This INDOS Financial article was first published in the April 2015 issue of InvestHedge and can read here (subscription required).
Almost nine months have passed since the final introduction of the Alternative Investment Fund Managers Directive (AIFMD) yet the definition of “reverse solicitation” or “reverse inquiry” continues to perplex alternative investment fund managers (AIFMs) mulling over whether or not to target their alternative investment funds (AIFs) at European institutional investors.
AIFMD defines marketing as “a direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM of units or shares in an AIF it manages to investors domiciled or with a registered office in the EU.” This definition is broad. Reverse solicitation on the other hand is not clearly defined by AIFMD. European regulators are taking different views as to whether communication and investment at the initiative of the manager is deemed to be marketing, or where this is at the initiative of the investor, is deemed to be reverse solicitation.
With only EU AIFMs managing EU AIFs currently able to access the EU marketing passport introduced by AIFMD, other managers (notably EU AIFMs managing non-EU AIFs or non-EU AIFMs) have the choice of marketing via so-called national private placement regimes or relying on reverse solicitation. Marketing subjects managers and their funds to additional regulatory reporting obligations, further investor disclosures including remuneration and, in many cases, the appointment of a depositary to provide cash-flow monitoring, oversight and safekeeping / verification of assets. Faced with these requirements, a substantial number of non-EU managers, and no doubt a good deal of EU managers prefer to rely on reverse solicitation despite the fact this carries a high level of risk.
Implementation of the AIFMD, particularly around the marketing rules, has been mired with challenges and regulatory arbitrage. Different jurisdictions have adopted different approaches towards enforcing the Directive requiring AIFMs to study the rules carefully in each of the markets in which they are soliciting investment from to ensure they are not breaching marketing rules. The UK’s Financial Conduct Authority (FCA) has adopted a pragmatic approach based on the guidelines laid down by the European Securities and Markets Authority (ESMA). In June 2013, the FCA published its policy statement on AIFMD implementation stating that confirmation from an investor that the purchase of units in the AIFM was done at the investor’s own initiative is sufficient to demonstrate passive marketing or reverse solicitation. However, the FCA has tempered its pragmatic stance with caution warning managers that investor confirmations cannot simply be window dressing to circumvent the Directive or mask marketing. Some jurisdictions have been less flexible. Sweden, for example, deems any contact between the AIFM and the investor – even prior to any fund being launched or marketing materials being published – as a breach of reverse solicitation. Other jurisdictions adopting a tougher stance include France, Germany and Italy. However, a fair number of jurisdictions have yet to produce any guidance whatsoever. If consistency is to be achieved, ESMA will need to produce more clear guidance – something a number of European trade associations have called for recently in response to ESMA’s consultation of the possible extension of the passport.
As such, the precise definition of what exactly constitutes marketing appears to be interpretational. While a common sense approach to marketing will probably hold sway in the UK, this might not be the case in jurisdictions which have regulatory bodies with a more hostile stance towards non-domestic managers.
The litmus test for marketing is not clear-cut. Lawyers have been understandably conservative and have warned some fund managers against distributing business cards to European investors on the continent or even outside of the EU. Others have gone further, and suggested that managers exercise caution when supplying performance statistics to data providers, which institutional investors may subscribe to. Capital introduction teams at prime brokers, at risk of being deemed “indirect” marketing per the marketing definition, have also been feeling the challenge. Some prime brokers have simply started documenting thoroughly all of the interactions they facilitate between investors and AIFMs in the EU so as not to be in breach of the Directive.
Reverse solicitation is ultimately proving to be a risky approach to take. In reality, EU investors will rarely call a manager out of the blue. Some firms have openly said they are relying on this mechanism and they are unlikely to raise meaningful capital. Others risk falling into the trap of soliciting reverse solicitation, or enticing an investor to approach the manager, which technically could constitute marketing. As such fund managers have to rigorously document all of their interactions with investors, and carefully log email and telephone communications to manage their business risk and regulatory scrutiny. Lawyers suggest some countries like France, Germany and Austria are likely to be the markets where regulators are the most proactive in this sense although the FCA recently revealed that it was investigating 67 AIFMs for a range of potential regulatory breaches. The penalties of falling foul of the rules should not be underestimated. The fines for non-compliance are subject to regulatory discretion but constitute a criminal offence in some countries. Regulatory sanctions would have to be disclosed to existing and prospective investors, which could prompt redemptions or a reluctance to allocate. Some investors are understood to be cautious about investing with managers that rely on reverse solicitation given they could be inadvertently affected by a manager’s non-compliance with the marketing rules. Perhaps the biggest risk is that investors can claim a right of rescission if a manager that had breached AIFMD’s marketing rules were to subsequently lose money. This could personally impact the manager’s own net worth and could have severe consequences. Prior to AIFMD, there were a handful of case studies of managers being sued by investors for mis-selling their product and it would not be unreasonable to suggest that the courts would probably side with the consumer were such an eventuality to occur in this post AIFMD world.
In reality, the only way to address the risk is to become compliant with the Directive and the various national private placement regimes. However, some US managers whose investor base is predominantly domestic have argued against registering under AIFMD because the capital they raise from Europe is minimal, and the cost economics of AIFMD compliance make little sense. Many cite Annex IV and the disclosure of their remuneration packages as being the major factors behind this decision to hold out from Europe. Other non-EU managers with a sizeable EU investor base have obviously swallowed the pill. Initial cost forecasts for AIFMD were significant but have reduced markedly. Depositary costs are in the low single basis points range while the cost of filing the Annex IV (particularly in jurisdictions where no look-through reporting is required on the master fund) has diminished too. Most managers are simply focusing on their core markets – the UK, Netherlands and Sweden – and adhering to the rules in those jurisdictions. These markets – especially the UK – are efficient and registration is via a simple notification process. However, for other EU markets, such as Germany and Denmark, registration can take around two to three months although a number of managers are known to have been successfully authorised in these markets and what is required to be successful is becoming clearer, cheaper and the process more commoditised.
Going forward, the regulatory landscape, particularly around marketing, remains uncertain. ESMA has to present to the European Commission by July 2015 its findings on whether the pan-EU passport should be extended to non-EU managers and non-EU funds. If this were to occur, non-EU AIFs and non-EU AIFMs marketed via the passport would be subject to all of the AIFMD’s requirements. One potential outcome is that ESMA will ask the Commission for more time to evaluate how the passport has worked so far. Delaying the decision on the passport has been urged by industry associations. Any delay could result in private placement being allowed to perpetuate beyond 2018 when it is otherwise expected to be phased out. One key challenge with the passport lies with the co-operation agreements signed between the EU and third countries since not all of these countries will attain regulatory equivalence. It has been suggested one outcome could be that the EU allows EU AIFMs of non-EU AIFs in certain jurisdictions such as the Cayman Islands to be provided with a passport. However, the passport would not be extended to US managers of Cayman funds. Those non-EU managers that have adopted a wait and see approach to Europe in anticipation of the passport being introduced may now decide to take the plunge and register for marketing through private placement.
Undoubtedly, AIFMD does throw up new challenges for managers seeking to market in Europe. Further guidance is needed from ESMA and European regulators but for any managers with an interest in European investors, the risk of reliance of reverse solicitation being non-compliant with the AIFMD marketing provisions is something which managers must be alert to.