Europe’s AIFMD: Will US Fund Managers Bite or Should They?

The EU’s new Alternative Investment Managers Directive (AIFMD) is supposed to give alternative investment fund managers the same cachet as their traditional investment manager peers following UCITS. Or so, European regulators think.

But the allure of AIFMD appears to have been lost on a critical sector of the alternative funds market. US fund managers aren’t eager to sign up as Alternative Investment Fund Managers (AIFMs) under the new legislation and some privately tell FinOps Report that they might even forgo marketing to European investors. “It’s a cost benefit analysis and we don’t see the value based on the stringent regulatory requirements,” says one compliance manager at a US investment management shop in a stance shared by ten peers contacted by FinOps.

So far, European fund managers are also staying away in droves, creating plenty of doubt as to whether AIFMD will be as successful as UCITS. A study released this week by asset servicing giant BNY Mellon doesn’t break out the difference in interest between US and European fund managers, but it clearly highlights the lackadaisical response. Of the 50 asset managers surveyed across the globe, less than one-fifth have submitted their applications to local European regulators to become authorized as AIFMs.

Short for Undertakings for Collective Investment in Transferable Securities, UCITS allows traditional fund managers to access investors cross-border as long as they also follow some new rigorous disclosure and reporting requirements. Complying with the legislation, now close to its fifth incarnation, has become a de facto marketing requirement for traditional investment funds whose demanding investors want to be reassured their funds’ operations are up to snuff.

No one wants to publicly comment on what the potentially disappointing scenario for AIFMD means for US fund managers or the EC’s image. Naturally, European investors will lose out on potential opportunities and alpha, while asset servicing providers, acting as depositaries, could also forfeit potential revenue.

European regulatory experts warn that the laggards should just bite the bullet and take on the necessary additional costs and administrative burdens to follow the AIFMD’s rules. One key reason: there is plenty of money to be made. Yet another, fund managers attempting the option of following the local status quo in various EU nations won’t find those local financial regulations much cozier.

“A lot of the talk about AIFMD has been about the costs and the pain of compliance, rather than the upside,” says Karen Conboy, director of financial audit for KPMG in Dublin, who acknowledges the difficulties. “Fund managers need to understand that having an AIFM gives them a marketing passport to 26 national investor markets across the continent. That’s an opportunity that shouldn’t be underestimated.”

Adopted at a high level by the European Commission in July 22, 2013, the AIFM Directive enables fund managers to obtain AIFM status in one country and receive a so-called “passport” to market their funds in any of the participating EU nations. To do this, they must be designated as AIFMs by June 8, 2011. So far, only twelve countries — including the UK, Ireland, Luxembourg and Malta — have transposed the EU legislation into national rules, leaving many fund managers domiciled or wanting to market investments in other countries in a quandary about just how to proceed. One thing is certain: those wanting to become AIFMs need to apply far earlier than the drop-dead deadline — February 22 with Ireland’s central bank and April 1 with Luxembourg’s securities watchdog, the Commission de Surveillance du Secteur Financier (CSSF).

Fund managers who pass regulatory muster must comply with extensive new reporting requirements which include leverage, liquidity and counterparty exposure. Reporting, aggregated at the manager level for each authorized AIFM, also includes information on compensation practices and side-letters to investors given preferential treatment.

Slow Going

“The uptake from fund managers, particularly from the US, has been slow,” concedes Kieran Fox, director of business development in charge of monitoring AIFMD developments for the Irish Funds Industry Association (IFIA) in Dublin. “At the core of their decision on whether or not to register as AIFMs is the additional expense involved compared to the merits of open marketing on the continent.” BNY Mellon’s study pegged the one-time cost about as an average of about US$300,000 with about half of the respondents citing technology changes as the key driver. So far, of the eight fund management firms Ireland’s central bank says have been authorized as AIFMs only one — BlackRock Asset Management Ireland — is US-headquartered and also UCITS-compliant.

Karen Conboy, director of financial audit for KPMG in Dublin, compares the resistance of US fund managers to AIFMD to some of the stages of grieving. “First they were angry about the AIFMD, then there was denial it would affect them, but they now accept they will have to make an active decision.”

Naturally, each European market is vying to be the top dog in AIFM registrations and leverage their existing strengths. So far, Luxembourg far exceeds Dublin when it comes to the number and value of UCITS-eligible funds under its belt and wants to keep it that way. “Luxembourg has established a successful tax transparent limited partnership structure ahead of Dublin,” touts Marc Saluzzi, chairman of the Association of the Luxembourg Fund Industry (ALFI).

However, Malta’s chief regulatory body, is also quick to cite the merits of becoming an AIFM under its jurisdiction. Although the AIFMD is a pan-European regulation and the watchdog European Securities and Markets Authority (ESMA) did offer some guidelines, there is plenty of room for interpretation, thereby encouraging jurisdiction-shopping by fund managers. Case in point: restrictions on the form and structure of compensation paid to “identified” staff at AIFMs such as senior management and risk-takers — an anathema for US fund managers in particular.

“Malta did not implement parts of the ESMA’s guidelines which require the delegate sub-manager of the AIFM to comply with the standards on remuneration,” explains Joseph Bannister, chairman of the Malta Financial Services Authority. “Other jurisdictions have yet to fully explain their position, so naturally US managers are increasingly attracted to Malta, as there is certainty around this issue.” Although Bannister insists that Malta’s interpretation of the requirements of the AIFMD provides investors sufficient protection, he won’t disclose just how many US fund managers are biting.

Alternatives Abound

Fund managers who already have a presence on the European continent — aka an operating or marketing office — may opt to register as an AIFM under that office, whereas those who do not will need to build such an infrastructure from scratch. Alternatively, they could outsource the role of AIFM to a third-party platform provider.

Outsourcing shouldn’t be taken lightly. The AIFMD specifically precludes so-called letterbox entities from being AIFMs. Instead they require the AIFM to handle investment and portfolio management. US-headquartered fund managers will doubtless want to retain the functions of investment strategy and stock-picking, leaving the rest to an external European fund manager.

Such a scenario requires plenty of coordination and oversight between the US fund manager and the AIFM, which is ultimately responsible for any activities it delegates. The AIFM has to prove to the local European regulator fielding its application that it has the appropriate procedures and infrastructure on hand to meet the AIFMD’s requirements.

Fund managers who believe they can rely on the existing marketing rules of each European nation had better look hard at where they intend to do business. France, for one, doesn’t even permit hedge funds to be marketed under its private placement regime while Spain and Italy make it pretty difficult.

“European countries are making private placement rules a lot more rigid and in the case of Germany might even match the AIFMD’s requirements,” says Claude Niedner, partner of the law firm of Arendt & Medernach in Luxembourg. “What’s more, non-EU managers — namely US fund managers– will find that loophole closed by 2018 and will need to register as AIFMs, if they want to solicit any European investors. Waiting it out isn’t an ideal option.”

The EC has left one narrow way around the AIFMD — reverse solicitation. In simplest terms, should a European investor approach a fund rather than than the other way around, the fund manager wouldn’t have to comply with AIFMD. It sounds like an ideal answer, with one important caveat. “No one seems to understand just how to interpret reverse solicitation,so it won’t be easy for fund managers to prove,” explains Niedner, who also heads ALFI’s committee on AIFMD. The reason: each European country defines reverse solicitation differently and some don’t even allow it.

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