By way of an early Christmas gift to the industry, the European Commission finally published the long-awaited Alternative Investment Fund Managers Directive ‘level two’ measures on 19 December, putting further meat on the bones of proposals due to be implemented on 22 July. One main cause of the delay was behind-the-scenes wrangling about controversial provisions limiting the way investment managers can delegate activities to third parties.
In particular, the directive prohibits an ‘AIF manager’ – meaning a fund operator – from delegating its functions to the extent that it becomes a ‘letterbox entity’. It had been feared that many real estate fund arrangements involving EU-based operators or managers would need to be largely restructured to comply with this requirement – including, potentially, closed-end investment companies such as REITs and classic real estate fund structures, such as limited partnerships and JPUTs. First, the good news.
The measures make it clear that the letterbox entity prohibition does not amount to a blanket restriction on delegation, so it does not go as far as the industry once feared. The not-so-good news is that it goes a lot further than the recommendations of the European Securities and Markets Authority (ESMA) to the Commission. Under these, a manager would only have been regarded as a letterbox entity in a narrow range of situations, such as where it lacked the expertise and resources to supervise delegated tasks.
The regulatory uncertainty may mean that new real estate fund launches will be thin on the ground in the short to medium termBut the measures introduce a quantitative test whereby an AIF manager will be deemed to have become a letterbox entity if it delegates to an extent that “exceeds by a substantial margin” investment management functions performed by the AIF manager itself. A number of not particularly clear or helpful qualitative criteria may be applied in determining whether or not this has happened.
The key question is likely to be whether the delegation of day-to-day portfolio investment decisions, as is common in real estate fund structures, will mean property fund operators are deemed to be letterbox entities – thus making the delegate the AIF manager and imposing on it the obligation to fully comply with the directive. The answer to this question is unclear, given the nebulous nature of the qualitative criteria and the fact that, unhelpfully, the legislation does not define what is covered by ‘portfolio management’.
In practice, much may depend on the approach taken by national regulators. Helpfully for UK firms, in its November consultation paper the FSA said it would assess delegation arrangements on a case-by-case basis, in a “robust and flexible” way. It has also recognised the potential advantages of delegation, as a way to stimulate competition by reducing barriers to entry for new participants, and in terms of the significant benefits for investors, including raising standards, lowering costs and economies of scale. It remains to be seen how the FSA will respond to the publication of the level two legislation, but the early signs are that it does not necessarily see any reason to revise its stated approach.
It is to be hoped that the FSA will take a commercial and pragmatic approach in assessing structures where delegation is carried out responsibly and effectively, with a view to benefiting the fund. However, it will also have to consider forthcoming ESMA guidelines that will seek to ensure a consistent assessment of delegation structures across the EU. The Commission has also included a provision allowing it to review the delegation rules in two years’ time, which is unhelpful at a time when the industry is seeking clarity and certainty.
In the meantime, existing funds will need to consider whether they need to restructure and take back some investment management functions to ensure that there is real substance in the operator entity. The regulatory uncertainty may mean that new real estate fund launches will be thin on the ground in the short to medium-term – or until clarity is provided on the new regime.
Tom Dunn is a senior associate in the investment funds team at Burges Salmon LLP