The UK AIFM Regulatory Regime in Post-Brexit Europe
Whether you are a Remainer or a Leaver the fact remains the same, on the 29th March 2019 the UK will exit the European Union. On the 23rd June 2016 the UK public voted in a referendum to leave the EU with a majority vote of 51.9%. 9 months later, on the 29th March 2017, the British Prime Minister, Theresa May, sent a letter to the EU invoking Article 50 of the Lisbon Treaty, notifying the EU of the UK’s intent to leave the EU.
The Clock is Ticking
With 6 months left until Brexit, and little information on how Alternative Investment Fund Managers (AIFM) regulatory regime will be impacted by this event, it is now time, if you haven’t already, to consider the future of the AIFM business in a post-Brexit environment.
Before I continue, it’s important to point out that this article is not a critique or commentary on the pros and cons of Brexit itself, or the handling of negotiations, but more importantly, an assessment of the potential impact on an AIFM’s regulatory environment, and what measures it can take to ensure business continuity after the 29th March 2019.
How Did We Get Here?
To understand the future, it is important to reflect upon the past. Today’s UK regulatory environment for hedge funds and private equity firms is overseen by the Financial Conduct Authority (FCA). The FCA adopted the EU Alternative Investment Fund Managers Directive (AIFMD) in April 2013, through the Financial Services Act 2012. The origins of the AIFMD go way back to 2008, with Europe entering into the Great Recession. With financial institutions reeling from a bloated lending environment and member states wrestling economic contagion, the European Securities and Markets Authority (ESMA) recognized that a fractured regulatory environment across EU member states was, in part, the cause. To address this systematic risk ESMA worked to create an EU wide harmonized regulatory environment, and reverse the previous decade of deregulation, by implementing AIFMD with the intent to secure future economic stability.
So, what exactly does AIFMD deliver to the European fund management industry? The most beneficial element is the ability to distribute (market) investment funds EU wide, via ‘passporting’, with little regulatory impact or expense. That’s the theory anyway! Unfortunately, the reality is somewhat different, in as much as the individual country’s regulators have adopted the directive with their own interpretations and fees still apply when manager’s passport in to third party countries.
Where Are We Going?
Let’s get down to business and explore the threats to the UK AIFM’s and discuss how the UK regulatory environment might be affected by Brexit and what impact it might have on the freedom to market funds across the remaining 26 states of the EU, accessing thousands of allocator and billions of dollars of investments! Let me remind you, as of today there is no clear picture coming out of the Brexit negotiations of how the regulatory environment will be impacted. Without a major breakthrough between the UK and EU in the next couple of weeks the best we can do is speculate.
Firstly, I shall address the UK regulatory environment post-Brexit. The retention of the AIFMD, including future assimilation, even though the UK will be outside the EU, would continue to provide UK AIFM’s with a harmonized regulatory regime with their European counterparts, and hopefully, in doing so, retain a relatively unaffected passporting regime. Alternatively, the UK government could see this as an opportunity to return to an environment of deregulation, as we have seen recently in the US, and press towards a more efficient and lower cost operating environment. In turn, retaining existing business and attracting those from a less competitive jurisdiction.
Whichever outcome, or combination thereof, materializes post-Brexit regulation in the UK would be a neutral to positive event. In as much that, either we continue along the current path, maintaining a status quo, or deregulation takes us to increased international competitiveness. But what about the risk that the FCA tilts towards a more prudent regulatory stance. Well, if that was the case, then the UK fund management industry would become uncompetitive and less likely to prosper. An outcome which is very unlikely given the spirit which drove the UK to leaving the EU in the first place.
Hope for the Best…Plan for the Worst
Secondly, and I believe most essentially, let’s review the threat to the freedom to distribute fund products across the EU, and the barriers that could be thrown up to restrict this. In as much as we are all hopeful, the ideal scenario would see the existing regime remain in place, and continued regulatory harmony prevail. However, the threat remains that the UK decides to move away from the AIFMD model completely, limiting the ability to passporting, or even leaves the EU without any deal. This is the true risk and one we must get our teeth in to. To best explore this eventuality the most effective tool is to identify a proxy, luckily we have an excellent example in our US cousins, who seem to do quite well raising assets in Europe, and by reflecting their experience to our own circumstances, we should get a clearer picture of the opportunities.
One option is to form an EU domiciled management company. By relocating your existing businesses, or branching out, into the EU you would be able to maintain direct access to the EU. If you elect on a branch option it is worth noting that in order to operate as a regulated AIFM one need only establish a risk management function, allowing the core discretionary management to remain in the home country. To establish an EU presence enjoys tremendous benefits, including brand identity and control but the costs and additional workload cannot be underestimated. There are plenty of jurisdictional opportunity to explore, and those such as Ireland or Malta have the added benefit of being English speaking.
This first option is clearly a costly and time-consuming exercise, and one which might be considered the ‘sledgehammer to crack a nut’ scenario, taking in to consideration the current level of uncertainty. The next option, which is along similar lines, is to partner with, or delegate to, an existing EU domiciled AIFM. This is a well-trodden path which permits those manager’s from outside the EU to gain access and distribute their funds within the EU. There are numerous structures that can be applied here, such as a dedicated third-party marketing firm or an affiliated ‘regulatory host’. The best fit for any business will be dependent on multiple factors, but ultimately the costs and time to market should make this an attractive solution. There are drawbacks, especially long term, such as brand identity and counterparty risk, but as a short-term solution, most feasible.
The final option I’ll present here is the reliance on ‘reverse solicitation’. This is a process under AIFMD which permits the distribution of non-AIF funds to specific investors within the EU as long as those investors directly initiated the interest in the fund, i.e. made first contact. This is widespread practice today for many managers from outside the EU. However, this process does not suit many managers purely because the process of reverse solicitation is counter to most managers marketing strategy. The advantage here for the UK AIFM’s is that they can leverage off their existing permissions by initiating a blanket marketing strategy in preparation for post-Brexit. The risks of its application cannot be underestimated though. The need to thoroughly document the process is essentials. There is also the matter of GDPR (General Data Protection Regulation) to contend with, but that’s a whole other article!
The End is Nigh
With only 6 months left until the UK leaves the EU the clock is ticking ever louder. Whether you believe there to be a deal or no-deal Brexit now is the time for UK AIFM’s to weigh up the opportunities and formulate a plan. While Brexit negotiations drag on, nobody in the industry has any real clarity on the future, so there are no right answers, only counter measures. What you can be certain of though is that your business will be impacted in some way. The future of the UK AIFM is dependent on many variables, but whether you choose to be proactive or reactive the planning stage is here. And let’s not forget, a short-term plan is still better than no plan!
To learn how Quay Partners can guide your business to success, contact us for more information.
Quay Partners Group delivers bespoke investment management solutions to independent hedge fund managers and family offices.
Thomas Underwood, the Founder, has over 20 years’ experience in managing and operating hedge funds.