Level two of the EU’s Alternative Investment Fund Manager Directive could radically reshape UK asset management models and lead to manager changes
UK asset management business models may be significantly changed by European Union regulations expected next month. The Alternative Investment Fund Manager Directive level two regulation will contain detailed delegation rules with the potential to drastically alter multi-managerpropositions. The rules could also lead to manager changes on portfolios, change the way the funds are managed as well as result in increased prices for groups overall, which could in turn, be passed on to investors.
While the EU’s AIFMD originally targeted alternatives such as hedge funds it has been written so broadly that it encompasses many retail investments such as non-Ucits unit trusts, pension or charity pooled funds and investment trusts. Ucits are excluded – for now.
Level one of the AIFMD is already law but level two is still in draft form even though it has to be implemented into UK law by 22 July 2013. The final level two regulations were originally expected to be revealed in May but each month has been pushed back and are now expected for Christmas.
The main reason for the delay is a controversial section concerning delegation of investment and risk management responsibilities, which bans their ‘substantial’ delegation. Virtually all UK investment houses outsource management functions to a degree yet the AIFMD does not distinguish between different types of delegation.
The most obvious outsourcing example is manager of manager offerings or where a group uses a specialist external manager to run a particular fund, such as a US portfolio. However, there are also far less apparent arrangements such as those that are intra-group, whereby the authorised fund manager delegates portfolio management to its own internal investment manager.
For example, M&G Securities would probably be the manager for all of its alternative investment funds, Peter Grimmett, head of fund regulatory development at M&G, says. Yet in order to adhere to existing FSA regulations, M&G delegates the management of its Nurs funds to a separate entity within the group, M&G Investment Management. Consequently under level two M&G Securities could be classed as a “letter-box entity”.
“The draft regulations are written in such a way to make it almost impossible to delegate any management or risk function. If you do then you are no longer the fund’s alternative investment fund manager,”Grimmett says.
If a fund does not have an AIFM, then it cannot be sold. So why cannot M&G Investment Managementsimply be the AIFM? Because, as in the case for most traditional retail houses, the investmentmanager is a Mifid firm and the AIFMD level one rules has already stated the AIFM cannot be a Mifid firm, Grimmett explains.
The draft is written in such a way as to make it almost impossible to delegate any function
Therefore, in order to conform to the level two regulations a company in such a situation mighthave to either create a new legal entity within the group to become the AIFM or to restructure in another way.
Richard Pavry, corporate finance director at Jupiter Asset Management, says: “It is likely, in my opinion, that many funds intended for EU investors which can be run within the Ucits framework will be reconstructed into Ucits.” But not all Nurs can be easily converted and if they are, such adaptation could change how they are managed as the latter has greater flexibility with regards to holdings and weightings than Ucits.
The creation of a separate legal entity within the group is one most companies are likely to choose. However, Grimmett notes this is no easy task. First off, it is costly. Adam Fairhead, global head of product development at HSBC Global Asset Management, notes the new legal entity would have to do all the same functions as the existing manager but may need to be capitalised separately. It would also need different headed legal documentation, new legal agreements with delegates and compliance reporting, for example.
Second, even though the directive aims to create greater accountability among alternative managers in the case of traditional managers the opposite could happen. By creating an extra layer of ownership and responsibility, defining who is managing the fund becomes more convoluted and confusing, Grimmett says.
The creation of another company may also harm efficiencies. The IMA’s Julie Patterson noted that for efficiency purposes a lot of fund houses consolidate activities like portfolio management across different product types, making them bigger players and providing scope for tighter trading commissions, which in turn helps to lower costs.
Then there is the timing issue. This entity would have to be created, apply and receive regulatory approval from the FSA all within a very tight timeframe: the UK has to issue final AIMFD rules by July next year, and groups will have at the most a further year formally to register their AIFM, but perhaps less in some countries.”
For companies with offerings using external managers the situation may be more complex still as the route taken will depend on a number of variables. Among these are the percentage of risk and portfolio management outsourced. Potentially level two AIFMD could end such arrangements. The same rule could also see UK houses lose overseas clients. For example, some US mutual funds sold only in the US use EU-based investment managers. If the AIFMD level two causes these EU-based investment managers to be classed as the AIFM then the US fund would be pulled into European reporting rules, which they will not want, so may look elsewhere.
Considering the complications of adhering to level two AIFMD and widespread industry criticism of its regulations, some contend it is unlikely to go ahead as it currently stands. This may be too hopeful. “It is a take it or leave regulation,” Fairhead explains, noting the delegation section is just one part of the AIFMD and the EU Parliament must either pass it as a whole or reject it as a whole.
Upon its release the European Parliament will have two months to approve or reject the regulation and then EU member states will work to incorporate it into national law. Even without it the FSA has already had to consult on its adoption – blind. While the FSA’s paper proposes what is considered to be a sensible, qualitative approach to delegation, it may have to backtrack on this depending on the final wording of the level two regulations.
Moreover, there is the threat of expansion. Grimmett notes the European Commission’s “UcitsVI” consultation suggests the AIFMD delegation requirements might be extended to Ucits.