European managers have a simple temporary solution to keeping their UK distribution rights after Brexit – but UK managers must contend with evolving substance rules to keep theirs in the EU.
In January, European fund managers started applying for ‘temporary permissions’ to continue marketing funds into the UK after Brexit. Even in the event of a so-called ‘hard Brexit’, the UK’s Financial Conduct Authority (FCA) has given them three more years to passport European funds with their existing permissions.
Fund managers contacted by Funds Europe that said they were going to apply for permissions included Amundi and Natixis Global Asset Management (see box below).
“Firms are taking comfort in the temporary permissions regime, particularly if they have umbrella funds and wish to add more sub-funds, because these also fall under the regime and that is a big deal for our clients,” says Akbar Sheriff, State Street’s head of global services in the UK and regional product lead at its fund administration arm.
Bill Prew, chief executive of Indos Group, a depositary business, says: “The situation with the temporary permissions regime is that if you are a European manager wanting to market your funds to UK investors, then you only need to notify the FCA and then, in the event of a hard Brexit at the end of March, you will have a three-year transition period.”
Before the temporary permissions regime, EU managers who lacked UK fund structures were faced with having to establish them so they could continue to access UK clients. According to a September 2018 figure from UK trade body the Investment Association, £375 billion (€428 billion) of assets are held for UK investors in funds passported from outside the UK.
“There had been an increase in enquiries from European asset managers interested in setting up UK fund structures, but this has become quieter now that the FCA temporary permissions regime has been introduced,” says Tim Oddy, senior relationship manager at fund administrator Maitland.
“The temporary permissions regime is similar to what happened with derivatives clearing, where a temporary moratorium was granted, pending formal regulatory applications, ensuring that the UK remains open to business.”
Oddy, who is based in London, adds: “But there is still a question of what the position will be in the longer term and it may be that more organisations will want to set up operations here to maintain access to the UK market.”
Prew at Indos says: “I would have thought that for many European managers distributing in the UK, it would be business as usual, if not a long-term plan. They can seek local authorisation during that [three-year] transition period.”
Both point out that the temporary permissions regime is not a reciprocal arrangement.
“Europe has not agreed to any temporary permissions regime, so in the event of a hard Brexit, UK managers will no longer be able to market European funds to European investors unless they have a European management entity,” says Prew.
And Oddy notes: “It is somewhat disappointing, given the uncertainty that surrounds Brexit, that other EU regulators have not followed the FCA’s lead to facilitate the continued operation and distribution of funds in both directions.”
The delegation memorandum
In January, the European Securities and Markets Authority (Esma) and other EU regulators agreed a memorandum of understanding (MoU) with the FCA over, among other issues, ‘delegation’ – the ability of some asset management functions to be carried out in a non-EU country. Portfolio management was the main area for clarification.
But official announcements from Esma and the FCA about the MoU were silent on distribution.
Fund professionals may have hoped for more. A week before the MoU announcement, Central Bank of Ireland (CBI) deputy governor Ed Sibley said in a speech: “From a regulatory perspective, it is desirable, given the size and role of London as a financial centre, that some form of sustainable link between the EU and the UK is found.”
He was “confident that the necessary MoUs will be in place to facilitate the continued high level of cooperation between UK and European authorities, including on a bilateral basis”.
For now, firms in the UK that want to continue - or start - selling funds to clients in the EU will need ‘passporting’ approval from an EU country – typically Ireland or Luxembourg, homes to the largest concentration of internationally distributed funds. And to get this, they must have ‘substance’.
This is the big question for firms moving to Ireland and Luxembourg: Just how much substance do they need to put in place and how much will it cost them?
From Artemis to Wells Fargo, the number of asset managers with bases in the UK that have made public their plans to relocate to Luxembourg because of Brexit now spans much of the alphabet.
Luxembourg for Finance, a promotional organisation, boasted that 47 financial firms (half of them fund managers) made public in 2018 their intentions to relocate to Luxembourg due to Brexit and that even more firms had chosen to expand their Luxembourg operations without making their plans public knowledge.
