The UK investment management industry is, from a variety of perspectives, an important industry. With the Brexit clock now ticking, is there huge uncertainty ahead or is the industry largely secure? Can investment managers get on with their business or should they put their plans on hold for the next 23 months until the future becomes clearer?
There are “experts” pointing in both directions. This article examines sources of income for UK investment managers to establish the extent of any risk and will also consider the position of investment managers in the U.S.
Set out below is a brief analysis having regard to the existing framework of laws in place and in progress in relation to targeted sales to clients and investors in the continuing EU member states (the “EU 27”). The article assumes that no special deal will be given to the UK and equally that the EU will not change the existing legal framework to “punish” the UK by giving it a worse legal position than that already applicable to other countries outside the EU. This seems a reasonable start point.
The three sources of UK investment manager income
UK based investment managers receive their income from, broadly, one or more of the following three sources:
- Income from managing UCITS (broadly, European retail funds).
- Income from managing AIFs (broadly, specialist or alternative investment funds).
- Income from segregated accounts (individual investor accounts).
Additional specialist areas tend to be a sub set of one of these categories. The potential impact of Brexit on these three sources of income is discussed below.
Income from UCITS
With a couple of notable exceptions, UK based investment managers target EU 27 investors through UCITS established in, primarily, Dublin and Luxembourg and, to a lesser extent, Malta (the “EU Gateways”). These EU Gateway UCITS have the right to passport around the EU and to delegate investment management to the UK and will continue to do so after Brexit.
In order to illustrate this more clearly, consider the position of US based investment managers. Many of them currently target the EU with EU Gateway UCITS which delegate day to day investment management back to the US. The US has a legal and regulatory regime very different from the EU. As the UK will have a legal regime identical in all the key areas to that of the EU 27 immediately after Brexit, it is hard to imagine the UK being treated more harshly than the US. Equally, it is hard to imagine the EU Gateways wishing to overturn a system that is so important to their domestic financial services industries (given the importance locally of US and UK sponsors).
Income from AIFs
Almost any fund that is not treated as a UCITS will be treated as an AIF. Historically, many AIFs that were sold into the EU were based in offshore tax havens. For a variety of commercial, tax and legal reasons, this offshore method of accessing the EU (particularly the EU 27) is becoming less favoured and is increasingly giving way to funds established in the EU Gateways.
With few exceptions, these AIFs can be marketed throughout the EU to professional investors and can delegate investment management to the UK (and US). This will continue after Brexit.
It seems therefore that there will be little change in the means by which UK investment managers access their EU 27 investors other than a continuing decline in the use of tax haven-based funds. The corollary of this, since the implementation of AIFMD, is that EU 27 investors increasingly have less access to the full range of globally available, specialist investment management products.
Under the Alternative Investment Fund Managers Directive (“AIFMD”), a key European directive in the area, there is provision for countries outside the EU to gain recognised status which, in principle, could be used by UK based funds and managers to access the EU. There has been considerable discussion as to whether the UK will be able to take advantage of this post Brexit. In principle it should be possible since, immediately post Brexit, relevant UK and the EU 27 laws will be identical. However, this will likely amount to no more than an interesting red herring.
This is because these provisions were originally included in AIFMD for the benefit of various UK linked tax havens in order to lessen UK resistance to the new directive. The EU has notably missed its deadlines on implementation in this area and there is no clear evidence that anything will be done in any close time frame for those jurisdictions knocking at the door. Going forward, the UK has rather less interest and influence in pushing this agenda, France and Germany were never in favour of these third country rights, the EU Gateways have no national interest in accelerating the admission of new competitors and the rest of the EU has little interest in this area. As a result, planning to work through the EU Gateways looks a more secure business proposition.
Income from segregated accounts
At present, UK investment managers can access individual investors in the EU 27 directly via segregated accounts utilising the passport available under a further European directive, the Markets in Financial Instruments Directive (“MiFID”). MiFID is due to be replaced by a second version (“MiFID 2”) prior to Brexit. Under MiFID 2, it should be possible for non EU investment managers (for example the UK and the US) to register with ESMA in order to have the right to provide segregated accounts to professional investors in the EU 27. An investment manager is unlikely to wish to offer and service segregated accounts in any meaningful scale to EU 27 investors who do not fall within the definition of professional investors. The new ESMA registration provision should, therefore, work well in practice.
