By Marco Boldini, head of financial services regulatory (asset management) – legal, and Robert Mellor, partner in the private equity funds team at PwC
With the announcement of the UK government’s proposals for a future UK-EU Partnership for Financial Services in July, the UK appears no longer to be seeking mutual recognition of regulatory equivalence. Instead, the focus has switched to a more limited EU markets access through “enhanced” regulatory equivalence for third countries.
The recent UK Government’s guidance on preparing for a ‘no-deal’ scenario flags a number of specific challenges and reinforces what the industry has already been planning for: the loss of passporting into the EU by UK firms. The guidance also acknowledges that many firms have already taken steps to ensure continued access to the EU post-Brexit through, for example, the establishment of new authorised EU entities.
In Brexit contingency planning to-date, the working assumption of many fund managers has been that the current portfolio management delegation model from EU Mancos will continue, however the rising possibility of a no-deal Brexit has significantly increased the pressure on the government to look for alternative solutions to avoid a regulatory exit. Delegation will not be possible post-Brexit until cooperation agreements are established between the UK and respective EU member state regulators. While the government has expressed its willingness to address this issue, this is now the biggest Brexit related challenge for the UK asset management industry.
There remain less than seven months until Brexit ‘day 1’, and clarification on any formal agreement on the transitional arrangement, which is vital in ensuring continued access to the EU markets, is needed as soon as possible.
Nonetheless, asset managers cannot wait (and many are not waiting) for the final detail of the deal (or lack of). Brexit continues to represent large-scale operational change for the majority of UK-based asset managers and there are three key areas that this sector needs to focus on:
- Management Company location and substance
The potential for the loss of distribution passporting rights has seen many UK-based asset managers increasing their European operations: be it by establishing a new EU Manco presence, through ‘top up’ permissions and ‘bulking up’ substance in territories where they already have a regulatory presence.
EU-based Mancos will become the main investment manager holding direct relationships with, and overseeing distribution to, EU-based investors. Following the ESMA guidance on substance, the CSSF in Luxembourg and CBI in Ireland have introduced new substance requirements which are being tested in regulatory applications. This potentially means moving more substance from the existing UK Manco.
Overseas regulators are becoming inundated with applications and have indicated that application processing times may run beyond the Brexit date. More firms are also receiving requests for detailed information on their ‘no deal cliff edge’ contingency plans, further slowing the approval process.
The movement of both senior sales individuals and client relationships from the UK Manco to an EU Manco is likely to carry with it high costs operationally and significant tax issues.
2. People and access to talent
A second challenge for many is the access to skilled personnel who can contribute to the running of the new EU business, as well as meet increased substance demands which call for greater ‘on the ground’ presence. For existing UK employees, particularly sales individuals, travel across the EU will become more frequent and they may need to relocate to perform marketing services under the EU Manco’s license. Employers and employees will also have to look at immigration considerations and tax costs brought about by this relocation.
3. Products and distribution
To continue to distribute across EU markets, “super Mancos” are becoming prevalent across the EU. Such dual-regulated Mancos enable distribution of funds and managed accounts under the relevant regimes (e.g. AIFMD, MIFID and UCITS) across the EU.
More specifically to products, and one of the biggest areas of ambiguity, is the post-Brexit treatment of existing UK UCITS funds in the EU and the marketing and treatment of EU UCITS in the UK after the expiry of the temporary permission regime (TPR) – a commitment made by the UK government that will allow EEA firms currently passporting into the UK to continue operating in the UK for up to three years after exit. The TPR regime is subject to the final terms of the withdrawal agreement and a reciprocal TPR has not yet been offered by the EU.
Is there a future for the UCITS funds in a post-Brexit UK?
The regime created by the UCITS Directive is a purely European concept which, unlike AIFMD, does not include third country provisions which may provide UK access to EU investors post Brexit.
If a Brexit deal is not reached, UK UCITS will lose their UCITS status in EU Member States, meaning UK UCITS funds could not be marketed to retail investors on an EU-wide basis.
With mutual recognition now unlikely, UK UCITS funds will be treated as non-EEA AIFs which can only be marketed across the EU under AIFMD or through national private placement regimes (“NPPR”).
Marketing under AIFMD is a less feasible solution for typical UK UCITS fund managers given that the NPPR and any future AIFMD third country passport access only allow access to professional investors but, more crucially, not to retail investors, which are the main target investor group for UCITS funds (unless a member state specifically permits the marketing of non-EEA AIFs to retail investors).
With no third country regime available under the UCITS Directive, UK fund managers would lose the ability to manage EU UCITS funds in their own right. Managers will need to establish a presence in the EU if they wish to continue to access the EU markets as they currently do. While some firms have already made good progress, it is important that those who haven’t consider their future EU model imminently to ensure business operations can continue from Brexit day 1. If there is no grandfathering for existing UK UCITS funds, firms may need to consider re-domiciling those funds to an EU jurisdiction, such as Ireland or Luxembourg, which facilitates the relocation of non-EU funds.
Existing EU UCITS funds could benefit from the TPR (if operated at all) for up to three years if notification is given to the Financial Conduct Authority (FCA). In a ‘no deal’ scenario and after the expiry of the TPR, EU UCITS would be treated in the same way as third country overseas funds under the current UK regime and would therefore lose their automatic recognition. Once the TPR has expired, marketing of EU UCITS funds to UK retail investors will require recognition by an individual application to the FCA which will be determined on a case by case basis. In the absence of recognition, they will be treated as unauthorised AIFs which can be marketed to limited classes of retail investors in the UK such as sophisticated investors or high net worth individuals, and which excludes local authority pension funds, for example. In a ‘no deal’ scenario, EU fund managers would also lose the ability to manage a UK UCITS fund after the TPR runs out.
The inability of UK UCITS funds to access EU investors and the management of EU UCITS is clearly a concern for UK hedge fund managers who operate UCITS products, and action, where possible, should be taken now.
One solution we are seeing some managers look to is the establishment of new UK onshore funds alongside existing EU UCITS to attract UK investors post-Brexit. For example, open-ended investment companies (OEICs), authorised unit trusts (AUTs) and the relatively new authorised contractual schemes (ACS).
However, there has historically been a slow uptake of such fund options in the UK to date due to the availability of traditional ‘tried and tested’ overseas vehicles, limited investment flexibility, unfamiliarity with target investors and, in the case of OEICs and AUTs, taxation of income at the fund level (albeit few generally do pay tax).
What’s the outlook for the future?
Separately, with UK UCITS likely becoming AIFs post-Brexit and a changing regulatory regime more generally, there are new opportunities for the UK government to enhance the international competitiveness of the UK alternatives fund industry. For example, a new onshore corporate tax exempt fund vehicle with sufficient investment flexibility to accommodate alternatives investment strategies would allow the UK to compete as a fund product location with traditional overseas equivalents. Secondary support industries such as administrators, prime brokers and lawyers would all benefit. The creation of such a vehicle would bring capital and fees into the UK which will benefit both the government and asset managers.