Loan-originating funds have long had to manage the fact that they can trigger banking license issues in certain borrower countries.
Recently, some countries have adapted their investment laws, recognising lending as an investment activity of alternative investment funds, thus often freeing them from being subject to bank license requirements.
For example, in Italy, no license requirements generally apply if the fund is an EU fund managed by a fully authorised EU Alternative Investment Fund Manager (AIFM). In France, French AIFMs managing French AIFs seem to be able to rely on exemption. In Germany, any EU debt fund managed by an EU AIFM would fall under the exemption, provided the AIFM complies with certain risk management requirements under German law.
The efficacy of EU structures is given further weight by requests (and sometimes even the needs) of some regulated investors. For example, German pension funds generally can only invest in EU debt funds which are managed by a fully AIFMD-compliant EU AIFM.
This is all well and good for EU structures and EU domiciled funds. In a post-Brexit world though, this picture will likely change for English and Scottish structured partnerships, and debt fund managers located in the UK. Structural changes may make sense if their investor base includes the above types of investors, and if they are making investments in the relevant EU countries.
Of course, structural changes should not be taken lightly. Each debt fund operates differently. Any structure should reflect how knowledge and expertise can be used in the most reasonable way. Artificial set-ups are not in the interests of investors and regulators, nor of the manager.
If a sponsor already has senior team members in one EU jurisdiction, it makes sense to think about setting up the AIFM in that country. For others, it may make more sense to grow existing risk management know-how in the EU, or to put in place delegation structures.
In a useful piece of recent guidance from ESMA, it outlines the stance on what it sees as suitable “substance requirements” in the context of delegations and authorisations – that is, when is an AIFM truly in the EU, and when is it simply a letter-box with the real decisions happening elsewhere.
The opinions are of relevance for all EU and non-EU sponsors because they all rely on the flexibility of cross-border arrangements. Whereas the portfolio management know-how may be in one country, the risk management team may be located in another. The investments are usually made all over Europe and hence advisory teams are often located in those countries.
ESMA stresses that an AIFM must not be bound to follow the recommendations received from its investment adviser. The AIFM must conduct its own analysis. A mere formal assessment as to whether the proposed investment complies with the investment restrictions does not suffice. ESMA stresses that if the AIFM follows the recommendations without substantive analysis, the arrangement will constitute a delegation of investment management activities.
Regarding delegations, ESMA repeats its position that any function set out in Annex I of the AIFMD is delegated when it is not performed internally by the AIFM. ESMA reiterates an AIFM must not delegate portfolio and risk management functions to the extent that they substantially exceed the retained, internally performed functions. Delegation of portfolio or risk management requires that the delegate has the appropriate license under MiFID.
It is clear that substance will be needed in the EU for whatever structural solution is chosen, but it does not mean the majority of functions must be relocated to one specific country. From a regulatory perspective, it can actually be an advantage to have functions and team members located in different countries, be it in the EU or outside the EU.
However, delegates will likely need a MiFID license. MiFID II, which will be implemented in all EU member states by January 2018, provides for a passport for non-EU firms subject to certain conditions, including equivalence. It seems reasonable to assume that the UK will meet such an equivalence test.
In summary, Brexit will certainly have some impact on structures. At least in the near future, it is not certain that UK fund structures will bring about the same benefits that an EU fund structure with an EU AIFM can provide. As know-how and expertise will remain to a large part in the UK, cross-border arrangements will continue to play an important role.
Substance in the EU will increase, though more so for some sponsors than others. If the UK is recognised as an equivalent country for the purposes of MiFID II and cooperation agreements are in place, the effect of Brexit on fund structures may well be less dramatic than some expect.
Patricia Volhard is a partner in the London and Frankfurt offices of international law firm Debevoise & Plimpton.