Background
In the context of the upcoming AIFMD review and a consultation process expected to be launched during the last quarter of this year, the European Securities and Markets Authority (“ESMA”) has issued a letter to the European Commission (“EC”) on 18 August 2020, highlighting some areas of the current framework where improvements could be made.
The letter builds upon recent opinions, considerations and recommendations published by ESMA, the European Systemic Risk Board (“ESRB”) and the International Organization of Securities Commission, taking into account recent and likely developments related to BREXIT and the COVID-19 pandemic, and widespread business models relying on extensive delegation.
Primary Change
ESMA’s suggestions are organized around 19 topics and include a specific analysis conducted on the reporting regime and data use. The scope of improvements is very broad and includes proposals to address specific pain points for the industry such as the semi-professional investor status, the external valuer regime, the application of the proportionality principle to remuneration rules and the availability of liquidity management tools across the European Union.
ESMA calls for targeted clarifications in the Directive concerning certain definitions, sub-threshold AIFMs, digitalisation and the application of depositary rules to central securities depositaries.
Fundamental recommendations are also made to foster convergence between the UCITS and AIFMD regimes, to revisit the delegation regime and substance requirements, and to strengthen the regulation and the supervision of loan origination funds, private equity funds, leveraged funds and cross-border entities as well as the discretionary portfolio management, investment advice or marketing activities performed by AIFMs and UCITS management companies.
Key Points
1. Convergence of AIFMD and UCITS frameworks
One of the main objectives overarching ESMA’s suggestions is to harmonize both regimes where appropriate, notably in relation to risk management, reporting and delegation requirements.
2. Delegation and substance
ESMA highlights that the UCITS framework lacks the level of detail of delegation rules in the AIFMD level 2 provisions and finds that the allocation of responsibilities lacks clarity with respect to the supervision of structures making extensive use of cross-border delegation.
The letter further develops a number of more concrete considerations based on ESMA’s Opinion to support supervisory convergence in the area of investment management in the context of the United Kingdom withdrawing from the European Union[1]. ESMA suggests to:
· limit more strictly the extent of the delegation by setting a quantitative criteria or a list of core functions which cannot be delegated to third parties.
· amend the AIFM and UCITS directives to make sure these frameworks are applicable to the delegated activities, irrespective of the type of license or location of the delegates. National divergences are highlighted in respect of the definition and regime applicable, notably the application of MiFID rules to the delegation of investment management.
· clarify the rules applicable to staff secondment arrangements and whether these rules are in line with the substance and delegation rules.
· clarify whether delegation rules apply to support tasks (e.g. external research) and to make a clear distinction between such tasks and collective portfolio management functions.
· address the conflicts of interest and investor protection risks arising from the influence initiators may exercise over white-label service providers and authorized AIFM or UCITS management companies, notably where such initiators perform portfolio management on a delegated basis.
3. Consolidation & harmonization of the existing regime
ESMA is of the view that:
· certain definitions should be more specific to better delineate the scope of AIFMD. It is recommended, inter alia,to establish a clear distinction between holdings and private equity funds and to clarify the treatment of certificates, crypto-assets and joint ventures.
· a specific framework for loan originating AIFs should be created. Such AIFs would have to be closed-ended vehicles only marketed to professional and semi-professional investors and subject to specific prudential requirements, notably in terms of leverage, liquidity stress testing, reporting and diversification.
· the supervision of cross-border entities should be harmonized and the respective roles and responsibilities of the home national competent authority (“NCA”) and the host NCA should be clarified, notably with regard to cross-border marketing and management.
· there is a need to amend the current reporting of the leverage using gross method calculation, to ensure alignment with the IOSCO recommendations for a framework assessing leverage in investment funds, issued in December 2019. It is also suggested to amend the calculation of the commitment amount by adjusting the notional amounts of interest rate derivative contracts by the duration of the ten-year bond equivalent.
· reverse solicitation should be clarified since this notion is subject to divergent interpretations across member states but acknowledges the assessment which is due by 2 August 2021 pursuant to the cross-border marketing regulation[2].
ESMA also believes that:
· the definition of significant influence should be harmonized (e.g. expressed in terms of harmonized EU thresholds)
· the calculation of the limit above which the shares carrying voting rights acquired by an investment company or a management company acting in connection with all of the common funds it manages and which fall within the scope of the UCITS directive, would enable it to exercise significant influence over the management of an issuing body should cover:
o voting rights stemming from UCITS funds managed by a UCITS management company consolidated with those stemming from AIFs managed by the same fund manager with similar strategies in relation to the exercise of significant influence,
o portfolios managed on a discretionary basis by the fund manager and,
o where permitted, investments made by the fund manager on its own account.