Some have argued that ESMA may be slow to honour requests for registration from UK based investment managers. It would be prudent for UK investment managers to have a written plan as to how they will continue to target EU 27 clients and investors post Brexit, and keep a watching brief on that plan, which can be adjusted according to future political developments.
In case of any doubt or otherwise because it suits an investment manager’s distribution strategy, a new MiFID authorised investment manager (or marketing arm) could be established in a suitable EU 27 jurisdiction in the six to twelve months prior to Brexit. The expense and complication will be real but relatively low and continued investor access will then be assured. The only concern here is that competition from a number of EU countries to attract financial services businesses from the UK in the run up to Brexit has led to discussions at EU level of the need to raise standards and local content requirements. Specific advice and planning will also be required in relation to EU 27 focussed sales staff currently based in the UK.
Other incidental issues
Sales of EU 27 UCITS into the UK: In principle, upon Brexit the automatic right to register and sell EU 27 UCITS into the UK will disappear. In practice, this is unlikely. The ability to access a wide variety of strategies and investment managers is a critical aspect in improving investment returns and, overall, reducing volatility. This is important to UK based investors whether they are pension funds, insurance companies, charities or individual investors. The UK government will likely put pragmatism and investor interest first and allow EU regulated funds to continue to be sold into the UK. Requiring specific new UK based funds to be formed in order to target UK based investors would lead to higher expenses and reduced choice for UK investors.
Loss of other passporting rights: At present, UK based investment managers can passport their operations into the EU and vice versa. The presumption would be that these reciprocal rights will disappear on Brexit. As such, EU 27 investment managers would be well advised to start the process now of seeking independent UK authorisation for any UK branches. Equally, UK based investment managers should start the process of seeking local authorisation for their EU 27 based branches, particularly given the possible increased local regulatory requirements outlined above. In the latter case, economies can be achieved by those investment management groups with branches in multiple EU countries, as only one will require local authorisation and the others can be reconstituted as branches of the newly authorised entity.
EU fund operators: Where an EU 27 fund is currently operated from the UK by a passported AIFM or so called “supermanco”, the manager concerned will need to consider creating a post-Brexit infrastructure and related license application in the relevant EU 27 country, changing their funds to self-managed funds (but note the twist that self-managed Luxembourg funds are ineligible to be sold into Switzerland) or hiring a local third party management company. These changes are unlikely to affect materially ongoing business if professionally handled.
It may seem foolish to predict the detailed outcome of a volatile political position over the next 23 months. What seems clear is that 17 months (the likely time available for negotiation to allow any agreement to be ratified in time) will be insufficient to negotiate and document a comprehensive agreement to govern the future trading position of the UK and the EU. What seems most likely is an agreement for a transitional position for the three, four or five years after Brexit. This would allow time for a comprehensive agreement to be entered into while avoiding the “cliff edge” effect. This would reassure most businesses and individuals throughout the EU, appeal to Brussels since it would likely be accompanied by a contribution to the EU budget during that transitional period and be accepted by many Brexiteers, as definitive departure from EU membership would be part of the process.
If there is a transitional period, investment managers have little to fear in the short term and business can continue largely as normal (to the extent there is such a thing as normal while the industry is struggling to cope with MiFID 2, new reporting obligations, the FCA competition review, etc.).
If a favourable separation arrangement is agreed, there is even less reason for concern.
If no agreement is reached but the legal position remains as at present, we have the default position outlined in this article. Legal work, preparation and some change will be required “at the edges” but there will be little to affect the fundamental viability, stability and strength of the UK industry for the benefit of investors throughout the EU.
While it is possible that the EU 27 could change the existing regime to make the position of the UK as a third country untenable, this would be easier to do in other industries where there is not already a settled framework under which it is clear how industry participants can operate post Brexit. If, however, it were to happen to the UK investment management industry, there would be much larger problems to worry about and rather more dramatic alternatives could be expected from the UK government to seek to safeguard its industry and populace.
While the distraction of the forthcoming UK general election may be unwelcome, the return of a government with a greater parliamentary majority should allow a beneficial focus on arrangements with Europe.
In conclusion, therefore, the future looks not too bad for an EU industry that has seen the net asset value of its open ended regulated funds rise from some euro 6.2 trillion in 2008 to over euro 14 trillion at the last count. I encourage investment management groups to get on with business while establishing and keeping a watching brief on their plans to ensure continued service to EU markets. Those frozen in uncertainty over the next two years will have only themselves to blame.
A version of this article was originally published in Law360.