On 24 June 2016, the world woke up to find it had entered a new era: the Age of Brexit. Since then, asset managers have had to come to terms with what this new reality could mean for their businesses, without any immediate clarity. While there is no first-mover advantage in enacting any Brexit plan, there is certainly a risk if firms are unprepared.
In this paper we discuss the possible outcomes of the Brexit negotiations and the implications of each for managers currently operating within the EU.
The Age of Brexit
In the months following the UK’s historic vote to exit the EU, there has been a cacophony of opinion and speculation on the economic and political implications Brexit will have on the UK, the EU, and the world.
While there are still far more questions about Brexit than answers, we are starting to have some clarity on timing. On 29 March 2017 Prime Minister Theresa May officially triggered Article 50, which is the formal method for a country to initiate withdrawal from the EU. Now that Article 50 is triggered, the UK and the EU will have two years to negotiate exit terms. This means that, all things being equal, the divorce should be finalized by 2019.
Though the timeline is now clear, we still do not know exactly what the world will look like when the dust settles. Despite the ambiguity about what the outcome will be, it is clear that Brexit is inevitable. When it does happen, there will be major implications for asset management. The only question is how big the impact will be.
How do you like your Brexit Served?
The biggest question about Brexit is: Will it be a conscious uncoupling or a Kramer vs Kramer style divorce? The tenor of the split will determine the UK’s relationship with the EU going forward. Obviously, the relationship between the UK and the EU is extensive and will impact everything from agriculture to financial services. For asset management, the big question is: What level of access, if any, will the UK have to the EU single market and the financial passports? There are a number of potential outcomes that can be classified into three broad categories of Brexit: soft, medium, and hard.
A soft Brexit would be the closest to the status quo. There is an existing framework for a soft Brexit, known as the European Economic Area (EEA), which allows for non-EU countries to participate in the EU single market. Non-EU members of the EEA are committed to the free movement of people, goods, services, and capital in the EEA and are required to implement most of the EU’s laws and regulations (save for the EU regulations governing agriculture and fisheries). Non-EU EEA members are also required to makes budget contributions to the EU. In return, EEA members get access to the EU single market.
For asset management, UK EEA membership would mean that nothing would change. Asset managers would still have access to the financial passports and maintain market access for UCITS funds. The downside to EEA membership is that the UK would be compelled to implement all EU regulations for financial services, while no longer having a say in the formation of new rules. Nonetheless, despite a diminished voice in EU policymaking, this is the industry's preferred outcome.
A medium Brexit would be a bespoke arrangement between the EU and the UK. The UK would have some level of restricted access to the EU single market. For financial services, this likely means accessing the EU through the so-called equivalence regimes, rather than the full passports.
Under equivalence, which exists in the Alternative Investment Fund Managers Directive (AIFMD) and the Markets in Financial Instruments Directive (MiFID 2), the EU would have to formally designate the UK's regulatory regime as equivalent to the EU's. This would be straightforward at the outset because the UK and EU regulatory regimes are identical. Over time, this could be a challenge because the UK would be required to ensure its regulatory regime kept pace with any changes in the EU. If the UK were to deviate significantly from the EU regulatory framework, equivalence could be revoked.
Notwithstanding the uncertainty associated with equivalence, the medium Brexit would probably work for asset managers. For the most part, they would be able to operate as they do today, except possibly with UCITS. The first issue is the management company passport under UCITS. The second is continued access of the UK market by EU UCITS funds. In both cases, there is no explicit equivalence regime within the existing regulations. As such, a new agreement would have to be drafted as part of the Brexit negotiations.
A hard Brexit means that the UK would be completely separate from the EU, with no negotiated access to the EU market. If this were to happen, the UK would have no access to the EU single market and equivalence would not be an option. The UK would have to negotiate a trade deal with the EU, which would be governed under the World Trade Organization (WTO) rules.
A hard Brexit would be the worst outcome for asset managers. It would certainly mean loss of access to the management company and MiFID passports, which would necessitate establishing an EU entity. It would also throw into doubt continued access of the UK market by EU UCITS funds. Perhaps the biggest risk of a hard Brexit is that it could be disorderly. If there is a clean break between the UK and the EU, it could happen more quickly than the two years envisioned in Article 50, leaving many asset managers unprepared.
The outcome of the Brexit negotiations hinges on the key issue of freedom of movement. The UK government has made it clear that any Brexit deal must allow the UK to limit the amount of immigration into the UK by other EU nationals, while the EU has insisted that access to the EU single market is dependent on the continued freedom of movement for EU nationals. The final Brexit deal will largely come down to how much either side is willing to compromise on this point. Given the current level of rhetoric between the UK and the EU, a soft Brexit is highly unlikely, making the best case scenario some form of medium Brexit. For asset managers, this means that they will likely experience some amount of disruption from Brexit.
