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7 February 2017

Options likely to be available to UK hedge fund managers post-Brexit

Journalistic speculation about the impact of Brexit on the London fund management industry has focused on the potential loss of the European Union (EU) "passport" to market funds throughout the European Union. The passporting reality is a lot more complex than the headlines suggest, and the impact of Brexit on individual businesses will vary not only by the terms of Brexit, but on the type of fund, the character of the fund management house and the sorts of business it is conducting.


Dominic Hobson asked Leonard Ng, a partner at Sidley Austin in London, what he thought were scenarios most likely to unfold in the wake of Brexit.


Co-head of the EU Financial Services Regulatory group

Leonard Ng is co-head of the EU Financial Services Regulatory group and a member of the firm’s Investment Funds, Advisers and Derivatives and Banking and Financial Services practices. Based in Sidley’s London office, Leonard advises a wide range of financial institutions on UK and EU financial services regulatory issues and has particular experience in advising investment fund managers and other clients on operating under the post-financial crisis regulatory framework. Leonard is a member of the UK Financial Conduct Authority’s (FCA) Legal Experts Group on the AIFM Directive. He is also a past member of the Board of the Managed Funds Association (MFA), the global trade association for hedge funds and is a frequent speaker at industry conferences.

Hobson: The terms of Brexit have yet to be decided, but what is your best estimate of the impact on hedge fund managers based in London?

Ng: For a start, it is important to recognise that the impact of Brexit on hedge funds is likely to be quite different from the impact on UCITS. In assessing the potential impact on hedge fund managers currently regulated under the Alternative Investment Fund Managers Directive (AIFMD), it is also important to distinguish between the types of hedge fund manager in the United Kingdom (UK). As a group, they are broadly divided between managers with funds domiciled outside the EU (often in the Cayman Islands) and those with funds domiciled within the EU (often in Ireland or Luxembourg). The impact of Brexit on each of these funds will differ. For the first group – which forms the majority – such UK fund managers managing non-EU funds from London do not currently have access to the AIFMD marketing passport. Instead, they market their non-EU funds to professional investors under the Article 36 AIFMD private placement regime. In other words, a UK hedge fund manager with a Cayman fund today does not get to use the passport anyway. Once Brexit occurs, and the UK is no longer part of the EU, they will move from the Article 36 national private placement regime (which governs EU managers marketing non-EU funds) to the Article 42 national private placement regime (which governs non-EU managers marketing – typically – non-EU funds). This means they would be in the same position as a manager based in the United States (US) is today. If that proves to be the case then, operationally speaking, Brexit should not have any meaningful impact on hedge fund managers based in the UK and distributing non-EU funds through the private placement regime. Today, those managers have got private placement. Tomorrow, after the UK leaves the EU, they will still have private placement. It will just be a different article of AIFMD that they are using. To be clear, a UK manager with a Cayman fund would likely want to use the AIFMD marketing passport if it became available, but the key point is that that is a “nice to have”; the passport is not something that is available at this time for managers of non-EU funds. We can discuss the second group – UK managers managing EU funds – later on.

Hobson: I thought the private placement regimes were going to be abolished. Will that not create a problem for UK managers without a passport?

Ng: Not for a while, because the private placement regime is not going away any time soon, and possibly not for a long time to come. Bear in mind the European Securities and Markets Authority (ESMA) is continuing to advise the European Commission on whether the AIFMD passport should be extended to non-EU managers and funds. The extension depends on a positive review of the country where the manager or fund is based. There will be no review of the private placement regime until the assessment of third countries (i.e. non-EU countries) is complete, and the extension of the passport to managers based in those third countries is activated. In fact, the review of the private placement regime will not even begin until three years after the European Commission activates the third country passport provisions, with the agreement of the European Parliament and the Council.

So far, ESMA has reviewed 12 non-EU countries, and given a qualified positive assessment to nine, which means that in the estimation of ESMA there is generally no obstacle to the third country passport being extended to these nine countries. Verdicts are still awaited on the other three countries.[1] In the meantime, there has been no indication of when the Commission, Parliament and Council will activate the third country passport but if, for example, the passport extensions were activated in January 2018, then it would not be until January 2021 that ESMA would be required to deliver its opinion and advice to the Commission as to the functioning of the passport and whether or not to terminate the national private placement regime. The Commission then has to consider whether to act on ESMA’s advice. So we really are some way away from the termination of the private placement regime.


Hobson: Is there a possibility that private placement will never be terminated?

