For years, alternative investment fund managers (AIFMs) outside the EU were encouraged by provisions in the Alternative Investment Fund Manager Directive (AIFMD). The key to their optimism was in the so-called “third-country passport” which would allow non-EU funds to distribute and market their products across the EU. That optimism, however, may have been premature: news recently broke that the AIFMD EU passport for third-country alternative investment managers may be scrapped.
Upon its introduction, AIFMD heralded a seismic shift in the distribution and marketing of alternatives funds in the EU and beyond. AIFMD, like all EU “mega regulations,” contained a post-implementation review provision. These reviews seek to highlight areas that are working well, those that are not working so well, and ultimately help decide whether targeted revisions are required to ensure rules are implemented as intended. A mixture of competing priorities and the mammoth overhang of Brexit forced the EU Commission to put the AIFMD review on the back burner. With the dust settling somewhat on the Brexit storm, we now expect the Commission to release the findings of the AIFMD review in early 2020.
The AIFMD passport allows approved alternative investment fund managers to manage and/or market alternative investment funds (such as hedge funds, private equity, private debt, and real estate funds) across the EU on the basis of a single authorization by their local regulator. Currently, the passport is only extended to EU-authorized AIFMs. Many in the industry, including global fund managers, have long hoped that regulators would extend the passport to non-EU countries (so called “third countries”). The Commission first planned to extend the third-country passport to certain assessed countries in 2015 and then again in 2018. Despite these plans, no country outside of the EU to date has been granted such a passport, even though many of these countries received positive assessments by ESMA. Now, according to recent reports, it appears the much anticipated AIFMD passport may not be granted at all due to a convergence of regulatory and geopolitical events.1
This will be a blow to any non-EU alternative fund managers with a desire to continue distribution of their product in the EU. That’s because without a passport the only way to become an approved AIFM is to have a physical presence of substance in the EU. Significant countries such as US, Switzerland, Hong Kong, and offshore jurisdictions like the Channel Islands all have held out hope that they would be granted regulatory “equivalence” under AIFMD and hence become eligible to receive the passport. Brexit, however, has had a chilling effect within the EU for granting the passport to any non-EU countries since doing so may set a precedent for the EU’s future relationship with the UK. The EU is not inclined to allow the UK to benefit from their decision to leave the EU, by potentially giving UK alternative fund managers a backdoor to access the lucrative EU single market.
NPPRs also in question
If the European Commission rejects the third-country passport, as is expected, one area that remains up to Commission debate is whether or not to maintain existing national private placement regimes (NPPRs). An NPPR is essentially a mechanism to allow AIFMs to market alternative investment funds (AIFs) without having to follow AIFMD. The Commission has two options: abolish NPPRs outright across the EU, making it mandatory for a manager to be AIFMD compliant if they wish to sell alternative funds within the EU. Or, keep the NPPR structure as it is today, with existing NPPRs, including those outside the EU, free to market their funds to investors in the EU. NPPRs, however, are not an ideal form of cross border distribution in terms of continuity and efficiency. EU NPPRs vary significantly from one member state to another, so it can be expensive to distribute in multiple EU markets. Some countries, like France and Germany, started to limit NPPR access to their markets even before the UK’s Brexit referendum in June 2016. Additionally, not all EU countries have NPPRs in place. It is also possible that a country retracts or materially alters the requirements to market in their country under private placement. Finally, to rely on NPPRs, the third country where the fund is domiciled must have a bilateral agreement with the member state in place.
Establishing a presence in the EU
Some in the industry suggest that continuation of the NPPR across the EU is the best possible outcome since it allows managers to avoid the cost and liability burdens of complying with AIFMD. As outlined above, the NPPR is far from ideal as a basis of a long-term distribution strategy since it is subject to change or revocation. It is also unlikely that there will be any support from member states for a situation that provides non-EU fund managers an unfair advantage as it allows direct access to EU investors without needing to comply with AIFMD, a luxury not afforded to EU-based managers.
Without an AIFMD passport, and with NPPR abolished, alternative firms wishing to sell product to EU investors would need to establish a presence with substance in the EU. This would involve setting up a new AIFM entity or contracting with an existing AIF management company in a member state to ensure they continue to have access to the passport. There remains a lot of discussion on the level of “substance” required by the AIFM in the member state and how much of its activities may remain in the third country. We expect the Commission to address what constitutes substance in the 2020 AIFMD report.
The hardening stance of the EU has been evident for some time now and many large managers have already made the decision to invest in creating substance in Luxembourg and Ireland as the main go-to jurisdictions, with the Netherlands and other countries also benefitting. This is evident in recent AIF domiciled fund growth in these countries: Ireland, for instance, now has more than 2,500 domiciled AIFs, representing more than €650 billion in net assets.2 Luxembourg has also witnessed a recent surge in AIF assets, particularly in areas like private equity, where assets under management in Luxembourg increased by twenty percent from 2017 to 2018.3 Now that AIFMD third-country passports are potentially no longer on the table, managers are likely to launch UK-specific funds, solely for UK investors, while European domiciled funds will likely be tailormade for European investors. For those unwilling to bear the costs of having a presence in both regions, they will have to make hard decisions on focusing their growth trajectories that will deliver the strongest gain.