The future of AIFMD

This OnPoint summarises the panel discussion on the future of the Alternative Investment Fund Managers Directive (AIFMD)¹ that took place on 24 November 2020 between Patrick Goebel (partner, Luxembourg), Dick Frase (partner, London), Angelo Lercara (partner, Munich), Ciara O'Leary (partner, Dublin), Cyril Fiat (national partner, Paris) and Karen Anderberg (partner, London/U.S.). Possible changes to the AIFMD in the areas of delegation, substance, conflicts and marketing, as well new liquidity constraints introduced in the wake of the coronavirus pandemic (COVID-19) were discussed from a cross-jurisdictional perspective.

Background

On 22 October 2020, the EU Commission (the Commission) published its long-awaited consultation on AIFMD (the Consultation).² The Consultation closed on 29 January 2021 and a draft proposal on a revised version of AIFMD (AIFMD II) is expected later in 2021.

In June 2020, the Commission assessed the application and scope of the AIFMD.³ Its findings were based, among other things, on the KPMG report ordered by the Commission in 2017, more recent feedback from the European Securities Market Authority (ESMA) and the recommendation of the European Systemic Risk Board (ESRB), whose influence on AIFMD II is likely to increase in the light of liquidity concerns caused by COVID-19.

AIFMD has undoubtedly been successful in harmonising the EU market of alternative investment funds (AIFs), and the availability of the marketing passport is an important factor in this development. Since the adoption of the AIFMD, total net assets of AIFs have more than doubled in the EU from EUR 2.3 trillion to EUR 5.9 trillion and cross-border marketing  of AIFs (facilitated by the passport) almost doubled between 2017 and 2019, rising from three percent to 5.8 percent.⁴

We anticipate that AIFMD II will focus on enhancing the current AIFMD framework, rather than rewriting the directive. Examples of possible changes are the introduction of measures to avoid impairing the efficiency of the passport by national gold plating, legislative clarifications from the Commission to avoid differences in the interpretation of national marketing rules, and/or clarification of the liability of alternative investment fund managers (AIFMs) when using external valuations. The current economic downturn caused by COVID-19 is also likely to influence AIFMD II, resulting in measures relating to liquidity management tools and the introduction of provisions setting common rules for loan originating funds, with the underlying aim of supporting a more efficient deployment of capital to support economic recovery. Unfortunately, AIFMD II also seems to be influenced by political considerations related to Brexit – particularly the discussions around delegation, substance and conflict rules. Focus on these areas increases the risk that proposals for AIFMD II will go beyond the objective of enhancing the robustness of the AIFMD framework. 

Delegation, substance and conflicts of AIFMs

Changing delegation model? 

One of the most controversial proposals for AIFMD II concerns the requirements on substance5 and the conditions to be met by the AIFM when delegating certain functions. The general consensus is that the current delegation model under AIFMD works well. Portfolio management may be delegated – including to managers outside the EU – with the AIFM remaining responsible for risk management, compliance and oversight of the delegation. The risk of failing the so-called ‘letter-box test’⁶ is low as the AIFM must have an adequate human and technical infrastructure to monitor the delegation of portfolio management. Delegation of functions when correctly monitored is also beneficial for AIFs and their investors as it enables the AIF to access the expertise the AIFM does not have and is also efficient from a cost/benefit point of view.

EMSA’s view – expressed in its letter of 18 August 2020 and addressed to the Commission (the Letter)⁷ – is that supervisory convergence (i.e. interpreting the rules in the same way across the various EU member states and to ensuring a higher level of scrutiny on the delegation process) is of the utmost importance, and ESMA sees tighter rules around delegation as justified by its convergence objective.

Requiring national competent authorities (NCA) to have sufficient control over the delegations by the AIFMs they supervise is undoubtedly important. If, however, the concern voiced by ESMA in its Letter is that delegation generally is a risk for investors and something that ought to be limited, it is easy to foresee this becoming a problem. The discussions around delegation in the Letter are likely to have been triggered by Brexit, particularly when EMSA’s concerns on delegation are linked to other issues, such as secondments and white label AIFMs,8 which are arguably not related to delegation, but rather to concerns about the influence of non-EU entities, which from 1 January 2021 includes UK entities.

The Consultation, which takes the form of a series of open-ended questions, is neutral on this point, in contrast to ESMA’s Letter which is more targeted and includes additional points to those referenced in the ESMA Opinion of 2017 on the substance of AIFMs.⁹ It should be noted that the Commission has no obligation to take into account the questions raised by ESMA.

