Introduced not only to strengthen investor protection and reduce the chances of systemic shocks happening following the 2008 financial crisis, the EU’s Alternative Investment Fund Managers Directive (AIFMD) was also supposed to promote market efficiency and support cross-border harmonisation.
Now in its tenth year, industry experts hosted by JTC Group sat down together for a roundtable discussion in London, to assess whether AIFMD has delivered on what it initially set out to do.
Protecting investors – the value of depositary
Coming shortly after the Bernard Madoff fraud was exposed, together with other high profile hedge fund failures, one of the main objectives of AIFMD was to give investors in funds better protection.
It did this partly through requiring alternative investment fund managers (AIFMs) to ensure an independent depositary is appointed by the alternative investment funds they manage, particularly when those funds are managed from Europe or marketed to European investors. Under the provisions, a depositary must verify that financial instruments are being properly safekept in custody and in some circumstances subjects them to strict liability provisions should those assets go missing or be stolen anywhere in the custody chain. Other depositary responsibilities include performing cash flow monitoring, verifying a funds ownership of its assets and overseeing compliance with the fund prospectus.
“The depositary acts as a check and balance on the activities of funds. It verifies certain things that a fund may do, and it has the ability to go directly to a regulator if there are issues,” said Abbie Bell, Partner at Dechert.
These safety nets, had they existed pre-financial crisis, could have prevented a number of hedge fund frauds from happening, according to Bill Prew, Group Director at JTC Group. “Weavering Capital is a good example here. If there had been an effective depositary solution in place, then it would have identified and raised warnings about weak fund governance and the inability to independently verify OTC derivative positions”,” continued Prew.
The safeguards provided by depositaries have arguably helped AIFMs attract funds from some of the more risk averse institutions, at a time when capital raising has been challenging As a marketing tool, managers should not underestimate the role of depositary in terms of the positive role it performs in the fund governance model.
Improving standards elsewhere
AIFMD has driven up regulatory standards not just in the EU, but outside of it too.
“The Cayman Islands, for example, have increasingly incorporated more of the AIFMD’s requirements into their own regulations,” highlighted Jon Masters, Head of Business Development at INDOS Financial.
The Cayman Islands Monetary Authority (CIMA) has tightened up its rules for private funds by insisting that managers now verify ownership of assets and monitor cash flows. Although CIMA’s provisions let managers conduct these activities in-house, rather than having to appoint an external depositary, the rules still loosely mirror AIFMD.
That AIFMD has galvanised countries into improving their domestic regulations which can only be a positive development for the funds industry.
More work needs to be done
However, the depositary framework is still far from perfect.
A recent consultation by the UK Financial Conduct Authority (FCA) said there have been several instances of depositaries not fulfilling their obligations, either by failing to intervene or not challenging managers when they should have done.
Another problem is that some fund administrators have established their own depositaries, and these present a conflict of interest, as the depositaries are effectively overseeing the activities at their parent groups, said Peter Northcott, Founder and Managing Director at Axzam, a consultancy. “I am not aware of any in-house depositary, which has pulled up its administration arm for any errors,” he added.
Reporting – is anyone benefiting?
In the past criticised by some for being opaque, AIFMD was also designed to make AIFMs more transparent.
As part of AIFMD, AIFMs must submit a reporting template – otherwise known as an Annex IV – to EU regulators, the contents of which include information about instruments traded, the nature of their investment strategies, a geographical breakdown of their investments, the investors in their funds, risk management processes and details about leverage.
The plan was for EU regulators to interrogate Annex IV data, so they could spot systemic risks earlier, or even identify instances of fraud or malpractice at individual managers.
However, there are questions within the industry in terms of what regulators are doing with the Annex IV data. Experts at the JTC Group roundtable were certainly sceptical. “What is happening to that reporting? I do not personally understand how this Annex IV reporting is being digested,” said one.
Some suggest regulators simply do not have the bandwidth to consume – let-alone analyse – Annex IV data. James Hopegood, Director, Asset Management Regulation at the Alternative Investment Management Association (AIMA), noted for example there is a challenge for all regulators when it comes to competing for IT professionals to make the best use of data.
Regulators have been urged (albeit to no or limited avail) to streamline the number of reports which managers are required to file, especially as there is so much overlap and duplication between them.
Marketing and distribution – complications persist
AIFMD promised to deliver efficiencies and harmonisation for managers when marketing and distributing their funds into the EU, but the results have been mixed.
Passporting – namely the ability to seamlessly distribute funds on a cross-border basis to EU investors – was a carrot once dangled by ESMA to alternative asset managers in third countries, but it never came into fruition, partly because of Brexit.
Instead, most firms targeting EU investors do so through national private placement regimes (NPPR). “Nobody is really shouting for third country passporting anymore. If you are a US manager and you want to distribute your fund to German investors, then you will just go through the NPPR route as it is simpler,” said Prew. Even if the passport were to be made available, Hopegood doubted many managers would take advantage of it, as it would require them to become fully authorised under AIFMD. While passporting failed to materialise, NPPRs seem to be working quite well.
Downsides to NPPR include certain EU member states interpreting the rules differently, meaning some countries have imposed additional restrictions on those managers using the scheme; in addition to several countries in the EU not allowing the marketing of non-EU funds via NPPR at all.
Nonetheless, standardisation of NPPRs – should it ever be considered by the EU – risks causing more harm than good for the industry. “Some people may say, ‘why don’t we harmonise the NPPR?’ the risk could be that it might be harmonised to the most onerous standard. The countries that want to have fund managers coming in under the NPPR make it reasonably easy for that to happen,” said Hopegood.
Updates to the rules around pre-marketing have, however, caused consternation across the industry.
Although ostensibly designed to clarify some of the prevailing uncertainties around what constitutes pre-marketing, the rules demand that firms notify regulators about their pre-marketing activities. It was noted that this is an additional layer of bureaucracy that would increase costs.
AIFMD – a positive piece of regulation for the industry
There are a number of positives to AIFMD.
For starters, the investor protection mechanisms offered by depositary providers – when done correctly – are a game changer and have the backing of many institutional investors. While recent amendments to the pre- marketing rules have frustrated some people, the NPPRs work pretty well, and few third country managers seem that bothered about the lack of pan-EU passporting rights.
Conversely, other aspects of AIFMD have been less successful, as far as there is genuine doubt about whether regulators are making use of the Annex IV data. Moreover, calls by the industry to consolidate regulatory reports (i.e. AIFMD and MiFID II etc.) have gone unanswered.
While imperfect in some places, the AIFMD has largely functioned well over the last 10 years. In addition, recently announced changes under the so-called AIFMD 2 will not materially change the requirements, which has been viewed positively by an industry which has already become accustomed and adapted to AIFMD. With AIFMD now well established, the appetite for alternatives in Europe looks set to flourish.
JTC Global AIFM Solutions
The acquisition of Blackheath Capital Management in November enhances the existing JTC Global AIFM Solutions businesses in Ireland, Luxembourg and Guernsey.
Our teams work together across key jurisdictions to provide EU and non-EU AIFM solutions bespoke to our clients’ individual situations. Backed by a well-invested and stable organisational structure, our AIFM services are comprehensive, cost effective and reduce risk, underpinned by agile teams with in-depth expertise and knowledge in operating in compliance with the AIFMD.
To find out more, please contact Jon Masters directly or visit the dedicated JTC Global AIFM Solutions site here.