Funds Regulation: A brighter distribution future?

funds europe

contents 01 Introduction

Three pending pieces of regulation can affect fund managers and their business

02 Overview

It’s time to brush up on the upcoming regulatory changes

03 UCITS IV Directive

This European directive aims to bring more harmonisaton across the continent

06 AIFM Directive

The most controversial piece of legislation seeks to add a greater level of supervision

08 Retail Distribution Review A UK initiative that will increase protection for retail investors

For more information Penelope Biggs, head of asset servicing business development, EMEA [email protected] +44 (0)20 7982 2200 Karen Hamilton, head of fund administration product development [email protected] +44 (0)20 7982 2234 northerntrust.com

INTRO

An industry takes note: Three is the magic number Undertakings for Collective Investment in Transferable Securities IV Directive, the Alternative Investment Fund Managers Directive and the UK’s Retail Distribution Review, are all pending pieces of legislation that can affect a fund manager’s order of business.

If you did not know that institutions could achieve a 50 basis points reduction in tax drag by investing in a master feeder fund when the Undertakings for Collective Investment in Transferable Securities (UCITS) IV Directive goes live, then it is time to brush up on regulation. Rarely, if ever, has the fund management industry faced such a barrage of regulation as it does at present. The UCITS IV Directive looms over the industry, as does that other European-wide proposal, the Alternative Investment Fund Managers Directive (AIFM). Then, in the UK, there is also the Retail Distribution Review (RDR), which will affect many managers from Europe with business there. The number of major regulatory initiatives affecting fund management firms – three – may seem small on the surface, but each of them is set to converge in the same year, 2012. They affect a fund manager’s business from the front office right through middle, to

‘We have a watching brief where we look at all regulatory issues. Our clients’ businesses are being impacted by all three of these developments’

the back. They even affect a fund manager’s external providers. These third-party investor service firms are often looked to for thought-leadership or guidance on regulatory matters and Northern Trust, a major asset servicer, here presents a synthesis of these three regulatory

challenges and how fund managers should prepare for them. “We have a watching brief where we look at all regulatory issues,” says Karen Hamilton, head of fund administration product development at Northern Trust. “Our clients’ businesses are being impacted by all three of these developments.” Each body of regulation cannot be looked at in isolation, she says. “There are synergies between the three although from a regulatory point of view they may not seem very joined up.” And the rules affect more firms than they may appear to at first glance. Do not forget that the AIFM Directive is not just about hedge funds. As Hamilton says: “Any fund that is not a UCITS fund is affected.” The Northern Trust guide describes how these pieces of legislation will affect them and discusses appropriate responses. 2012 is not that far ahead, so an early start is advised. 1

OVERVIEW

Why change means opportunity

The European funds industry faces a barrage of new regulations over the next two years. Northern Trust explores three significant regulatory initiatives: The Undertakings for Collective Investment in Transferable Securities (UCITS) IV Directive, the UK’s Retail Distribution Review (RDR) and the European Union’s Alternative Investment Fund Managers (AIFM) Directive. The initiatives all have one thing in common: they are all due to converge throughout 2012 so investment managers should be considering implications on their business model. Although all three initiatives share similar overriding goals – increased investor protection, greater transparency and a more harmonised European investment landscape – they each have their own means of reaching these goals. They are all at different stages of development; they all have different timetables; they have different industry drivers; and they will impact different businesses in different ways depending on the distribution of and nature of their investments. “Investment

Gerry Brady

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‘Investment managers must understand the implication of each regulation, recognise the potential opportunities that exist as well as overcome the significant challenges they present’

Karen Hamilton

Wilson Leech

managers must understand the implication of each regulation, recognise the potential opportunities that exist as well as overcome the significant challenges they present,” says Wilson Leech, head of Northern Trust’s Global Fund Services business. “The key opportunity for investment managers will be an increased ease of distribution across Europe. Europe’s supervisors are looking for ways to get more investors investing in the markets and to keep them involved while providing a framework for improved governance. The challenge for the regulators is to ascertain the appropriate level of oversight so that the market becomes more and not less efficient. The challenge for investment managers is understanding the impact the regulations will have on their business and their investor base and the overhead required to support and implement these. Whether they are based in Europe, the United States or Asia-Pacific, these regulations may impact how they do business so they need to be prepared.”

