The Alternative Investment Funds Managers Directive (AIFMD) and the expected changes to the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive will dramatically alter the European funds’ landscape.
Undoubtedly, on the AIFMD side, there will be a different approach to marketing with many funds, perhaps more than expected, opting, at least until 2018, for the lighter touch regulation of the private placement route. But, at the same time, several currently lightly or non-regulated funds will come under closer scrutiny. The definition of alternative funds includes hedge funds, private equity funds, real estate funds, and infrastructure funds.
The major benefit of these changes is the ability to market funds throughout the EU. But, there is likely to be a hiatus before this becomes a reality. First, not all jurisdictions will meet the EU deadline, for there is already substantial slippage. Secondly, detailed regulation will introduce meaningful nuances in interpretation between the more liberal regulatory regimes such as London and some of the more conservative ones. Thirdly, regulation permits pan EU distribution, but that does not ensure there are the vehicles available for distribution in each and every jurisdiction. And, finally, we need to recognise that even plain UCITS equity funds do not dominate many markets, especially in our CEE region, where money and bond funds still retain a prominent role.
In the custody world, much of the focus of AIFMD and the expected UCITS V regulations has been on the depository obligations, and, especially, the liability for sub custodians in particular and the safety of assets in general. But AIFMD covers much more, and most of its requirements affect the duty of the fund administrator.
Indeed the changing role of the administrator is another of the vital changes created by this evolving funds’ landscape across Europe. AIFMD changes risk monitoring by requiring greater transparency as well as clearer lines of liability. AIFMD codifies more clearly the liability of different parties where functions are delegated and also the capital backing needed for funds. AIFMD changes the processes for business conduct, liquidity management, and valuations. And it impacts remuneration of key executives in a fund. As UCITS affect the broader public much more than alternative funds, it would be naive to the extreme to believe that the upcoming UCITS changes will not be at least as stringent as the AIFMD ones.
There is concern that the new regime will lead to a consolidation of funds across the major suppliers, or perhaps even the annihilation of smaller funds. The regulators have adopted lighter touch regimes for smaller funds. These are defined as funds with less than EUR 100 million of assets, including those acquired through leverage, or EUR 500 million if the fund is both unleveraged and closed to redemptions for a five year period. This will help start-ups, although the EUR 500 million concession looks rather too restrictive to have major effect.
The registration regime for AIF managers is quite onerous. As an example, there needs to be a detailed business plan identifying the organisation structure and also the mechanism for AIFMD compliance. In an industry sector that tends to be entrepreneurial, this is quite a culture change. The funds need to provide investment strategies and again there will be a challenge to codify these in line with regulatory demand and match those with investment reality. Non EU managers have a similar challenging task. This is the sector of the market that may opt for a private placement regime or even abandon the EU for marketing purposes. The centre of gravity for the hedge fund market is, after all, heading east rather than west. A non EU fund manager has to meet similar requirements to its EU counterpart if it wants an EU passport. But there are further requirements, including the establishment of an EU based legal representative to perform the compliance function for AIFMD requirements. And both have to identify and explain any area where compliance would be incompatible with a provision of another mandatory law. This is a difficult judgement call, especially as we enter the realms of extraterritoriality. Once again, this allows EU based administrators a new opportunity, but it brings new risks in virgin territory.
One valuable by product of the AIFMD, and indeed the regulatory thrust in the EU, is the greater clarity it gives to the obligations of the different stakeholders. Unfortunately, that also gives rise to tensions as risk is not always allocated in accordance with industry practise. It is, at times, allocated in accordance with regulatory preference. The board is clearly liable for compliance with regulation and the effectiveness of policies and arrangements. Senior management has equivalent liability for compliance as well as for investment strategies, policies, reviews, and active supervision of delegated functions. Compliance, risk management, and internal audit have distinct roles and duties, and they report to both senior management and the board to ensure all are clear that the activities of the fund comply with both the letter and the spirit of the regulations. The administrator links into the senior management, as does the custodian, but they also will need a line, direct or indirect, into the three pillars of risk control, namely compliance, risk management, and internal audit.
The depository, and in turn the custodian, will also be impacted by any prime brokerage arrangement as the prime broker is likely to have a sub custodian responsibility. It is not absolutely clear how extensive the depository’s general oversight role will be; this is more likely to evolve with experience rather than through scrutiny of the regulations. But administrators need to adapt to a changing role in liquidity management and a more judgemental one to ensure functional independence of valuations. Disclosure requirements have also been tightened, and, although these remain the primary responsibility of the AIFM, there may be once again a contingent and real liability for the administrator in their general oversight role.
The AIFMD gives the depository three specific core functions. These are cash flow monitoring, safe and record keeping, and the oversight of certain operational functions. The first two have been much discussed, but it is the third which is perhaps the most complex. Functions include the oversight of creations and redemptions, valuations, general compliance with the rules, timely settlement, and income collection. The major challenge is the need to ensure general compliance with the rules, as experience in many jurisdictions has shown in the past, this can be used as a catch all to say the depository takes extremely broad responsibility for the actions of the funds under their remit.
As a result, depositories are likely to focus on substantial fund managers of undoubted integrity and with proven risk management policies. In any event, despite the lip service paid by regulators to funds outside of this population, such a focus is perhaps the aim, or at least the intended unintended consequence, of the AIFMD and the expected new UCITS regulations.
John Gubert
Chairman
Global Securities Services
Executive Committee