For the most part, the management companies (ManCos) used for alternative investment funds (AIFs) and Undertakings for the Collective Investment in Transferable Securities (UCITS) funds across Europe have met the challenge of the coronavirus successfully. The most significant tests, however, may lie ahead.
ManCos have flourished since the introduction of the Alternative Investment Fund Management Directive and passporting rights in 2011. Providing the regulatory infrastructure to AIFs and UCITS funds, they manage the fund in line with current regulations, local laws and its prospectus. This leaves the fund manager to concentrate on investment decisions and promoting the fund.
Fund managers don’t have to use a third-party ManCo, of course. They can do the management themselves, as with the self-managed investment company (SMIC) in Ireland, or they can use a captive management company. The latter is a separate management entity that is nevertheless part of the investment management group (as opposed to a third-party ManCo).
There are benefits of using a ManCo, though, for both investors and fund managers. First, the ManCo specializes in regulation, governance, and management, bringing expertise and independent oversight. It also provides the necessary regulatory capital and saves fund managers from the task of finding local people for compliance and risk roles. And finally, these benefits can, in theory, be delivered more cheaply than an in-house solution. ManCos can leverage economies of scale since they provide the same services for numerous fund managers.
Fund management through COVID-19
Regardless of the solution, those managing AIFs and UCITS funds faced a considerable challenge with the pandemic and lockdowns across Europe.
The biggest issue was continuing effective oversight and management of the range of delegated functions: administrators, distributors, custodian/depositaries and investment managers. While all of these, and the ManCos themselves, had arrangements for remote working in place under their business continuity plans (BCP), the pandemic provided an unprecedented live test. Indeed, very few if any BCPs would have envisaged a global outage where shifting work to another location or a BCP site was not an option and the majority of the industry switched to working from home.
The most striking thing about the last few months is how few issues there have been. Delays or outages in valuations, reporting and other services have been remarkably rare. Oversight of delegates is difficult when on-site visits haven’t been possible. Still, regulators recognized this and showed flexibility. Virtual onsite inspections have worked well, as have virtual fund board meetings.
Challenges remain, of course, and some will grow rather than diminish over time if we see further restrictions with a second wave of the virus. In particular, while the switch to remote working has generally gone smoothly, we are all still learning. Maintaining a team culture, encouraging collaboration and safeguarding morale in a virtual world are all issues that require attention. Recruitment, too, remains challenging.
Overall, though, the industry as a whole has coped remarkably well.
Levelling the playing field
The greater challenge for ManCos and others in the medium term is likely to come from regulators picking up where they left off when the virus struck.
Concerns over the governance and substance of ManCos are long-standing. Authorities are keen to tackle “letterbox entities”: corporate registrations in an EU jurisdiction to allow marketing of funds throughout Europe, without a genuine presence and local resources.
Regulators in both Ireland and Luxembourg–the leading centers for cross-border funds–have both addressed the issue in recent years. The Central Bank of Ireland published Fund Management Company Guidance in December 2016, after two years of industry dialogue. Luxembourg’s Commission de Surveillance du Secteur Financier (CSSF) issued a circular in August 2018 covering much of the same ground.
Brexit has significantly increased the pressure on both. The European Securities and Markets Authority (ESMA) is deeply concerned about the possibility of regulatory arbitrage, with UK firms shopping around for the lightest touch regime in Europe. Consequently, it established a supervisory coordination group to harmonize the response to Brexit related applications. This can be seen in the increased level of substance being required in many EU jurisdictions. This escalation of requirements is likely to be reflected in the Central Bank of Ireland’s publication of its review of the implementation of the Fund Management Company guidelines, due in Q4 2020. This will also impact pre-Brexit authorizations requiring them to re-evaluate their level of substance against the new expectations.
It will also be felt in the review of AIFMD being conducted by the European Commission starting in Q4 2020. ESMA’s letter to the Commission this August is worth an article on its own and substance/ delegation are at the heart of many of ESMA’s observations in the letter. It called for several changes, including greater harmonization of AIFMD and UCITS, and a focus on delegation and substance. In particular, it urged a focus on the extent of delegation, liquidity risks and the risks of white label solutions.
Tipping the balance?
Ultimately, the choice of whether to use a ManCo, captive or keep management in-house comes down to a question of cost and control. Investment companies must decide whether the savings achieved by using a third party ManCo compensate for handing over the regulatory, risk and compliance function to a third party.
That won’t change, but the regulatory focus on substance could alter the relative weight of each side of the equation. Greater demands from regulators for substance is likely to increase the headcounts required and demand for human resources in these areas. That, in turn, will potentially inflate salaries and add to recruitment difficulties. (It’s worth noting that seconded staff, an alternative that many have chosen instead of going for a third party ManCo entirely, was another area mentioned in ESMA’s letter.) All of this is likely to push up the cost of compliance.
At the same time, regulatory pressure on fees continues to grow. The FCA’s insistence that funds perform an annual “value for money” assessment is being closely followed by ESMA and the local EU regulators. Longer term, this will at least limit opportunities to pass on additional costs in fee rises.
Cost, then, is likely to be an increasing concern, and third party ManCos have the potential to offer a scalable, cost-effective solution. To do so, they need to demonstrate genuine independence (managing any conflicts between revenue and governance). They also need sufficient financial strength to be able to supply the required regulatory capital to manage any blow-ups. Finally, they need to meet all their regulatory obligations consistently – not only to protect their own reputations, but also those of the fund managers, their funds and the shareholders associated with them.
This article was first published by International Investment on October 14, 2020.