On 25 November 2021, the European Commission (Commission) published its long-awaited legislative proposal following the review of the Alternative Fund Managers Directive (AIFMD) (Proposal). The Proposal focuses on delegation arrangements, liquidity risk management, supervisory reporting, provision of depositary and custody services, and loan origination, with amendments to the AIFMD, the Undertakings for Collective Investment in Transferrable Securities (UCITS) Directive, and the European Long-Term Investment Funds (ELTIF) Regulation.
Delegation of portfolio and risk management functions had been an essential part of the post-Brexit planning of many UK-based asset managers. How permissive the delegation provisions under the AIFMD and UCITS Directive should be has been a point of contention in the European Union (EU) for some time. EU policymakers and regulators have been increasingly concerned about the prospect of UK-based managers relying on the delegation model to enjoy the benefits of passporting while continuing to conduct the lion’s share of their business from the UK.
EU regulators are keen to ensure that they have adequate oversight of AIFMs and UCITS managers that operate a delegation model. This was exemplified by the European Securities and Markets Authority’s (ESMA) letter to the Commission in August 2020, in which concerns were raised about the substance of AIFMs and UCITS managers that delegate to a large extent (or entirely) collective portfolio management functions to third countries, which may increase operational and supervisory risks.
Against this backdrop, it is perhaps no surprise that the AIFMD review proposed amendments to the AIFMD and UCITS Directive in respect of delegation arrangements, particularly around the governance of such arrangements and the substance of firms that operate this model. The Commission states that, although the delegation regime allows for the efficient management of investment portfolios and for sourcing the necessary expertise in a particular geographic market or asset class, different national supervisory practices in fulfilling EU requirements for delegation of risk or portfolio management to third parties create inconsistencies that may reduce the overall level of investor protection. As such, the Commission considers it necessary to introduce additional measures in order to implement the requirements ensuring that AIFMs deploy the necessary human resources to perform retained tasks where some of their functions are delegated to third parties.
Despite its contentious background, the Proposal does not envisage an overhaul of the delegation model, and AIFMs and UCITS managers would continue to be permitted to delegate both portfolio and risk management functions to third countries. Generally, the Proposal aims to bolster transparency of delegation arrangements and clarify supervisory expectations around substance. In many respects, the Proposal simply substantiates existing obligations under the AIFMD preventing delegation to such an extent that the AIFM becomes a letter-box entity. However, increased oversight of delegation arrangements will naturally result in greater scrutiny, which may in turn lead to stricter rules as ESMA seeks to harmonise approaches among Member State national competent authorities (NCA) and prevent regulatory arbitrage.
Below we summarise the Proposal’s key provisions in respect of delegation and discuss the impact for AIFMs and UCITS managers that currently rely on the delegation model.
Appropriate human and technical resources
The Proposal clarifies that AIFMs should have appropriate technical and human resources when applying for authorisation. The human and technical resources that the AIFM will use to carry out its functions and to supervise the delegates must be described in detail, comprising the following information:
- the persons effectively conducting the business of the AIFM, including: (1) a detailed description of their role, title and level of seniority; (2) their reporting lines and responsibilities in and outside the AIFM; (3) an overview of their time allocated to each responsibility; and (4) a description of the technical and human resources that support their activities;
- the identities of the AIFM’s shareholders or members, whether direct or indirect, natural or legal persons, that have qualifying holdings and the amounts of those holdings;
- a programme of activity setting out the organisational structure of the AIFM, including information on how the AIFM intends to comply with its obligations and a detailed description of the appropriate human and technical resources that will be used by the AIFM to this effect;
- remuneration policies and practices; and
- arrangements made for the delegation and sub-delegation to third parties of functions, and a detailed description of the human and technical resources to be used by the AIFM for monitoring and controlling the delegate.
Similar provisions have also been proposed in respect of UCITS managers.
Although these requirements are applicable when an AIFM or UCITS manager is applying for authorisation, it is likely that those that are already authorised will also need to ensure that they have appropriate human and technical resources. There is the possibility that more active NCAs will rely on these requirements to request such information from existing AIFMs and UCITS managers that operate a delegation model.
The Proposal includes provisions for AIFMs to employ at least two persons full-time or engage two persons who are not employed by the AIFM but nevertheless are committed to conduct that AIFM’s business on a full-time basis, and who would be resident in the EU. Such persons who effectively conduct the business of the AIFM will need to be of sufficiently good repute and sufficiently experienced in relation to the investment strategies pursued by the AIF managed by the AIFM. The names of those persons and their successors will need to be communicated to the relevant NCA.
Equivalent provisions have also been proposed in respect of UCITS managers, including a requirement preventing the manager from delegating its functions or provision of services to the extent that, in essence, it can no longer be considered to be the manager of the UCITS and therefore becomes a letter-box entity. In addition, delegation arrangements must not prevent the effectiveness of supervision over the manager and impact its ability to act in the best interests of investors and clients. Delegation arrangements must also not prevent those who conduct the UCITS manager’s business from giving further instructions to the undertaking to whom the functions or services are delegated or withdrawing the mandate with immediate effect. The undertaking to whom the functions or services are delegated will need to be qualified and capable of performing those functions or services.
The requirement of at least two persons to be employed or engaged by the AIFM is not a particularly onerous requirement and simply substantiates the existing AIFMD requirement to not delegate functions to such an extent that the AIFM becomes a letter-box entity. However, this is a minimum requirement and NCAs may expect a greater number of personnel in order to demonstrate appropriate human resources. It is significant that the Commission has not specified that staff from portfolio management and/or risk management functions must be employed or engaged by the AIFM, which could entail significantly greater substance.
The proposal envisages that AIFMs submit notifications where they delegate more portfolio management or risk management functions to entities located in third countries than they retain. The competent authorities will notify ESMA of all such notifications. The notifications will need to include the following:
- information on the AIFM and the AIF concerned;
- information on the delegate, specifying the delegate’s domicile and whether it is a regulated entity or not;
- a description of the delegated portfolio management and risk management functions;
- a description of the retained portfolio management and risk management functions;
- any other information necessary to analyse the delegation arrangements;
- a description of the NCAs’ supervisory activities, including desk-based reviews and on-site inspections and the results of such activities; and
- any details on the cooperation between the NCA of the AIFM and the supervisory authority of the delegate.
Equivalent provisions have also been proposed in respect of UCITS managers.
It is expected that regulatory scrutiny will increase as the mandated notifications will provide NCAs with greater oversight of AIFMs’ delegation arrangements. Where the retained portfolio and risk management functions are low and those delegated are high, this may put NCAs on alert and prompt them to review the AIFM’s delegation arrangements and potentially require appropriate changes.
Peer review of delegation regime
ESMA will be required to conduct regular peer review analyses (at least every two years) focusing on the measures taken to prevent AIFMs that delegate performance of portfolio management or risk management to third parties located in third countries from becoming letter-box entities. This may lead to stricter rules in the future if ESMA deems that the current framework is failing to prevent NCAs from taking too permissive an approach to supervising delegation arrangements, which may result in regulatory arbitrage.
The Proposal will now be subject to the EU legislative review process before it is agreed and published in the Official Journal of the EU. Member States will have 24 months after the entry into force of the directive to transpose the new rules into national legislation.