Mark Schoen

Revel Wood

UCITS IV

UCITS IV – a more harmonised Europe? The UCITS brand has been a resounding success for Europe’s funds industry, particularly in its most recent guise. However, there is always room for improvement and UCITS IV aims to address the limitations of its predecessors and to take the principle of harmonisation further across the European landscape. The Directive comprises five key elements: • The ability to create a master feeder fund • A simplified notification process (SNP) • The ability to merge cross-border funds • Simplification of the key investor documentation (KID) • Passporting of a fund management company In terms of the regulatory timetable for UCITS IV, the Committee of European Securities Regulators (CESR) will be providing its advice to the EU Commission who will then look to adopt implementing measures by July 2010. Member states will then be required to implement the directive into national law by July 2011. Historically, it is at this stage – the handover of the rulebook from the European Union (EU) supervisors to individual state supervisors – that inconsistencies can emerge and the threat of regulatory arbitrage may loom large. For new funds it is clear that from July 2011, the UCITS IV Directive will apply, however, clarity is still required on the conversion process and timeline for existing funds. Regardless, investment managers should already be looking at the Directive and the potential opportunities and challenges it presents for their business. Ability to create a master feeder fund The master feeder fund stands out as the most significant opportunity under UCITS IV for investment managers. “For the first time under the UCITS banner, managers will have the opportunity to rationalise and consolidate their asset management activities. At the same time this structure will facilitate their distribution strategies by supporting a range of feeder funds to meet different investor requirements, therefore the establishment of a master feeder

The master feeder fund stands out as the most significant opportunity under UCITS IV for investment managers

fund should be a key consideration for most investment managers who distribute their funds cross-border,” says Karen Hamilton, head of fund administration product development, Northern Trust. The choice of vehicle for the master fund will be a key decision. As a pioneer of cross-border pooling for multinationals and investment managers, Northern Trust has seen how the use of the Irish Common Contractual Fund (CCF), the Luxembourg Fond Commun de Placement (FCP) and the Dutch Fonds voor Gemene Rekening (FGR) can not only provide fund management consolidation but can also mitigate the tax drag of investing in a fund with a heavy equities bias. The end result would be a win-win for investors and investment managers alike. “By using a tax-transparent structure the feeder funds would remain tax neutral and therefore retail investors would continue to benefit from their local tax regime. Institutional investors investing directly into a master fund could benefit from a 20 to 50 basis point reduction in tax drag. For example, a UK corporate pension plan will eliminate 42 basis points in tax drag on its returns by investing in a tax-transparent CCF fund benchmarked to the MSCI World

Index, as opposed to the same investment via an Irish Variable Capital Company (an opaque vehicle). This calculation is based on Northern Trust’s experience applying withholding tax rates for investors under these two different scenarios. Meanwhile investment managers would enjoy economies of scale from consolidating their activities on a single operating model,” says Hamilton. The example in Figure 1 overleaf shows how this may work in practice. Finalised level two guidelines due at the end of June will provide greater clarity around the implementation of a master feeder fund, which will be essential for any fund manager considering this structure. The Directive sets out detailed rules in relation to UCITS master feeder structures that are designed to ensure a consistent governance structure applies to both master and feeder fund. This will involve additional legal agreements between the master and feeder fund as well as their depositaries and auditors. Additionally, it will be vital to ensure the master feeder structures work on a day-today basis and there is consistency on matters such as: • Pricing policy • Pricing error policy • Depositary notification, dealing and settlement policy • Fund distributions and year-end process • Reporting required for all investors and who is responsible: the master or the feeder fund. What is clear is that careful consideration and planning will be required in order to maximise the potential opportunities available through a master feeder fund. 3

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UCITS IV

FIGURE 1: Example master feeder fund structure

In this example, the investment manager has three separate management companies in the UK, Luxembourg and Ireland as well as an authorised corporate director in the UK. The fund range includes a UK open-ended investment company, UK unit trust, Irish unit trust and a Luxembourg Société d'Investissement à Capital Variable (SICAV). Under UCITS IV, the manager could rationalise the fund range into a master feeder structure and also consolidate the three current management companies into one. The choice of jurisdiction for the single management company will be dependent on a number of factors: tax is the main consideration, however, location of the asset management head office, the domicile of the master fund, and the working relationship with the local market regulator will all have to be taken into account.

