AIFMD review: ESMA goes after delegation structures

In a letter that is attracting significant attention, the European Securities and Markets Authority (ESMA) has made several recommendations to the European Commission (the Commission) ahead of the Commission’s impending review of the Alternative Investment Fund Managers Directive (AIFMD).

ESMA recommends several changes to the AIFMD regime which, if adopted following the outcome of the review, would have a considerable impact on private fund sponsors. In particular:

• Limits on the use of delegation – ESMA questions whether funds managed on a delegation basis (i.e. with an EU AIFM delegating portfolio management to a third party) are in fact “effectively managed by the licensed AIFM”; it therefore suggests that the Commission consider (i) imposing quantitative limits on the maximum permissible extent of delegation or (ii) restricting the functions that can be delegated in the first place (with those functions having to be performed by the AIFM).
• Introduction of a level playing field in delegation structures – to tackle what ESMA sees as “regulatory arbitrage” in delegation structures, particularly where functions are delegated to non-EU firms, ESMA would like to see new rules requiring delegates – wherever they may be in the world – to be subject to AIFMD regulatory standards.
• Increasing the functions caught by delegation rules – ESMA suggests that all the functions listed in Annex I to AIFMD (not just portfolio management and risk management) should be covered by the delegation rules so that, if they are not performed by the AIFM but by a third party, that would be considered a delegation. If implemented, this would appear to mean that a fund administrator would be considered a delegate of the AIFM, as would a firm of tax accountants preparing the fund’s tax returns, with the AIFM retaining responsibility for those functions.
• Increased scrutiny of “host” AIFMs – ESMA effectively calls into question the legitimacy of the “host” AIFM model, expressly noting that some member states doubt the model’s compliance with the AIFMD regime. ESMA’s view is that, even if the Commission considers the model to be “permissible”, it should be subject to increased regulation to tackle what it sees as increased conflicts of interest and investor protection risks, arguing that the fund sponsor’s engagement of the host AIFM may hinder the host’s ability to act in the best interests of the fund’s investors.
• Semi-professional investors – ESMA would like to “clarify” the definition of “professional investor” used in AIFMD, although without specifying the changes it would like to see. It also says that, even if a new definition of “semi-professional” investor were to be introduced, the marketing passport should still remain limited to professional investors only.
• Loan origination framework – of particular relevance to managers of credit funds, ESMA recommends that AIFMD should be amended to include a framework for loan origination funds. In light of the opinion issued by ESMA in 2016, it is likely that ESMA envisages this new framework as laying down certain requirements to be met by loan origination funds – e.g. that they must be closed-ended and potentially even regulated at a fund level.
• Standardised approach on reverse solicitation – ESMA is keen to see a standard approach to reverse solicitation across the EU, with a single EU-wide definition and interpretation.
• Leverage – ESMA proposes a number of potentially highly significant changes to the AIFMD leverage provisions; for instance, it proposes adding in a new definition of “leveraged AIF”, meaning an AIF that uses leverage. This seems a small and non-controversial amendment but could well change the way in which the €100m and €500m thresholds for sub-threshold AIFMs are applied in practice. In addition, for managers of private equity funds in particular, ESMA appears to be suggesting that leverage at SPV and portfolio company level should now be treated as fund-level leverage – if this is a correct interpretation of ESMA’s letter, this will be a concerning development.

Comment

ESMA’s general direction of travel is towards greater regulation, more standardisation and less member state discretion. In many respects, these proposals – particularly those looking to restrict delegation – are not surprising, given the tone of previous ESMA communications in this area, especially since the 2016 vote for Brexit.

We can expect the Commission to give these proposals serious consideration as part of the AIFMD review; but we can also expect significant pushback from Ireland and Luxembourg, in particular, as well as from the global asset management community, who will want to protect the existing delegation frameworks and who see delegation as an industry standard practice. UK firms planning to use delegation structures post-Brexit will also be hoping that any amendments to the existing delegation regime are considered carefully so as to preserve legitimate business arrangements intended to provide investors with the combined advantages of the EU regulatory framework and the many talented investment management professionals who choose to base themselves in the UK.