Asian GPs and AIFMD: Shades of gray

"I'm not going to bother fundraising in France anymore. It's a shame, but the regulatory situation means it is just too much trouble." This view, expressed by a GP in the process of raising a China growth fund, is a common refrain among Asia-based private equity managers getting to grips with Europe's changing regulatory environment.

France has emerged as the prime example of a jurisdiction that has erected a bureaucratic blockade around its investor community in the wake of the global financial crisis and then the EU's Alternative Investment Fund Managers' Directive (AIFMD) intended to protect citizens from any future fallout. Once a market of small but not insignificant interest to non-European GPs now it is largely off limits to them.

The problem is not necessarily AIFMD itself. Announced in 2011 and implemented two years later, the passport regime enables EU-based funds and managers (AIFs and AIFMs) to market their products freely within the region, albeit on condition of meeting more stringent regulatory requirements.

Alongside AIFMD, member states run private placement regimes used by non-EU managers. Not only must these GPs submit separate documentation for each jurisdiction in which they want to market, but extensive "gold-plating" has resulted in systems that vary hugely in terms of ease of access. France is a tricky one.

"The private placement regime in France is to my knowledge largely untested and few people have the appetite to navigate registering there," says Gus Black, an investment funds partner with Dechert. "France is also a country in which we run into a strong investor preference for an onshore European vehicle. It is academic whether you could register an Asian GP with a Cayman fund if the investor actually wants a European fund."

Uncertainty reigns

Other jurisdictions are also home to difficult investors and challenging private placement regimes. If the UK, Luxembourg, Ireland and the Netherlands are described as generally accommodating - in the UK and Luxembourg a manager simply notifies the regulator of its intent to market a fund rather than having to go through a registration process - other member states fall into two categories.

Germany, France and Austria, for example, have systems that make private placement more difficult, while much of Southern and Eastern Europe remain completely unfathomable.

Across all the interviews conducted for this article, the phrase "huge gray area" cropped up with alarming frequency. Yet this is the reality confronting Asian managers. They must establish what they are legally allowed to do where, and then cover the relevant costs. For many smaller players it might be a bridge too far - and the potential opening up of the passport system to non-EU managers is not necessarily a panacea.

"In Asia it hasn't really been that much of a focus," says Alexander Traub, head of Asia at Augentius, a private equity fund administrator and depository. "If people are not avoiding Europe as a whole they are only just coming around to the fact that something has to be done and they are getting in line."

The reporting deadline for managers that registered for marketing in the EU after July 22, 2014 fell at the end of last month. For EU-based AIFMs this is now a matter of habit, but the vast majority of their non-EU counterparts this was a first experience of the system. There are some exceptions - for example, the Netherlands has said that does not yet expect external managers to start periodic reporting - but in most jurisdictions there was a rush to submit year-end 2014 reports.

The UK's online reporting system set up by the Financial Conduct Authority (FCA) was beset by a much larger volume of traffic than it had ever seen before and duly crashed. "I know just from dealing with some clients in the last week that they still haven't received their login details enabling them to register, let alone file reports. They have missed the deadline but it's not their fault," says John Adams, a partner with Shearman & Sterling's UK investment funds practice.

His view is that, with regulators under so much pressure to get the reporting to work, managers are unlikely to be investigated for all but the most wanton flouting of the rules. This does not, however, mean that GPs are getting a free ride: everything they do may ultimately be assessed in hindsight.

Retrospective risk

An ethically dubious position on AIFMD would be to ask how the regulators can tell if a non-EU manager is marketing without a license - the very nature of the infraction is that there is no registration. Two parties would be able to tell: a disgruntled GP that is following the rules could inform the regulators of a rival that is not; or, more worryingly, a disgruntled LP.

"If someone is found to be marketing a fund in certain jurisdictions without authorization they could be looking at a jail sentence," says Christopher Stuart Sinclair, a director with Deloitte's advisory and consulting department in Luxembourg.

"What is also coming to the fore is the regulatory put option. If in the future things turn sour between a GP and LP, an LP could turn around and say, ‘You marketed to me improperly. I bought in good faith but you weren't in compliance - I want my money back.' That is the biggest consideration keeping people from walking too fine a line."

The threat of retrospective action has influenced how certain managers view the various ways in which AIFMD might be outmaneuvered, honestly or otherwise. When the legislation was first announced, a number of Asia-based GPs indicated they would source commitments out of Europe through reverse inquiries from investors aware of their fundraising plans. Fast forward to the present and their enthusiasm for this approach has been dimmed by uncertainty over the potential regulatory response.

The message coming out of a number of European jurisdictions is that reverse solicitation is not a mechanism around which a marketing program can be structured. France's Financial Markets Authority (AMF) has said reverse inquiries must relate to specific products and refer to them by name; a broad request for information on any future fund is not acceptable. The FCA in the UK also issued notice that widespread abuse of its accommodating stance on reverse solicitation would result in tighter guidance.

