The implications of a potential BREXIT for non-EU hedge fund managers are hard to fathom. At present, public opinion polls appear to be neck and neck although fund managers seem confident BREXIT is unlikely to occur. A survey by Aviva Investors in February 2016 found 20% of equity fund managers and not a single bond fund manager thought BREXIT would happen. Whether this is misplaced optimism will be revealed on 23rd June but hedge funds globally should be cognisant of some of the potential issues BREXIT could bring.
Should BREXIT occur, its impact on hedge fund managers would depend on the exit terms the UK agrees to with the EU. There are three principle exit models; the EEA model, the Swiss model, the World Trade Organisation model.
The EEA model
Should the UK agree to remain as a European Economic Area (EEA) country, rules such as the Alternative Investment Fund Managers Directive (AIFMD) and the Markets in Financial Instruments Directive II (MIFID II) would continue to apply although UK policymakers would have less say in their formulation.
The Swiss model
The UK could adopt the ‘Swiss model’, whereby they would apply to join the EFTA, the European Free Trade Association (constituted of Switzerland, Iceland, Norway and Liechtenstein) and negotiate access to the single market on a sector by sector basis. The UK would be bound to follow the regulation in the covered sectors but would otherwise negotiate Free Trade Agreements (FTAs).
The World Trade model
A complete withdrawal would designate the UK as a third country. This would have a more noticeable impact as Britain may have to rely on its World Trade Organisation (WTO) membership to negotiate additional trade deals going forward. However, this model is fraught with potential complications.
Director General of the World Trade Organisation Roberto Azevêdo has stated, “pretty much all of the UK’s trade [with the world] would somehow have to be negotiated,” The WTO had never gone through such discussions with an existing member.
If the UK were to vote to leave the EU, the transition time is estimated as only two years. It would be imperative that the UK establish the terms of their exit quickly in order to facilitate the transition for both the UK electorate and the market at large.
Much has been written about the potential consequences of BREXIT on the domestic UK hedge fund management industry often at the expense of its impact on non-EU managers. So how could BREXIT impact non-EU hedge funds in key areas such as Marketing and Operations?
A number of non-EU managers of non-EU funds have made it no secret they find Alternative Investment Fund Managers Directive (AIFMD) burdensome and would much prefer to rely on reverse solicitation as a mechanism to circumvent the Directive. Reverse solicitation is when EU investors actively solicit the manager about their product rather than the manager directly marketing to them. There is a fine line managers must tread when relying on reverse solicitation and the punishments for breaching the rules can be serious. In a Preqin survey from June 2015 just 15% of US and 25% of APAC/Rest of the World hedge funds surveyed confirmed they were AIFMD compliant. Some of those surveyed do not feel a huge obligation to market into the EU. They are happy therefore to just field calls from EU investors through the reverse solicitation framework. Clearly the impact of BREXIT on these managers will be negligible.
National Private Placement Regime (NPPR)
General reliance on the reverse solicitation framework appears to have shifted as many lawyers warn US hedge funds that the consequences of breaching the rules can be severe. A number of these managers are electing to use NPPR in markets where they are confident of raising meaningful capital. This subjects managers to aspects of AIFMD but not the obligation to appoint a full depositary subject to strict liability for loss of assets. While some hope the UK will scrap aspects of AIFMD in the event of the UK becoming a third country, this is unlikely for both political and practical reasons. The UK – should full BREXIT occur – would want to still benefit from the pan-EU passport regime and having equivalent rules is key to attaining this. Scrapping unpopular elements of AIFMD is a sure-fire way in which to scupper that ambition.
The European Securities and Markets Authority (ESMA) is assessing third countries’ regulatory equivalence with the EU. Jurisdictions, including the US and Cayman Islands, the latter of which has made regulatory changes to bring its rules more into line with the EU, could very well be granted AIFMD regulatory equivalence by 2018. This would enable managers in these jurisdictions to freely passport into the EU once National Private Placement Regimes (NPPR) expire. It should be noted that both the jurisdiction of the manager and the fund must be deemed equivalent before they can passport. However, if the US and Cayman Islands received equivalence, it could be argued a New York manager of a Caymanian fund would be in a better position to market to EU institutions come 2018 than a UK counterpart if BREXIT actually happens.
BREXIT would have undeniable operational consequences for managers with EU interests. US managers which are fully AIFMD or UCITS compliant through management companies or by basing their AIFMs or UCITS managers inside the EU, specifically the UK, could have operational issues. If the UK becomes a third country, UK-based AIFMs and UCITS could be forced to reorganise their business structures with a greater presence in Ireland or Luxembourg. This could be an administrative headache. Simultaneously, those non-EU managers which have structured their businesses through an Irish or Luxembourg management company may be unable to passport their Alternative Investment Fund (AIF) to the UK if the latter became a third country. While NPPR marketing options would remain for the UK, utilising an EU management company to access the UK alongside the EU may not be viable.
US managers using NPPR in certain EU countries (Germany and Denmark) are obliged to appoint a depositary-lite, some of which are domiciled and regulated in the UK. Other managers have appointed full-scope depositaries, which are part of UK custodian banks. A legal briefing by Ashurst highlighted that AIFMD restricts providers that can act as depositary to EC credit institutions. If the UK became a third country, its custodians would not qualify as EC credit institutions. The banks could in theory apply for third country recognition, although Ashurst highlighted this could be “politically fraught.” As such, it could force banks and depositary-lites to relocate more of their UK operations to EU jurisdictions such as Ireland or Luxembourg.
The legal consequences are therefore very complicated. The interim period – depending on the nature of BREXIT – could result in the UK setting legal precedents on a number of issues affecting financial services which would not necessarily be bound by the EU legislature. This could cause confusion, particularly if the UK took diverging views to the EU, which could result in practical problems for managers with UK and EU interests or locations.
BREXIT could have a negative impact on the marketing and operational structures at non-EU hedge funds. The overarching sentiment is that BREXIT will not be good for the global economy and would certainly result in a reduction in net inflows into UK funds, something which is already happening amid the uncertainty of the vote outcome. Sterling insurance has risen while the Sterling has also depreciated markedly against the euro and USD. This could potentially have an impact on investors’ risk appetite into hedge funds. Non-EU hedge funds should be considering the implications a BREXIT could have on their European interests.