The funds industry has remained tight-lipped on the EU’s regulatory review of alternative investment funds for fear of unnecessary change, reports Fiona Nicolson. however, others see an opportunity to bring alternative investments to a wider range of investors.
The Alternative Investment Fund Managers Directive (AIFMD), which emerged in the wake of the global financial crisis, is currently under review. AIFMD was introduced to tighten regulation of private equity, real estate and hedge funds. Unlike the Ucits directive that covers traditional and liquid investments such as listed shares, the AIFMD regulates the managers rather than the funds.
At the heart of AIFMD is investor protection and market stability. The directive’s introduction was a torturous and expensive event for the alternative investment funds industry.
AIFMD came into force in 2011 and was implemented in 2013. A review clause in the directive meant that AIFMD was due to be revisited in July 2017. Consultant KPMG was brought in to assess the directive against the principles of effectiveness, efficiency, coherence, relevance and added value.
A report following this was published in January 2019 and found that most AIFMD provisions had contributed to achieving the directive’s protection-and-stability objectives. But there were a few question marks, and a public consultation is taking place that could lead to the so-called AIFMD II.
Following KPMG’s input, the European Commission sent a report to the European Parliament and Council in June 2020. The European Securities and Markets Authority (Esma) then wrote to the Commission, indicating areas to consider during the review.
This letter, says Emmanuel Gutton, director, legal and tax at the Association of the Luxembourg Fund Industry (Alfi), has been key for the evolution of the directive. “The actual scope of the consultation – and to a certain extent the review itself – has been influenced by Esma’s letter, highlighting 19 priority topics to be considered.”
Esma’s recommendations for changes in 19 areas included greater harmonisation between the AIFMD and the more retail-focused Ucits regime. They also touch on the extent to which outsourced activities may not be delegated to third parties where these activities are carried out beyond the EU’s borders. This is the so-called ‘substance’ requirement.
Further, the 19 points cover liquidity management, leverage, the AIFMD reporting regime and use of data, and the harmonisation of regulatory supervision of cross-border entities.
The Commission launched its 87-page consultation paper on the AIFMD in October last year with 102 questions in total, requesting input by the end of January 2021. Based on the consultation’s results, the Commission plans to publish a proposal for amendments in the third quarter of this year.
Greater access for retail
In the meantime, what outcomes does the industry expect to emerge from the review, and what are some of the most pressing issues, challenges and opportunities?
Elizabeth Gillam, head of EU government relations and public policy at Invesco, points to the potential for AIFMD – which covers generally professional or ‘sophisticated’ investors – to be re-pointed so that it might aid the participation of retail investors (who fall under the Ucits directive) to gain greater access to less liquid, possibly higher-returning asset classes such as private equity.
“Though the EC’s [European Commission’s] stated ambition is to launch a targeted legislative review of the AIFMD framework, the wide-ranging scope of its public consultation suggests a broader focus, which may also lead to equivalent changes to the Ucits regime, to ensure a consistent approach across both pieces of legislation,” she says.
“The review of the AIFMD framework presents an opportunity to build on the global success of the EU’s AIF [alternative investment fund] industry, the market for which topped €6.8 trillion in assets under management at the end of 2019.”
She adds: “The success of the EU fund and asset management industry is founded on robust investor protection rules, effective supervision and industry innovation, and so policymakers will want to nurture this EU success story.
“As part of this, policymakers should seek to improve retail investor access to AIFs, which means creating an effective and appropriately supervised passporting regime for the distribution of retail AIFs.
“For example, we consider that retail AIFs that have Ucits-like features should be eligible as non-complex products under the MiFID II framework [the second Markets in Financial Instruments Directive] and, under such circumstances, should not be subject to additional, national marketing rules. This would reduce market fragmentation and create economies of scale in the retail AIF space.”
If it ain’t broke…
Considering how well AIFMD has worked to date, Gutton at Alfi is of the view that the directive has had a positive impact for the funds industry and investors. This is true of many industry professionals, who consider the tortuous birth of AIFMD – with its sometimes draconian expectations placed on private equity firms who had largely escaped regulation in the past, and on the custody and depositary banks that were made responsible for the safekeeping of assets – being worth it, in the end, for making the EU alternative-investment sector a trusted, global brand.