In Ireland during 2018, according to the CBI, the regulator authorised 17 alternative investment management companies – or ‘AIFMs’ – and 17 Ucits management companies. In his January speech, Sibley said: “From large investment banks through to small payment-servicing firms, well over 100 firms have applied for new authorisations or for permission to expand their businesses.”
UK firms Hermes Investment Management and Legal & General Investment Management are among those that announced they had chosen Ireland as their EU base.
It shows that, for all the economic damage EU countries may sustain, Brexit has given Europe’s two premier cross-border fund locations a chance to fortify their positions as centres of excellence for processing international investment funds, as well as in other financial services and fintech.
Esma - fund management’s ‘super-regulator’ - and the European Banking Authority (EBA) have called it a “unique” and “unprecedented” situation, respectively, when referring to the increasing number of requests from firms in the UK to relocate into the remaining EU countries as part of their Brexit plans. But the regulators were also concerned to maintain high regulatory standards: the EU wants to guard its Ucits funds ‘brand’. Ucits are increasingly sold in Asia but suffered some damage at the time of the Bernie Madoff scandal.
Similarly, the EU and its funds industry has been building the ‘AIFMD’ brand around funds investing in private equity and other alternative assets.
Yet regulation of these funds is not always the same from one domicile to another, so with Brexit looming, each super-regulator published an opinion in 2017 on the regulatory aspects of relocation with the aim of ensuring supervisory standards were evenly spread across the EU. They wanted to make regulatory arbitrage virtually impossible as each country competed to attract firms from the UK.
Esma and the EBA emphasised the need for national regulators – the ‘National Competent Authorities’ (NCAs) – to ensure firms’ structures and governance were fit for purpose. Reflecting this, Sibley sounded a grave tone in his January speech, saying the CBI’s gatekeeping role was “hugely important” in mitigating financial stability risks and in protecting market integrity and customers, not just in Ireland but also the EU.
He spoke about the imperative of making sure firms relocating to Ireland were regulated in line with high EU standards, including in some cases these firms viewing Ireland effectively as their EU head office.
Prew, at the depositary Indos, says: “Esma has had monthly meetings with national competent authorities to review applications they’ve received from UK managers to establish entities in Europe, and I understand there has been a significant focus on ‘substance’ in terms of people and infrastructure that will be deployed locally.”
David Montgomery, risk and regulatory partner at business advisory firm EisnerAmper, says that while core substance requirements have not increased, Esma and the EBA set out principles in 2017 relating to authorisations concerning substance, among other topics. “The supervisory authorities in each jurisdiction are engaging with the relevant agency during the authorisation process and much of the engagement concerns substance issues,” he says.
The EU hopes to prevent firms having “largely empty entities outside the UK”, which they could control from within the UK to maintain their business activities, he adds. “This could result in a conflict with EU regulatory requirements, and higher than anticipated substance requirements in some instances where this should not be the case. This is leading to frustration on the part of entities and their regulators, as each case seems to require more interaction and many iterations of lengthy applications and supporting documentation.”
Philippe Belche, advisory leader for alternative funds at EY in Luxembourg, says: ““The substance requirements in Luxembourg need to be proportionate to your current operational model. If today you have hundreds of people working on fund management in the UK, you cannot merely hire a hand full of people in Luxembourg and continue managing your operations with the same people in the UK.”
The M&G way
M&G Investments was one of the first fund management firms to announce it would launch operations in Luxembourg as a Brexit measure. It has become a case study for others, according to one person in the Luxembourg industry, adding: “It’s called ‘Doing it the M&G way’!”
Micaela Forelli, head of European distribution for M&G Investments in Luxembourg, says the firm has established a Luxembourg-based ‘super management company’ – known colloquially as a ‘super manco’ - and a distribution firm regulated under the EU’s MiFID II capital markets rules.
“Both are now fully licensed and operational, distributing funds, products and services across our European network of offices and internationally,” says Forelli.
Before executing its Brexit programme, M&G Investments had about ten real estate employees in Luxembourg, supporting five institutional alternative investment funds investing in property.
“Today, we have around 30 people, including team members from risk, legal and compliance, portfolio management, operations and distribution,” adds Forelli. “The CSSF has, rightly, been clear that as a firm we need sufficient substance in Luxembourg to carry out our duties to the standard required.
