Patricia Volhard, Debevoise & Plimpton
Until quite recently, the private equity industry has been rather relaxed about Brexit and its potential impact on their operations. However, it has become necessary to think a bit harder about potential alternatives, now that a hard Brexit is suddenly a real option which will have an impact on each sector of the financial industry.
This decision has potential consequences on nearly all aspects throughout the life of an investment fund, from fundraising, to deal sourcing and exit, to taxation of the fund. As the deadline of March 2019 draws ever closer, no transitional period is agreed upon yet (at the time of writing), and the post-Brexit world still has to take shape. At this point even optimists have to ask themselves if they are willing to bet the continuity of their business on their predictions. It is no surprise that those possibly affected are busy taking precautions for the worst-case scenario: a no-deal Brexit. Private equity sponsors are also facing questions from their investors on how they will deal with Brexit, and they need to be able to give a convincing answer.
With next March approaching, more and more private equity sponsors reach the conclusion that they cannot wait any longer for clarity, and are moving from relying on an orderly Brexit to actually implementing changes preparing for the scenario of a no-deal Brexit, although much remains unclear, in particular for private equity managers and their advisers.
Not surprisingly, the uncertainty is mostly felt by UK private equity sponsors, and by extension, US sponsors that have opted for London to establish their EU presence. Sponsors who have established a UK alternative investment fund manager (AIFM) to manage their UK funds will no longer be able to rely on the marketing passport afforded to them by the Alternative Investment Fund Manager Directive (AIFMD) to market their funds throughout the EU. Sponsors who have decided to establish UK funds, either instead of Channel Island funds or as parallel sleeve to US funds to accommodate investor preferences for EU funds, may no longer be able to achieve those goals. For those having established a UK AIFM several years ago for the purposes of having an EU structure in place for their EU investor base, the question is whether such a UK AIFM would still be fit for purpose after a no-deal Brexit. A UK AIFM could not necessarily manage all EU funds.
While Luxembourg, for instance, allows non-EU AIFMs to manage Luxembourg funds, this is not the case in all jurisdictions.
Another question to answer is whether the regulatory burden to maintain an authorised AIFM is still justified if the marketing passport is no longer available.
Many UK private equity sponsors who want to continue to rely on the marketing passport, or to be able to offer their investors EU structures, are already migrating their UK funds into EU jurisdictions. Some who are not yet ready (or not in a position to build a new AIFM in the EU) are choosing to approach third-party service providers to serve as AIFM which will, in turn, engage the sponsor as investment adviser or delegate portfolio management to the sponsor. Others are establishing their own AIFMs, preferably in Luxembourg or Ireland.
Foreseeing this development, the EU regulators ESMA and EBA have focused in the past year on the delegation rules of the AIFMD, and made an effort to coordinate with national regulators to avoid a race to the bottom to compete for UK business. They have emphasised that the AIFMD does not allow for letter-box AIFMs and warned that they would not tolerate UK sponsors establishing an EU AIFM and delegating basically all material functions back to the UK.
In the wake of those proclamations, some national regulators have published additional guidance on the substance required for AIFMs established under their supervision. While larger market participants are not facing challenges to simply ramp up staff where needed, smaller sponsors may have to ask part of their staff to move, or engage local directors for hire.
At least with respect to fund vehicles, Luxembourg seems to be the preferred jurisdiction at the moment. Luxembourg partnerships (usually organised as unregulated SCSps) are well established in the market. Ireland would seem to be the first choice as a common law jurisdiction rooted in UK law, which also feels familiar to US sponsors and investors, and is a known investment fund hub. But Ireland lacks a suitable partnership structure and has not previously been a destination of choice for private equity funds.
Despite reform efforts, Ireland is not currently able to offer a limited partnership structure that functions as a viable fund vehicle, and most private equity sponsors prefer limited partnerships to Ireland’s bestseller, the corporate ICAV. It remains to be seen when the anticipated reforms of the Irish investment limited partnership are passed and if, at that point, the train has already left the station. Once the funds have migrated or been established in Luxembourg, Luxembourg will likely stick for many sponsors.
A considerable number of UK funds and their managers are established on the Channel Islands. On first sight, one might ask how much those funds are really affected. After all, they have been non-EU funds all along. However, the actual fundraising and deal sourcing for those funds are often undertaken by an authorised UK investment firm regulated under the Markets in Financial Instruments Directive (MiFID), which until now have been able to conduct such services on a cross-border basis in Europe.
A similar issue arises for US sponsors who do not necessarily maintain a UK fund manager, but rather a UK investment firm advising the US manager regarding fundraising and deal sourcing in Europe. Sponsors who have just migrated their funds out of the UK and prompted their new AIFM to enter into an advisory agreement with their UK based investment firm are in a similar situation.