Ng: Well, for a start, as we discussed a moment ago, if the AIFMD third country passport is never activated, then we can say the private placement regime will never be terminated, short of the AIFMD text being amended. More broadly speaking, the AIFMD was negotiated in 2009-2010, and I would say there was a desire amongst policymakers at that time to push everyone towards a passport regime and away from private placement, but six or seven years on I am not so sure policymakers feel as strongly about this. It is important to note that there is no requirement as such under the AIFMD for the private placement regime to be terminated. Under Article 68 of the AIFMD, ESMA is to give its opinion on “the functioning of the passport,” and advice on the termination of the private placement regime, three years after the third country passport provisions are activated. The AIFMD requires ESMA, when reviewing the functioning of the passport, to consider a number of factors, including “the use made of the passport.” If the third country passport provisions are activated but few or no managers use it because people perceive that the conditions are too onerous, then the Commission will have to ask itself,  ”If the passport does not work, should we really terminate private placement?” After all, if the third country passport does not work and private placement is abolished, the EU will effectively be locking up Europe against third country managers. Of course, the EU could always say, ”Tough, if you want to play in Europe, you have got to play with an EU passport, or go away.” But we are some way away from that determination and much of that will be part of the Brexit negotiations.

Hobson: If the private placement regime were to be terminated, leaving only the passport regime, and the UK leaves the EU, the ability of managers based in London to distribute in Europe would depend on a positive assessment by ESMA. How likely is that?

Ng: To be clear, you are talking about a speculative future where the AIFMD third country passport has been activated and is considered to work, so that the private placement regime could be terminated. A definitive answer to that is of course wrapped up in the politics of the Brexit negotiations. In theory, the UK could decide to abandon the AIFMD altogether. Practically speaking, however, the UK is unlikely to deviate significantly from the major pieces of European financial services legislation for all kinds of reasons, including – in the case of AIFMD – the desire for a positive assessment by ESMA. If the UK keeps the AIFMD more or less as it is written, then it would be very odd if the UK did not get a positive assessment from ESMA for purposes of the third country passport regime. It would mean penalising a country that has actually implemented AIFMD in full while giving a positive assessment and granting the AIFMD passport to managers and funds based in jurisdictions such as Canada and Japan that have regimes that are quite different from the AIFMD. The UK would have to deviate quite far from the AIFMD for ESMA not to give a positive assessment and, given what the government has said, such a deviation seems unlikely at least for the immediate future.


Hobson:  What about the impact of Brexit on the second set of UK-based managers you referred to – UK-based managers running funds domiciled in the EU?

Ng: Today, such UK managers are able to use the passport under the AIFMD because they are EU managers with EU funds. When Brexit occurs, they will no longer have that passport automatically. The UK would become a “third country” - that is, a non-EU country. UK managers would lose the passport, and therefore no longer be able market their funds throughout the EU freely, unless they set up an AIFM in one of the remaining EU member states and have that AIFM delegate portfolio management services back to the UK office – that is, turn the existing UK operation into a delegate or sub-manager of an EU AIFM. However, they would need to ensure the EU AIFM, say in Ireland or Luxembourg, is not just a “letter box” entity with no substance. Alternatively, in order for such UK managers to continue to have access through the passport upon the UK leaving the EU, ESMA would need to assess the UK positively as a third country, and the Commission would need to take steps to activate the passport for the UK (with agreement of the Parliament and Council). If that happens, then UK managers of funds domiciled in, say, Luxembourg or Ireland, will need to apply for authorisation with the regulator in their ’member state of reference’ (MSR) – in this case Luxembourg or Ireland – for the right to manage and market their funds throughout the EU. Even though it seems likely that, since the UK would have implemented AIFMD, the UK as a non-EU country would be assessed positively by ESMA, the problem is that so far the Commission has taken no steps to propose legislation activating the third country passport even for the nine non-EU countries already assessed positively by ESMA. There is a concern that the Brexit vote has resulted in the EU putting the third country passport process on hold. This concern has been fed in part by statements from EU policymakers that the EU single market passport and equivalence concepts were designed for countries like the US, Hong Kong or Japan, but not for a key European country like the UK. If the EU activates the third country passport for countries like the US, Hong Kong or Japan, which have different regulatory frameworks, it would find it difficult to justify not activating the passport for the UK, which has implemented AIFMD. So it might be easier simply not to activate the passport for any third country, until it becomes clearer what the UK’s post-Brexit relationship with the EU will be in the financial services sector. We simply do not know what is really being considered on the issue at this time.