The appointment of delegates by an AIFM is not undertaken without considerable due diligence when one considers, for instance, the energy and time generally spent on negotiating delegation agreements and ensuring the delegates obligations mirror those of the AIFM. Providing more specific and granular requirements on the number and scope of delegation – as proposed by EMSA in its Letter – would fundamentally change the mechanics of the delegation model, and would expose AIFMs to additional regulatory and operational burden without necessarily resulting in better outcomes for AIFs and their investors.

In France, the French financial markets supervisory authority, the Autorité des Marchés Financiers (the AMF), has always been in favour of supervisory convergence, with the AMF supporting the strengthening of ESMA’s powers and a more harmonised approach to delegation and outsourcing throughout the EU. The AMF’s strong views on these topics are likely to have influenced ESMA. In particular, the AMF currently wants further clarification on the maximum scope of delegation by an AIFM including clear quantitative criteria and a list of core or critical functions that must always be performed by the AIFM internally (i.e. that cannot be delegated). Such action can be seen as an attempt to ensure the uniform application of the ‘letter-box test’.

Another matter now reopened for debate is the question of which of the roles carried out by an AIFM through delegation, which is already covered by the delegation rules under article 20 of the AIFMD. While delegation of portfolio or risk management are clearly subject to the delegation rules, there are some other AIFM functions which are currently not considered to be subject to the delegation rules, for example legal advice is not something that is covered.

Functions carried out by an AIFM

There are different approaches in the EU as to which functions (apart from the core functions of portfolio and risk management) that an AIFM must assume, which are set out in annex I of the AIFMD.

For example, many Luxembourg-based AIFMs only carry out portfolio management (often delegated to a third-party portfolio manager) and risk management functions, while the AIF delegates the administration function directly to the administrator. The AIFM’s responsibilities are then limited to the obligations specified under the AIFMD (for example, valuation) but the AIF administrator will not act as the delegate of the AIFM.

In contrast, German and French AIFMs are operating more like UCITS management companies, with the AIFM taking over all the activities from the AIF, carrying out some of them and delegating others.

Use of white label AIFMs

ESMA’s Letter requested the Commission to look closely at the white label AIFM model, arguing that an intrinsic conflict of interests arises if the AIFM delegates some functions to the AIF initiator. It does not seem that the Commission has taken on this point in its Consultation – at least not directly. The Consultation poses several questions on conflicts of interests and asks whether the current rules are appropriate and proportionate, but without tying these questions specifically to requirements for white label service providers.

While Luxembourg, Ireland and Germany have many white label AIFMs, France has less. Generally, the AMF considers that white label AIFMs create significant risks of conflict of interests. The AMF’s scrutiny of white label AIFMs, and its approach to the management of conflict of interests and investment decision management, especially when using the advisory model, explains why the white label AIFM industry is not as developed in France as elsewhere.

As well as Luxembourg and Ireland, Germany also has a well-developed white label AIFM industry, the so-called Master-KVGs which establish the AIFs, administer them and take initial responsibility for all of the control functions, including risk management, but delegate portfolio management to entities located in or outside the EU. It has also been clarified that delegation of portfolio management to UK-based portfolio managers post-Brexit is not an issue.¹⁰

It is not clear that it would be beneficial to impose more requirements on white label service providers in AIFMD II, and there is little evidence that the white label AIFM model poses a threat to the orderly functioning of the EU asset management industry. 

Reading the Letter, it seems that ESMA’s main concern is that the AIF initiator would be able to exert significant influence over any white label AIFM. A deeper investigation would be welcome to see whether EMSA’s concerns are justified. Inherent conflict of interest arguments can be made against any service provider of an AIF as, in practice, their appointment is ultimately based on a selection by the AIF initiator. It is also worth highlighting that white label service providers are regulated in their own right, they have their own fiduciary obligations, and their own regulatory status to consider.

In contrast, where the AIFM functions are all kept in-house, the potential conflicts of interest between investment decision-makers and those responsible for operating the fund are at least as great, if not greater, than those experienced by the white label AIFM which, because it is less connected to the AIF initiator and economically not dependent on a single client is better equipped to provide independent oversight of the investment decision-makers.

