Reforms to the AIFMD are entering the final stages and include greater clarity on delegation and private credit – but inevitably more reporting will follow, finds Piyasi Mitra.
EU proposal to update regulations for hedge funds, private equity and other alternative investment managers, known generally as AIFMD 2, is especially relevant for London-based firms because it addresses industry concerns about stricter post-Brexit rules.
The spotlight is on the Alternative Investment Fund Managers Directive (AIFMD), which applies to sophisticated and complex investment strategies, like hedge funds, private equity, private debt and many real estate funds. Challenges and opportunities co-exist as fund managers gear up to navigate the revamped landscape.
What to expect
Subject to approval, the agreement, resulting from EU member states and European Parliament negotiations, aims to boost the EU economy by promoting investment across a range of assets.
Initiated by the European Commission in November 2021, the proposed changes to AIFMD and the Ucits directive – which covers more ‘vanilla’ investments - seek to provide more transparency to regulators about European asset managers' investments in non-EU countries like the United States and Britain.
For London-based managers overseeing EU-domiciled funds in Luxembourg and Dublin, the agreement avoids stricter "delegation" rules for non-EU asset managers, avoiding Brexit-related complications.
‘Delegation’ in the funds industry refers to where a fund that is legally formed and registered in the EU may delegate certain functions – such as portfolio management – to other locations outside of the EU, which now includes the UK. Asset managers typically outsource many functions, albeit a lot of these outsourced activities – such as fund administration – will often be carried out in the same country where a fund is registered.
However, portfolio management remains heavily weighted towards London, particularly for UK and US firms.
The updated rules impose stricter regulations on loan-issuing funds – for example, private credit funds, which are a growing portion of private-assets strategies. The rules mandate increased reserves if fund managers need to manage market liquidity issues and introduce limits on their leverage and debt levels, with details to come in the final legislation.
Jiří Król, deputy CEO and global head of government and regulatory affairs at the Alternative Investment Management Association says that the main impact of the revised rules is related to introducing further transparency and reporting to regulators.
"Reforms introduced to delegation and liquidity management remain targeted and build on existing practices. This is an important recognition from policymakers that the current rules are working well and that hedge funds are a valuable part of the EU capital market," shares Król.
One exception is the fund managers involved in loan origination, who will be subject to new product-level rules, he highlights. The global alternative investment sector relies heavily on delegation arrangements, underscoring the importance of ensuring that EU investors can access expertise and investment strategies, regardless of their geographic location.
While there were initial concerns that restrictions on delegation would be introduced to the AIFMD, Król is pleased to find that the reforms will not substantially change long-standing practices. Although the new regulations will necessitate additional reporting on delegation arrangements, the review's conclusion represents an "important validation of the current delegation models and their significance to EU investors", he adds.
Król emphasises that the AIFMD is not designed to regulate alternative investment funds but, instead, regulates the alternative investment fund managers that manage the funds, meaning the new rules introduced for loan-origination funds is "a significant change to the directive".
"...the review's conclusion represents an "important validation of the current delegation models and their significance to EU investors."
On the positive side of the ledger, these new rules address the patchwork regulatory frameworks for loan-origination fund managers in the EU. A single set of rules will permit loan-origination fund managers to lend on a cross-border basis and play a more prominent role in financing EU small and medium-sized enterprises, which are deemed vitally importance by policymakers to the broader health of the EU economy. However, the new rules also introduce restrictions on leverage and the sale of loans, which are harder to justify, adds Król.
Finally, Król shares: "Our dialogue with policymakers during the review ensured that the final rules are an improvement on those originally proposed. We will continue working with policymakers to nurture the growing EU private credit market and improve the funding environment for EU businesses."
“Evolution vs revolution”
According to Mark Shaw, funds partner at lawyers Pinsent Masons, the changes in AIFMD rules are an "evolution rather than revolution", as many of them codify good practices around liquidity management, fund terms, or the suggestion that funds need at least one non-executive director to improve governance.
However, like Król, Shaw also highlights a key exception around loan-origination funds, where the AIFMD now strays into product regulation to harmonise the regulation of loan-originating funds with leverage limits and risk retention requirements.
"There have been concerns around the politicisation of delegation, particularly as some EU financial centres sought to benefit from Brexit. However, it's crucial to recognise that delegation has been essential for the success of the European fund industry," adds Shaw, highlighting that a large portion of funds that may be domiciled in the EU – particularly in Ireland and Luxembourg - are managed by London-based portfolio managers.
Amid Brexit-fuelled concerns around the future of delegation, the European Commission initially sought to centralise the review and approval of delegation arrangements, previously the preserve of National Competent Authorities (the European Commission's review of the European Supervisory Authorities – September 2017). Shaw points out that this move was "walked back" with the clear signal that the risk of regulatory forum shopping was under scrutiny.
"There have been concerns around the politicisation of delegation, particularly as some EU financial centres sought to benefit from Brexit. However, it's crucial to recognise that delegation has been essential for the success of the European fund industry."
"The new proposals will require EU AIFMs to report delegation arrangements to National Competent Authorities using a pro forma reporting template that will require more granularity than is currently required, including details of the organisational structure, persons and functions involved, as well as portfolio and AUM information," says Shaw. While he thinks common sense has prevailed at this stage, data gathered through this next stage of AIFMD will be used to form future policy.
According to Charlie Tafoya, co-founder & CEO of Chronograph, which provides private equity analysis tools, the post-Brexit AIFMD rules further affirm private markets and alternative investments as a “connected and critical element” of the global economy.
This move comes when sovereign wealth funds, pension schemes, family offices and other limited partners increasingly direct more investments towards private markets, Tafoya highlights. "European funds can remain competitive globally, and European asset managers can seamlessly engage in diverse private markets, thanks to the AIFMD's provisions."
But while institutional investors – the ‘limited partners’ in a private markets fund - continue to demand higher quality, more granular information, the fund managers – or ‘general partners’ - sometimes struggle to meet these demands.
"Additional compliance burdens will force many funds and managers to revaluate their operating models, technology and business organisations," says Tafoya.
Additionally, the AIFMD's transparency and reporting requirements will result in further expectations of data granularity and transparency within Europe. Tafoya says: "This regulation makes it more critical for fund managers to have the right technology throughout the investment lifecycle."
Arun Srivastava, fintech and regulation partner at law firm Paul Hastings, envisages that many alternative investment fund managers will delegate portfolio management to third parties, such as UK or US-based managers or advisers.
He points out there was concern that the European Commission would pursue the imposition of qualitative and quantitative criteria on delegation, which, if implemented, could have had a structural impact on the sector of delegation to managers located in countries outside the EU. However, this has been avoided and the changes to delegation models will be more limited.
Srivastava hints at "positive news for UK managers". Under the current proposal, reporting and information requirements will be imposed so that EU alternative investment fund managers must report to their local regulators concerning delegation.
“Post-Brexit, using an EU-authorised alternative investment fund manager with delegation of portfolio management back to a UK manager has been a frequently used model,” he says, suggesting that this model should not be disrupted – at least for now.
Srivastava highlights another area of interest to UK and US managers: the proposed new rules on marketing. The new rules will introduce a prohibition in the EU on the marketing of funds established in countries that the EU has recognised as "non-cooperative" for tax purposes, which currently applies to funds from high-risk jurisdictions for anti-money laundering.
The extension to include tax non-cooperative jurisdictions might pose practical challenges, he says, especially considering that popular offshore fund formation locations have occasionally found themselves on these non-cooperative lists.