Hobson: Even if the third country passport is still on the table, most hedge funds are domiciled in Cayman, and Cayman has not yet received a positive assessment from ESMA. Is that not a problem after Brexit?

Ng: Not necessarily. A UK manager with a Cayman fund can already market that fund under the Article 36 national private placement regime, and even after Brexit, the Article 42 national private placement regime would still be available (since the UK would be a third country at that time, just like the US). However, it is true that, if the UK manager wants to market the fund throughout the EU using the passport, then the third country passport must be activated both for the UK as well as for Cayman.  At this point ESMA has yet to assess Cayman positively, mainly because Cayman has not yet put in place a regulatory framework that ESMA would like to see. But Cayman is in the process of putting in place what positively assessed jurisdictions – such as Guernsey and Jersey – have done already. By the time the UK leaves the EU in, say, 2019, one would hope that Cayman will have been assessed positively by ESMA. Then it would be a question of the UK also being assessed positively, and the third country passport being activated for both the UK and Cayman, assuming the passport has not been put on hold. There would also be an additional layer of regulation, but the operational burden should not be unbearable.


Hobson: What is the additional operational burden?

Ng: Managers using the third country passport have to comply with AIFMD in full, unlike the national private placement regime. At the moment, the difference between a UK manager with an Irish or Luxembourg fund and a UK manager with a Cayman fund is that the manager with an Irish fund has to appoint a single entity to perform the full AIFMD depositary functions with strict liability for loss of assets, whereas the manager with Cayman fund can opt for a “depositary-lite” solution, which allows for more flexibility as to providers and without strict liability for loss of assets. A manager marketing under the third country passport has to appoint a full single depositary.


Hobson: How popular do you expect the third country passport to be post-Brexit?

Ng: If the third country passport became available, I would expect UK managers with Cayman funds to be interested in using the passport, because such UK managers already comply with the AIFMD but for the single depositary requirement. US managers with Cayman funds will be less enthusiastic because US managers, which are already registered with, and supervised by, the US Securities and Exchange Commission (SEC), are unlikely to want to become fully authorised with, and supervised by, an EU member state regulator. Not to mention the whole host of AIFMD compliance that would be very unfamiliar, including remuneration restrictions, the full depositary requirement, regulatory capital requirements, investment restrictions, and so on. US managers that want to use the AIFMD passport will probably set up a separate AIFM within the EU, though they could in fact still set up in a post-Brexit UK and apply for a third country passport as well.


Hobson: In sum, it sounds as if Brexit will not be that disruptive for UK hedge fund managers, especially for the majority who currently manage non-EU funds. Does the same apply to UCITS funds?

Ng: No, because UCITS does not have a third country passport dependent on a positive assessment by ESMA of the regulatory regime of the third country. AIFMD has it, UCITS does not. A fund manager based in the UK, managing a UCITS fund based in Ireland or Luxembourg and distributing it throughout Europe, therefore has a potential problem post-Brexit. The only reason today UK fund managers are able to manage and distribute Irish and Luxembourg funds is because they have the UCITS passport, which allows them to establish themselves as a manager in one EU member state, manage a UCITS domiciled in another EU member state, and market that UCITS throughout the EU. That passport will disappear with Brexit.

Hobson: What is the solution for UCITS managers based in the UK?

Ng: The solution would be the same as that for the UK hedge fund manager with an Irish fund that is going to lose the AIFMD passport. That is, have the management company for the UCITS moved to Luxembourg or Dublin, and then delegate the management of the fund back to the UK entity, which would be a sub-manager. There would need to be some “substance” in Luxembourg and Dublin but, operationally speaking, this model is fairly commonly used today. UCITS managers in the UK already often act as sub-managers of UCITS management companies domiciled in Ireland or Luxembourg.


Hobson: What does `substance’ mean?

Ng: “Substance” means you have to have a management company presence, and what that presence consists of is a matter of what local law in the EU member state requires. The requirements can be fairly specific, but essentially regulators want more than a “letter box” entity, to borrow a term from the AIFMD. They want to see people with experience in portfolio or risk management in situ, rather than have everything delegated back to London. But it is impossible to predict what, in two years’ time, the Irish or Luxembourg regulators’ substance requirements will actually be. They change constantly and in general are getting more demanding.


