Reverse solicitation – AIFMD solution or regulatory minefield?

The excellent article below on reverse solicitation was written by Gary Kaminsky, Managing Director, Global Regulatory and Compliance, ConceptONE, LLC and is reproduced with the author’s permission.

I get concerned when I hear alternative investment fund managers (“AIFMs”) describe their strategy for dealing with the Alternative Investment Fund Managers Directive (“AIFMD” or “Directive”) as reverse solicitation. Reverse Solicitation is not a strategy. By definition, one can’t “do” reverse solicitation – it is a passive activity reactive to third-party inquiries of interest in the AIFM. Since the key triggering activity subjecting an AIFM to the Directive is marketing to EU domiciled persons, it is imperative that managers understand what this means and tailor their actions accordingly.

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 of an alternative investment fund (“AIF”) it manages to or with investors domiciled or with a registered office in the Union.” See Directive 2011/61/EU of the European Parliament and of the Council on Alternative Investment Fund Managers, 2011 O.J. L 174/18.

This definition begs further inquiry as to what is an “offering or placement at the initiative of the AIFM…” Further complicating the analysis is that each Member State may define marketing differently. The FCA has adopted the ESMA definition but has offered some further guidance on the question of whether the marketing inquiry was at the AIFM’s initiative or the client’s, and hence a reverse solicitation. In its June 2013 consultation, the FCA suggested that “a confirmation from the investor that the offering or placement of units of shares of the AIF was made at [the investor’s] initiative, should normally be sufficient to demonstrate [passive marketing], provided this is obtained before the offer or placement takes place.” See FCA Policy Statement on Implementation of the Alternative Investment Fund Managers Directive, June 2013 Marketing 7.8. It has been suggested that a written certification from the investor should suffice. The FCA notes, however, that AIFMs should not be able to rely on such confirmations if they have been obtained to circumvent the requirements of the AIFMD. In other words, the regulators reserve the right to disagree with the AIFMs characterization of its marketing activity based on each facts and circumstances. The classic “regulatory pornography” – they will know a violation when they see it.

Where does this leave the AIFM in trying to decide whether it should actively market in the EU and thereby subject itself to the Directive? Many firms are struggling to answer this question in light of the cost of complying with the Directive. In fact the overall cost of compliance with the ever-increasing global regulatory initiatives is a pervasive issue impacting AIFMs today. Dodd Frank, and now AIFMD have added substantial burdens and costs to being an alternative manager. Some view regulation as an unnecessary nuisance that takes the manager away from its primary mandate, generating alpha. AIFMs are suffering from regulatory fatigue from SEC registration, PF and PQR reporting, FATCA, VoP applications, EMIR and soon to be Annex IV reporting. It is not surprising that when presented with the option to avoid some of these burdens, AIFMs may elect to pursue the course of least resistance. Many believe reverse solicitation is that course when it relates to AIFMD compliance. This may well be a mistaken belief.

A large percentage of US managers appear to be under the impression that reverse solicitation is the panacea to the added burdens that AIFMD may place on them. This impression could be greatly flawed and rife with serious potential consequences. It is ironic that the same portfolio managers who have been successful in being able to effectively analyze the probabilities and expectancies of trade opportunities, fail to use the same metrics when it comes to regulatory matters. Rather than focusing on the cost of complying with AIFMD and using that as the determining factor for marketing activity, a better approach is assessing the probability of obtaining EU capital and the positive expectancy the AUM growth will bring to the business. If that probability is high, then the cost of complying should be immaterial. If the probability is low, then the prudent business decision is to avoid the EU and focus on other more fruitful jurisdictions. Relying on reverse solicitation to obtain EU capital is most likely not a viable alternative for managers that are truly interested in and capable of, marketing in the EU.

As explained earlier, reverse solicitation is not intended to be a strategy nor an alternative to marketing. It is meant to allow for the specific and narrow situation where an investor actively seeks out the manager without having been solicited (directly or indirectly) in any manner. In today’s multimedia environment with numerous means for information to be disseminated and numerous parties willing to make introductions that is a difficult threshold to maintain. Clearly, the FCA believes the burden of proof is on the manager to evidence the source of interest initiation. They go so far as suggesting a written certification as the accepted means of proof. This may be a challenge to get investors to execute, particularly if the facts are not clear, which will likely be the case. The cost of a re-characterization of a failed reverse solicitation could be immense to the AIFM. The remedy for non-compliance with Member State marketing requirements is rescission of the trade. In essence, the manager is writing a put option with all interest sold to a EU investor as a result of reverse solicitation. Where that put is struck is really a function of the facts and circumstance surrounding the process of the investment decision and each party’s recollections thereof.

More and more EU-based AIFMs are rejecting reverse solicitation for fear of facing unwanted regulatory scrutiny of their capital raising and operations by regulators. Additionally, institutional investors conducting ODD are delving into the firm’s regulatory enterprise risk management and overall philosophy towards compliance with global regulatory mandates.EU institutional investors are starting to exam firm’s AIFMD compliance as a prerequisite to making allocations. In other words, there are very good business reasons to choosing to comply with AIFMD.

Managers “relying” on reverse solicitation may be short the “tail puts” of their businesses. This risky regulatory arbitrage can be avoided by simply choosing to appropriately navigate the regulatory obligations that will enable the manager to directly market their products. AIFMs need to balance the true cost of non-compliance with regulations versus the benefits to their business that may be garnered through regulated activities. Before embarking on the decision to rely on the moving target of reverse solicitation as a business plan, AIFMs should give due consideration to the overall expectancy they are seeking to achieve and the cost of non-compliance.

About the Author:

Gary S. Kaminsky has over 28 years of experience in the securities industry, particularly with regard to issues relating to the legal/compliance and operational infrastructure of asset management companies. Gary has worked in financial services sector as an attorney with the Enforcement Division of the Securities and Exchange Commission; CCO of Susquehanna Investment Group; principal and co-founder of two AIFMs and a principal at Rothstein Kass. He is a frequent speaker and author on Dodd Frank – Form PF, AIFMD – Annex IV and other regulatory matters.

Gary S. Kaminsky Managing Director, Global Regulatory and Compliance, ConceptONE, LLC 646.840.4966 gkaminsky@conceptonellc.com