The UK’s title as Europe’s leading hedge fund centre is unassailable. Eighty-five percent of Europe’s hedge fund AuM (assets under management) is controlled out of London, translating into roughly $906 billion. The impact of a no deal Brexit on banks, insurers and market infrastructures is potentially very troublesome and painful, but the implications for hedge funds appears to be far less destabilising.
Some hedge funds will inevitably be affected by Brexit, namely those running UCITS or fully compliant AIFMD (Alternative Investment Fund Managers Directive) products whereby the AIFM is based in London and the AIF is domiciled in an onshore EU market such as Luxembourg or Ireland. These fund structures will have been set up to maximise managers’ European distribution footprint, giving them unfettered access across all member states.
As the government confirmed it will withdraw from the Single Market and has vanquished all hopes of achieving a mutual recognition deal with the EU, AIFMD and UCITS will be voided at domestic funds post-Brexit. This means hedge funds using UCITS or AIFMD wrappers to passport will lose their cross-border distribution rights, which may incentivise some firms to re-domicile or build up substance in onshore markets to retain EU access.
Still no clue
One hedge fund COO in London said that while larger managers with EU investors had built up substance in Luxembourg and Ireland and registered in a handful of other markets, most firms were procrastinating because they did not want to accrue large legal and administrative costs implementing a Brexit contingency plan when the outcome of negotiations is still painfully unclear. Others are simply waiting for the European Securities and Markets Authority (ESMA) to issue concrete guidance about delegation before making any definitive decision on substance.
The debate around delegation continues to mystify and frustrate market participants in equal dosage. Neil Robson, partner at Katten Muchin Rosenman, said the announcement by the Autorité des marchés financiers (AMF), the French market regulator, stating it would not challenge the existing delegation model, was a “win” for the UK, although warned against complacency. Robson acknowledged the AMF may have simply reined in its hostility because it was fully aware ESMA is taking a tough line on the delegation matter already.
The status quo remains unchanged
Not everyone is convinced a mass relocation or ‘Brexodus’ will happen in large numbers. Firstly, European Commission data shows just 3% of AIFs are authorised to market in more than three countries. Most UK managers run non-EU funds and will market to EU investors through National Private Placement Regimes (NPPR), an arrangement whereby firms must register and file an Annex IV with the regulator in each member state they are selling into.
“The reality is that very few UK hedge fund managers solely managing non-EU funds have been focussing on the introduction of the AIFMD passport, so the impact of Brexit on this segment of the industry is not going to be as serious as it has been in other sectors, such as UK managers of EU domiciled funds,” said Bill Prew, founder and CEO at INDOS Financial, an independent provider of depositary services.
Prew added most UK firms will simply continue using the NPPR arrangement, assuming EU regulators do not change the rules post-Brexit. He also said managers will avoid EU markets where the regulatory regimes are less accommodating, much as they already do today. However, any rash or ill-thought out revisions to NPPR by the EU would be a hammer blow at hedge funds with European investors.
AIFMD is under review and regulators are considering whether NPPR should be allowed to expire, a decision which would force third-country managers with EU clients to park themselves firmly inside the Single Market. While some have argued the Financial Conduct Authority’s (FCA) absence in ESMA’s policy discussions may lead to a protectionist approach being taken, others are confident this will not happen, arguing it would prompt managers to exit the EU entirely.
No cutting corners
A well-oiled trick perfected by a number of non-EU hedge funds determined to side-step AIFMD compliance has been to rely on reverse solicitation, a spurious legal concept that lets managers avoid the rules providing they do not contact investors directly. Instead, they must wait for prospects to call them. It is an approach that is open to enormous risk and abuse, at least by a small minority of managers. Some believe more UK managers may opt to use the reverse solicitation route post-Brexit if they are shut out of Europe.
However, this plan is likely to fall flat as the EU is pushing through prescriptive rules limiting pre-marketing activities such as the dissemination of fund documentation with would-be clients prior to launch. Pre-marketing is a ploy used by managers to scope out EU investor interest without having to register under AIFMD. By nullifying the pre-marketing AIFMD exemptions, the EU is in effect closing the door on reverse solicitation, making it harder for managers to avoid mandatory registration with national competent authorities.
What about the rest?
All UK managers – irrespective of whether they sell into the EU – must adhere to AIFMD, a requirement which has been a source of immense irritation at firms whose book of business resides exclusively outside of the EU. The extent to which AIFMD will be amended or dis-applied post-Brexit is unknown, but it is possible UK firms will still have to continue complying with broadly similar rules even if they do not sell into the EU. Those UK hedge fund unperturbed by Brexit are, however, becoming increasingly alarmed at political developments elsewhere.
“The industry’s mood has changed and firms are certainly less concerned about Hard Brexit than what they once were. Instead, firms are worried about a Soft Brexit where the industry is forced to comply with EU regulation without having any say on how it is framed. A number of prime brokers have also spoken to us about some of the risks facing hedge funds based on the contents of the current Labour Party manifesto. These policies are sufficiently hostile to cause a lot of the industry to leave the UK altogether irrespective of what happens with Brexit,” said the COO.