Monthly Archives: April 2018

AIFMD marketing proposals threaten reverse solicitation

Four years have passed since AIFMD was introduced, yet inconsistencies in its application still exist across EU member states. Marketing is one area where consensus has been elusive, with different regulators adopting their own separate approaches, thereby sowing confusion among fund managers.

Whereas the UK allows some ‘pre-marketing’ – including the sharing of draft fund documentation – to take place between managers and EU investors without triggering AIFMD compliance, other countries have been far less generous, insisting that the point of initial contact with prospective clients constitutes marketing, subjecting the manager to local registration, costs and occasionally reporting.

Defining marketing

The European Commission (EC) is seeking to iron out these contradictory interpretations of marketing as part of its CMU (Capital Markets Union) initiative, the overriding purpose of which is to bring about greater harmonisation and uniformity across member states in order to facilitate easier cross-border investment.

The EC’s proposals – announced in March 2018 – aim to coherently define ‘pre-marketing’ under AIFMD as “a direct or indirect provision of information on investment strategies or investment ideas by an alternative investment fund manager (AIFM) or on its behalf to professional investors domiciled or registered in the Union in order to test their interest in an alternative investment fund (AIF) which is not yet established.”

Under the proposals, pre-marketing will be unavailable to existing AIFs, nor can firms share with investors details about their prospectuses and constitutional documents of soon-to-be-established AIFs. Some industry bodies have come out against the provisions, warning the rules introduce added complexity and restrictions for asset managers looking to sell into the EU.

The Direction of travel

At present, the pre-marketing rules – according to some legal firm commentary – appear to apply to authorised EU AIFMs only, and not to non-EU AIFMs, unless local regulators choose otherwise. It is highly probable that non-EU firms will be impacted eventually, should these proposals be implemented. While the proposals are unlikely to become legislation any time soon, they will surely affect UK firms that market in Europe, and that will become non-EU AIFMs when Brexit arrives in 2019 or 2021.

Inside the EU, many managers of non-EU AIFs utilise National Private Placement Regimes (NPPR) to distribute their products, and will have appointed depositary providers pursuant to the rules. Based on INDOS’ experience, few UK firms rely entirely on reverse solicitation, a somewhat ambiguous term interpreted differently across EU national regulators, which excuses managers from certain areas of AIFMD compliance provided they can demonstrate that an EU investor initiated first contact and not the other way around.

However, INDOS notes that reliance on reverse solicitation is more prevalent among US and other non-EU asset managers, a strategy some European lawyers believe exposes them to regulatory risk given the differences of opinion about what constitutes marketing across member states. Non-EU managers have been warned by lawyers, for example, that innocuous activities like distributing business cards to EU investors could fall foul of AIFMD’s marketing rules. While no penalties have, to our knowledge, been levied by regulators on managers to date for marketing violations, many believe it is only a matter of time. There is also the risk that investors can claim a right of rescission if a manager that had breached AIFMD’s marketing rules were to subsequently lose money.

The new prescriptive definition of pre-marketing, however, is likely to constrain non-EU managers’ from using reverse solicitation going forward. Some of the activities proscribed by the EC (i.e. sharing draft prospectuses) under its pre-marketing rules have reportedly been common practice at non-EU managers using reverse solicitation. The proposed changes may result in more managers transitioning towards NPPR registration and subjecting themselves and their funds to the relevant AIFMD rules.

The shift away from reverse solicitation would require non-EU managers to make some relatively modest changes to their operating models and procedures, including the appointment of depositaries (if marketing in certain EU countries, such as Germany and Denmark), provide additional investor disclosures, as well as file Annex IV regulatory reports in the EU jurisdictions where they are distributing products. AIFMD is bedded down, and most managers have found the costs and operational impact to be acceptable, mainly because the entire process is now tried and tested.

