Developments with the AIFMD passport, private placement and depositaries

This INDOS Financial article was first published by HedgeWeek and can also be read here.

After further analysis and deliberation, on 19 July 2016 the European Securities and Markets Authority (ESMA) issued its second set of advice on which countries it believes the AIFMD (Alternative Investment Fund Managers Directive) passport could be extended to. Nine out of an initial 12 countries under review (Australia, Canada, Guernsey, Hong Kong, Japan, Jersey, Singapore, Switzerland and the US) were told by ESMA there were either no or very limited impediments in their fund management regulatory regimes which would deny them access to the AIFMD marketing passport.

Cayman Islands and Bermuda – both of which are creating regulatory regimes that are more compatible with the EU’s AIFMD – have been notified that further reviews will need to be undertaken by ESMA before a decision can be reached. The Cayman Islands and Bermuda have been making progress on developing a regulatory regime in line with AIFMD, and approval ought to be forthcoming in due course. The Isle of Man was told it did not have a sufficient AIFMD equivalent regime in place to warrant approval.

These potential approvals/non-approvals are important because managers located in AIFMD-equivalent third countries or EU managers with funds domiciled in offshore centres cannot use the AIFMD passport if that offshore jurisdiction has not obtained ESMA approval. The ESMA advice now needs to be considered by the European Commission, European Parliament and European Council before a decision is made to extend the passport formally to any third country. There is no clear timetable for this process.

The path forward may now be further complicated by Brexit. The UK’s historical associations with many of these offshore centres could make EU policymakers disinclined to grant approval quickly. Enormous amounts of conjecture have been written about the UK’s legal and constitutional relationship with the EU post-Brexit. As a result, it is not unfair to suggest there is uncertainty as to whether the AIFMD passport will be automatically available to the UK post-Brexit. Since the UK has transposed AIFMD into its domestic legislation and implemented the rules accordingly, demonstrating equivalence ought not to be a problem in theory. This, however, cannot be guaranteed.

So what does all of this mean for the future of marketing via National Private Placement Regimes (NPPR)? At the time of AIFMD’s introduction in mid-2014, NPPR was supposed to be switched off in 2018, or three years after the passport was initially expected to be extended to third countries. The slow progress of ESMA’s advice on third country passport extensions means that the 2018 time-frame is now unlikely, and will be pushed back to 2020 or beyond. NPPR will therefore exist for some time yet.

However, some countries could switch off NPPR earlier. In Germany, NPPR will shut down to managers or funds domiciled in third countries that have been granted the passport. This could have adverse consequences for non-EU managers that have registered under Article 42 of AIFMD so as to use NPPR to market into Germany.

Many UK managers do not view the passport extension as a primary concern, as most only use NPPR in a small number of EU countries. Whether this changes if the passport becomes a reality remains to be seen. In addition, many non-EU managers may have little interest in obtaining the passport despite its distribution potential since access to it will require full compliance with AIFMD and subject firms to a number of regulatory obligations including remuneration disclosure requirements and restrictions. Those non-EU managers with EU marketing operations tend to have concentrated investor bases in a few countries such as the UK, Holland, Denmark, Germany and Sweden. As such, NPPR which has fewer AIFMD compliance obligations is more appealing.

The uncertainty around NPPR, third country passport extensions and Brexit also causes challenges for the depositary-lite model. Depositary-lites need to contemplate future proofing their business model to ensure it is compatible in the new regulatory order. This could be achieved through conversion into a full depositary or re-domiciling to an onshore jurisdiction with a strong funds servicing industry such as Ireland, Luxembourg or even Malta. At present depositary-lites need to be considering their options and this will help reassure fund manager clients and their end institutional investors, who are no doubt enquiring about service providers’ contingency plans in this unclear regulatory environment.

The value of the depositary beyond meeting regulatory compliance obligations should not be discounted. Many managers initially viewed depositary as a box-ticking compliance exercise which lacked value. In fact depositaries are there to help safeguard investor capital, and ensure managers are compliant with various rules and agreements. If there is malpractice in any shape or form, the role of the depositary is critical. This is gradually being recognised by managers, as evidenced by numerous depositaries losing mandates to those providing a value add, independent offering.

A number of managers initially hired depositaries based on pricing or whether their custodian/administrator offered it as a bundled service. This is changing too. Managers realise that hiring a depositary based purely on commercials rather than service quality and protection is a false economy. Equally, investors and managers are pushing for depositaries to be independent from the administrators – much of whose work they oversee. Sceptics doubt a depositary tied to an administrator would flag wrongdoing at that administrator as required under AIFMD. The push towards independent depositaries such as INDOS Financial is therefore gathering momentum.

Moving forward, the European depositary model may also gain traction in emerging hedge fund markets such as South Africa or Australia. Many markets do look towards the EU and its regulations as way of example. UCITS’ influence is noticeable in numerous emerging fund structures, such as the ASEAN Collective Investment Scheme (CIS). Should depositaries be adopted in markets seeking to boost their fund management industry, European providers with AIFMD experience and a track record could have a competitive advantage over local players.

Many uncertainties exist around AIFMD but depositaries need to evolve with those challenges, and rise up to new ones. Firms need to be reflecting on how they may need to restructure their businesses to deal with developments that may arise in the EU. That being said, there are opportunities for depositaries and it is very possible other countries will look to EU law when developing their funds regimes. This could result in the internationalisation of the European depositary model.