The UCITS regime is merging more and more in to something that looks a little like AIFMD, but convergence of the two may be a way off yet, according to Etienne Deniau, Serge Balatre and Jean-Pierre Gomez of SGSS
Distribution is a critical consideration for those wishing to market their hedge funds into Europe.
But regardless of whether that fund is UCITS-compliant or an alternative investment fund (AIF), the continuous evolution of European regulation means that managers have to stay one step ahead and evaluate just how much of an impact it will have on their marketing distribution strategies.
The Alternative Investment Fund Managers Directive (AIFMD) was broadly transposed into national law across the EU in July 2013, and since then asset managers have steadily adjusted to life under the new regulatory regime, one which, unlike UCITS, which is a fund-based regulation, focuses on regulating the alternative investment fund manager.
Most EU asset managers are now fully compliant with AIFMD and availing of the funds passport to launch AIFs from various jurisdictions. We are seeing, in particular, quite a lot of UK AIFs being distributed into continental Europe.
One of the biggest headaches that managers face today is reporting.
Under AIFMD, this involves completing an Annex IV report, which contains over 300 separate data fields, similar to Form-PF reporting in the US.
It has been a new opportunity for service providers because a lot of asset managers do not know how to produce Annex IV reports. The expertise of firms like SGSS means that we can provide an Annex IV reporting solution to asset managers.
Time for a refresh
UCITS V is the first sign of EU regulators attempting to harmonise the UCITS regime with AIFMD. UCITS V will provide even further protection to retail investors. The problem is that while level-one measures have been clarified, which broadly outline the scope of regulation, the industry is still waiting for clarification on level-two measures. These regulatory technical standards are yet to be approved by the European Parliament and Council, meaning that asset managers will have to appoint a depository in compliance with UCITS V without knowing the contractual details of what that arrangement will entail.
Depository roles
Under UCITS V, an appointed depository must be a Capital Requirements Directive (CRD) IV-authorised credit institution, another legal entity that can meet the minimal capital requirements or a national bank. The role of the depository under UCITS V will cover the main tasks as apply to AIFMD, namely safekeeping of the AIF’s assets, cash management and general oversight, and as such, most European depositories should be well placed to carry out their duties under UCITS V.
However, UCITS V goes further. While it has replicated the higher standard of protection under AIFMD, there are additional duties placed on the depository. Principally, the depository has to control the entire custody chain under UCITS V. There will be no exemption to the restitution of assets of a sub-custodian, which in some cases can apply under AIFMD.
Under UCITS V the depository has much wider responsibilities with respect to both the custody and the safekeeping of assets. This will require more control processes and legal expertise in non-EU countries where sub-custody arrangements apply.
There will also be more stringent cash controlling and global asset restitution, meaning the depository will need to do proper due diligence on the counterparty to have full oversight of all counterparts to the UCITS fund and have a global view of the fund’s assets.
The assets of a UCITS fund will also need to be fully segregated and held in the custody account, which again goes further than AIFMD, where the depository is responsible for the AIF’s assets under custody, but not responsible for the safekeeping of those assets.
Before, securities had to be you had to segregated depending on the country. Now, the segregation of securities has to happen across the sub-custody network.
Under AIFMD, the depository can relinquish responsibility of the AIF’s assets if it has third-party custody arrangements in place, as chosen by the asset manager. Under this arrangement, the depository is not responsible for the AIF’s assets, should anything go wrong. This is not an option for depositories under UCITS V.
Also, with respect to the oversight function under UCITS V, if the asset manager or shareholder in the fund can prove that the depository did not properly perform its oversight duties, the depository will be on the hook for any losses incurred in the fund.
Another important point under UCITS V is that there is independence of asset managers and depositories within the same group.
Where a group acts as both the depository and also as asset manager within the same group, there must be a set of rules and walls between the two businesses. This is to guard against potential conflicts of interest.