Staff seconded to AIFMs

Secondments are one of the tools that an EU AIFM can use to access professionals based in other EU and non-EU jurisdictions. However, there is no harmonised approach to such secondments as they are assessed from a national perspective – not only from a regulatory point of view but also for the purposes of tax, social security and employment laws.

While the Luxembourg financial markets supervisory authority, the Commission de Surveillance du Secteur Financier (the CSSF) requires, in principle, seconded staff to be physically present in the Luxembourg AIFM’s office, the Central Bank of Ireland (CBI) has previously authorised AIFMs whose seconded staff were not physically located in the AIFM’s office, nor even present in Ireland. Recently, the CBI has adopted a more cautious approach and thoroughly reviews any such secondment arrangements in order to ensure that there is no circumvention of substance requirements or employment law.

The CBI generally takes the view that using seconded staff is a temporary solution (generally limited to the four years following establishment) to assist with the establishment of the AIFM and give it the time to recruit appropriate staff for the relevant positions.

Impact of liquidity issues on AIFMD II

A dedicated framework for loan originating funds across the EU?

ESMA considers that there should be a specific framework for loan origination within the AIFMD. This builds on an ESMA opinion on key principles for a European framework on loan origination by funds, issued in April 2016¹¹ which compared the different approaches across the EU to loan originating funds. Lending activity by an AIF is a sensitive topic for certain NCAs but also firmly established as one of the main financing sources in the EU, providing enhanced market liquidity which is increasingly important for the post-COVID-19 economic recovery. ESMA’s recommendations, which mirror the content on the 2016 opinion, are diverse, covering topics such as authorisation, and organisational and prudential requirements for loan-originating funds.

While AIFMD is recognised as a manager regime, ESMA’s proposals for the framework on fund loan origination resemble a product regime. For example, if an AIFM operating a loan-originating AIF must obtain a special form of authorisation, which includes rules on competent systemic risk management, protection of borrowers and investors, diversification, eligible investments, eligible debtors, limitation on leverage, restrictions on short selling and other topics, these are all features of the individual AIF and not its AIFM. Other considerations are whether a loan originating AIF should be able to conduct other activities, whether it must be closed-ended, and whether its marketing should be limited to professional investors. Views on these points vary between EU member states.

Harmonising the tools to manage illiquidity

The Consultation raises the question of whether there should be a common definition of inherently liquid/illiquid assets and whether the AIFMD II should provide NCAs with the right to require the suspension of subscription/redemption of AIF units in certain circumstances. While further harmonisation makes sense, questions remain around how these changes would be implemented in a cross-border scenario. Liquidity management tools designed to manage a lack of liquidity are embedded in the AIF’s documents. In some cases, they must be applied by the AIFM and in other cases, by the AIF’s management body. If specific powers are granted to the AIFMs under AIFMD II to manage illiquidity, these powers should be aligned with the tools available at the AIF level which are governed by the law applicable to the AIF.

In terms of specific tools to manage liquidity (for example, gating and swing pricing), it is doubtful that harmonisation at the level of the AIFM is necessary or beneficial because liquidity issues generally concern AIFs rather than their AIFMs.

In a cross-border context where, for instance, a Luxembourg AIF is managed by an Irish AIFM, both Luxembourg law and Irish law need to be considered. Procedures and policies related to liquidity testing, back testing, stress testing and others, generally empower the AIFM to apply certain tools to the AIF. If the CBI became aware that the Luxembourg AIF was facing a liquidity shortage, the CBI would contact the Irish AIFM requiring it to rectify the problem. The CBI would have no authority to require action from the Luxembourg AIF but it would have the ability to summon the directors of the Irish AIFM.

Germany: Earlier in 2020, the German legislator created tools to manage liquidity risks by introducing redemption gates for swing pricing and by providing the ability to delay and suspend the execution of redemption requests. While these tools are well known in other EU member states, they are new in Germany. The German supervisory authority, Bundesanstalt für Finanzaufsicht (BaFin), has not issued any specific guidance on application of these tools but it has made it clear that it expects AIFMs to make use of and to implement them as appropriately as possible. BaFin expects that the documentation establishing an AIF will include provisions relating to the use of these liquidity management tools.