Key Passport Implications
For asset managers currently operating within the EU, there are three key financial passports that will be affected by Brexit and it is important to understand the potential implications.
Management Company Passport
UCITS management companies oversee the operation of UCITS funds and act as the central coordinator of all service providers. Since UCITS 4 came into effect in 2011, managers can use cross-border management companies to operate and oversee funds in multiple jurisdictions. For example, an asset manager can use a Luxembourg management company to oversee both its Luxembourg and UK UCITS funds.
The question in a post-Brexit world is whether cross-border management companies will still be allowed to oversee UK funds? And will UK asset managers be able to oversee funds in other EU countries? If not, asset management firms will have to bifurcate their cross-border management companies, causing them to lose economies of scale as they will incur extra costs and inefficiencies for creating one for the UK and one for the EU.
The MiFID regime has a wide scope that includes portfolio management, execution, and investment advice. Under MiFID, firms are able to passport their permissions and provide financial services across the EU. Typically, asset managers establish their MiFID firm in the UK and then use the passport to sell their products across the EU. Brexit raises the possibility that this may no longer be possible.
The potential effects of the loss of the UK’s MiFID passport will really depend on the asset manager’s scale. Many large asset managers already have offices in other EU countries. For them it will be a matter of moving the MiFID license to an EU entity. This may also require them to move of some functions to appease local regulators and ensure that the MiFID license is not merely a “brass plaque.” While certainly inconvenient, this may not be overly disruptive.
For smaller managers, who only have offices in London, the loss of the UK’s MiFID passport could be much more disruptive. Many US and Asian asset managers who don’t have another EU office to rely on, will be forced to establish a new office within the EU. The question then becomes: Do smaller managers need to maintain a UK presence or should they completely decamp to other countries in the EU?
There are two cornerstone pieces of regulation that govern asset management in the EU. The first is UCITS, which is the regulatory framework for retail funds in the EU. The second is the AIFMD, which is the regulation for “alternative” asset managers in the EU.
Perhaps the biggest threat that Brexit poses to asset management is to the UCITS passport. The purpose of the UCITS framework was to create a single market for collective investment funds. The term “UCITS passport” refers to the fact that any authorized UCITS in one EU country can be sold freely into another. Asset managers typically use either Ireland or Luxembourg, as domiciles for their UCITS funds and then sell them across Europe and, indeed, the world.
The big difference between the UCITS passport and other financial services passports, like MiFID, is that UCITS is regulated at the fund level, not the manager level. This is a crucial point and means that the calculus around Brexit and the UCITS passport is very different from the other passports. Local regulators are responsible for approving UCITS funds and unlike, for example, the AIFMD, in the UCITS framework there is no distinction between “EU Managers” or “Non-EU Managers.”
If Brexit results in the UK losing access to the EU market, UK managers will go from being EU managers of UCITS funds to non-EU managers of UCITS funds, which will have no impact on their Irish and Luxembourg UCITS passports. In this way, they will join managers in New York, Hong Kong, and Melbourne who all freely manage and distribute UCITS across the EU. Bottom line, the UCITS passport has nothing to do with the domicile of the asset manager and is based solely on the domicile of the UCITS fund.
Will reciprocal access between the UK and the EU end?
This is the bigger question: Will Brexit end the reciprocal access between the UK and the EU? The EU classifies the fund world into two categories: UCITS and everything else. And everything else falls under the AIFMD framework. If UK UCITS funds are not granted access to EU investors, they will be classified as “alternative” by EU rules and governed by the AIFMD framework. This classification could have huge implications on fund distribution because most alternative funds cannot be sold to retail investors. If formerly UK UCITS funds are denied access to the EU, the question becomes: Will managers be allowed to sell EU UCITS to UK investors?
If the reciprocal fund passports do disappear, it will force asset managers to assess their fund ranges. Managers who use Ireland or Luxembourg funds will need to consider if they want to set up UK domiciled funds in order to pursue UK investors, while managers with UK funds will need to decide if they want to set up EU domiciled funds to pursue EU investors. In the long run this could lead to the UK being viewed as an entirely domestic market. Some managers, who can no longer access the UK through their cross-border funds, may abandon the market completely, leaving UK investors with fewer investment choices.
Unlike UCITS regulations, the AIFMD directly regulates alternative asset managers and indirectly regulates alternative funds. As a result, there are specific provisions in the AIFMD that apply to EU and non-EU Alternative Investment Fund Managers (AIFMs). This means that when the UK does officially part ways with the EU, UK AIFMs will go from being EU AIFMs to non-EU AIFMs and this change
in status has two key consequences.