4. Clarifications and troubleshooting
· ESMA supports the ESRB recommendations to:
a. establish a common EU framework governing the liquidity management tools to ensure their availability across jurisdictions
b. clarify the role of NCAs when using their power to suspend redemptions, in particular in situations where there are cross-border financial stability implications and
c. clarify ESMA’s facilitation, advisory, and coordination role in relation to suspension of redemptions and subscriptions
· ESMA is of the view that the EC should:
o clarify that the proportionality principle applies to the full set of remuneration rules to prevent a disproportionate application of the quantitative variable remuneration thresholds and payout structures.
o explicitly limit the liability of external valuers to cover only cases of gross negligence.
o clarify the definition of professional investors under AIFMD and warns that any new category of investors such as semi-professional investors should come with appropriate investor protection rules and that passports should be limited to marketing to professional investors.
o clarify at level 1 that both the AIFMD and the UCITS directive delegation rules on depositaries apply to investors central securities depositaries (“CSDs”) and not to issuer CSDs.
o study risk and benefits of a passport for both UCITS and AIF depositaries.
o clarify NCAs’ powers to introduce additional national requirements to sub-threshold AIFMs.
o formally allow NCAs to inform applicants for AIFM authorization in an electronic format.
5. Reporting
ESMA is of the view that UCITS reporting requirements should be aligned with the amended annex IV of the AIFMD. The letter highlights in particular that ESMA and NCAs should be able to gather sufficient data to identify large exposures to corporate debt and real estate markets, analyze outflows, performance and use of liquidity management tools for supervisory purposes and for systemic risk monitoring.
Annex II of ESMA’s letter suggests introducing the following requirements with regard to the reporting to ESMA/NCAs:
· acquire and report a Legal Entity Identifier for the AIFM and the AIFs it manages
· provide detailed information on the composition of assets and liabilities of the funds, counterparties and issuers
· report monetary values and not percentages, except for specific items such as performance
· ensure greater standardization and alignment with international standards and other regulatory reporting requirements (MiFIR, EMIR, SFTR, Securitisation regulation, European Central Bank statistics) and remove duplicated items.
· include key information disclosed in the annual report[3]or disclosed to investors[4] in the report to the NCA
· consider in the information on valuation, if feasible, the impact of each item on AuM, NAV and leverage metrics
· apply the AIFMD regulatory reporting rules to all funds, including those distributed under a National Private Placement Regime (“NPPR”)
· include in the ESMA public register information on sub-threshold AIFMs, AIFs distributed under a NPPR and non-EU AIFs managed by non-EU AIFMs
· report to NCAs on a monthly basis rather than the current quarterly basis to enable monthly update of the ESMA register.
· include leverage at the level of special purposes vehicles in private equity funds’ reporting of leverage
ESMA recommends that a reference that ESG factors should be considered in the AIFMD reporting in order to guarantee sufficient flexibility to take account of future ESG disclosures stemming from the regulatory technical standards being developed under the sustainable finance disclosure regulation[5].
Practical considerations
Some of ESMA’s suggested areas of improvement have been included for comments in the public consultation which is opened until 29 January 2021, but it is not yet clear to which extent ESMA proposals will materialize in the revised AIFMD framework
However, a more stringent regime in relation to delegation arrangements and tightened substance requirements could disrupt significantly the business models in place and bring additional costs for initiators and investment fund managers. Third party management companies may also see their business models challenged and will most likely have to provide for stronger investor protection in terms of conflicts of interest management and Chinese walls. Reallocation and internalization of resources would come with a number of challenges in terms of organization. Access to the appropriate expertise and infrastructure in relation to portfolio management or risk management may become more competitive and put additional pressure on margins.
The extent of the suggested harmonization and amendments to the current reporting requirements is likely to carry IT development costs which can only be amortized in the longer term once greater standardization will be achieved.
On the other hand, greater availability of liquidity management tools, limitation of external valuers’ liability and the creation of a semi-professional investor status would certainly reduce some of the burdens fund managers are currently facing.
Link to ESMA letter to the European Commission
[1] ESMA34-45-344
[2] Article 18, Regulation (EU) 2019/1156
[3] Pursuant to article 22, AIFMD
[4] Pursuant to article 23, AIFMD
[5] Regulation (EU) 2019/2088
