The full impact of Brexit for the alternative funds sector will not be known for some time. But in this article we argue that UK, EU and non-EU alternative fund managers are unlikely to be significantly adversely affected and that even in a worst case scenario there will be relatively straightforward work-arounds.
Managers are understandably concerned to understand how their current and proposed business models will be affected by Brexit. As ever, it will be necessary to consider the position on a-case by-case basis, but the general position of UK, EU (ex-UK) and non-EU managers marketing to their products and services to non-UK EU investors and to UK investors pre- and post-Brexit is considered below.
First, some practical legal issues that are worth noting:
If the UK and EU do proceed to divorce, then there are two basic alternative scenarios for their future relationship:
In Scenario 1 above, there is no change for UK investment managers as they would retain full access to EU markets. However, as a non-EU member state, the UK may not be able to influence EU rules going forward, it will have to make some budgetary contributions. However, this would probably involve accepting freedom of movement of labour which was one of the Leave campaign’s most important ‘red lines’, and, arguably, the issue which swung the referendum result.
Scenario 2 might be considered the ‘worst case scenario’ for the UK. However, whilst no doubt potentially very ‘bad’ for ordinary commercial businesses (particularly importers and exporters of goods with significant EU business as a result of high customs duties etc.), fund managers may not be significantly impacted as a result of the third country provisions in AIFMD and MiFID and which have the effect of allowing non-EU managers to market their products and services within the EU on the same terms as EU managers. The third country rules in AIFMD and MiFID work on a different basis, as described below.
AIFMD includes a ‘passport’ right allowing compliant EU fund managers to market EU funds throughout the EU under a single notification to their home state regulator. Others must market under the national private placement rules (NPPRs) of each country and this can be an expensive and complex approach involving delays and compliance with local requirements, such as appointment of a depository and/or local paying agents; and some EU countries simply ban the marketing of non-AIFMD/ non-UCITS compliant funds. In practice, marketing under the NPPRs works seamlessly in only five EU countries at present: Belgium, Holland, Ireland, Luxembourg and the UK.
Although AIFMD has brought in a requirement that funds marketed under individual countries’ NPPRs must register in each such country, at present it makes little difference whether such managers are EU or non-EU persons as similar filing requirements apply to both in respect of non-EU non-passportable funds. The UK’s departure would therefore make little or no difference to UK managers wishing to raise money from non-UK EU investors under the NPPRs post-Brexit. AIFMD currently envisages the phasing out of the NPPRs by 2018. However, in light of ESMA’s country by country approach to approving third countries and the pace at which it is moving, our own view is that this date will either get pushed out or, more likely, the concept of phasing out the NPPRs will be abandoned.
Currently the AIFMD ‘passport’ right is limited to compliant EU managers of EU funds, but AIFMD explicitly envisages that this right will be extended to non-EU managers and non-EU funds in due course. The European regulator, ESMA, published an opinion in June 2015 stating that it had conducted research on certain non-EU countries and concluded that this passporting right should be extended to Jersey, Guernsey and Switzerland. It is due to publish a further opinion this month, having reviewed a further 19 countries including Hong Kong, Singapore, the USA and the Cayman Islands.
If the UK leaves the EU it is highly likely that it would apply to be a recognised third country for AIFMD purposes. Like Jersey and Guernsey (and as proposed in the Cayman Islands too), the UK could introduce a dual regime whereby managers would have a choice of being AIFMD compliant or non-compliant, with compliant managers having the same passporting rights as EU managers. ESMA assesses countries according to whether they have sufficiently ‘equivalent’ rules to AIFMD as the UK has fully implemented AIFMD already it should automatically comply as long as it leaves current legislation in place or enacts very similar legislation as would be expected (albeit amended to reflect the UK’s exit from the EU).
The UK already has rules allowing non-EU managers to market their products and services to UK investors and so should also satisfy AIFMD requirements that third countries provide reciprocal access to their markets in the same way as their managers would be afforded under AIFMD. However, the position of UK managers would differ in the following respects under AIFMD as a third country, as compared to the current position:
An alternative to the UK manager itself becoming authorised in an EEA state would be to form a special purpose management company (Manco) (or use a third party Manco) in the country of domicile of the fund and delegate investment management back to the UK manager, leaving risk management offshore. This would likely reduce compliance costs and reporting obligations as the activities of the offshore Manco would be much more limited – e.g. reporting would exclude information about the UK manager’s UK business (such as managed accounts and other funds not marketed in the EU such as U.S. master and feeder funds).
MiFID gives EEA investment firms a passport to conduct cross-border business and to establish branches in other EEA countries, free from additional local authorisation requirements except in the case of passported branches where local conduct of business rules may be applied. MiFID is relevant for non-AIFMD EU firms undertaking investment management, advisory and other services.