Focused on the European single market, MiFID leaves the regulation of third-country firms’ activities in Europe largely to the national law of the respective member states, at least until the third-country passport recently introduced by the recast MiFID (MiFID II) will take effect. This leaves UK sponsors with the questions of whether their fundraising and deal-sourcing activities in EU member states are regulated activities in the EU, and if they can meet the necessary requirements.
Unfortunately, these are questions which are rather unclear on the Continent. A variety of interpretations are available in the EU. Some member states apply their regulatory laws only if material relevant acts are performed on their territory. Other member states look at where the client is located to decide when their regulations are triggered. Different views may also be taken on one-off and on irregular activities, and if those fall under applicable regulation.
Previously, UK sponsors were able to avoid answering those questions, as under UK rules they were generally seen to be subject to licence requirements and hence they could simply obtain a passport for other EU countries. For instance, as relatively lightly regulated adviser/arranger, they were able use the MiFID passport to engage in fundraising and deal sourcing throughout Europe under the supervision of a regulator known for their more practical than heavy-handed approach without concerning themselves with the nuances of the different national regulations. This simplicity and legal certainty also played into the decision of many US sponsors to establish a presence in London and gain a foothold in the European single market.
Brexit leaves UK advisers active in the EU with the options to either take a country-by-country approach and design their future activities around each EU member state’s individual regulatory regime, or to remain in the single market by having a regulated subsidiary in the EU.
By taking a country-by-country approach, sponsors may also, depending on the relevant member states, restrict the scope of their activities and considerably increase the red tape in their compliance guidelines that has to be observed on a day-to-day basis. They will also have to weigh legal certainties with practical consideration; there will be more than a few grey areas where the laws are ambiguous, or not precisely drafted, and no administrative guidance exists.
If the sponsor decides to remain in the single market, there are several options to do so. Each sponsor has to look at the character of its own business to decide which approach is right for them. Options include opening an EU subsidiary outside the UK and obtaining a MiFID licence, establishing an EU office as tied agent of a third-party MiFID firm to piggyback on its passport (much like the service provider AIFM model described above), or moving away from MiFID adviser/arranger model and relying on the AIFM and the AIFMD.
ESMA is currently working to alleviate another issue that has the potential to become a regulatory headache. The AIFMD relies heavily on cooperation agreements when it comes to regulating third-country relationships. Most relationships involving non-EU countries, from marketing over delegation to cross-border management, require a cooperation agreement between the regulators of the relevant non-EU country and the relevant EU member state. A no-deal Brexit without such agreements in place between the FCA and their EU counterparts could have the potential to bring most fund-related activities involving the UK to a screeching halt.
Even though such cooperation agreements are entered into between the competent regulatory authorities, ESMA is taking the lead on behalf of national regulators leading discussions. Cooperation agreements are important to make sure that, for instance, delegation to the UK remains possible even in the case of a no-deal Brexit.
EU AIFMs intending to market to UK investors have less reasons to be concerned. The UK government has announced that it wishes to maintain continuity for any EU AIFMs using the marketing passport to market funds in the UK prior to Brexit. It intends to bring forward new legislation (pursuant to powers included in the UK’s European Union (Withdrawal) Act 2018) to give eligible EU AIFMs access to a temporary permissions regime. To be eligible for entry into the temporary permissions regime, it is expected that EU AIFMs will need to be authorised to carry on a regulated activity in the UK under the EU passport regime pre-Brexit, and to have exercised that right with regard to the specific fund in question. Even if those plans do not come to fruition, the UK’s national marketing regime for investment funds does not put up much red tape.
UK sponsors may also look to the third-country regimes set out in the AIFMD and MiFID. Brexit might even reinvigorate the efforts to put the AIFMD third-country regime in motion. That was scheduled for late 2015, but seems to have been on the backburner until now. The AIFMD third-country regime affords non-EU AIFMs the same privileges as EU AIFMs in exchange for complying with the AIFMD and submitting to the supervision of the regulator of an EU “reference member state”.
With the AIFMD regime already in place, UK AIFMs should have the least trouble to meet this condition. The MiFID third-country regime allows investment firms authorised in a non-EU country with an equivalent regulatory regime to provide investment services to per-se professionals (notably not including elective professional investors like individuals and medium-sized companies). However, with the timing on those regimes unclear, this seems a more medium-term option than a reliable solution for March.
In the end, operators in the private equity industry are left with the unsatisfying situation that they have to prepare for Brexit based on unclear premises, with almost daily updates on the developing situation. There isn’t a one-fits-all Brexit master plan, and each sponsor will have to assess with their advisers which solution best suits their business model, investment strategy and investor base, and what the costs are. With so much being unclear it remains important to get investors onboard by ensuring maximum transparency on compliance efforts to justify the costs, in case the dust settles and it (unexpectedly) turns out that some of the concerns were “much ado about nothing”.