We recently flagged the European Commission’s review of the Alternative Investment Fund Management Directive (AIFMD). The Commission’s initial report was short and sweet but flagged certain significant probable changes to the composition of AIFMD at a high level. In response, last week, European Securities and Market Authority (ESMA) published a letter which addresses AIFMD at the surface, but at the same time, the EU watchdog took the opportunity to raise numerous other weighty issues to the EC, which will be of great interest and some concern to asset managers.
ESMA’s AIFMD comments were highly anticipated given AIFMD is an important EU regulation and some impactful revisions were expected. In 2020, maybe we should expect the unexpected, but it is fair to say most commentators were taken aback by the ESMA letter in terms of its scope, but also the worry that elements of the commentary could be disruptive to current global asset management models.
ESMA’s remarks specific to AIFMD revisions are merely the tip of the iceberg. Let’s jump to the main points of interest:
The theme of “regulatory substance” has been a burning question in the main EU fund domiciles of Luxembourg and Ireland for some time now. Most recently in Ireland, the industry has been waiting for the Central Bank of Ireland to publish a “Dear CEO – CP86” letter to industry addressing required resources for Irish management companies required to be retained in Ireland.
ESMA’s focus on EU substance has increasingly intensified during the Brexit transition period. There has been a push to ensure EU funds are not merely “letterbox entities,” where the actual services are conducted in non-EU locations which by nature are harder for EU regulators to monitor. The industry’s has countered that both UCITS and AIFMD management companies (ManCos) leverage global expertise with appropriate oversight in the regulatory residence of the fund. The industry contends that this model protects investors by allowing local regulators to monitor services provided globally by supervising local oversight of these services while still allowing fund management access to the best investment and administrative expertise for their products, usually by using group company resources that would be expensive and inefficient to duplicate.
The question of what represents “appropriate levels of substance” has to date focused on nature, scale complexity of funds, largely a subjective assessment. There has been a divergence of opinions expressed during the course of the Central Bank of Ireland CP 86 review, but these are in the context of ESMA’s desire to increase the services performed within the EU and to establish a more objective assessment of regulatory substance. Ultimately, this might result in adequate substance being assessed by a headcount of staff in the fund domicile or otherwise within the EU, which likely means less access to third country global resources.
So generally, global regulators are shifting towards better-defined and data-led quantitative assessments for supervision. Here again, ESMA appears to wish to move to a calculation of substance using a more formulaic approach. More objective, less subjective. More numbers, less words. How the calculation of substance lands will have significant impact on the current globally dispersed UCITS & AIFMD model.
Any enhanced local substance requirements will directly affect a UCITS’ or AIFM’s ability to delegate certain key fund responsibilities to third country entities. This is particularly significant in the present moment because many asset managers’ contingency plans for Brexit envisaged an uninterrupted continuation of delegation of portfolio management to UK based firms. The ESMA letter throws that into some uncertainty as the issue of third country delegation is addressed in this context.
The letter proposes amendments to the AIFMD (and UCITS) delegation rules. As with substance considerations, further restrictions to the ability to delegate tasks to third countries would limit AIFMD and UCITS funds’ access to certain key global asset management hubs. Brexit plays a significant role in ESMA’s thinking on delegation, specifically flagging London’s importance as a hub in the letter: