December-January 2017

ALTERNATIVE FUND ADMINISTRATION: The closed-border funds industry

With much uncertainty around cross-border fund distribution after Brexit, Nicholas Pratt asks what steps fund firms could take now to support their international businesses.

In recent years, the distribution of funds has been dependant on the ability to cross borders without hindrance. This model has been especially popular in Europe, where both Ucits and the AIFMD have allowed firms to set up a single management company within the EU and then market and distribute their funds to all other EU states.

Up until six months ago, alternative investment funds looked set to be exported beyond the EU. The European Securities and Markets Authority (Esma) was set to extend passporting rights and the EU equivalency regime to other markets with similar supervisory and regulatory standards, such as the US and several Asian markets.

But then the referendum-voting public in the UK upset things with the June Brexit vote, and recently the US electorate created another surprise by electing Donald Trump, a president who plans to abandon the Trans-Pacific Partnership trade agreement between the US and every major power outside of Europe.

Both votes have been widely interpreted as a protest against globalisation and the international trade agreements upon which globalisation depends.

Back in the summer, when the funds industry was still reeling from the Brexit vote and wondering about the implications for the distribution and marketing of their cross-border funds, it was assumed that the EU’s equivalence rules and passporting rights would mitigate any concerns.

However, recent comments from Esma suggest that the regulator may roll back the expansion of the equivalence regime as both the EU and UK adopt hard-nosed stances towards Brexit negotiations, with Britain seemingly told by the EU that equivalence is a privilege, not a right.

The EU’s equivalence regime is still relatively new and untested. It was introduced during Michel Barnier’s tenure as European Commissioner for Internal Market and Services – and Barnier is now the EU’s chief negotiator for Brexit.

“Previously, we thought that equivalency rules would protect the UK market and any UK-domiciled funds,” says Tim Thornton, managing director, fund services, at MUFG Investor Services.  “Unless there was any material change to the UK’s regulatory environment, those passporting rights would apply in the same way that they do for the US, Singapore and other markets.”

However, the concern now is that political will could override dispassionate analysis. Should the worst-case scenario come to pass where passporting rights are withdrawn, alternative fund managers could face a dilemma. Do they set up duplicate structures, create parallel funds and employ third-party managers?

These steps would be rolling back the developments and the principles that have emerged in Europe’s investment fund market over the past decade and more, such as common reporting standards and cross-border marketing and distribution.

The distribution aspect is particularly concerning for fund management firms that may have a UK investor base but are domiciled in another fund domicile, such as Luxembourg, or else are based in London but want to distribute their funds in mainland Europe. Thornton says that managers will have to evaluate their current state as well as their future plans.

“Where are you distributing from and where are you looking to distribute to? If you are UK-domiciled with a UK investor base, there is less of a risk. But if you have that same investor base but are domiciled in Luxembourg or Dublin, then you will have to make some contingency plans.”

STEPPING INTO THE BREACH
Should the UK be deprived of passporting rights or EU equivalence, then other domiciles such as Luxembourg are ready to step into the breach, says Marc-Andre Bechet, director, legal and tax at the Luxembourg funds industry association, Alfi.

“In Luxembourg we have always been very close to UK asset managers. They know us well and use Luxembourg as a hub. We don’t want to take business away from London but we want to have a solution for those UK managers that don’t have an EU management company.”

Alfi has a working business model for those managers. They can set up a management company in Luxembourg or use an existing management company offering a turnkey solution to third parties.

“These solutions exist and they are pragmatic and flexible,” says Bechet. “Under the AIFMD it is possible to delegate to third parties [managers and distributors] as long as you still assume the liability for their actions. It is a model that is currently used by Swiss and US managers.”

This is not to say this model is entirely without disruption. Managers would have to reconsider their contractual relationships with investors, but the model is well suited to delegation, says Bechet.

There will likely be different distribution options for different managers and promoters, depending on their size and geography. While the bigger firms may be able to finance parallel funds and separate management companies in all of the big markets, smaller firms will have to be more selective in their approach and delegation may be an option, says Bechet.

Some managers could be selected as a delegate for another manager that did not have permission to directly access the market. This may lead to some cross-border collaboration between fund management firms, particularly for specialist or alternative funds. For example, a Chinese private equity firm may team up with a European fund manager and both could act as delegates for each other in their respective markets.

One of the conclusions from a 2015 survey into distribution of alternative funds and carried out by PwC and the Alternative Investment Management Association was that managers are now more focused on the need to have a distribution strategy. Pressure is coming from vigilant regulators, who expect greater product governance from everyone involved in the distribution chain, and from investors.

“We have seen both regulators and investors become increasingly critical of investment managers not meeting the stated objectives or targets and, going forward, this will not be acceptable,” says Olwyn Alexander, who leads the Irish asset and wealth management and global alternatives businesses at PwC.

She says that alternative managers need to develop a clear distribution strategy and monitor political and regulatory agendas to see how they affect strategy. “The two big unknowns at the moment are the outcome of access to markets as a result of Brexit, and what changes the new administration in the US will make.”

While many in the industry hope that AIFMD-type arrangements will continue to exist and equivalency will be recognised between the UK and the EU, it is simply not clear at this stage if that will be the case, says Alexander. Furthermore, there could be further political changes with the French, German and Dutch elections due in 2017.   

ANOTHER TWO YEARS OF PASSPORTING
In the short term, alternative managers may not face too many problems with their distributions strategy, according to Sarah Murphy, director of fund strategy and distribution at PwC in Ireland, who says Brexit does not have any impact on the ability to sell a product into any other EU country and AIFMD passporting will continue for at least another two years.

However, PwC has been recommending that alternative managers have a short-term plan that focuses on certainties of access, such as the National Private Placement Regime, continuing for another two years. A longer-term plan should address the unexpected and consider what minimum action should be to address the threat of single market access being denied to the UK – for example, relocating staff, or changes in funds structures such as introducing feeder funds. 

“In terms of Europe on a wider basis, the option of an EU alternative investment fund manager is still on the table for accessing EU investors,” says Murphy. “Over-reliance on the third-country passport being approved is probably not advisable as a strategy option and worst-case scenario planning is advised. Analysis of target markets, including which distribution channels, what actually sells and to who, and costs and implications of accessing particular markets are key to developing a strategy.” 

It may be hard to find cause for optimism amid all the political posturing in what are the early stages of negotiations between the UK and the EU, but perhaps some solace can be taken from the example of the AIFMD.

When the legislation was first proposed in the wake of the 2008 financial crisis, the industry was concerned about a politicised step that put protectionism above pragmatism, but the initial hard stance softened considerably before the AIFMD was implemented, inspiring the equivalency and passporting rules that now seem under threat.

Might we see a similar softening with Brexit negotiations? “We can certainly hope so,” says MUFG’s Thornton. “Hopefully what we are seeing now is political posturing and it is not a zero-sum game that would ultimately increase costs for investors because that is in nobody’s interests.”

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