"Our understanding is that because the burden of proof is so onerous, only the largest and biggest brand name firms can to some degree rely on making a case that inbound calls were truly made by these investors," says Vincent Ng, partner at placement agent Atlantic Pacific Capital. "If you are a lower mid-market fund, the chances of an LP calling you directly without any degree of shoving or hinting are small."

One consistent piece of advice amongst all the uncertainty is that GPs should track their communications carefully, just in case they are asked to present evidence that backs up a contested claim of reverse solicitation.

"We've had plain vanilla reverse solicitations," notes one Asia-based manager who is currently fundraising. "Someone heard about us - we don't know how, they've never met any of us - and they literally called the front desk. They wanted to know more about the fund so we asked for an email confirming the phone conversation and logged it into our system. That is very rare. The bigger, savvier LPs just send us reverse solicitation letters. They know who is in the market."

An added complication is what to do about existing investors. Some GPs are advised to scrutinize materials presented at annual general meetings for any mention of a successor fund. But if a manager informs existing LPs that the current vehicle is 90% drawn down and those LPs logically conclude that another fund is in the pipeline, prompting inquiries, then who is soliciting whom? The consensus view among the advisors that spoke to AVCJ is this constitutes a GP fulfilling its fiduciary responsibilities to existing investors, not subtle pitch for a new fund. But it shows how managers have become wary.

One approach taken by some managers is informing LPs that after July 22, 2013 they will receive no further communication and must get in touch directly if they want further information.

Alternatively, a manager might avoid regulatory issues by marketing separate accounts, which can be structured so they don't count as funds or AIFs. However, the same issue of credibility crops up. The GP must genuinely be able to offer a separate account - and have prior experience running them - while the LP should be sufficiently experienced and well-capitalized to accept one.

"On the basis that everything is judged on hindsight, if at the end of the process all the GP has done is gather a load of commitments into a fund, it raises a question mark over whether they were trying to market separate accounts or market their fund via the back door," says Dechert's Black.

Marketing mechanics

Infused in this debate are the different lines jurisdictions have drawn in terms of how far a GP can go before pre-marketing becomes actual marketing and therefore requires registration or notification.

The Asian manager currently in the market, who has gone through notification in the UK and is waiting to see whether LP demand warrants similar action elsewhere, reels off a list of dos and don'ts for different markets.

At one extreme sits the UK, where a GP can engage in a variety of pre-marketing activities - sending emails, making presentations, issuing pitch books, circulating draft private placement memoranda - provided they don't involve near final form constitutional documents. At the other: the Netherlands, where any information, written or oral, citing a specific fund is deemed to marketing.

Opinion is divided as to which jurisdiction is most stringent on marketing. Sweden is cited by several advisors as tough if not tougher than the Netherlands, although both jurisdictions are said to have relatively straightforward registration processes. Sweden processes applications in a few weeks, while the Netherlands follows the notification procedure, although attestation is required from a regulator.

By contrast, registration in Denmark and Germany is complicated by the need for a depository. Even though the system created by Germany's Federal Financial Supervisory Authority (BaFin) is "depo-light" - unlike Denmark, the depository can be anywhere within the EU - it can still be a hindrance.

"It is not just the presence of an additional service provider that managers otherwise wouldn't have to think about or pay for, but the time and cost involved in going through the BaFin application where there is no guarantee of success," says Shearman & Sterling's Adams. "Some GPs are reluctant to follow that route unless they have a good sense that there is a huge opportunity to raise capital in Germany."

A potential workaround is to target a German institution with a presence outside of Europe, such as a fund-of-funds that has an office in Hong Kong. Here, too, care is required. This approach is acceptable provided all marketing takes place in Hong Kong and the subscription documents are signed there. But the regulator is likely to look through any structure to the ultimate investor, so if a GP receives the completed subscription documents and finds they have been signed in Germany it could pose a problem.

"If it is clearly an EU organization and the decisions are being made in the EU and you try to get around it by pretending the decisions are not being made in the EU, the regulators are going to see through that very quickly," says Oliver Morris, director in the advisory department at KPMG Channel Islands.

Similar issues of substance apply in situations where a manager decides to eschew the private placement uncertainty and set up an AIF and an AIFM under the passport regime. Several industry participants say they have so far seen little demand for such structures: managers don't want to bear the additional cost when there are still acceptable private placement regimes through which they can enter key markets.