Distribution and development
The AIF brand has a long way to go before it can ever be considered on a par with UCITS, which has had the best part of 30 years to build its reputation as the ‘gold standard’ for investment funds among global investors. AIFs have only been able to avail of the AIFMD passport since July 2014.
But there are signs that the distribution potential of AIFs is on the rise. In Ireland, for example, assets in qualified investor alternative investment funds (QIAIFs) were up 21 percent through November 2015 over a 12-month period.
Net inflows to QIAIFs were €31 billion through November 2015, giving an overall aggregate total of €384 billion.
Europe wants to create a brand with the AIF just as it has done so successfully with UCITS. Indeed, UCITS V has just been translated into Chinese, representing a major distribution channel for asset managers in the coming years.
AIFMD needs to walk before it can run. The question is, with greater convergence between UCITS V and AIFMD, could Europe see the emergence of a single regulatory regime in the form of AIFMD II or UCITS VI? If so, what impact could that have on the distribution and brand potential of AIFs?
Despite some differences, regarding the role of the depository, for example, the two are roughly the same. Why continue with two regulatory regimes? One could argue that UCITS is designed for the retail investor and AIFs are designed for professional investors, but if the regulation is well written, one regime could suffice. The AIF may not yet be a brand, but it could become one as AIFMD evolves.
That was certainly the case with the UCITS regime, which has gone through multiple iterations. But AIFMD is still in its first iteration, and we haven’t seen a tremendous evolution. Why?
The passport is given to the fund under UCITS. Under AIFMD, the passport is given to the fund manager. Therefore, if you have an AIFMD licence, in theory you are allowed to sell your fund across the EU. A manager based in London or Paris, with a Luxembourg special investment fund, that wants to sell its fund to German investors, for example, will need to apply to BaFin, the German financial regulator, and await its approval.
Under UCITS, managers can freely distribute their funds to German investors without requiring any approval from BaFin. BaFin has the right, under AIFMD, to prevent a EU AIFM from passporting its Luxembourg AIF into Germany if the regulator feels it is too different to the German AIF.
That is a big difference, from a distribution perspective, between UCITS and AIFMD.
The other distribution hurdle that the AIF brand must overcome is that it currently only seems to be available to professional investors, even though some people know about non-UCITS retail schemes.
One of the main attractions of UCITS is that it can be distributed to all types of professional and non-professional investors.
This is thanks to the strong regulation that UCITS funds must adhere to. AIFs, while attractive to hedge fund or private equity managers wishing to fully replicate their offshore strategy, do not have to offer daily liquidity. This limits the scope of distribution.
Nearly 70 percent of funds registered for distribution worldwide are Luxembourg-based funds. When clients want to sell an AIF to German investors—institutions or high net worth individuals—it remains complicated.
There are many questions from BaFin. Under AIFMD, managers can still use the National Private Placement Regime or reverse solicitation, so there are other distribution options available.
Third-country passports
One catalyst for increased distribution of AIFs in Europe will be the third country passport. The European Securities and Markets Authority (ESMA) has recommended Guernsey, Jersey and Switzerland for passporting, meaning AIFMs and AIFs operating out of those jurisdictions would be able to market freely across the EU, provided there were equivalent enforcement capabilities of the home regulator to ensure that they comply fully with the directive.
The decision on when the passport will become enforceable in those three jurisdictions has been delayed, at least until the end of June, by which time ESMA will have assessed a second wave of jurisdictions including the US, Singapore and Hong Kong.
There may be some kind of boom, an increase in fund activity under AIFMD, once ESMA establishes the rules of conduct, but this may not be feasible in 2016.
If the third-country passport is enacted next year, it is possible that the number of AIFs being distributed across Europe will grow.
When ESMA allows US managers to enter the European market and passport their funds, it will enhance the AIF brand.
Under these regulatory conditions, there would appear to be a convergence between UCITS and AIFMD regulations, which in turn should make managers’ compliance frameworks easier to implement. But from a pure branding point of view, AIFMD will likely need to go through one or two more iterations before AIFs start to resonate with professional investors.
