ESMA Letter: AIFMD Revisions just the Tip of the Iceberg

“I didn’t have time to write a short letter, so I wrote a long one instead.”

Mark Twain

We recently flagged the European Commission’s review of the Alternative Investment Fund Management Directive (AIFMD). The Commission’s initial report was short and sweet but flagged certain significant probable changes to the composition of AIFMD at a high level. In response, last week, European Securities and Market Authority (ESMA) published a letter which addresses AIFMD at the surface, but at the same time, the EU watchdog took the opportunity to raise numerous other weighty issues to the EC, which will be of great interest and some concern to asset managers. 

ESMA’s AIFMD comments were highly anticipated given AIFMD is an important EU regulation and some impactful revisions were expected. In 2020, maybe we should expect the unexpected, but it is fair to say most commentators were taken aback by the ESMA letter in terms of its scope, but also the worry that elements of the commentary could be disruptive to current global asset management models. 

ESMA’s remarks specific to AIFMD revisions are merely the tip of the iceberg. Let’s jump to the main points of interest:


The theme of “regulatory substance” has been a burning question in the main EU fund domiciles of Luxembourg and Ireland for some time now. Most recently in Ireland, the industry has been waiting for the Central Bank of Ireland to publish a “Dear CEO – CP86” letter to industry addressing required resources for Irish management companies required to be retained in Ireland.

ESMA’s focus on EU substance has increasingly intensified during the Brexit transition period. There has been a push to ensure EU funds are not merely “letterbox entities,” where the actual services are conducted in non-EU locations which by nature are harder for EU regulators to monitor. The industry’s has countered that both UCITS and AIFMD management companies (ManCos) leverage global expertise with appropriate oversight in the regulatory residence of the fund.   The industry contends that this  model protects investors by allowing local regulators to monitor services provided globally by supervising local oversight of these services while still allowing fund management access to the best investment and administrative expertise for their products, usually by using group company resources that would be expensive and inefficient to duplicate. 

The question of what represents “appropriate levels of substance” has to date focused on nature, scale complexity of funds, largely a subjective assessment.  There has been a divergence of opinions expressed during the course of  the Central Bank of Ireland CP 86 review, but these are in the context of ESMA’s desire to increase the services performed within the EU and to establish a  more objective assessment of regulatory substance.  Ultimately, this might result in adequate substance being assessed by a headcount of staff in the fund domicile or otherwise within the EU, which likely means less access to third country global resources.

So generally, global regulators are shifting towards better-defined and data-led quantitative assessments for supervision. Here again, ESMA appears to wish to move to a calculation of substance using a more formulaic approach. More objective, less subjective. More numbers, less words. How the calculation of substance lands will have significant impact on the current globally dispersed UCITS & AIFMD model.

Delegation Models

Any enhanced local substance requirements will directly affect a UCITS’ or AIFM’s ability to delegate certain key fund responsibilities to third country entities.    This is particularly significant in the present moment because many asset managers’ contingency plans for Brexit envisaged an uninterrupted continuation of delegation of portfolio management to UK based firms.  The ESMA letter throws that into some uncertainty as the issue of third country delegation is addressed in this context.

The letter proposes amendments to the AIFMD (and UCITS) delegation rules. As with substance considerations, further restrictions to the ability to delegate tasks to third countries would limit AIFMD and UCITS funds’ access to certain key global asset management hubs. Brexit plays a significant role in ESMA’s thinking on delegation, specifically flagging London’s importance as a hub in the letter:

“Moreover, in light of the withdrawal of the UK from the EU, delegation of portfolio management functions to non-EU entities is likely going to further increase..…..”

The delegation of portfolio and risk management services specifically lie at the center of this debate. EU funds seldom directly employ staff to conduct functions and in terms of portfolio management specifically, delegation to a UK or US asset manager is quite routine. This is ESMA’s primary delegation concern. The use of third country entities not directly supervised by ESMA or an EU national regulator are characterized as creating “increased operational and supervisory risks” and further raises “regulatory arbitrage and investor protection concerns,” since these delegates are not directly subject to either the AIFMD or UCITS standards. 

ESMA’s comments on delegation further raise specter of regulatory equivalence, a real hot button Brexit issue, but the EU’s more general focus remains on ensuring that any third country delegates to EU fund be closely aligned to EU regulation.  

While many have rightly focused on the future relationship and interactions between the UK and EU, for the most part Brexit-inspired changes to third country rules equally impact other critical asset management hubs. New York, Tokyo and Hong Kong are a few examples of hubs where portfolio management is routinely delegated by UCITS and AIFMD funds. The globally dispersed delegation model has always meant EU funds can access the best investment expertise globally with very strong control and oversight measures within the domicile. The ESMA letter now suggests use of non-EU firms increases risk and their ability to supervise hence a push to restrict such delegation and force more services to funds to be conducted by regulated entities within the EU. 

Specifically, ESMA outlines three concrete changes to the current view on delegation:

  • Clearer legal drafting for delegation requirements across AIFMD and UCITS;
  • Formally listing core and critical functions which may not be delegated to third countries; and
  • Likelihood of setting maximum levels of delegation allowed outside the EU.

These are all new concepts raised by ESMA in their latest letter and certainly these are restrictive enough to affect the existing model of delegation for EU regulated funds. A key driver of the continued growth and success of AIFMD and UCITS funds to date has been the able to access “best of breed” skillsets to the benefit of EU funds and their investors without incurring the expense of replicating capabilities in multiple jurisdictions, a reason why the EU must delicately balance these considerations. In particular, the UCITS brand and governance model has been a spectacular multi-year EU policy success story, greatly aided EU investors with long terms savings and is the envy of many other financial centers.  Any debate on changes to the model should consider these factors, as this will be a key policy battleground for global asset managers now that ESMA has indicated its intentions. 

While the delegation and substance issues certainly jump out and will take the lion’s share of attention for asset managers with EU funds, the ESMA letter is also notable for the wide range of issues it addresses. These are issues that impact AIFMD but also UCITS and the rulesets’ interactions with another foundational EU regulation such as MIFID 2 for example. 

ESMA take the opportunity to alert the EC to a litany of other crucial asset management issues that are highly significant. We will undoubtedly revisit these in due course, but other points of great interest within the letter include:

  • Harmonization of Regulatory reporting across AIFMD and UCITS
  • Enhanced Fund Liquidity reporting
  • Leverage calculations
  • “White Labelled” management company
  • Private Equity leverage calculations (aggregated / look thru to SPV leverage)
  • Management company secondments
  • New EU investor categorization: Semi-professional investors
  • New Loan Origination Funds Regime
  • Depositary rules to CSDs & Depositary passport
  • AIFMD External valuer liability – lower liability threshold
  • EU reverse solicitation definition
  • Mandatory LEI for all AIFMs / AIFs
  • Harmonization of supervision for cross-border entities and branches
  • ESG integration

This non-exhaustive list is proof that while ESMA have flagged certain key AIFMD revisions and brought regulatory substance to the forefront, these issues are merely the tip of the EU regulatory iceberg and global asset managers must stay tuned.