Simplified notification process The aim of the SNP is to increase harmonisation and reduce bureaucracy by introducing a regulator-to-regulator process which will significantly reduce the time taken to launch an existing fund in a new market. Once a UCITS fund is registered in one EU country it must be recognised as an authorised fund in any other EU jurisdiction, thereby removing any administrative obstacle to it becoming active across different EU markets. “The SNP should facilitate pan-European distribution by removing some of the significant local regulatory roadblocks encountered under UCITS III,” says Hamilton. Managers who have historically only targeted their home market for distribution may now consider branching out as it should be easier to launch into a new market, with the only true additional requirement being the production of the KID 4

in the local language. However, it remains to be seen if the initiative is as successful in practice as it would seem to be in theory,” says Hamilton. “Europe is a continent with multiple cultures and we will have to wait and see if these cultures and their regulators can cooperate to the extent outlined in these revised regulations. If they do then investment managers may well find it considerably easier to distribute their funds into another European country.” Ability to merge cross-border funds Although there is potential opportunity under UCITS IV for investment managers to merge their funds cross-border – with the aim of making the funds industry more efficient and cost effective – the benefits are limited. The reality is that UCITS IV brings with it more regulation in terms of notifying investors and announcing any mergers but without taking

into account the lack of tax harmonisation that exists between the European communities. Under current legislation an investment manager only has to notify the investors of the funds that are to be merged to another fund, whereas under UCITS IV managers are also required to notify the investors of the entity into which those funds are being merged. In the majority of cases investment managers will be merging to larger funds so there would be many investors requiring notification. “Until the key issues are addressed then it is unlikely that the fund merger procedures will result in significantly fewer funds in Europe. In the meantime we are seeing many managers conduct a comprehensive funds review with a view to completing some mergers before the Directive is implemented in July 2012. Consequently there may be some rationalisation of funds in the next couple of years prior to implementation,” says Hamilton. Simplification of the key investor documentation The abridgement of the KID should be good for investors in that it enables them to compare like-for-like investment opportunities through a transparent and standardised document. It has to be produced in the local language of any market in which the fund is distributed and should be easy to understand. According to the Directive, the document should be clear about the fund’s strategy, its performance, the charges, the risk appetite of the fund and any other information which should be considered key. However, by reducing the document to only two pages, its success will depend on how investment managers use the limited space they are given. Investors may find they need a glossary to understand the various terms used as there may not be enough room to explain them all. While it is clear that a 20 page KID is too long, two pages may be too short. Passporting of a fund management company UCITS III achieved many positive things but it did not deliver the ability to passport a fund management company. UCITS IV aims to address this through its management company passport which will give managers the opportunity to have one pan-European UCITS management company rather than one in every jurisdiction. To truly capitalise on this opportunity, investment managers will need to take a number of steps. “They need to

carefully consider the tax and business implications of such a move and undertake detailed analysis of their fund range, jurisdictions, distribution channels and location of investors,” says Hamilton. “Managers also need to understand that the additional governance requirements laid out under UCITS IV will apply to all fund management companies, including self-managed funds and not just those that are looking to avail of the cross-border opportunities.” Other key considerations for investment managers include: • The cost of such a move • Whether to merge existing UCITS management companies into one or to set up a new pan-European management company • Which jurisdictions would best suit their existing distribution and investor base • What their existing relationship is like with their proposed home regulator • How they will address the increased governance requirements, for example the Markets in Financial Instruments Directive (MiFID) rules and the compliance function Overall, there are lots of opportunities presented by UCITS IV but the two mandatory elements are the implementation of the KID and the adoption of the additional governance rules regarding the management company passport. What will be the funds domicile of choice? One implication of UCITS IV is the potential consolidation of funds and their administrator to one jurisdiction. Ireland and Luxembourg will be the two most active jurisdictions but one cannot discount markets with strong investment management such as France, Germany and the UK. “The low tax fund domiciles such as Malta may also have some appeal but I expect that it will be the more established markets that will dominate because clients will want to align themselves with strong regulatory regimes first and foremost,” says Hamilton. “We’re already seeing a strong trend of funds re-domiciling to more regulated onshore environments and until this trend stops it will prove highly challenging for domiciles like Malta to compete with more regulated centres. Overall,

