Delegation model under spotlight as European Commission reviews AIFM Directive
All eyes will be on the European Commission’s legal proposal pertaining to the AIFM Directive, which is expected to be published sometime in the first half of 2021, and could usher in an updated version – AIFMD II – a decade after it was first adopted.
The more interesting parts of the consultation for UK fund managers to be mindful of are delegation and marketing of non-EU funds to EU Member States. European fund domiciles including Luxembourg and Ireland will be especially keen to understand what changes, if any, are made to the delegation model, upon which third-party AIFM platforms have built substantial business models.
On 10 June 2020, the European Commission published a report assessing the application and scope of the AIFM Directive. This was followed by a response from ESMA on 18th August 2020, following exchanges with National Competent Authorities (NCAs), which the EC is now considering. Delegation is a politically charged topic and was raised in ESMA’s letter, where it pointed out that AIFMs rely on delegation of portfolio management functions, which often go to entities outside of the EU, where the AIFMD rules do not apply. This could well change if the EC decides to address the issue.
The questions being asked in ESMA’s letter appear to have a touch of political influence; the French have a burgeoning asset management sector, which they would see as a competitor to the UK in the future. Many of the questions being directed to the EC allude to the future relationship between the UK and the EU, where the UK will be outside of AIFMD and effectively become a competitor as a non-EU AIFM jurisdiction.
The European Commission’s review covers a range of issues touching on systemic risk, leverage, liquidity management etc., but from a UK perspective, none of those things are especially relevant. For example, if AIFMD were to be updated such that a specific leverage cap were imposed, or a specific rule on liquidity management were introduced, they would only apply to EU AIFMs.
But the twin issues of delegation and marketing of non-EU funds to EU Member States are certainly something UK fund managers need to be mindful of.
Regarding delegation, the EC is asking the question, ‘What is the appropriate delegation model? Should there be substantive criteria?’
For example, right now AIFMD states that delegation should not result in substantially more investment management taking place outside the EU. But what does that mean in reality?
ESMA has suggested that the Commission should introduce quantitative criteria.
In the EU’s world, if you’re a French asset manager and you want to offer a new fund with a global mandate, you may well want to delegate some portfolio management activities to a Latin American-based manager, or a China-based manager. If you’re ESMA, that makes sense because it’s beneficial to the end investor; it’s no problem because the actual AIFM is based in France.
However, the EU don’t want a world where all the portfolio management activities are being driven by someone located in Latin America – or indeed the UK – and sets up a nominal management entity in the EU: a bare bones AIFM with little substance and which does little more than delegate the portfolio management back to the non-EU entity.
That’s where the politics comes into this. The EU wants to protect its interests. It will have a bearing on how the UK – and the rest of the world – relates to the EU. It’s a big deal for EU AIFMs as it could directly impact their ability to support non-EU managers wishing to set up funds and use their AIFM passport.
Moreover, it is conceivable that whatever is done for AIFMD – under the guide of AIFMD II - will also be applied to the UCITS regime, for consistency and to maintain a level playing field.
That would be even more damaging to UCITS management companies because the UCITS delegation model is very light, in terms of rules and regulations.
How might the European Commission address the delegation model question?
One option might be that if an AIFM manages X per cent of AUM, they will be allowed to delegate Y per cent of AUM. Right now, there is very little AUM actually being managed by AIFM platforms in Luxembourg and Ireland. These are asset servicing hubs and fund distribution hubs, they are not fund management centres like London, Paris or Frankfurt.
Another option might be to stipulate that the AIFM needs to have X number of people on the ground, actually performing portfolio management in addition to risk management activities.
The existing AIFMD legal text already states that investment management functions delegated shall “not exceed by a substantial margin” the functions retained by the authorised AIFM.
Given the key importance of this legal requirement, the European Commission is being asked to further specify this concept of “substantial margin” to ensure greater legal certainty for the sector and supervisory convergence amongst NCAs.
ESMA has observed that investment managers often make use of large-scale delegation arrangements and that Brexit will likely make delegation to non-EU entities more pronounced.
ESMA’s Executive Director, Verena Ross, focused on this issue of substantial margin in a speech she gave on 19 November 2020, during which she said: “I want to emphasise upfront that ESMA fully acknowledges the benefits of delegation in terms of enhancing efficiency and scale as well as getting access to more specialised investment expertise. We are therefore aware of the importance of delegation arrangements for the fund industry and the need to keep an open global model and avoid creating unnecessary barriers.”
Determining what the right amount of delegation should be is a fair question. But it remains to be seen how this will be addressed and resolved by the European Commission.
If there is too much tightening of the delegation rules, it might limit the ability for non-EU managers to set up sub-funds on AIFM platforms – unless they are willing to move some of their people to the Continent; namely portfolio and risk management professionals.
Of course, as with any regulatory issue there are always unintended consequences. Even if the European Commission does codify ‘substantial margin’ and increase the portfolio management requirements expected of EU AIFMs, it could end up impacting the end investor. They might find their ability to access talented non-EU investment managers is stymied going forward. Some will still be happy to invest in offshore fund vehicles, of course, in which case managers could continue with private placement activities under NPPR rules, but it could impact those who need to invest in EU regulated funds.
European institutional investors need to get involved in this discussion. If they don’t, they might find they have less access to alternative investment managers than they had in the past.
Expect to see a legal proposal coming out of the European Commission some time in Q1 or Q2.
Then we will have some clarity on what to expect with AIFMD II.