While some of the proposals could be harmful to market participants, the review presents an opportunity to clarify certain elements of AIFMD, says ICMA’s Arthur Carabia.
The European Commission (EC) on 22 October published its long-awaited consultation of a proposed review of the Alternative Investment Fund Managers Directive (AIFMD).
With EUR 6.6 trillion in AUM, alternative investment funds (AIFs) account for almost 40 percent of the EU fund industry and cover a wide range of profiles – including hedge funds, real estate, private equity, funds of funds, and infrastructure funds, among others.
While the EU label for AIFs is not yet hugely popular in Asia (only a handful of them are managed from Asia and sold there), market participants should keep an eye on this development, as it may have significant implications for UCITS funds (particularly popular in Singapore, Hong-Kong and Taiwan) and the existing delegation model, which is the cornerstone of the asset management industry.
The EC is indeed contemplating the idea of having a single rule book for investment funds, with the aim of harmonising the UCITS directive and the AIFMD despite them having different objectives (UCITS funds target retail investors and invests in liquid securities whereas AIFs are mainly sold to professional investors, and therefore can invest in less liquid securities and use significant leverage).
In the very short term, that could mean aligning reporting requirements for supervisors, leverage calculation methodologies, delegation rules, and the use of liquidity management tools.
While some of these alignments may provide legitimate benefits, ICMA believes the harmonisation exercise currently under consideration fails to recognise the diversity of underlying asset classes and asset management structures, and in the end would undermine both labels and the capacity of the EU to attract capital.
The delegation allowed under the UCITS Directive and AIFMD enables asset managers to set up a fund in the EU and carry out portfolio management or risk management activities from other jurisdictions. But the EC is exploring possible options to change the current rules in order to prevent the creation of ‘letter-box entities’ in the EU and ensure appropriate risk management by specifying quantitative criteria and a list of core or critical functions that should always be performed internally.
Here, we believe that the risks of loopholes, regulatory arbitrage and lack of substance are already being properly tackled by existing rules and the emphasis should instead be on the enforcement of these rules.
Existing UCITS and AIFMD provisions on delegation are already crystal clear in this respect: “The management company shall not delegate its functions to the extent that it becomes a letter-box entity”. In addition, the European Securities and Markets Authority (ESMA) has already issued far-reaching Legal Opinions covering delegation in 2017, which apply to both UCITS and AIFMD, and have prompted a number of changes in individual national practices and requirements.
For instance, management companies are now required to have at least two Senior Managers, and additional scrutiny is applied to management companies with less than three full-time employees for the investment function and/or monitoring of delegates.
With respect to delegation of portfolio management functions to non-EU entities: compliance with EU rules is achieved because (1) the EU delegating entity remains responsible for the operation of the fund and all activities related thereto and (2) the entity receiving the delegation is required to comply with the appropriate EU legislation by NCAs (e.g. paragraphs 491 and 492 CSSF 18/698).
ICMA sees this delegation model as trustworthy because it is underpinned by MoUs giving EU national supervisors the right to ensure proper monitoring of delegated activities: ESMA has recently reaffirmed this by adopting a MoU with the UK Financial Conduct Authority (FCA) on behalf of EU NCAs in the context of Brexit.
Curbing delegation beyond what is currently authorised would not be in the interest of EU investors, since it would leave them with narrower diversification and investment options. This would also put asset managers with a European footprint at a disadvantage vis-à-vis overseas competitors, because of increased costs and the inability to leverage internal and external expertise globally, including in Asia.
A calibrated approach
The EC is also pondering, on the basis of a level playing field consideration, whether it needs to review the National Private Placement Regimes (NPPR), the main route used by non-EU AIFs to reach EU investors.
Non-EU AIFs distributed in Europe accounted for EUR 1.7 trillion of AUM via the NPPR at the end of 2018, with Asian domiciled AIFs – including a number of Japanese and Singapore real estate funds – contributing modestly to the tally.
Whether the EU will actually go ahead with the policy options mentioned above remains to be seen. Certainly, ICMA will suggest addressing some of the concerns using a more granular and well-calibrated approach.
It’s important to also note that the review is not just about the items mentioned above; there are in fact 102 questions in the consultation. This could ultimately represent an opportunity to clarify certain elements of AIFMD, with a view to enhancing the EU’s global competitiveness.
From an Asian perspective, this could also present an opportunity to clearly exempt sukuk from AIFMD. In 2013, ICMA had already asked ESMA to clarify that sukuks are excluded from AIFMD, as they are comparable with ordinary bond issuances.
In the absence of clarification at the pan-EU level, some national regulators in the EU such as the Central Bank of Ireland and Luxembourg’s financial regulator (CSSF) have helpfully treated sukuks as asset backed securities or guaranteed debt securities, rather than AIFs. This review could be the opportunity to clarify whether sukuks are excluded in the core legislation.
The EC’s consultation document, available here, is open for comment until 29 January 2021.
This article was written by Arthur Carabia, a Director in ICMA’s Market Practice and Regulatory Policy team.