Deloitte: Changes on the Horizon for Europe’s Alternative Investment Fund Market

The European Commission’s ongoing efforts to establish the Capital Market Union have reached the alternative investment manager’s market in Europe.

It has launched a legislative review cycle of the Alternative Investment Fund Managers Directive (AIFMD), giving the industry the first chance to weigh-in on the proposed changes and the future functioning of the alternative investment fund market.

In June 2020, the European Commission issued its review report on the AIFMD’s application and scope to the European Parliament and Council. Overall, the report concluded that AIFMD was successful in establishing an internal market for alternative investment funds, providing a high level of investor protection, and enabling EU-wide risk monitoring by the authorities. It also identified several topics for review to strengthen and adjust the framework.

“The fact that depositary banks can only provide their services in the country where they are domiciled runs counter to the idea of the Capital Market Union.”

To receive industry feedback, a market-wide consultation was issued with questions across 11 topics. This consultation closed on January 29, and the industry has shared its perspectives on the market within the European framework. The conclusions attest to a generally well-functioning market, and discourages changes by the European Commission for the AIFMD’s Level 1 provisions, suggesting a focus legislative texts for Levels 2 and 3.

Several topics emerged, where industry participants differed on the best approach for the commission. These points diverge further between member states, driven by the respective local flavour of the industry.

Investor Access to Alternative Investment Funds

Should the AIFMD provide broader investor access to alternative investment funds? In the current market, alternative investment funds are available only to professional investors, as defined under the Market in Financial Instruments Directive (MiFID). While some national laws allow broader access (“well-informed investors” under Luxembourg laws), these national variations are not harmonised, and many clients are left out of the alternative market’s rise in assets and returns.

With private equity, real estate and infrastructure delivering highly sought-after returns in a low interest rate environment, European investors are looking for easier ways to access these products, and all retail investors are not equal. Some ultra-high-net-worth individuals still qualify as retail investors, despite having the resources and experience to understand and manage the risks. At the same time, the 2018 revamp of the MiFID framework left the criteria of client categorisation largely unchanged, showing that European regulators have no appetite to increase the population of professional investors in the market.

One key focus is whether the AIFMD review will tackle this access obstacle, or whether the industry will be left to wait for a broader change under the MiFID framework.

Amendment or Extension?

In 2013, the AIFMD introduced a sub-threshold manager regime, where managers of alternative funds below a certain threshold of AUM did not need to apply for a licence, but merely register with authorities. While theoretically useful for new market entrants, the applied assets under management size (€500 million/€100 million when leveraged) is very quickly exceeded in practice. It has done little to increase the entry of new players. Applying for a full license is often expensive, requiring substance and expertise; this can deter even large third-country players from entering the European market.

The consultation sparked a debate to either (i) extend the existing sub-threshold regime to allow for larger asset bandwidths considered “below threshold”, or (ii) introduce a “light” license for players of up to €2bn, to reignite market growth and attract more players. Whichever direction is taken, a study should be conducted to assess the relevance of the sub-threshold regime in today’s climate and the average size of players in the European alternative investment market.

Outsourcing and Delegation

Over the years, Luxembourg has developed a strong notion of substance requirements for management companies that delegate certain of their functions. It ensures that any manager retains at least one crucial function of portfolio management and risk management and can effectively service the retained function.

This call for substance is not harmonised across the European Union, but is nationally-driven. And while other member states are slowly following this trend, there are expectations that the AIFMD review will balance the substance rules and introduce a minimum level that is acceptable Europe-wide. The recent political environment surrounding Brexit has brought it to the forefront of the discussion.

European Depositary Passport

The fact that depositary banks can only provide their services in the country where they are domiciled runs counter to the idea of the Capital Market Union. It even runs counter to the European single market and its principles of freedom of establishment and freedom to provide services. Numerous European authorities have highlighted situations where a limited number of depositary banks in certain countries had led to quasi-monopolies, something a European-wide passport could address. The AIFMD review is a chance to rectify this.

The market has rather mixed feelings about this passport. On the one hand, large groups and top European depositaries see a chance to streamline and consolidate their operations. On the other, it introduces a new bar for market entrants, who will compete locally and against the entire European market of depositary banks. At least one of the large depositary groups has spoken out against such a passport due to its practical implications.

Another argument against these passports is the possible strain on consumer protection of the alternative investment market. By increasing the distance between investors and depositary banks, whose strong control function contributes to investor protection standards within the European Union, these standards may fall and present cross-border hurdles, at the cost of investors.

The call for such a passport pre-dates the AIFMD and was first voiced in the context of the UCITS regime. While the European Securities and Markets Authority (ESMA) has considered such a passport under both regimes, it has not issued an outright recommendation to introduce one. Instead, it has asked the European Commission to assess the passport’s risks and benefits.

Ultimately, the extent of the final changes remains to be seen in the regulatory text’s first draft, which is expected at the end of Q2 or in early Q3. Nor is it known how far the European Commission will honour the industry’s wish for changes through Level 2 and 3 regulatory texts, rather than a fundamental reworking of Level 1.

It is prudent for the industry as a whole to follow the current discussions and to review the consultation feedback to gain an insight into the market opinions, and the directions proposed. While the European Commission is of course not bound by the findings, they have not ignored feedback in the past.

The industry has only recently concluded its efforts regarding MiFID II, which indirectly affected alternative fund managers as product providers, and its efforts around Packaged Retail and Insurance Based Investment Products (PRIIPs). The European Commission has now announced the industry’s next major change. MiFID II and PRIIPs have shown that these changes should not be viewed as a compliance burden, but also as an opportunity to reposition, strengthen and explore new sectors and activities.

If carefully anticipated, all the topics presented here could represent key opportunities for market players, further strengthening the dynamic alternative investment fund market in Europe.

About the Authors

Lou Kiesch joined Deloitte Luxembourg in November 2001 as Director in the Investment Management Services department, where he currently heads up the Compliance and Regulatory Practice.

Since 1 June 2005, he is a partner within Deloitte Luxembourg’s Investment Management Services.

Lou has a work experience of almost 30 years within the financial industry gained in Luxembourg, London, Frankfurt and Paris.

Prior to joining Deloitte, Lou was with Allianz Asset Management and Fidelity Investments where he was in charge of the Continental European Compliance Department.

Lou is co-founder of the Luxembourg Compliance Officer’s Association (ALCO) where he occupied the role of Vice President until April 2003. Lou was a member of different ALFI working groups and chaired ALFI’s committee for International Distribution. He was furthermore Vice-

President of the ALFI Regulatory Board and served the Alfi Board for 10 years. He was responsible for the Distribution Committee at Alfi and represented Deloitte at the EFAMA Distribution Committee.

Xavier Zaegel is leading Deloitte’s Consulting Investment Management & Private Equity / Real Estate Sub-Service Line in Luxembourg.

Before joining Deloitte, he worked for another audit firm where he focused on the audit of banks and vehicle with derivative instruments or guaranteed funds. He was also seconded to a Capital Markets department in London for 1 year.

Xavier is member of ABBL, ALFI, EFAMA and Invest Europe working groups. He is certified Financial Risk Manager from GARP (the Global Association of Risk Professionals).

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