ESMA has written to the European Commission (“the Commission”) setting out areas for legislative review in the Alternative Investment Fund Managers Directive (“AIFMD”) and UCITS. The letter is input to the Commission’s forthcoming review of AIFMD.
Whilst it covers recommendations in 19 areas, ESMA’s comments on delegation and substance are the most striking. They could impact established operating models that make use of existing delegation rights in the organisation structure of an AIFM or where a “host” manager provides “white-labelling” services. Both models are currently used widely and, of course, can involve significant delegation to UK investment managers.
Potential hurdles to delegation
The ESMA letter highlights that portfolio management is often largely or even entirely delegated to third parties and, in light of the withdrawal of the UK from the EU, delegation of portfolio management functions to non-EU entities is likely to increase further. As a result, the majority of resources needed for fund management operations could be maintained by one or more third parties outside of the EU, making the EU manager a “letter-box entity”. ESMA observes that an indicator of the extent of delegation can be the amount of management fees paid by the manager to its delegates.
ESMA therefore sees merit in the Commission considering “clear quantitative criteria” (we assume they mean the share of fees paid to delegates) or providing a list of core or critical functions that must always be performed internally (by the AIFM in the EU) and may not be delegated to third parties.
Delegates will need to follow EU standards
Even where delegation will still be permitted, to avoid regulatory arbitrage and protect EU investors, ESMA wants legislative amendments to ensure that the management of AIFs and UCITS is subject to EU standards, irrespective of the regulatory license or location of the delegate. That would mean AIFMD provisions applying to non-EU managers on an extra-territorial basis.
Hosting Platforms (or “white labelling”)
ESMA recognises the development of the fund hosting model whereby funds are set up at the initiative of a “white-labelled” third party business partner and the “host” manager delegates investment management to that partner or appoints it as an investment adviser. ESMA recommends “more specific regulatory provisions” to address conflict of interest and investor protection risks inherent in these models. The bête noire given to illustrate these risks is, of course, a UK one, Woodford.
ESMA has also observed an increasing use of secondments whereby professional services firms and consultancies or group entities second staff to the AIFM or UCITS management company on a temporary basis, sometimes outside the Member State of establishment “or even outside of the EU”. ESMA believes these arrangements raise questions over whether they are in line with the substance and delegation rules in both AIFMD and UCITS.
Direction of travel?
ESMA’s comments highlight its view that delegation to 3rd countries risks increasing operational and supervisory risks and raises questions as to how effectively EU licensed AIFM and UCITS firms can operate funds that are portfolio managed outside the EU (notwithstanding that ESMA recognises delegation can bring increased efficiencies and access to external expertise).
We know that, following Woodford, the FCA is addressing similar concerns and has looked at both the host model for funds and umbrella model for managers relatively recently. It is ESMA’s positioning on delegation that should be of most concern, especially the risk it represents to UK managers providing services to EU based AIFMs and UCITS firms.
However unclear the final position the Commission will take on delegation is, what is clear is that the UK will be treated as a third-country at the end of the transition period.
To receive Ellis Wilson’s Regulatory & Enforcement Issues Tracker (our “REIT”) and podcast “The REIT Stuff” monthly, click here.