this development is to be welcomed by investors as different jurisdictions compete for their business. From a Northern Trust perspective we are looking to support our clients in making these kinds of decisions. We have extensive experience in the major fund markets and proven expertise and robust processes in supporting pooled vehicle structures.” According to Gerry Brady, managing director, Northern Trust Ireland, any funds centre in Europe could become the domicile of choice for UCITS funds but such is the groundswell that has built up in Ireland and Luxembourg over the last few years that it is difficult to imagine the likes of the UK or France becoming more dominant. “In Ireland and Luxembourg there is already the political will and much simpler economies making it easier to present a more accommodating tax regime for fund promoters and service providers, as well as investors.” Brady refers to the recent clarification contained in the Irish Finance Act, 2010 which confirmed that non-Irish resident funds that are managed by an Irish management company will not be deemed to be tax resident in Ireland. “This clarity is helpful and shows Ireland’s appetite to position itself as a domicile of choice for UCITS IV master funds and their management companies. And if we continue to have the Finance Minister, Brian Lenihan making positive statements and building partnerships between government and business, then I think Ireland can do very well in the UCITS IV market given its strong regulatory regimes with a proven track record and well developed financial services infrastructure.” It is a similar tale in Luxembourg according to Revel Wood, head of client service and business development, Northern Trust Luxembourg. “The Association of the Luxembourg Fund Industry (ALFI) has been heavily involved in the formation of UCITS IV and has been very active in the consultation process. There has also been significant input from local accounting and law firms in advising investment managers on what they should be doing in preparation for UCITS IV.” In concurrence with his Ireland counterpart, Wood believes that Luxembourg and Ireland will continue to prosper under UCITS IV due to the well established infrastructure in these jurisdictions. “These jurisdictions complement each other: Ireland tends to cater for the Anglo-Saxon managers, while Luxembourg

The low tax fund domiciles such as Malta may also have some appeal but I expect that it will be the more established markets that will dominate remains attractive to managers looking to distribute across mainland Europe and Asia, owing to the multilingual capabilities and central location in Europe. Luxembourg will remain an attractive location in the longer term as it has a stable and business-friendly political environment, combined with an economy heavily reliant on the funds industry. The industry associations like ALFI work very closely with the Commission de Surveillance du Secteur Financier and business leaders allowing the industry to adapt quickly to the changing regulation and needs of managers, as evidenced by the success of the introduction of the Specialised Investment Funds law for alternative funds.” The competition between Ireland and Luxembourg need not mean one domicile succeeds at the expense of the other, according to Brady – therefore the important issue for service providers is that they continue to offer a credible support service in both Luxembourg and Ireland. “I don’t think it will be a straight forward win or lose situation with wholesale migration of business to one or other of the two jurisdictions. And I think the end-investors are not too concerned with what goes on behind the scenes as long as they receive the right quality of service, get value for money and can speak to someone knowledgeable in their domicile of choice when they need to. Therefore it is important that there is a credible and knowledgeable presence in all of the feeder jurisdictions.” For every investment manager the potential impact of UCITS IV is different and only time will tell whether the Directive truly achieves its goals of a genuinely open panEuropean market. However, depending on their business, managers also need to assess the impact of and opportunities presented by the AIFM Directive as well as the Retail Distribution Review in the UK. 5