“We believe that overall, the AIFMD has achieved its objectives. It has succeeded in creating a single market for alternative investment funds, and in strengthening investor protection and financial stability,” says Gutton. “The management and marketing passports under the AIFMD work well. The regulatory framework ensures a level playing field and there are clear rules in terms of depositaries and risk management. As a result, the AIFMD is developing into a brand, just like Ucits.”
Jeff Rupp, director of public affairs at Inrev – the European Association for Investors in Non-Listed Real Estate Vehicles – also takes a positive view on AIFMD. “We believe that AIFMD is generally working well. Investors globally are familiar and comfortable with it and it is sufficiently robust to achieve the stated regulatory goals of protecting investors; increasing transparency; reducing systemic risk and the use of leverage; and enhancing market efficiency and integrity. It has become a brand that investors outside Europe can trust when deciding to invest in European real estate funds.”
And to the extent that there is scope for improvement, the success of AIFMD means care must be taken, says Invesco’s Gillam.
“The risk remains that wholesale changes to AIFMD, which policymakers and industry agree has proved to be working well thus far, rather than targeted improvements, is likely to be disruptive and add significant burdens to the industry.”
Gutton says: “Don’t fix what isn’t broken. There should only be a targeted/technical review of the AIFMD. In the event of a substantial reshaping of the AIFMD framework, we see a risk of overcomplexity, cost increase and potential adverse impact on the main triggers which contributed to the success of the AIFMD as a brand, the latter being detrimental in particular when trying to position AIFMD as a worldwide brand to repeat the success of the Ucits brand in non-EU jurisdictions.
“This is why we are convinced that product rules should not be introduced and the overall concept of the AIFMD as a manager legislation should be maintained.”
He further adds that the AIFMD review should not be seen as an isolated piece of work but should be analysed in the context of all ongoing initiatives that, in aggregate, may have a substantial future impact on the asset management industry.
Rupp, at Inrev, also has concerns around the level of amendments that might be made and suggests some should be avoided.
“Opening up the directive itself [meaning a ‘Level 1’ review] for revisions would trigger a legislative process seeking agreement between the EC, the European Parliament and the European Council, and should be avoided. The process would require years to complete and would have an uncertain outcome, which creates regulatory risk.
“Proposed changes to the directive would also likely cause investors to pause and take a wait-and-see approach before making further investments, just at a time when investment, especially in real assets such as real estate that make an important contribution to job creation and economic stimulation in Europe, is so badly needed, to speed recovery from the Covid-related economic downturn.”
Rupp says all improvements to AIFMD that Inrev has identified could be achieved through Level 2 or Level 3 supplemental measures and do not require a revision of the directive itself.
Improvements, as noted by Esma, might include greater harmonisation of risk and liquidity management. AIFs are subject to more granular requirements than Ucits funds – a reasonable position given that Ucits funds generally invest in assets with higher liquidity than the illiquid private-markets assets of alternative investment funds. But this can give management companies operating both types of funds additional burdens as they try to comply with differing rules.
Jean-Pierre Gomez, head of regulatory and public affairs at Societe Generale Security Services (SGSS), also believes that issues can be addressed without undue upheaval.
“There is consensus from the fund industry in general not to change anything to the Level 1 text of the directive. Guidelines issued by Esma and/or through the fund associations should be enough to solve and manage technical issues.”
No major changes?
However, some are confident that there is not a significant overhaul on the horizon. Simon Thomas, a partner and funds lawyer at solicitors Osborne Clarke, says: “It is likely that targeted amendments will be made to the AIFMD, with the introduction of some Level 1 changes, but a significant rewriting of the existing AIFMD framework is not expected.”
Looking at how the main AIFMD changes might be received, Thomas observes: “There has been some hope expressed that the changes may introduce some helpful clarity and standardisation on AIFMD provisions, but changes can often be seen as unwelcome.
“The funds industry has not commented much on Brussels’ proposals, which is probably because it prefers not to risk the creation of a more burdensome framework than the AIFMD regime currently in existence, which AIF managers generally find workable if not perfect.”
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