We have been covering the ongoing review of the Alternative Investment Fund Managers Directive (AIFMD) for some time now. Last week, the European Commission (EC) released its public consultation which the industry is currently parsing. The consultation questions are largely consistent with issues highlighted by the ESMA letter sent to the Commission in August. Certain issues have grabbed the headlines, while other items might not grab headlines but remain important. Let’s look at both:
Not unusually, most initial industry attention and market commentary has focused on the thorny issues of delegation to non-EU based entities, and the ever-increasing likelihood that so called third country passports for managers based outside the EU will not be forthcoming. The consultation paper asks whether the use of national placement regimes for non-EU managers, which allows them to sell in individual EU countries, creates an “uneven playing field” between EU and non-EU fund managers. This indicates that rather than an extension of third country passports, further curbs on non-EU managers selling into Europe is the likelier outcome.
The delegation point is particularly key since it’s a central pillar of most global investment managers model. For asset managers, it is common practice to base themselves and sell funds in the EU, while at the same time outsource certain investment decisions or other tasks to financial centers such as the UK or United States where the expertise resides. This dispersed global model is increasingly challenged by a focus on increased substance and activity to be conducted within the EU’s borders. AIFMD also already contains specific rules to govern such delegation; however, the consultation questions whether the rules should go further and be more specific. The consultation asks whether prescribing “quantitative” maximum limits on delegation or a list of “core or critical functions” that should be performed in the EU is necessary.
It is rightly a crucial area of focus for global asset managers who look to leverage global resource and expertise to best serve their European client base. It’s also, however, an issue heavily entwined in the wider Brexit negotiations, and will essentially be dictated by how that saga ends.
Delegation is an issue which more parochially has reared its head very recently in Ireland, where the Central Bank of Ireland released its findings in relation to its thematic review (CP86) of fund management companies (FMC). Again, one of the central themes was whether the local Irish fund management company displayed thorough enough scrutiny of non-Irish delegates in terms of due diligence, ongoing supervision, and independent challenge of the foreign delegate by the Irish FMC
Three Sleeper Issues
There are host of issues addressed within the consultation which is not unusual given AIFMD was one of the most widespread and all-encompassing regulatory implementations imposed after the great financial crisis. Among these are issues that have nothing to do with the “international relations” but rather might have a sizeable impact on EU AIFMs operating within the current regime. What follows are three issues worth exploring:
ESMA’s Wider Remit
Some years ago, ESMA’s changed its terms of reference and they were given certain “superpowers” to directly supervise the EU markets. The main aim was to increase regulatory harmonization in instances where multiple national regimes might be sub-optimal for supervision. Recently, ESMA has increasingly begun to use its overarching powers to conduct EU-wide market assessments itself, rather than delegate such reviews to national competent authorities (NCAs).
An example is a Common Supervisory Action (CSA) where ESMA sets the questions, then requests the NCAs in member states collect responses and data from regulated entities under their supervision and provide them back to ESMA for their review. As a result, this means consistency of approach and uniformity of data which ultimately leads to more consistent implementation and application of EU rules. ESMA has already conducted CSAs on fund liquidity this year and will do so once more in 2021, while they have also flagged an upcoming assessment of costs and fees using the same mechanism. ESMA’s direct supervision mandate appears to increase year-on-year.
Once more within the AIFMD review the concept of ESMA taking a more central role in pan-EU supervision is raised in several ways within the CP. There is a suggestion that ESMA be given “strong and binding coordination powers in market stress situations” so they have a single view at a time where systemic risk might increase across the EU. There is also suggestion that AIFMD reporting be centralized with ESMA rather than submitted to NCAs and also that ESMA be given powers to take action against individual AIMFs and AIFs where their activities threaten integrity of the EU financial market or stability the financial system.
What is certain is that ESMA appear to have a desire to be more rather than less involved in direct supervision of the EU market. What this means for national regulators and for asset managers operating in Europe is less certain but remains an area worth monitoring.
One of the biggest shifts that occurred due to the original AIFMD implementation was the amplification of the importance of the fund depositary as it relates to asset safekeeping and investor protection. The role of a fund depositary is now seen as an essential oversight function for all EU regulated funds, but it wasn’t always so.
The consultation asks in broad strokes what difficulties depositaries have faced in exercising their duties under AIFMD. It then drills into some very technical but very important asset safekeeping and other depositary related topics, such as:
- Tri-party collateral management
- Prime broker reporting
- International central securities depositaries (iCSDs) as delegates
It also raises the issue of an AIFMD depositary passport. Currently, the appointed depositary must be located in the domicile of the AIF fund. The two dominant AIFMD domiciles are Ireland and Luxembourg and as such this is where the largest most experienced depositaries reside. A depositary passport opens up the possibility that an authorized depositary could provide oversight of AIF funds in other EU domiciles. For instance, an Irish or Luxembourg depositary might be appointed to a Polish AIFMD fund. One of the drivers of the concept is that some smaller EU AIFMD markets are not well served with local depositaries and a depositary passport could address the lack of supply of depositary services in smaller EU markets.
There are pros, cons, and complex legal considerations when it comes to each of these depositary considerations. These are issues that exercise BBH as a matter of course but they are also consequential to asset managers operating under AIFMD and as such we are also happy to discuss the gory details as required.
AIFMD imposes very specific asset valuation provisions in order to ensure investors can have confidence that the value of their investment is accurate, and if they redeem the value of their redemption proceeds can reasonably be assured. AIFMD fund assets are either valued “internally” by the asset managers or by an external valuer, an entity totally independent of the AIFM. It’s currently an either/or scenario and a mixture of the two models is not possible.
Also, external valuer liability standards are quite strict, which results in certain reluctance by some agents to act in this capacity or ones who do to charge premium pricing to cover their liability risk. The CP therefore poses the question whether the liability provisions are too onerous and should be reduced in order to tempt more providers into the space increasing choice and reducing costs in a classic supply & demand market dynamic.
If amended, this, in theory, would be a very beneficial change to all stakeholders. But asset managers who often must reluctantly take on this valuation liability even though they still utilize third party entities to value the asset. Further, any cost efficiencies that can be brought to bear currently are most welcome in a very competitive market and another area of intense regulatory focus.
These are each important issues in their own right, but an exhaustive list of all issues covered in the CP. There are several other important issues not covered here but that have material impact on managers operating or thinking of operating under the AFMD regime in the future. With the consultation running until January 29, 2021 we are sure to be hearing plenty more about AIFMD from now until then.