Beware the threat to delegation

Having had more than four years to prepare for Brexit, the majority of UK investment firms appear to be in a reasonably robust position to withstand any challenges that may arise. In July 2020, the European Securities and Markets Authority (ESMA) and national EU regulators reiterated that the memoranda of understandings (MOUs) it agreed with the UK Financial Conduct Authority (FCA) on cooperation and information exchange in the event of a no-deal Brexit were still valid. According to ESMA, the MOUs will help facilitate continuity for financial institutions if no UK-EU deal is obtained.

Although fund managers are confident that existing distribution channels will not be disrupted when Brexit takes effect on January 1, there are some more longer-term concerns about the ease in which investment firms will be able to sell into the EU. This trepidation stems in part from a letter penned by ESMA in August 2020. While the bulk of the letter’s contents were not especially controversial or substantive in nature (i.e. calling for greater harmonisation between UCITS and the AIFMD [Alternative Investment Fund Managers Directive]), its comments on delegation elicited criticism.

Delegation is the process whereby an EU entity – known as a ManCo (management company) – outsources investment and risk management activities to a third country manager – enabling them to seamlessly passport or distribute their funds into the EU. For non-EU managers, this allows them to maximise their distribution footprint. It is also one of the reasons why UCITS and AIFMD structures are so universally popular, especially among SME (small to medium sized) asset managers who otherwise would be unable to afford the costs of building up a physical presence inside the EU.

While the ESMA letter did not say it would ban delegation outright, it did acknowledge there were flaws in the model. ESMA accepted that delegation arrangements did generate efficiencies for investment firms but added it “may also increase operational and supervisory risks and raise questions as to whether those AIFs and UCITS can still be effectively managed by the licensed AIFM or UCITS management companies.” ESMA continued there needed to be legal clarification on the maximum extent of delegation that is permitted so as to ensure supervisory convergence and that authorised AIFMs and UCITS management companies maintain sufficient substance within the EU.

Any attempt to impose additional barriers around delegation is likely to frustrate third country asset managers – including those located in the UK post-Brexit, as it could force them to increase their operations and headcount inside the EU at significant cost. In the past, there have been attempts by some member states to restrict delegation but these efforts came to nothing, owing to effective lobbying by industry groups and representatives from onshore fund domiciles such as Ireland and Luxembourg. However, fund managers are under no illusion that future bids to roll back on delegation by European policymakers could potentially gather more momentum over the next 18 to 24 months. As a result, this is an issue, which UK fund managers should be paying close attention to.