“We conducted a robust internal assessment to determine what roles must be conducted in Luxembourg and determined the number of staff and the required skillsets we needed. This plan was further tested by the CSSF, and upon agreement with the CSSF, we recruited new staff across our two businesses.”
Substance, essentially, refers to staff senior enough to assume responsibility and capable enough to carry out checks and balances rigorously.
Aspects related to ‘substance’ that were perhaps ill-defined are becoming clearer – for example, how many people firms will need to run operations in their EU fund centre and how much time should be taken up on certain tasks.
The luck of the Irish?
In Ireland’s case, requirements for funds in the country’s €2.47 trillion industry that relate to substance – the industry says these are “governance, compliance and supervisability” – had already been clarified in 2017 when the CBI published a set of rules and guidance known as CP86.
CP86 allowed funds to appoint a ‘designated person’ who lived outside Ireland and was not a fund director, provided at least half the other designated persons lived in the European Economic Area. This revised ‘location’ rule and other changes were the result of a prolonged period of consultation.
Etain de Valera, an asset management partner at law firm Dillon Eustace in Dublin, says applications to the CBI are being looked at in the context of CP86 and the CBI is focusing on the manner of implementation, not at changing the rules.
“Despite Brexit, CP86 and fund management company guidance remains the same as the CBI now focuses on CP86 implementation. But it’s probably fair to say that the Bank does consider the broader framework for regulated fund management companies to be constantly evolving and this will impact on the implementation of CP86 by such firms.”
For example, she says, what the CBI considers to be best-in-class fund management models is evolving and a dialogue exists around the number of people that firms need. It is not simply a case that bigger managers need more people. She adds: “I think to this extent, the Central Bank has taken the view in line with Esma that any application by a market entrant must be subject to a critical analysis if there are less than three full-time employees on the ground discharging key functions.”
What about Luxembourg?
CP86 happened separately from Brexit – it was on its third consultation by the time of the UK’s referendum in 2016 – but the same cannot so easily be said for Circular 18/698, issued by Luxembourg’s CSSF in August 2018. This concerns the approval process, organisational requirements and anti-money laundering processes of alternative and traditional fund managers. The circular was welcomed by fund professionals that Funds Europe spoke to in Luxembourg, in large part for bringing clarity to the question of substance.
Lou Kiesch, regulatory consulting leader at Deloitte, says the circular has raised the bar for substance and broader regulatory requirements of the CSSF “to the better of the industry”.
At EY, Belche says the circular has been welcomed by players intending to set up their operations in Luxembourg because it increases legal and regulatory certainty, as well as gives more transparency on substance and organisational requirements.
Belche says: “The circular doesn’t prevent you from setting up a particular operating model. Luxembourg is a jurisdiction where international operating models such as the UK, German, French or even non-European models can co-exist.
“In addition, the circular streamlines certain requirements, such as the submission timeline of all reporting for alternative investment fund managers which has now been aligned to five months following the financial year end and is no longer all over the place as previously was the case.”
Daniela Klasén-Martin, country head for fund administrator Crestbridge, says: “The circular is helpful because we have in writing quite a lot of existing regulation and now also best practice.”
For example, she says the circular makes it clear that firms need two full-time conducting officers resident in Luxembourg, but firms with fewer than €1.5 billion of assets under management may have one that is resident part time, provided they have appropriate local support staff.
Furthermore, a significant development is that firms cannot have a management company without having local people in place. “Some established managers may have operations that are a bit light from a local substance perspective and would now have to have dedicated local people in place,” says Klasén-Martin. “In the past, some may have had conducting officers that were not in Luxembourg. The circular clarifies that is not acceptable for bigger operations.”
Another practitioner comments: “Nothing had been written down in the past, meaning firms needed someone like me to tell them how to do it!”
Luxembourg and Ireland have had a Brexit boost. Jobs have been created and more fund processes are being carried out there than ever before.
Yet far from needing fewer practitioners, these countries need more. What remains to be seen is any drag on resources this “unprecedented” arrival of fund management companies may cause.
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