Regulatory developments are unlikely to usher in a new era of fund structures, but adjustments will be needed, finds Lynn Strongin Dodds.
The Alternative Investment Fund Managers Directive (AIFMD) is a set of regulations governing investment managers of hedge funds, private equity and other ‘alternative’ investment funds (AIFs). Considered roughly as successful as the Ucits regulations that preceded it (and which have driven the wider use of investment funds in relatively simpler asset classes), it has recently been the subject of a major review. During this period, there have been appeals to regulators not to tinker with it.
Market participants hoped to find out before the end of 2021 what the future of this regulation would hold. An outline emerged when Brussels delivered its update on the Capital Markets Union (CMU) project. But the final outcome is still “far from clear”, says Thiha Tun, a partner at law firm Dechert in Luxembourg.
The development of ‘AIFMD II’ has been keenly watched from Luxembourg, which is a major centre for the administration of AIFs. The same is true of proposals to revamp the European Long-Term Investment Fund (Eltif) framework. “Both sets of proposals will be debated among different EU agencies and at national levels,” says Tun.
In addition, he notes that the European Securities and Markets Authority (Esma) has been charged with developing a significant amount of the Level 2 technical details. This has previously resulted in a major expansion of the scope and burden of the Commission’s original proposals.
“There is a long way still to go before the industry can really know for certain what AIFMD II and Eltif II will look like,” says Tun.
It is a slow process. EU member states have 24 months to transpose AIFMD II, which is expected in early 2023, into national legislation. This means that the legislative changes will not take effect until early 2025. But it is clear why the EU has sharpened its focus on alternative asset classes. The AIF market is large.
The latest report from Esma shows that the net asset value of AIFs in the European Economic Area was €5.9 trillion at the end of 2020. The size increased 8% from 2019 thanks to the launch of new AIFs and positive valuation effects.
“In the past, firms would look at Guernsey or the Cayman Islands to domicile funds,” says Clive Bellows, head of global fund services in Europe, Middle East and Africa at Northern Trust. “But over the past few years, they have increasingly turned to Luxembourg, aligned with the expansion of its solutions for alternative investment funds under the wider ambit of AIFMD.
“One of the main drivers is that investors want the alternative product to be domiciled in a European Union-regulated jurisdiction. Alternatives are no longer seen as a specialised segment of fund administration but mainstream. Regulators in all jurisdictions want to ensure the right infrastructure is in place to address the differing requirements of the investor base, especially if they want to attract the retail investor.”
While the Commission acknowledged that the AIFMD has “generally worked well”, it found there were still difficulties in monitoring and managing financial stability risks, including regulatory fragmentation in the loan origination sector. There were also inefficiencies in managing investment funds, for example relating to supervisory reporting and depositary services in smaller markets.
The proposals also cover revisions to the provision of liquidity management tools (LMT) to better manage market stress.
In addition, the remit addressed issues around delegating fund management activities – a hot topic of debate. The recommendations were not as stringent as feared, but they look to impose requirements on a fund manager’s structure and operations to better monitor, manage and effectively supervise the increase in delegation of portfolio management to non-EU entities, and the use of ‘white label AIFMs’ [alternative investment fund managers]. A further aim is to avoid ‘regulatory arbitrage’ when structuring operations.
The proposals provided clarity and a coherent approach to these activities, according to Tun. “In order to develop a reliable overview of the delegation activities in the EU, Esma will receive data on delegation and conduct peer reviews and report its conclusions to the Commission and the co-legislators,” he says.
For now, it’s mainly business as usual. Monica Gogna, a financial services legal partner at EY, says: “There are tweaks to be looked at and reviewed to see how they work in the jurisdictions that [AIFMs] are operating in. It will mean an increase in reporting, but fund managers will not have to do anything radically different in this respect.
“However, as always, the real focus and a watching brief should remain on any proposals to alter the current state of delegation rules.”
An evolutionary process
Mathieu Maurier, country head Luxembourg at Societe Generale Securities Services (SGSS), says the changes to the existing framework will be evolutionary, not revolutionary.
“They have been welcomed and I do not see them transforming the existing framework. Over the longer term, though, the big question for me is the crossover between the AIFM and Ucits regime that will allow retail investors to benefit from the returns of non-listed investments. There will be a tipping point and they will converge, but not right now,” he adds.
Bellows believes that as in other parts of the fund management industry, increased digitalisation will form part of the solution. “The structures are in place, but alternative assets will require more data than the traditional space because they are illiquid assets.
“Also, at the moment, there is no one platform that has private equity, hedge funds, real estate and private credit. They each have their own specialist platforms and the challenge for fund managers will be to provide a uniform and consistent user experience across the board.”
A positive light
The CMU announcement before Christmas also included news about the Eltif.
Eltifs are funds that invest in unlisted companies and projects, focusing on parts of the economy that often lack access to traditional finance. They comprise small and medium-sized enterprises, perhaps working in infrastructure, public buildings, transport, sustainable energy and communications.
Under the Eltif review, the Commission wants to make redemption periods more flexible, remove minimum investment thresholds so that retail investors could participate in the market, and help simplify pan-European distribution. In addition, the Commission is looking to relax rules relating to eligible assets for Eltif products, which will no longer need to be in the EU.
These modifications are seen in a positive light. The most interesting changes from an investment perspective, according to Georg Lasch, head of offshore sales at BNP Paribas Securities Services in Luxembourg, are the abolition of the EU location requirement for investments; the use of fund-of-funds that comply with Eltif eligibility, which will allow for faster deployment of capital; feeder funds for Eltifs; the acceptance of co-investment vehicles; more flexible leverage for professionals; and fewer diversification requirements.
“The foreseen changes also relax rules on investor thresholds and adapt the suitability test to MiFID II [the second Markets in Financial Instruments Directive], which will further facilitate the intermediation of the distribution,” he adds. “We expect that there will be more fund-of-funds and master feeder funds and finally more investment in private capital through co-investment vehicles and securitisation vehicles. Eltifs will not have to broaden their range of assets, but they may take advantage of it.”
To some extent, Eltifs do not seem to have captured asset managers’ attention, although they have been on the market since April 2015. Commission figures show that as of October 2021, 57 Eltifs have been launched with around €2.4 billion in assets under management. These authorised Eltifs are domiciled in only four member states: Luxembourg (which has 26), France (16), Italy (13) and Spain (two).
One reason for the slow start, according to Jean-Pierre Gomez, head of regulatory and public affairs at SGSS in Luxembourg, is the lock-up period. Investors were not keen on investing in a fund with that requirement. “The regulation says precisely that ‘investors in an Eltif shall not be able to request the redemption of their units or shares before the end of the life of the Eltif’.
“This means that in practice, there is a five-year lock up period corresponding to the minimum long-term period of an Eltif,” notes Gomez. Citing exchange-traded funds in Europe, which he says only accelerated in the past year, he notes too that new products take time to gain traction.
Gogna agrees, adding that Eltifs are still new and have not been fully tested in the market.
“It is difficult to say how quickly they will be taken up by a potential investor base. The market is opening up to retail investors, and it will be key to ensure that they have the right safeguards and investment in place,” she says.
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