Why ESMA should reconsider its position on Host AIFMs

Under the Alternative Investment Fund Managers Directive (“AIFMD”), fund sponsors have two options for marketing funds in Europe; either set up a European domiciled fund managed by a full scope AIFM, which gives access to the EU marketing passport, or register to market under the relevant National Private Placement Regimes (“NPPRs”) for each member state. Particularly with respect to non-EU sponsors, the latter has been the status quo since the inception of the directive, but more recently we have seen an increasing number of these sponsors opting to set up European funds in order to access the market passport and a wider pool of institutional capital.

The European Securities and Markets Authority (“ESMA”) recently wrote a letter to the European Commission outlining recommendations for change in 19 areas of the AIFMD, ahead of the Commission’s forthcoming review of the directive. Amongst the number of proposed legislative changes, ESMA recommends more prescriptive regulations and requirements in respect of delegation structures, both between host AIFMs and fund sponsors, but also between the AIFM and third parties such as fund administrators and tax advisors.

What is the intention of this letter?

The letter published by ESMA encourages the European Commission to support the ideas proposed, “to improve the effectiveness and soundness of the AIFMD.” Specifically, the letter encourages the European Commission to place greater regulation on those functions which are commonly delegated to third parties, including portfolio management but also fund administration and tax compliance. The viability of Host AIFMs is also called into question, with the conflict of interest for the AIFM between investor protection and client retention being highlighted. Other areas mentioned include ensuring there is enough regulation of “sub-threshold” AIFMs, as well as significant changes to the definition of leverage, which contributes to the definition of a sub-threshold AIFM. Ultimately, we believe the intention of this letter is to encourage the European Commission to allow ESMA to regulate a greater scope of activities pertaining to the marketing and management of EU domiciled vehicles, specifically with one eye on the UK financial services industry.

How do the proposed changes differ from current legislation?

Historically, most non-EU sponsors have marketed non-EU funds (e.g. Cayman, Delaware) to the EU under the relevant NPPRs. More recently, we have seen increasing numbers from both the US and Asia setting up parallel vehicles domiciled in the EU, to avail themselves of the marketing passport under AIFMD. This vehicle requires the appointment of an authorised AIFM, whether sponsored, owned or provided by a host. In the case of a host, it is common that portfolio management would be delegated back to the investment manager, assuming they are suitably regulated in an equivalent jurisdiction (e.g. by the SEC in the US). The ESMA letter notes that “portfolio management functions are often largely or even entirely delegated to third parties” which are often situated outside of the EU, with this only likely to increase as the Brexit deadline draws nearer. The letter suggests that the commission consider clarification on the maximum extent of delegation permissible, or even restricting which functions can be delegated.

In addition to recommendations on delegation, the letter also calls into question the validity of the Host AIFM model, noting that an external AIFM may face conflicts of interest while facing pressures from the fund sponsor. In particular, the letter highlights the scenario where the host AIFM should challenge the fund sponsor for the best interests of the investors, but this may come at the risk of losing a client and therefore revenue.

Why the Host AIFM model is a net positive for the European Union

Since the implementation of the AIFMD, several Host AIFMs have become authorised in various member states, with Luxembourg proving one of the most popular. We strongly believe that the use of Host AIFMs benefits the fund management industry in several ways, each specific to the key stakeholders affected by the directive:

Regulators

• Host AIFMs provide a further layer of independent oversight, reducing the inherent conflicts that come with having an in-house team. Areas such as appropriate deal costs and consistency of valuation methodology are particularly common areas of discussion;
• By using an experienced Host AIFM, the regulator can effectively achieve consistency in the complex regulation of multiple managers from multiple backgrounds rather than allowing hundreds of global managers to establish and monitor their own interpretation of the regulatory environment;
• As well as financial sanctions and reputational damage, employees of a Host AIFM themselves can be personally liable for any negligence whilst conducting their duties. This  ensures stronger reference to the guidelines than perhaps an inexperienced manager or one from an emerging economy;
• Host AIFM fees are not linked to the performance of the fund, and they are not incentivised to take risks relating to fund management, a key pillar of the AIFMD.

Managers

• Using a Host AIFM allows access to smaller first time managers or established overseas managers who don’t wish to risk the cost of establishing their own office in the EU;
• Reduces the time to market for managers that already have an existing pipeline of deals. Direct authorisation can take as long as 12 months, and requires significant upfront time, cost and people resource;
• Reduces the middle and back office resource required by managers looking to operate in Europe, allowing them to concentrate on greater value-add work;
• Allows managers to access a greater pool of capital than they otherwise would under the relevant NPPRs, which are not workable in all 28 EU member states;
• A Host AIFM works with a range of clients, so can provide fund sponsors with best practices relating to AML, due diligence, investment committee processes and more.

Investors

• By facilitating market access for a greater range of fund sponsors, the Host AIFM model increases competition, whilst providing investors with a greater investment universe;
• Host AIFMs allow a more diverse range of investment opportunities for investors, including access to strategies, geographies and assets that they might not otherwise have had exposure to;
• Using a Host AIFM can lead to reduced operating costs, and so increasing returns for investors;
• Appointing a truly independent third party as AIFM reduces the risk of negligence and wrongdoing by the fund sponsor.

How would the proposed changes affect the fund management industry?

If implemented, we believe these proposed changes would be harmful to the fund management industry for several reasons. Firstly, the barrier to entry is already high for first time managers, whether as startups or spin-outs. By removing the ability to appoint a Host AIFM in the early years, it will not be economically viable for these fund sponsors to commence operations, and so European investors will miss out on a large section of the fund management market. Even the largest US fund managers are only now taking their first tentative steps to establishing operations in Europe via the AIFM route. These managers don’t just “bite the bullet” and set up a five person operation with the hope of raising a fund. They universally take small steps up the regulatory curve from NPPR in a small handful of countries. The Host AIFM stage is very much on that critical path and its removal will severely curb their interest in providing product to the EU market.

Secondly, should delegation of portfolio management no longer be permissible, it is highly likely that many non-EU sponsors will simply choose not to set up in Europe. For countries such as Italy, France and Spain without workable NPPRs, this means no access for investors to the immense talent pool found in the US, Asia, and soon to be the UK. Again, it is too much of a leap for overseas managers, with sometimes decades of established working practices, to hand over control beyond a point which impairs speed and certainty of deal execution.

Finally, by making it tougher to appoint an AIFM, but also to appoint an administrator or tax advisor, ESMA risks increasing the operational costs associated with running a fund, ultimately damaging the total returns of European investors.

For these reasons, we believe that the Host AIFM model is a positive one for European fund sponsors and investors and the financial markets in which they operate, and the European Commission should strongly consider its position with respect to delegation arrangements when it undertakes its review of the AIFMD.

Langham Hall is an award-winning provider of Fund Administration, Depositary and AIFMD services to global fund managers. To hear more about how we can help, whatever the requirements, please get in touch with a member of our team.