In the first quarter of 2018, private fund managers saw a number of important European regulatory changes take effect, with additional changes in the pipeline. This note is intended to summarize certain headline changes, and should be of interest to managers active in, and marketing into, Europe. Highlighted changes include:
- the entry into force of the Second Markets in Financial Instruments Directive (“MiFID II”), in particular changes to the classification of local authorities;
- the entry into force of the Packaged Retail and Insurance-based Investment Products (“PRIIPs”) Regulation, in particular the requirement for the production of a key information document where materials are made available to retail clients;
- changes to the European Venture Capital Funds Regulation (the “EuVECA Regulation”);
- changes to European data protection rules under the General Data Protection Regulation (“GDPR”); and
- the announcement this week of a proposal for a new European Directive on the cross-border distribution of investment funds (the “Distribution Directive”), which (amongst other things) seeks to introduce a harmonized definition of “pre-marketing”.
MiFID II came into force across the EU on 3 January 2018. A detailed examination of MiFID II is outside the scope of this note, and since implementation has been a work in progress for a number of years, those EU investment firms in the asset management space that have been impacted by MiFID II (including investment managers, investment advisers and placement agents) should by now have completed the required updates to their internal policies and procedures.
One key point worth flagging for EU and non-EU firms alike is the change in default categorization of local authorities, from “professional clients” to “retail clients”. Whilst it is still possible for an EU investment firm to classify a local authority as an “elective professional client”, as long as the local authority fulfils certain criteria (which may vary from Member State to Member State), in the absence of such a classification, it will be a retail client – meaning it is subject to a greater degree of regulatory protection, marketing alternative products is more difficult and, most importantly, it will be within the scope of the PRIIPs Regulation (see below).
The PRIIPs Regulation came into force across the EU on 1 January 2018. The PRIIPs Regulation is primarily intended for the retail investment market, and is designed to improve transparency for retail investors by requiring product manufacturers to prepare a standardized key information document (a “KID”) wherever a packaged retail investment or insurance product is made available to retail clients.
Whilst targeting the “true” retail market, the breadth of the relevant definitions in the legislation means that it will potentially apply much more widely, thus capturing private funds (even though these are typically designed for and marketed primarily to professional and institutional investors) if they are made available to retail clients in any way. The PRIIPs Regulation is applicable not only to EU managers, but also potentially to non-EU managers marketing funds into Europe.
If the offering is confined to the “professional clients” (referred to above), then the offering will be outside the scope of the PRIIPs Regulation. However, the interaction between PRIIPs and MiFID II creates complications around fund offerings to would-be “elective professional clients”, such as local authorities, high-net-worth individuals and certain family offices.
It is not enough that prospective investors qualify for treatment as elective professional clients – the “optup” procedure stipulated in MiFID II must actually be followed. Contrast the position under the Alternative Investment Fund Managers Directive (“AIFMD”) where a prospective investor that qualifies for treatment as an elective professional client is automatically a “professional investor”.
The point here is that only an EU investment firm can formally classify a person as an elective professional client. Therefore, a non-EU manager wishing to market a fund to an EU investor that it knows could be classified as an elective professional (and who is therefore a “professional investor” to whom marketing is permitted) would itself be unable to formally classify the investor as a professional client, meaning it would be required to treat it as a retail client and prepare a KID.
A further inconsistency is that marketing restrictions under AIFMD do not apply where an investor approaches a manager at its own initiative (so called “reverse solicitation”). By contrast, the PRIIPs requirements apply whenever materials are made available to an investor that is a retail client, whatever the basis on which the communication takes place.
In the absence of regulatory guidance, there also remains uncertainty in the market around whether carried interest schemes should be treated as PRIIPs.
The KID is a heavily prescribed document with little discretion as to how it should be completed, and it may be that preparing this is not too burdensome in practice. However, it represents another regulatory hurdle in the EU private funds space, and the nuances referred to above are bound to cause confusion for non-EU managers already struggling to understand Europe’s ever-expanding regulatory framework.
More positively, changes to the EuVECA Regulation came into force on 1 March 2018, which should make the regime for European venture fund managers more accessible (though sadly will be of little use to non-EU managers).