- UK managers will also be regulated by an EU regulator
The first consequence of becoming non-EU AIFMs is that UK managers will have to be regulated by an EU regulator. All non-EU AIFMs must be authorized by the EU regulator from the “Member State of Reference.” Under the terms of the AIFMD, the Member State of Reference is the EU country where the manager intends on selling the majority of its Alternative Investment Funds (AIFs). For example, if Germany is the primary market for a manager’s funds, it must get authorization from BaFin.
Of course, in addition to the Member State of Reference, UK asset managers will still be regulated by the Financial Conduct Authority. Bottom line: post-Brexit, UK managers selling alternative products in the EU will end up with additional regulatory oversight.
- UK hedge funds could lose access to the AIFMD passport
The second consequence of becoming a non-EU AIFM is that UK hedge funds will ultimately lose access to the AIFMD passport as it is only available to EU managers and EU funds. So, even if a UK manager has an EU fund, when it becomes a non-EU AIFM it would lose access to the passport. Without access to the passport, managers will have to rely on various national private placement regimes to sell their products in the EU.
In order to get access to the AIFMD passport as a non-EU AIFM, the UK would need to be granted an “equivalence” ruling from the EU Commission, Council, and Parliament. On the face of it, this should be pretty straightforward since the UK has already transposed the AIFMD into UK law. Assuming there is no post-Brexit regulatory bonfire, it would be hard to argue the UK did not have an equivalent regulatory environment. However, extending the AIFMD passport is not as easy as it seems. At the moment, a non-EU country has yet to be granted access to the AIFMD passport. Depending on how the divorce proceedings go between the UK and EU, it is not hard to envision the EU dragging its feet on granting AIFMD equivalence to the UK.
While losing access to the AIFMD may not seem significant now, sooner or later not having access to the AIMFD passport will become an issue for UK managers. In 2018 the EU is scheduled to evaluate abolishing private placement all together. If this were to happen, not having access to the AIFMD passport would become a real issue.
UCITS and the AIFMD regulate asset management from different angles, one via the product and the other via the manager, and the potential impact of Brexit is different for each. For UK asset managers, the impact to AIFMD could be more severe and may require additional consideration about possible remedies, such as creating an AIFM in an EU country.
What is the Industry Thinking?
We asked the readers of our blog, ontheregs.com, on how they anticipate Brexit will affect financial regulation. The respondents to our survey can be described as “cautiously pessimistic” about the Brexit negotiations.
42% of respondents think it is somewhat unlikely that EU UCITS will lose access to the UK market, while 31% believe it is at least somewhat likely that EU UCITS will lose access. When it comes to MiFID 2, 44% think that it is somewhat likely that UK will be granted equivalence. However, nearly 30% expect it is somewhat unlikely. Taken together, the responses show that the industry anticipates that the UK is probably heading towards a medium-hard Brexit.
While Brexit will have many other economic and political implications, there are three key decision points that could have the largest impact on asset management: Management Companies, MiFID, and Fund Passports.
The immediate challenge is that there is unlikely to be any clarity on what the UK’s future EU relationship will look like anytime soon. This period of limbo could have a direct impact on the growth of the UK asset management industry. There are already stories of UK asset managers delaying hiring decisions pending further clarity on the direction of Brexit.
For new managers thinking about coming to Europe, the uncertainty will certainly give them pause. Before Brexit, London would have been the natural choice for asset managers looking to establish a European presence. Now, that is no longer necessarily the case. After all, why set up a London office if you may not be able to use the passports to access the EU market?
Fail to Prepare, Prepare to Fail
While there is no first-mover advantage in enacting any Brexit plan, there is certainly a risk if groups are unprepared for when the tide goes out. Additionally, asset managers may face market pressure to resolve any uncertainty before the Brexit negotiations have concluded.
There is no doubt there will be many more twists and turns to come but having a thoughtful and well-articulated plan is a necessity for asset managers. As a wise man once said, “Fail to prepare, prepare to fail.”
Key Considerations for Asset Managers
Although there is still a long way to go, below are key actions asset managers should consider in their Brexit planning.
Assess the significance of losing access to their key asset management passports
- Do you have a cross-border management company?
- What MiFID permissions are you using?
- Do you have a UK AIFM?
- Are you selling UK funds into the EU?
- Are you selling EU funds into the UK? If so, what portion of your assets come from UK investors?
- Review key contracts
- Plan for any potential restructuring
- Does your organization have another entity in the EU that can be used for a MiFID license?
- Do you need a new EU management company and or AIFM. If so, where?
- What are the substance requirements?
- What fund vehicles will you need to service your existing clients?
- Determine a timeline to enact a contingency plan
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