The implications of Brexit for asset managers were brought into focus when the European Commission (EC) published a comprehensive notice, on February 8, 2018, that outlined the stark consequences facing the industry as and when the United Kingdom (UK) becomes a third country. The message was directed at UK asset managers operating funds regulated under the Undertakings for Collective Investment in Transferable Securities (UCITS) regulatory framework and the Alternative Investment Fund Managers Directive (AIFMD). The EC's statement highlighted that the UK's withdrawal would effectively void UCITS and AIFMD's application in the country.
Should third country status become a reality, UK-based asset managers with UCITS funds and alternative investment funds (AIFs) would no longer be authorized by the European Union (EU), meaning their right to passport across borders would be annulled1, resulting in UK managers being treated as third country AIFs by EU regulators post-withdrawal.2
Life as a third country AIF
Key insights
- Activities will become more challenging for UK asset managers as they risk losing passporting rights and instead fall back on NPPR, a practice that could expire in the next few years
- Delegation is one solution for asset managers, but it too faces challenges from ESMA, which is looking to restrict the practice
- The possibility of the UK and EU failing to reach a deal cannot be excluded and such a scenario would challenge the continuity of the industry post-Brexit
Third country asset managers are allowed to sell into the EU, albeit not with the same degree of flexibility as an onshore AIF or UCITS fund. Importantly, for UK asset managers post-Brexit, National Private Placement Regimes (NPPRs) have not been switched off, providing firms with the option of selling to professional investors on a market-by-market basis rather than having pan-EU distribution access.3 While NPPR subjects managers to marginally less regulation, it does have constraints.
First, third country asset managers are required to register in each Member State in which they market. As AIFMD gives local regulators the right to introduce additional requirements over and above the minimum standards, gold-plating has emerged with some jurisdictions imposing restrictions on NPPRs and, on occasion, forbidding it altogether.4 One of the key risks for managers relying on NPPR is that it is being scrutinized in the current EC-led review of AIFMD,5 and could potentially lead to further restrictions or even its dissolution.
The EC has instructed UK asset managers to disclose to clients what the consequences of Brexit will mean for their businesses. As a result, AIFs need to outline in their annual report any material changes that may result from Brexit, while UCITS funds must do the same in their Key Investor Information Document (KIID). “UCITS management companies and AIF managers must assess whether the change of the legal status of the investment fund would still be compliant with the investment strategy of the fund as communicated earlier to investors."6
Future-proofing businesses
The uncertainty about NPPRs and the legal risks encumbering reverse solicitation are prompting UK asset managers to find ways to future-proof and protect their access to EU clients. An obvious yet expensive solution would be to re-domicile operations into the EU, with candidate cities such as Paris, Luxembourg, Dublin, Frankfurt7 and Milan8 all strongly articulating their business case to the UK asset management industry.
ESMA indicated that it does not want to abandon delegation entirely, but said the practice should be reviewed on a case-by-case basis
Alternatively, UK firms could appoint EU management companies (ManCo), which can delegate investment decisions and risk management back to a third country entity. While a ManCo is a less expensive substitute for managers, and easier than establishing a new onshore subsidiary, the concept of delegation is, however, facing its own unique regulatory challenge from the European Securities and Markets Authority (ESMA).9 ESMA aims to prevent the propagation of letterbox entities inside the EU, and has insisted delegation should only be possible under strict conditions.10
Delegation opens up divisions
“ESMA has issued an opinion on the risks of letter-box entities which may arise from the use of outsourcing arrangements or from the use of non-EU branches for the performance of functions/services with respect to EU clients," read the EC statement.11
ESMA indicated that it does not want to abandon delegation entirely, but said the practice should be reviewed on a case-by-case basis 12 in what may result in the pan-EU regulatory body having a more prominent role in the delegation approval process.13 While this is supported by the Autorité des Marchés Financiers in France, it has stirred divisions elsewhere, most notably in Luxembourg.
Brexit negotiations are unlikely to reach conclusion until the end of the year
“We question this proposed additional layer in the authorization procedure, required when a fund wants to delegate part of its activities to third countries," said Denise Voss, chairman of the Association of the Luxembourg Fund Industry (ALFI), a recognized trade body. "This is increased bureaucracy, it lengthens time to market, and it increases costs. This will undoubtedly have a negative effect on the competitiveness of EU funds as a whole, and ultimately on the investor. We see no added value in this as the local regulators, being close to the asset managers and the market, remain best placed to authorize and oversee funds and their operations."14
A positive outcome is still possible
Some market participants are hopeful that a form of equivalence could be granted to the UK's fund industry, an outcome that would potentially preserve existing passporting processes.
The UK and EU are currently trying to finalize an agreement for a transitional arrangement in what may help prevent a ‘cliff-edge Brexit’ in March 2019, a development that would give UK and EU businesses, including fund managers, additional time to prepare for Brexit.15 However, it has recently been reported that Brexit negotiations are unlikely to reach any conclusion until the end of the year owing, in part, to the ongoing deadlock between the UK and EU over Irish border arrangements.16