One of the key changes is the broadening of the definition of “qualifying portfolio undertaking”. By way of recap, in order to qualify as a “qualifying venture capital fund” (to which the EuVECA Regulation applies), a fund must intend to invest at least 70% of its aggregate capital contributions and uncalled committed capital in assets that are “qualifying investments”. Whether or not an investment constitutes a “qualifying investment” depends in part on whether the instrument pursuant to which the investment is made is issued by a “qualifying portfolio undertaking”. The definition of “qualifying portfolio undertaking” has now been relaxed, increasing the scope of the EuVECA Regulation and enabling EuVECA funds to invest in unlisted companies with less than 500 employees, small and medium-sized enterprises listed on an SME growth market (with a market capitalization of less than €200m) and to allow follow-on investments which would otherwise push the existing portfolio company outside the relevant criteria.
The revisions also allow full scope EU AIFMs (larger managers) to access the EuVECA regime, lifting the cap that previously restricted the EuVECA manager designation to “sub-threshold” EU AIFMs, whilst making it clear that local marketing fees should no longer be levied by “host” state regulators, and specifying guaranteed turnaround times for the registration of new managers.
The flip side is that the new rules also introduce regulatory capital requirements for EuVECA managers for the first time, but at the higher of 1/8 fixed annual overheads or €50,000, these are substantially lower than those in place for a full scope AIFMs, and should not stop the regime from being attractive.
GDPR is due to come into force across the EU from May 2018, and anyone that collects or processes “personal data” relating to EU individuals should review their data protection policies and practices as a consequence.
For many managers in the private funds space, the impact should be relatively limited – it may well be that a certain amount of personal data is collected in connection with investors, and this will therefore require the review referred to above, but these managers are not really in the business of collecting or processing personal data, and consequently a proportionate approach should be taken.
However, this does not mean do nothing, or simply adjust disclosures in investor-facing documents. Managers should be auditing the personal data they hold so that they at least understand what data they are holding and why they are holding it, determining the legal basis on which they are doing so, determining the basis on which it will be shared with others – particularly others that are based outside the EEA and that may not be subject to the same regulatory requirements – and looking at amending existing contractual arrangements to ensure compliance.
This may be a relatively limited exercise for most private fund managers, but it should not be overlooked – the very significant increase in penalties for breach (€10m or 2% of global revenue for minor breaches, rising to €20m or 4% of global revenue for significant breaches, in each case whichever is the higher) means that there is every reason to get this right.
The European Commission this week published a proposal for a Distribution Directive, which would amend various pieces of European funds legislation (including the AIFMD) with the intention of reducing regulatory barriers to the cross-border marketing of funds within the EU. The proposal is open for comment until 8 May 2018.
A key change for private funds under the draft Distribution Directive is the introduction of a harmonized definition of “pre-marketing”, coupled with a provision which establishes conditions under which an EU AIFM may engage in pre-marketing activities.
Currently, pre-marketing is only recognized in certain EU Member States. It is a matter of national law or regulatory guidance. There is currently a divergence in approaches across the EU, with certain Member States (including the UK) recognizing distribution of promotional presentations and draft offering memoranda as “pre-marketing”, and others taking a much more restrictive stance.
The introduction of a harmonized pre-marketing concept is therefore theoretically welcome. However, there is some concern about scope. Pre-marketing is set to be defined as the “provision of information on investment strategies or investment ideas … to professional investors … in order to test their interest in an AIF which is not yet established”. Under the proposal, no offering documents, even in draft form, could be provided at this stage, and where an AIF has already been established then communications would not be regarded as pre-marketing and the relevant marketing approvals would need to be in place.
Whilst it is helpful that even those EU Member States that have not previously recognized pre-marketing would be required to do so under this proposal, the scope is considerably narrower than that already in place in many EU Member States. This may present difficulties in practice, in particular for open-ended funds that have already been established and marketed in other jurisdictions. It is therefore hoped that the scope will be reviewed during the consultative process.
In addition, the proposal only addresses pre-marketing by EU AIFMs. It therefore remains unclear whether Member States will apply the same principles in the context of offerings under National Private Placement Regimes, where non-EU managers will be keen to gauge the interest of European markets before making the relevant registrations. Whether such interest can be gauged however based solely on the “provision of information on investment strategies or investment ideas”, and without reference to fund terms, is another matter.
As currently drafted, the Distribution Directive will not require Member States to transpose these new provisions into national law until 24 months after it enters into force. As such, managers will continue to have to navigate divergent local pre-marketing laws for some time.