EU Securities Regulator calls for review of delegation arrangements under AIFMD

In a letter published this week, the European Securities and Markets Authority (ESMA) has called on the European Commission to consider legislative clarifications under the Alternative Investment Fund Manager Directive (AIFMD) that may have a significant impact on the ability of European alternative investment fund managers (AIFM) to delegate key functions outside the European Union.

Delegation and substance

ESMA’s letter identifies several substance-related concerns that it says merit further attention from EU policy makers with a view to enhancing investor protection and avoiding regulatory arbitrage. These concerns include:

• the fact that portfolio management functions may be delegated entirely outside the group of the AIFM;
• in some cases the majority of human and technical resources needed for day-to-day operations of an AIFM are maintained by third parties outside the EU;
• that a large amount of the management fees generated by an AIFM are sometimes paid to delegates;
• that different national authorities take different approaches on minimum local substance requirements; and
• in the case of delegation outside the EU, regulatory arbitrage and investor protection concerns are increased since the non-EU delegate is not directly subject to the AIFMD framework.

ESMA also raises particular concerns about the use of temporary staff secondments and the absence of clear distinctions between “core” portfolio management functions and unregulated “supporting tasks” such as legal and compliance activities, investment research and risk data analyses.

None of these concerns are really new, but they have clearly taken on new urgency in light of the withdrawal of the UK from the EU and recent COVID-19 related stresses. Moreover, ESMA’s proposed solutions mark a departure from the somewhat relaxed approach to delegation that applied until recently.

In addition to calling for clarification of existing qualitative criteria on delegation, ESMA has- for the first time- called on the EU Commission to propose a list of “core or critical functions” that must always be performed internally by an AIFM and may not be delegated to third parties. ESMA also calls for new “quantitative criteria” to be introduced, suggesting that the EU Commission may consider minimum headcount levels and specific amounts of management fee revenue that must be retained by the EU AIFM.

White-label service providers

As if this were not enough, ESMA reserves it toughest criticism for so-called “white-label service providers” that provide an AIFM platform to business partners by setting up funds at the initiative of the latter and typically delegating investment management functions to those initiators or appointing them as investment advisers or informally following their guidance or instructions.

ESMA’s letter openly questions the legitimacy of such business models and calls on the EU Commission to enact specific regulatory provisions should it consider that such models are permissible.

In this respect, ESMA highlights what it sees as a conflict of interest inherent to the white-label business model: i.e., that the initiator of a white-label fund is also the client of the AIFM and may therefore decide to replace the AIFM with another white-label service provider. As a result, the white-label AIFM faces significant conflicting interests since controlling and challenging the delegate/investment adviser in the best interest of investors may come at the risk of losing a client/business partner and therefore losing its own revenue/management fees.

The future of delegation under AIFMD

All eyes will now turn to the EU Commission to see how the AIFMD framework may evolve in these respects. ESMA is justified in focussing attention of the use of delegation in the alternative investment fund industry, but these questions do not easily lend themselves to “one-size fits all” solutions and one would hope that the EU Commission will take a wholistic and proportional approach when considering ESMA’s call for action.

Conspicuously absent from ESMA’s letter is any reference to the “equivalence” of non-EU regulatory regimes. This concept is at the heart of Brexit negotiations between the UK and the EU on financial services so it is unsurprising that ESMA left it out. Nonetheless, it is hard to see how the EU can argue that investor protection is undermined by delegating an AIFM’s portfolio management functions to a jurisdiction (like the UK) having substantially the same legislative framework.

Also absent from ESMA’s letter is any meaningful discussion of the benefits of delegation for investors. Cleary, delegation arrangements can be used to increase efficiencies and ensure access to external expertise. In some cases delegation of portfolio management functions outside the EU is the only way that EU investors can have access to certain investment strategies and to certain geographies. Moreover, professional investors are generally comfortable with such arrangements and understand that different functions may be carried out by different entities within the same group or by external service providers without compromising the overall level of investor protection.

When considering ESMA’s proposals, the EU Commission would therefore do well to listen to the concerns of EU investors and consider delegation criteria that are adaptable to the circumstances of each AIFM, including the relative sophistication of its investors and the extent to which external resources are required to implement a particular investment policy. By way of example, the case for limiting delegation by an AIFM managing opened-ended funds marketed to high net worth individuals may be far more compelling than the case against delegation by an AIFM managing, say, a closed-end private equity fund investing in North American and marketed exclusively to large institutional investors.

In any event, the battle lines have been drawn and the fight to agree criteria for permissible delegation under AIFMD has begun…