Going local

However, there are a number of ways in which the passport regime can be accessed cost-effectively. For example, a host of service providers have emerged offering to be an Asian GP's AIFM-for-hire. Much like the rent-a-management-company approach employed for UCITS, an AIFM in Ireland or Luxembourg is responsible for multiple sub-funds under an umbrella vehicle. The cost is lower than operating independently and setting up dedicated in house teams, but control is sacrificed at the same time.

An AIFM cannot be a letterbox entity taking instructions from the Asia-based manager of a Cayman Islands-incorporated fund; the latter is a delegate of the former. What this means is the AIFM-for-hire retains responsibility for a number of the risk management functions and has complete oversight regarding portfolio management. It is also able to fire the Asia-based delegate if this course of action is in the best interests of shareholders.

"You are relinquishing some power, both legally and over the management of your portfolio. Some of these managers don't like the idea that they can be fired by an AIFM they feel they are hiring, although legally it is the other way around," says Shearman & Sterling's Adams.

Opting for a full AIFM also exposes a manager to a host of requirements that are more demanding than those imposed under private placement regimes. Remuneration is one of the more contentious issues.

Initial fears that GPs would have to disclose individual remuneration have abated. The annual report submitted when marketing in the EU as an AIF or on a private placement basis must reveal the number of staff and the size of the overall remuneration pool. Indeed, in cases where the staff is so small that it might be possible to calculate individual remuneration, separate legislation can be invoked to maintain privacy.

AIFMD goes beyond the private placement regimes in dictating how staff are paid - for example, it outlaws guaranteed bonuses and stipulates the mode and timing of certain payments. An Asia-based delegate would be drawn into this system and it represents a huge cultural shift for many managers.

Nevertheless, a shift of some sort is all but inevitable. Later this year, the European Securities and Markets Authority (ESMA) will issue an opinion on whether the passport system that currently applies to EU-based managers should be extended to GPs from outside the region. There is uncertainty as to whether the framework outlined is politically tenable or practically workable.

"A lot of this comes down to the amount of pushback you see in wanting this passport in the first place and the willingness of member states to open up to external managers," says Grant Lee, a director in PwC's advisory division. "The legislation is there, so to a certain extent hands are tied so it is more about the detail. But it could get to the point where the regulators make it so difficult that people don't do it."

For Asian managers to qualify for access to every EU jurisdiction they would have to be brought into the regulatory fold by agreeing to oversight from a European state of reference. The process for determining the state of reference is complex and it is unclear what additional demands Europe might try to impose on a manager's local regulator to address areas not directly covered by AIFMD.

At the same time, some but not all jurisdictions are likely to begin to wind down their private placement regimes. GPs would be left with a choice between a passport system inside and outside of the EU or reverse solicitation.

"I don't see a lot of people lining up to take advantage of the third-country passport because what that is essentially going to do is expose the third-country management company to European regulation," says Dechert's Black. "Most people who want the benefits of the passport are quite keen to ring-fence the regulatory impact in an EU entity and are in no rush to subject their main management company to that regulation."

Favorable future?

It points to is a situation in which AIFMD is an accepted, and to some extent contained, part of a non-EU manager's strategy. In this way, AIFMD may eventually become part of the fabric of the industry, just as private equity has largely come to terms with the new reality presented by the US Foreign Account Tax Compliance Act (FATCA).

On one hand, compliance may become cheaper and easier for managers as familiarity with the process grows. On the other, LPs may get more comfortable and sophisticated at reverse solicitation.

There is also the prospect of AIFMD emerging as a regulatory gold standard. Much as investors in the hedge fund space often demand exposure to a certain strategy through UCITS rather than a Cayman fund, LPs could do the same with AIFMD. Suzanne McNeil, managing director of depository at Augentius, says she is already seeing this. Augentius was recently approached by a non-EU manager about performing depo-light functions because one of its major LPs made it a stipulation to invest in the fund.

The cost implications of this would not be welcomed by smaller managers that still face being squeezed out of the market because they don't have the resources to participate under AIFMD or private placement.

"The bottom line is if European capital is important to you it is wise to look at cost-effective ways of having an onshore structure to meet those requirements and get rid of all those uncertainties," says Deloitte's Stuart Sinclair. "If it's marginal, do you really need Europe?"

This begs the question of whether Europe needs them. Industry participants already refer to smaller managers focusing on investors in a particular jurisdiction in order to justify the higher regulatory overheads. It will result in less eclectic LP bases, and maybe some groups missing out.

"If you are a big beast continually raising money left then you can register a holding group that covers all your funds and the economies of scale work," says Atlantic Pacific's Ng. "But if you are a single-entity fund that goes to market every four years, would you want to do this? This regulation is penalizing the small guys. LPs only get exposure to the biggest guys - but are these the best funds?"

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Regulation
• Fundraising
• Europe
• Greater China
• GPs
• LPs
• regulation
• Asia
• Europe
• Fundraising
• GPs
• LPs