France: In March 2020, the AMF issued a Q&A dedicated to the continuity of management activities, and in July 2020 it published a presentation on the liquidity management tools implemented by AMF-regulated funds under French law.¹² The AMF approves and encourages swing pricing mechanisms and adjustable fees. However, the presentation also specified that adjustable exit fees must be justified, non-confiscatory and non-dissuasive, and that investors must be adequately informed of any increase in adjustable exit fees payable to the fund. The AMF also considers that the suspension of redemption rights is a last resort which can only be used in exceptional circumstances. The AMF favours further harmonisation of liquidity management tools within the EU, with AIFMs granted specific statutory powers in addition to the contract-based tools incorporated in the AIF’s constitutional documents.

Marketing of AIFs

Pre-marketing regulation – Harmonised definition of reverse solicitation

Before any discussions on AIFMD II, the EU enacted a directive and regulation on the cross-border distribution of collective investment undertakings,¹³ which entered into force on 1 August 2019. EU member states have until 2 August 2021 to transpose it into national law.

For some EU member states this will provide clarity, or even allow unrestricted pre-marketing, for the first time. In other member states, such as Germany, where a market practice already exists, the new legislation is seen as an unnecessary burden. BaFin currently considers that under certain circumstances, certain activities of a preliminary nature or that happen well in advance of the establishment of the fund are not sufficient to be deemed marketing within the meaning of AIFMD. For example, in BaFin’s view, marketing only starts once the AIF is ‘ready to be offered’ and consequently no registration or authorisation is needed since the AIF is still only an investment idea or a concept.

In France, pre-marketing of AIFs (or UCITS) is defined as contacting no more than 50 investors to assess their interest in the fund before its actual launch. This practice is restricted to contacting professional investors and retail investors who will invest no less than €100,000 each. French pre-marketing rules do not permit a subscription form or a document presenting final terms about the fund to be shared with the investors. The French pre-marketing regime applies to authorised AIFMs (and UCITS management companies), whether they are French or not. For new market entrants that have not yet received their authorisation this is a grey area, as there is no clear legal regime that they can rely upon when marketing their fund.

The Consultation also seeks respondents’ views as to whether reverse solicitation should be harmonised at EU level. Certain EU member states, such as France, have a strict interpretation of reverse solicitation requiring the AIFM to document the investor’s approach as evidence of genuine reverse solicitation. It seems unlikely that any such harmonisation would result in a lighter-touch approach.

Debate on semi-professional investors

The Consultation asks whether further harmonisation is needed when marketing to so-called semi-professional investors – a concept that is primarily German. In its Letter, ESMA favours clarifying the definition of ‘professional investors’ under AIFMD and takes the view that the introduction of any new categories of investors (such as “semi-professional” investors) should be accompanied by appropriate investor protection rules. ESMA also recommends that passporting activities should be allowed only for marketing to professional investors.

Germany

In Germany, the semi-professional investor concept was created when the AIFMD was implemented in German law in 2013. Implementing the AIFMD with only two types of investors, namely retail investors and professional investors, would have meant a significant proportion of German institutional investors being classified as retail investors and precluded from investing in German Special AIFs, which is why the semi-professional investor concept was included. The German definition of a semi-professional investor is one who is investing at least €200,000 and who can prove that they understand the risks associated with the investment and that they are making their own investment decision. Certain persons are per se semi-professional investors, for example directors of an AIFM or an investor investing at least €10 million.

France

In contrast to Germany, there is no ‘semi-professional investor’ concept in France, but French funds reserved for professional investors (such as fonds communs de placement dans l’innovation (FCPI), fonds professionnel spécialisé (FPS), or société de libre partenariat (SLP)) may be invested in by non-professional investors provided that they invest a minimum of €100,000. In France, the European Long Term Investment Funds regime (ELTIF) is seen as a mechanism for accessing retail investors, provided the investors are investing at least €10,000 and are properly assessed. The intention behind the ELTIF Regulation14 is to enable EU-authorised AIFMs to market EU AIFs which they manage as ‘ELTIFs’ to both professional and retail investors across the EU. Authorised AIFMs are also able to make use of an EU-wide passport, subject to the same notification procedure established by the AIFMD. Given that the terms ‘professional’ and ‘retail’ investors are based on MiFID, the French view is that it would be more appropriate to introduce the concept of a semi-professional investor by amending MiFID, not AIMFD. For PE strategies, the funds accessible to retail investors (investing less than €100,000) are funds approved by the AMF, such as fonds communs de placement à risques (FCPR), FCPI or fonds d’investissement de proximité (FIP). For PE and real estate strategies, AIFs accessible to retail investors (i.e., investing less than €100,000) are AIFs which are approved by the AMF (e.g., fonds communs de placement à risques (FCPR), fonds d’investissement de proximité (FIP), sociétés civiles de placement immobilier (SCPI), and organismes de placement immobilier (OPCI)).