INDOS’ non-EU manager clients, which registered through NPPR and became subject to AIFMD, have since been rewarded with capital inflows from European allocators. With reverse solicitation likely to be trimmed, more firms targeting EU investors will transition towards AIFMD compliance, a policy which could reap benefits.

Private equity funds: the benefits of an independent depositary

Private equity fundraising is riding high with unprecedented levels of institutional capital rushing into the asset class, frequently due to portfolio reallocations from other fund sub-sets like fixed income and hedge strategies.

The investors are institutional and highly sophisticated. Institutions of this calibre expect their managers to adopt best practices around fund governance, a key element of which is the appointment of an effective depositary that must act in the interests of investors and perform oversight of the fund during its life-cycle.

Having historically been subject to limited regulatory scrutiny, private equity is now facing far greater oversight following the implementation of the Alternative Investment Fund Managers Directive (AIFMD) in July 2014. AIFMD introduced the concept of depositary to private equity, whereby a third-party provider is responsible for ensuring the ownership and title to fund assets are verified; monitoring cash-flows in and out of the fund; and providing a qualified assessment as to whether the manager is compliant with its fund rules.

Some institutions are starting to question the potential conflict of interest risk at some providers. Many organisations will offer depositary as a bundled service with private equity fund administration, leading sceptics to ask whether these firms are properly incentivised to report oversight issues, particularly if it takes place under the same corporate umbrella. An independent depositary offering unbiased oversight has clear advantages for investors over an affiliated model.

A lack of proper engagement by some depositary providers is also leading to rudimentary errors and mistakes on the fund administration side of their business being missed. As awareness of the role and benefits of the depositary increases, more institutional investors will exert pressure on managers to appoint an independent depositary provider instead of relying on the bundled model.

Depositaries that adopt a minimalist approach to oversight could find themselves being black-listed by some investors. As such, private equity managers are being encouraged to hire proactive depositaries that will independently scrutinise their activities and flag concerns where appropriate.

Appointing an independent depositary serves private equity managers well during investor due diligence examinations. Unlike conventional financial instruments, real assets are held by the manager and not safe-kept at a custodian or prime broker, making it difficult to qualify asset ownership and existence. A private equity manager using a fully engaged, independent depositary will be able to demonstrate that the portfolio assets are legitimately owned thereby expediting the due diligence process.

Tax reform is also indirectly having an impact on the role of the independent depositary in private equity. Corporate governance is one area where private equity has been making material improvements, although some of these enhancements are being driven by rule-changes such as the OECD’s BEPS (Base Erosion and Profit Shifting) provisions, which seek to clamp down on tax avoidance and places the onus on organisations to show they have substance in the jurisdictions they are located in.

BEPS is aimed at rooting out domiciliation abuse, and preventing companies from establishing themselves in low-tax jurisdictions with limited substance on the ground.

Substance comes in many forms, but it is likely to result in directors having to prove that they are fulfilling their fiduciary obligations and that the fund is not simply based in an offshore location for tax purposes with no palpable business in the country.

One way directors can demonstrate BEPS adherence is through regular interactions with an independent depositary, which will be providing them with a steady flow of information on the underlying funds.

Fund managers looking to passport post-Brexit will also need to satisfy EU regulators that they have substance within the Single Market. ESMA has repeatedly warned that letterbox entities will not be acceptable, so managers will need to ensure their EU-27 directors are actually making meaningful decisions and reviewing operational processes.

Again, the role of the independent depositary in providing directors with the necessary information will be critical if firms are to prove that they are not running letterbox entities as and when the UK loses its Single Market access.

While it is relatively straightforward for an investor to withdraw capital from a poorly managed hedge fund offering quarterly liquidity, it is significantly harder to exit a private equity vehicle with a ten-year lock-up period. It is therefore critical for investors to ensure that their private equity managers are subject to thorough and regular oversight by an independent and well-versed depositary, especially as regulatory changes such as BEPS and Brexit begin to take effect.