MiFID 2 envisages non-EEA firms being able to provide investment services to professional clients on a pan-EEA basis from January 2018 subject to registration with ESMA and ESMA making an equivalency determination. Again it is envisaged that there would be a dual UK regime allowing firms to opt in or opt out of MiFID 2; and there is no reason why the UK would not provide reciprocal access to UK markets by EU firms.
Under MiFID, EEA countries must also permit investment firms from other EEA countries to access regulated markets, clearing and settlement systems established in their country. Post-Brexit, UK investment firms would no longer be able to rely on those provisions, but conversely nor would EEA firms looking to access the UK. The UK’s status as Europe’s leading financial centre should enable it to negotiate a mutually agreeable outcome.
The UCITS Directive does not have equivalent third country recognition provisions to those in AIFMD or MiFID 2. UCITS is a product Directive and therefore only managers of UK UCITS funds wishing to market such funds to EU investors will potentially be affected. Any need to have an EU manager for Irish, Luxembourg or other EU UCITS funds can easily be resolved by forming an EU Manco and delegating management back to the existing UK manager.
In any case we would expect that the UK and EU to agree to mutual recognition of UK UCITS compliant funds in future in return for the UK allowing EU UCITS funds to be marketed to UK investors as the UK is the single largest market for Irish, Luxembourg and other EU funds. UK managers targeting mainly EU investors will continue to form Irish, Luxembourg or other EU domiciled funds as they do at present, again with a local Manco if required.
Again, if Scenario 1 prevails, then there is no change for U.S. and other non-UK investment managers.
In the case of Scenario 2, non-EU managers looking to raise money for funds from UK and other European investors typically rely on the relevant NPPRs. There will be no change in the current position when using the NPPRs in non-UK EU states and in practice most probably nothing will change in respect of fund raising in the UK if and when the UK leaves the EU.
This follows from the fact that pre-AIFMD the UK allowed non-EU managers and funds to raise money from non-retail UK investors without the funds or their managers/placement agents needing to be licensed or registered in the UK. AIFMD brought in a registration requirement, but in the UK this is a mere filing and notification obligation (plus payment of a small fee) and which is effective upon filing with no delays or approvals required and no vetting of documentation etc. If the UK leaves the EU it is possible that this registration requirement will be abandoned and the UK may revert to its pre-AIFMD rules, but it is equally likely that, having established this system, it will maintain it. Either way the UK was (pre-AIFMD) and continues (post-AIFMD) to be one of the most easily accessed markets for non-EU managers and funds.
If a non-EU manager currently wishes to market funds in Europe with the benefit of the AIFMD passport then they must establish an EU manager and an EU fund or use third party EU platforms. If establishing a closed-end fund which will complete its fund raising by 2018, the UK remains an appropriate domicile as once the fund raising is completed the passport becomes irrelevant. This is most likely to apply to private equity and other closed-end funds structured as partnerships. Conversely if such managers are forming open ended hedge or other ‘evergreen’ funds they may wish to form their EU funds in Ireland, Luxembourg or other non-UK EU centres. Indeed, for hedge and other ‘trading’ funds this would always have been the case as such funds are almost always formed as corporations for tax reasons and the UK does not have a favourable tax regime for onshore corporate trading funds. Contra UK UCITS and other UK authorised retail and certain other non-trading funds which are exempt from tax on capital gains.
For managers looking to market separately managed accounts (SMAs), again there is no immediate change. Unlike many other European countries, the UK does not require non-EU managers to be authorised or licensed in the UK in order to market discretionary or advisory services to non-retail investors provided they do not have a permanent place of business in the UK. As detailed above, MiFID 2 will potentially impose an obligation on non-EU managers to establish a branch office in an EU country in order to market SMAs or other advisory accounts with EU investors. Currently the UK does not require non-EU managers and advisors to be authorised or licensed to deal with non-retail UK customers and it is doubtful the UK will require such non-UK managers to establish a branch office in the UK post-Brexit. In this respect the UK may become a more attractive jurisdiction than EU jurisdictions post-Brexit.
The prospect of the UK leaving the EU clearly raises significant concerns and a period of uncertainty.
However, so far as existing UK and other EU (non-UK) alternative investment managers are concerned, we advise a ‘wait and see’ approach. UK managers should be able to take advantage of the third country rules in AIFMD and MiFID 2 and if not they should be able to structure around the rules without undue cost. Certainly thinking on moving operations outside the UK seem premature.
Non-EU managers thinking of establishing a European presence for the first time face a more nuanced position though, on balance, we think the UK (and London in particular) will remain the first choice for managers establishing a full blown investment management operation . The UK’s current position as the premier European fund management centre with its highly respected legal system, a sympathetic regulator and deep bench of support services and qualified personnel should stand it in good stead. Such firms will be in the same position as UK firms going forward and either able to use the third country AIFMD and MiFID 2 rules or use the same workarounds as UK firms will use and as outlined above, noting that under MiFID 2 such UK managers will have to establish a branch office in the EU to access the MiFID passport or use a third party platform solution.
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