Whether AIFMD II will include an EU definition of semi-professional investors – either inspired by the German regime or the ELTIF/the French regime governing professional funds open to non-professional investors – remains to be seen.

The UK

Following the loss of the AIFMD marketing passport because of Brexit, UK funds wanting to access the EU market need to use the existing private placement regime, under article 42 of the AIFMD.

For EU funds wanting to market their products in the UK, the relevant legislation is article 42 of the UK version of the AIFMD. The UK onshore funds regime is, however, mostly nationally-focused, and UK managers who want to utilise the AIFMD passport are likely to continue to do so by using Luxembourg or Irish funds.

For inward business, the UK created a temporary permission regime (TPR) which enables firms and funds that had already passported into the UK to continue doing so once the EU passporting regime fell away. The Financial Conduct Authority (FCA) required fund managers to notify it about entering the TPR by 30 December 2020. The TPR will only run for a limited time. The UK’s proposals for a longer-term plan are set out in the Financial Services Bill, currently making its way through Parliament. This proposes that a new overseas fund regime will be in place by 2025 (the OFR). Funds that have notified the FCA under the TPR will at some point need to re-apply to be authorised under the OFR to continue their activities in the UK. They will be many technical issues around this new regime, but it is generally expected to operate in a similar manner to the EU passporting regimes.  

Conclusion

The recent initiatives around AIFMD as set out in the Consultation can be separated into proposals that would enhance the existing AIFMD framework and proposals that are politically motivated. In the current economic climate, there are good arguments in favour of increasing the focus on liquidity – preventing systemic risk was the primary intention of AIFMD. There are also benefits from harmonising the EU market for AIFs which was one of the key objectives of AIFMD, albeit less obvious than some of the other aims.

Discussions around substance of AIFMs and delegation, which are recognised to have worked well up till now, appear to be politically driven. ESMA’s focus on these topics seems to be disproportionate considering the challenges of the current crisis. Arguably time and energy would be better invested on other areas which require genuine improvement. There is also the risk of overregulation having an adverse impact on entrepreneurship and creativity.

Footnotes

1) Directive 2011/61/EU.

2) Consultation document of the European Commission of 22 October 2020 to amend Directive 2011/61/EU on Alternative Investment Fund Managers, available here.

3) This assessment was based on article 69 of the AIFMD which invites the Commission to propose amendments on the AIFMD after a public consultation.

4) Morningstar, 2019. 

5) The concept of ‘substance’ is closely tied to the ‘letter-box test’ which requires that an AIFM has sufficient substance and does not delegate to an extent that would turn it into a mere letter-box.

6) The basic position is that an AIFM must not delegate its functions to the extent that, in essence, it can no longer be considered to be the AIFM of the AIF and to the extent that it becomes a letter-box entity. Examples of where an AIFM will be viewed as a mere letter-box include where the AIFM no longer retains the necessary expertise and resources to effectively supervise the delegated tasks and manage the risks associated with the delegation or if it no longer has the power to take decisions in key areas which fall under the responsibility of the senior management or loses its contractual rights to inquire, inspect, have access or give instructions to its delegates.

7) ESMA letter to EU Commission of 18 August 2020, and available here.

8) Meaning AIFMs that provide a platform to business partners by setting up funds at the initiative of the latter and typically delegating investment management functions to those initiators/business partners or appointing them as investment advisers or informally following their guidance/instructions.

9) ESMA Opinion (35-45-344) to support supervisory convergence in the area of management companies and alternative investment fund managers in the context of the United Kingdom withdrawing from the European Union.

10) See EU Notice to Stakeholders “Withdrawal of the United Kingdom and EU Rules in the field of asset management” dated 7 July 2020, available here, which states “The delegation of certain functions to providers established in the United Kingdom may be undertaken provided that the relevant requirements in Directive 2009/65/EC and Directive 2011/61/EU are complied with.”

11) See the opinion issued on 11 April 2016 (ESMA/2016/596), available here.

12) The AMF’s presentation of the Liquidity Management Tools is available here.

13) Directive (EU) 2019/1160 and Regulation (EU) 2019/1156.

14) Regulation (EU) 2015/760.