the marketing rules, differing opinions on what constitutes a “professional investor”, along with different interpretations of what constitutes “marketing” under the AIFMD.
The trouble with the AIFMD passport, coupled with the fact that hedge funds have traditionally been sold more discreetly, means most managers are using private placement to distribute their hedge funds. ESMA’s decision seems unlikely to change this.
Finally, it’s important to remember that the final decision is in the hands of the EU Commission, Council, and Parliament. ESMA’s decision to extend the AIMFD passport is simply a recommendation. This will be a more political and less technocratic decision making process since all three parties have to agree on extending the passport. It’s not inconceivable that some of ESMA’s suggestions could be disregarded. Also, getting agreement amongst the EU Commission, Council, and Parliament will not be a quick process. Given their other priorities, I wouldn’t exactly hold my breath waiting for a final decision.
When you add all this up, you get something that looks remarkably like the status quo. As I said earlier this year, for the foreseeable future, non-EU managers will have to continue to make due with private placement or reverse solicitation, which will require managers to navigate the distribution process on a per country basis. If the decision drags out long enough, they may be better off launching EU-domiciled AIFMD funds. Of course, the more cynical among us might suggest this was the point of the delay all along.