Hobson: A lot of the UCITS funds in Luxembourg and Ireland are already sub-managed by firms outside the EU, such as the US and Switzerland, so why should the UK be treated any differently?

Ng: I agree. The fund industries in Luxembourg and Ireland are generally based on a delegation model. The UCITS directive has been beneficial to Ireland and Luxembourg, precisely because it allows for a delegation model. But there is inevitably a balance to be struck between allowing pure letter box entities and requiring so much in terms of substance that no manager wants to establish its UCITS in Ireland or Luxembourg. The balance that is struck with the UK will depend on the politics of the Brexit negotiations.


Hobson: Do all of your comments about the impact of Brexit on AIFs apply equally to private equity funds as to hedge funds?

Ng: Yes they do, because private equity funds are subject to the AIFMD in the same way hedge funds are. But of course I have been talking more about hedge fund structures. Private equity funds are a bit different. Certain private equity firms have their AIFM domiciled in Guernsey or Jersey rather than London, for example.


Hobson: The Channel Islands are outside the EU. How do their regulatory regimes interact with AIFMD and UCITS?

Ng: Managers based in the Channel Islands have a choice. Jersey- or Guernsey-based managers of Jersey or Guernsey funds are indeed outside the EU and, if they choose not to distribute in the EU should the AIFMD third country passport become available, will continue to be governed by a relatively light touch local regulatory regime set by the regulators in Jersey or Guernsey. If, however, a Jersey- or Guernsey-based manager wants to market a Jersey- or Guernsey-based fund in the EU using the AIFMD passport, it has to opt into an AIFMD-like regime, which ESMA has positively assessed, so as to then be able to apply for authorisation with the regulator in its EU MSR. Effectively, Jersey and Guernsey have dual regulatory regimes. There is a light touch regime where managers do not deal with the EU at all, and a heavier, AIFMD-like regime that allowed ESMA to assess Jersey and Guernsey positively for purposes of the third country passport. This is also the path that Bermuda and Cayman are going down, as we discussed earlier. However, as I noted earlier, the question is whether, in the post-Brexit political landscape, the third country passport has been put on hold.


Hobson: You said the UK was most likely to retain the AIFMD and UCITS regulations. Could it not, post-Brexit, establish a dual regime like the Channel Islands?

Ng: In theory, the UK could do the same thing. The UK government could decide they want London to be the fund management centre of the world. They could split regulation of managers between a light touch regime, which attracts managers based in the US, the Middle East, Asia and South America, and a heavier regime for those managers who want to manage EU funds or market to EU investors using the AIFMD third country passport. After all, successful global financial centres like Hong Kong or Singapore or Tokyo or New York do not rely on being members of an extended political union. They succeed because of other factors including infrastructure, ease of doing business – including employment laws – and talent. As long as the UK remains flexible, and innovative - which London has historically shown it can be – there is the possibility of designing a new regulatory structure that could make the UK a very attractive place to carry on a fund management business. There is also the possibility of the UK creating fund structures that are tax-efficient and thus create an incentive for the UK to be the domicile not only of the manager but also of the fund.


Hobson: A dual regulatory regime for managers in the UK is not an idea many have put forward post-Brexit. How viable is it?

Ng: It is very speculative at this point and would certainly be controversial. For a start, the dual regime would only work if the EU were willing to activate the third country passport for the UK. As I noted earlier, the third country passport is certainly not guaranteed and has possibly been put on hold for the time being. It is possible that the EU might take the position that it will not allow a huge financial services player like the UK to have its cake and eat it, so to speak, and so not grant the third country passport to the UK. Separately, unlike in offshore fund domiciles, the funds industry is not one of the main drivers of the UK economy. So there may be other groups within the UK economy, including within the financial sector, who might object to carving out the funds industry in this manner. There is a lot of careful economic, regulatory and political analysis that will need to be carried out before such an idea could become reality.


Hobson: Would a dual regime not give the EU an excuse to exclude the UK from Europe on grounds it was deviating from EU regulatory norms’?

Ng: Yes, exactly. The EU might say that the only basis it might be willing to give the third country passport to a huge economy like the UK is if the UK adopts all the EU regulatory norms, instead of allowing for a light touch regime for part of the funds sector. Of course, to be clear, there is no need for the UK to have a dual regime; it could decide that it will simply be in the same position as say the US, so that UK fund managers post-Brexit will not have access to the marketing passport, but rather market their funds on the basis of the AIFMD private placement regime.


