AIFMD Review Places EU Passports at its Center

The European Commission (EC) recently provided a roadmap about how it intends to revamp the Alternative Investment Fund Management Directive (AIFMD). The plans could have a significant impact on UK investment firms post-Brexit and smooth the way for custodians to expand their depositary services across the entire single market. The EC report packs a lot into its 11 pages including fostering greater private equity growth, non-bank lending rules, and revisiting its controversial remuneration provisions.  What is certain is that the wheels are now in motion for an AIFMD sequel. 

The Commission released its report assessing the effectiveness of AIFMD to the European parliament on April 10, which was in part based on prior work an in-depth survey of market participants carried out on behalf of the EC by KPMG. While generally praising the implementation of AIFMD, first adopted in 2011, the report acknowledges the need for greater harmonization, reduced market fragmentation, and steps to foster growth in alternative funds across the EU.

While noting that assets invested in Alternative Investment Funds (AIFs) has grown from $2.5 trillion to $6.6 trillion, it is also noted that the vast majority of AIFs do not successfully sell across Europe’s borders. As such, revision of the AIFMD’s passporting regime as well as cross-border distribution barriers rear their head here once again. 

Gold Plating Problems

On the one hand, the EC recognize that AIFMD has been a success, but on the other hand they see that its growth has also been “impaired by national gold plating, divergences in the national marketing rules, varying interpretations of the AIFMD by national supervisors and its limited scope.”

As a refresher, gold plating generally refers to instances where national regulators apply additional requirements to those already contained in AIFMD.

Gold plating practices may include additional local requirements to provide documentation or a requirement to appoint a local country agent for the fund on top of the core AIFMD requirements. And by having to jump through these extra hoops — often adding layers of additional cost and risk — managers are forced to decide whether selling locally is worth the additional investment. This is a large contributory factor to the muted growth of cross border AIFs.

In addition, the EU passport only allows firms to market to “professional investors,” not the retail segment. The gold plating and distribution challenges are broad-based and cannot be solved solely within the AIFMD regime. 

For example, changing definitions of eligible investors would also require amendments to the Markets in Financial Instruments Directive (MIFID 2), which is also currently under open consultation. The trend of fostering greater retail access to alternative funds is very much on the table presently both in Europe and elsewhere. 

Third Country Rules

One of the most hotly anticipated aspects of the AIFMD review was whether a so-called “third-country passport” would be extended to non-EU Alternative Investment Fund Managers (AIFMs) (i.e., those operating from outside the EU) to allow them access to sell alternative funds into the single market. AIFMD regulates the asset manager not the fund structure so the location of the AIFM is always crucial. This issue has hovered above the EU alternatives funds space for many years now. It appears that it will remain in animated suspension for the time being since the Commission has not addressed the issue at this time.  

It had been hoped that provision of AIFMD funds by managers based in the US, Japan and elsewhere might gain access to the EU with extension of the third country passport. The debate, however, has been somewhat sidetracked by the UK’s departure from the EU, which takes effect in December. UK investment advisers already have a significant presence in the EU alternative funds market, but this might change if Brexit causes UK AIFMs to lose their EU passports as they become third-country funds (incidentally, UK-based UCITS will be considered “Third-Country AIFs” as well). This has already spurred many to set up AIFMs and UCITS ManCos within the EU to retain distribution rights to the single market. 

Without the passport, third-country managers must recognize the limitations on marketing and distribution across the EU, limitations that appear to be increasing over time. Third country AIFMs can only sell to investors in EU member states under local country regulations known as National Private Placement Regimes (NPPRs). But there is little consistency in the way the NPPRs are written, with some member states not allowing third country funds to sell in their markets at all. Unfortunately, as the Commission has apparently chosen not to recommend “switching on” a third-country passport regime for non-EU AIFMs, the NPPRs will remain in place as the only basis upon which to offer them into the EU.

The Commission’s report laments the fact that many EU retail investors lack sufficient choices with retail investors generally only being able to access bank and insurance company in-house funds under NPPRs rather than through a broad variety of third-party fund providers who are far more likely to rely on the AIFM passport (which does not permit retail investors). However, the Commission notes the situation is changing with an expanding market share of on-line platforms. 

With respect to Third-country AIFMs, the EU would clearly like to see investors given more options and foster greater competition. Two solutions are proposed:

  1. Harmonizing the NPPR rules across the EU
  2. Giving third-country managers AIFM passports, which likely would require tightening requirements on non-EU AIFMs to level the playing field between EU and non-EU AIFMs

Depositary Passport

The other important issue raised by the Commission relates to depositaries. One of the main driving forces behind adoption of the original AIFMD was concern about safekeeping of a fund’s assets and depositary liability. The role of the Depositary has become more central to the market as the concepts of asset safekeeping, liability, and restitution are increasingly seen as important and have increased investor trust in the AIFMD regime. As currently framed, however, the AIFMD rules state that an entity can only act as a depositary for funds domiciled in the country where it is based (e.g., an Irish depositary oversees an Irish AIF, a Luxembourg depositary a Luxembourg AIF, and so on). This, however, goes against one of the central principles of EU regulations and the AIFMD specifically. That is, the provision of services from one EU member state should be possible across all 27 member states that represent the single market through utilization of a passport. 

The report also cites concerns that some smaller EU countries are currently served by a single depositary in some cases. The Commission suggests that a solution may be to create a passport for depositaries similar to the one for fund managers to better serve those markets and generally increased choice and competition across all member states. This passport would allow Depositaries with depth of experience and scale in one country to provide the same services to funds in other EU member countries.

At a time where EU regulators are focused on liquidity, value for money assessments, and fostering longer term investment horizons, it seems like a good time for enhancement of the rules which govern regulated alternative and illiquid funds. At the same time, the specter of Brexit hangs over AIFMD and for now appears to be a constraining factor to progression of the third country AIFMD passport, which remains a burning question for many non-EU alternative managers.