AIFM DIRECTIVE

The Alternative Investment Fund Managers Directive – a greater level of EU supervision The AIFM Directive is the newest piece of legislation facing the funds industry and is perhaps the most controversial. The AIFM Directive was drafted by the EU in response to a series of high-profile scandals, including Lehman Brothers and Madoff and aims to provide a framework for direct regulation and supervision of the alternative fund industry. The political nature of the Directive’s origin creates a challenge for Europe’s supervisors – they must be seen to be responding to recent, highly public events but any Directive that emerges must also be practical and implementable for market participants. According to some of the Directive’s critics, the whole project resembles a bar-room brawl in that the people being hit are not necessarily the ones who started the fight, or even threw the last punch. They say the legislation has been rushed through in an emotionally and politically charged atmosphere and this kind of approach tends to polarise opinions, particularly between different regions. Although there are aspects of the draft Directive that have been welcomed by the alternatives industry, there are some key areas where the industry is still seeking greater clarification. Depositary requirements The first of these concerns is the depositary requirements. The AIFM Directive significantly increases the scope and potential magnitude of the depositary’s liability in respect to a fund, particularly in relation to its sub-custodians. This creates a substantial systemic risk in the case of sub-custodian failure. The additional liability will also increase the depositary’s costs, which would have to be passed onto investment managers and investors. The industry has 6

suggested that a better approach would be to make the AIFM Directive depositary rules consistent with existing UCITS rules. Valuation Valuation is another area where overlap exists between UCITS and the AIFM draft Directive. The valuation function should be segregated from the investment management function to ensure independence and may be delegated by the alternative investment manager to an administrator for example, in line with the Alternative Investment Management Association’s recommendations on best practice. Critics argue that one of the major failings of the AIFM Directive is that it does not recognise the existence and responsibility of the board of directors for alternative investment funds (AIFs). The Directive seems to have been drafted on the premise that all AIFs are quasi-managed accounts where the investment manager is all powerful. In the majority of cases it is the directors who have responsibility for making sure a valuation policy is in place. To assign this responsibility to an undefined third-party – the valuator – assumed to be the administrator in practice, and to place unlimited liability with the administrator for this new responsibility is clearly questionable. Delegation and marketing passport/private placement Further clarification is also required on the delegation of activities. The Commission has proposed that portfolio management and risk management can only be delegated to another AIF manager and sub-delegation should be prohibited. Although some of the newer suggestions appear to improve the original proposal, this area remains unclear. This is a similar situation to the area of marketing passport/private placement where, despite significant progress greater clarity is still required concerning scope and governance. The latest draft of the Directive was circulated in March with Spain, the current holder of the EU’s rotating presidency, pushing for a resolution before the end of its term at the end of June. During this period the EU Council Working Group and the Spanish presidency are continuing to meet and liaise with the Parliament’s rapportuer to establish agreement on the Parliament text. A trialogue phase between the Commission, Parliament and Council is set to take place between May and June with a possible plenary vote and adoption to take place in July.

Critics argue that one of the major failings of the AIFM Directive is that it does not recognise the existence and responsibility of the board of directors for alternative investment funds

“Northern Trust has studied the draft proposal in depth and is closely monitoring any further developments and their implications for the market and its participants. This includes participating in a number of industry working groups such as the Association of Global Custodians, the Irish Funds Industry Association, the European Fund Management Association and the Alternative Investment Fund Managers Association,” says Mark Schoen, head of product development EMEA at Northern Trust. The immediate reaction to the Directive from the alternatives world was that hedge funds could be forced to operate from outside of the EU to either off-shore domiciles or Switzerland. However, given the current trend of hedge funds to seek greater and more transparent regulation and the potential overlap between the draft Directive and the UCITS model, there could be an even greater take-up of the UCITS funds structure by alternative managers. This could mean yet more business for Luxembourg and Ireland as well as an increase in convergence, says Schoen. “We are already seeing AIF managers hedging their bets and setting up products in EU domiciles in the wake of the proposed legislation. Quite rightly there has been a lot of focus on the product range which can be accommodated within a UCITS III wrapper (which also takes the fund out of the AIFM Directive) but Northern Trust is also working with clients on non-UCITS products available in the EU regulated jurisdictions such as Ireland’s Qualified Investment Fund which can be authorised quickly and for which investment and borrowing constraints do not apply. In general I think greater convergence will be good for the market in terms of relative comfort for investors but I also think it will restrict returns. Long/short funds and event-driven investments and convertible arbitrage can all fit into a UCITS structure. But there will still be those strategies and asset classes that do not fit into a UCITS structure and require a lot of leverage. So that is a challenge for the regulators and the market – to accommodate both ends of the alternative funds spectrum.” As for Northern Trust’s clients, Schoen says, “We are advising them to keep their eyes and ears open, to stay close to their custodians/administrators and industry associations and to not make any sweeping changes until it is clear what the Directive will entail.” 7

RETAIL DISTRIBUTION REVIEW

The Retail Distribution Review – providing investor transparency on charges The RDR is a regulatory initiative limited to the UK market and designed to add further protection for retail investors.

