How can UK alternative fund managers access European investors post-Brexit?

With the passing of the UK-EU post-Brexit trade agreement and expiry of the Brexit transition period on 31 December 2020, UK fund managers – including those operating unlisted real estate and other alternative funds for professional investors – no longer have access to the European Economic Area (EEA) single market for financial services.

This loss of ‘passporting rights’ is relevant in the context of the EU Alternative Investment Fund Managers Directive (AIFMD) and the Markets in Financial Instruments Directive II (MiFID II).

The post-Brexit agreement refers to UK and EU cooperation and progressing discussions on equivalence, though each reserving prudential carve-outs, “including in order to preserve financial stability and the integrity of financial markets”. They commit to a memorandum of understanding (MOU) to be agreed by March 2021. The agreement does not refer to a continuation of passporting rights, nor presumably are such rights envisaged in the MOU and for the time being.

Prior to the expiry of the Brexit transition period, full-scope EU alternative investment fund managers (AIFMs) under AIFMD were entitled to market funds to professional investors in the EEA, which then included the UK. In terms of operating an alternative investment fund, the AIFM is responsible for portfolio and risk management, as well as appointing an AIFMD depositary for cash-flow monitoring, asset safekeeping and custody. The FCA has ‘gold-plated’ aspects of MiFID II in the light of certain AIFM operations – for example, telephone recording, inducements and research, as well as distribution.

“The fund management industry must lobby so that the norm of delegation is preserved”

Within this model, the EEA AIFM can delegate portfolio management responsibilities to another regulated entity including a non-EEA entity. For example, managers can centralise (with associated economies of scale and other efficiencies) their portfolio management hub. It is crucial for the competitiveness for the EEA fund-management industry to be able to continue to utilise this global norm of delegation.

The UK has now introduced its own domestic legislation, replicating the EU AIFMD and MiFID II regimes from 1 January 2021. The loss of the EEA passporting rights means that UK managers that want to continue to market alternative investments via a UK fund to EEA professional investors have two choices:

• Rely on national private-placement regimes where the investors are located (although the scope of the regimes is limited in certain EEA states);
• Operate via an EEA AIFM with portfolio management delegated to the UK.

For the latter, managers have another two options. The first is to establish and operate their own EEA AIFMs, which also comply with any applicable MiFID II requirements. This is an investment choice that some managers can justify, depending on their current (and prospective) assets under management. If managers cannot justify establishing and operating their own EEA AIFMs, they could enter into arrangements with a third-party ‘host’ EEA AIFM.

There is no current prospect of the EU activating third-country AIFMD legislation, which could benefit UK managers – given that the UK is now a third country. In addition, the AIFMD prohibits the marketing in the EEA of an EEA feeder to a non-EEA master fund (a UK master fund is now a non-EEA fund).

Portfolio management delegated to the UK

In July 2020, the European Securities and Markets Authority (ESMA), EU national regulators and the Financial Conduct Authority in the UK confirmed that a February 2019 MOU would apply, with the consequence that an EEA AIFM is allowed to delegate portfolio management back to the UK, and outsource under MiFID II. This month, ESMA and the FCA published the text of a MOU for mutual assistance between regulators to ensure – given delegation/outsourcing arrangements – that relevant entities are effectively supervised.

However, in an August 2020 letter to the European Commission, ESMA expressed concerns with the delegation model linked to increased operational and supervisory risks and AIFM effective management. ESMA recommended that future AIFMD II legislation should:

• Clarify the extent of delegation to ensure EEA AIFMs maintain sufficient EU substance;
• Address concerns with the third-party ‘host’ EEA AIFM model about conflicts of interest with third-country managers and investor-protection issues.

The ESMA letter recognises that “in light of the withdrawal of the UK from the EU, delegation of portfolio management functions to non-EU entities is likely going to further increase”.

In view of the EU prudential carve-out and the ESMA concerns, any eventual AIFMD II legislation might result in tighter delegation provisions, but hopefully will not materially hinder the efficiencies of delegation. The fund management industry must lobby so that the norm of delegation is preserved.

UK managers now need to explore – and monitor – solutions to continue their operations in the EEA and access European investors, given that the EEA passport is no longer available. If marketing via national private-placement regimes is not viable, the manager might have to consider operating with an EEA AIFM subject to complying with EU delegation legislation.

Melville Rodrigues is a senior consultant, UK funds services at Ocorian