Hobson: MiFID II comes into effect in January 2018, which will be before Brexit. Should fund managers worry about that measure as well?

Ng: Yes, for two reasons. First, in some EU member states marketing a fund is deemed to be covered by MiFID, because it is considered to be “advising on investments” and/or “receipt and transmission of orders,” both of which are regulated under MiFID. In those countries, managers will need a MiFID licence to market their funds. Secondly, a lot of UK managers are managing not just UCITS and AIFMD funds, but also managed accounts, and managed accounts are covered by MiFID, not the AIFMD or UCITS Directive. At the moment, the only way a UK-based fund manager can manage a managed account on behalf of, say, a German pension fund, is on the basis of a MiFID passport.


Hobson: So what happens to managed account managers if the UK leaves the EU?

Ng: The manager loses the MiFID passport. However, this is where the “equivalence” concept in MiFID II can help. MiFID II, unlike MiFID I, says that, if the regulatory regime of a third country is determined by the European Commission to be “equivalent” to that of the EU under MiFID II, then firms from that third country can provide investment services to professional – not retail – clients throughout the EU, on the basis of a simple registration with ESMA. When the UK leaves the EU in, say, 2019, it will have implemented MiFID II since 2018, and thus have exactly the same rules as EU member states. Unless the UK government suddenly drafted a new set of rules to replace MiFID II – which is extremely unlikely – it would be an odd result if the Commission did not determine the UK to have an “equivalent” degree of regulation, because it would literally have exactly the same set of rules as the EU. On that basis, the UK-based manager would be able to offer its managed account service to professional clients throughout the EU on the basis of a simple registration with ESMA. The same “equivalence” would also allow the manager to market its fund in those EU member states that regulate the marketing of funds under MiFID, assuming AIFMD/UCITS compliance. The ESMA registration process for MiFID is fairly straightforward. It is more about providing information about the firm than signing up to a compliance regime.


Hobson: So it looks like even fund managers offering managed accounts to EU professional investors will face no more than one more layer of regulation post-Brexit. Is it not too good to be true?

Ng: It is very important to emphasise, over and over again, that everything that we are envisaging as possible or even probable at this stage could be undone by politics, and Brexit is a hugely political discussion. Even if the UK keeps its current financial services legislation, there is no guarantee that UK managers are in a safe place. And if the UK starts deviating from EU regulation, then of course it will give the Commission the ability to say, “Well, actually, we should not give the UK this degree of access because they are starting to deviate.” We do not know, even if the EU is relatively accommodating when Brexit occurs in, say, 2019, whether it would continue to be accommodating if UK regulation starts to deviate significantly from AIFMD, UCITS and MiFID II over the subsequent three to five years. Also, bear in mind that, particularly with the EU’s Capital Markets Union initiative, there may well be changes made by the EU to existing legislation that the UK may have implemented – if the UK fails to make the same changes over time to its legislation, then the UK would start drifting into non-equivalence as a consequence of inaction. Finally, post-Brexit, the UK will have no say in the way EU legislation is drafted or amended. Who knows if what the EU does in future will be palatable to the UK? We are making all sorts of assumptions here, and in a highly charged political environment.

[1] The 12 countries are Australia, Bermuda, Canada, Cayman Islands, Guernsey, Hong Kong, Isle of Man, Japan, Jersey, Singapore, Switzerland and the United States (US). Guernsey, Jersey, Switzerland, Canada, Japan and - subject to an amendment to local law – Australia, have received positive assessments. The US, Hong Kong and Singapore have also all been granted some form of positive assessment. Only Bermuda, the Cayman Islands and the Isle of Man have not received a positive assessment at this stage, but are likely to receive one eventually.

Dominic Hobson

Dominic Hobson is an independent consultant. He was one of the founders of Asset International, whose titles include Global Custodian. After Asset International was sold in 2009, Dominic founded a peer group network for fund managers. As an independent consultant, he has worked with banks and infrastructures. Dominic has written for Financial News, contributed to the BBC, and has three works of non-fiction to his name. He was amanuensis to Nigel Lawson, former Chancellor of the Exchequer, in the preparation of his memoirs. Dominic was born in Southern Rhodesia in 1958, and educated there and at Magdalene College, Cambridge. He worked at Morgan Grenfell before choosing to work for himself. Dominic is co-founder of the Future of Finance conference held at Oxford University, a member of the Innovate Finance Policy Advisory Board, and served on the Government Office of Science group of experts on distributed ledger technology.