Despite being focused on the UK, the RDR will nevertheless affect any fund that is distributed in the UK to retail investors so compliance will stretch beyond the UK borders in many cases. Furthermore, the EU has commenced a study – the Packaged Retail Investment Products – the findings from which may lead them to introduce similar legislation in other European markets. Investment managers should 8

Investment managers should keenly watch any developments on the RDR even if it does not directly impact them

therefore keenly watch any developments on the RDR even if it does not directly impact them today. The main goal of the RDR is to help ensure that UK retail investors are given good and proper advice at all times and to mitigate the effect of uninformed or unscrupulous independent financial advisers (IFAs). The RDR will demand more transparency around what consumers are

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paying for – the servicing or the expertise – and look to answer queries such as why some IFAs receive regular commissions without providing regular advice. From the investment managers’ perspective, the main issue is how retail investors will now pay for their services and the likely change from regular commissions to a flat fee. The need for more transparency around fees may also impact the distribution chain. Potential investors will have to pay an up-front fee for their advisory services but this may not be possible or desirable for many retail investors, particularly if they cannot be convinced that they are going to receive better service and a good return, even if the process does become more transparent. This may see distributors targeting high net worth individuals, possibly at the expense of the more modest investors. The rules are due to come into force in 2012 but greater clarification is still required. On 26 March 2010 the FSA issued a further consultation paper 10/6 which the industry is gradually digesting. The paper reveals that the FSA has gone ahead with its proposals requiring firms to describe their advice services as either “independent” or “restricted” to improve clarity for consumers on advisory services. In particular the FSA has extended the range of products to which its rules apply so that firms providing independent advice will be expected to conduct a detailed and fair analysis of the broader range of retail investment products. In addition, they have also looked at the potential for remuneration bias so that under the new rules, adviser firms will no longer be able to receive commissions set by product providers in return for recommending their products. Instead they will have to operate their own charging tariffs. In the event that they wish to do so, providers will be able to facilitate the collection of adviser charges through the product on a matched basis. The FSA has also made some changes to its rules and guidance on the inducements, to reflect the introduction of adviser charging and to ensure that it cannot be circumvented by firms being paid through “soft commissions”. Despite these developments, there is still much uncertainty as to how the RDR will work in practice, says Hamilton. “In terms of opportunities much will depend on the outcome of the ongoing consultation with the industry and feedback statement from the FSA which is due in the 3rd quarter 2010.”

Looking forward to 2012 The next 18 months promise to be highly challenging and preparation will be vital for investment managers worldwide. “At Northern Trust many of our clients viewed 2009 as the year of survival whereas 2010 and beyond is very much about opportunity,” says Leech. “We believe that our global operating platform allied with our multijurisdictional expertise means we are well positioned to help our clients navigate these changes and to help them capitalise on the increased ease of distribution, increased

investor protection and greater transparency across Europe.” There is still a lack of clarity around some of the uncompleted regulatory drafts, making it difficult for investment managers to understand how their business will be impacted and put a strategic plan in place. What will be critical to their success is working with a partner that can help them achieve this – and more importantly working with a partner that has the expertise and solutions to enable them to capitalise on the significant growth opportunities in store.

‘At Northern Trust many of our clients viewed 2009 as the year of survival whereas 2010 and beyond is very much about opportunity’

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For more information Penelope Biggs, head of asset servicing business development, EMEA [email protected] +44 (0)20 7982 2200 Karen Hamilton, head of fund administration product development [email protected] +44 (0)20 7982 2234 northerntrust.com

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