We regularly write about the difficulties fund managers face in determining if and where marketing under AIFMD has taken place. Today we have good news and bad news. The good news is that the European Union has today published proposed legislation that aims to harmonise the definition of "marketing" across Europe. The proposed changes to the definition of "marketing" will reduce the uncertainty that managers face working out exactly when they are "marketing" and need to register their funds. This harmonisation is an aim of the Capital Markets Union (CMU) and, on the face of it, is a good thing.
You can see where this is going….The bad news is that the cure will be hard to swallow at best. Unfortunately, as we have predicted (numerous times) before, the new definition of "marketing" makes an already difficult concept in the private (and closed ended) fundraising context even more difficult to grapple with. Surely there is a sensible solution to this? We consider if there is in this briefing.
The current position – marketing
No guidance has been provided by the European Commission or ESMA on the meaning of "marketing" in the AIFMD. This has left the question up to individual regulators. The UK FCA and Luxembourg CSSF, which regulate a significant proportion of European AIFMs, have taken a pragmatic approach. In their view, providing draft documentation (including LPAs, PPMs and subscription documents) and other similar material is not marketing provided that such draft documents cannot be used by the prospective investors to invest in the AIF. Essentially, it is only when providing 'final' documents that marketing occurs and a marketing passport is required. This allows for efficient and commercial processes for these documents - if a Fund is waiting to be launched and terms agreed. Other regulators have not been as helpful (or have been silent) leading to the market and managers taking a risk based approach.
This "pre-marketing" enables managers to gauge investor interest in new products and discuss key terms with cornerstone investors before having to establish their fund, finalise documents and notify regulators. This doesn't happen with UCITS (retail) funds. But private, institutional funds are a different beast which should not be assimilated to retail products.
Proposed position - a new definition of marketing
The European Commission has recognised that AIFMs face divergent treatment of pre-marketing activities in different national legal systems. Determining where the boundary lies between marketing (which requires a passport) and pre-marketing (which does not) can be difficult to determine. The Commission has, therefore, proposed a definition of "pre-marketing".
The recitals to the proposed legislation state that in order for an AIFM to be pre-marketing a fund (i.e. prior to requiring the passport):
(a) investors must be unable to subscribe to the units or shares of an AIF because the fund does not exist
yet; and
(b) no offering documents, even in a draft form, are permitted to be distributed to potential investors during
this stage.
Pre-marketing does not occur if an AIFM provides:
(a) information on an AIF that has been established; or
(b) (where the AIF has not been established) information that amounts to draft or final form prospectuses,
constitutional documents, subscription forms, offering documents or other similar documents.
This means anything undertaken once the AIF is established or the provision of early draft documents is marketing that requires the passport. This is significantly less pragmatic than the position taken by many European regulators in key fund management hubs and appears completely nonsensical.
The cure is worse than the disease
The problem we identified in a previous client briefing was that the same drunken conversation held by an Englishman in different European jurisdictions could be categorised as marketing in some and not in others, thus creating uncertainty for managers. Unfortunately, as we predicted, whilst this problem is now "cured", the patient might end up wishing that they had never been given the medicine.
The proposed definition of "pre-marketing" brings forward the date on which actual "marketing" starts to a much earlier period than market practice currently generally accepts throughout Europe. Taking the UK as an example, "marketing" only occurs when documents are in materially final form. Pitchbooks, draft LPAs and other early stage documents cannot therefore be "marketing". This means the requirement for the marketing passport begins at a relatively late stage in the fundraising process in the UK, which gives managers and investors certainty.
However, under the proposed rules almost everything that the UK and many other regulators in the EEA currently define as "pre-marketing" will be "marketing". As marketing can only be done once a fund manager has obtained permission from the relevant regulator, this brings forward the date on which the AIFM must apply for the new fund under management and marketing passports by a number of months.
In the diagram below, we show just how much earlier marketing will occur in the UK compared to now. The position is differs in other jurisdictions, but for many there will be a substantial change.
What does this mean for EEA Managers
EEA managers will be stuck between a rock and a hard place. On the one hand regulators, such as the FCA, state that they will only accept an application for the marketing passport when the relevant documentation is in materially final form and the fund has been established. On the other, the proposed rules require the passport to be applied for at the earliest stages of the fund when some of the key provisions (including fund size, exact investment strategy, side letters and fees) are all up for negotiation and when it is possible the fund will not be successful and never actually come to fruition. Do fund managers apply at the earliest stage and breach the requirement to provide near final form documents or "pretend" they are final, or do they file later and risk "marketing" in contravention of the rules? It is difficult to see how an AIFM can provide the necessary information required in order to manage and market an AIF if they need to 'market' in order to develop that documentation.
We hope that regulators will be pragmatic on this – we could end up in a situation where a regulator, taking a literal reading of the proposed legislation, rejects a marketing application on the basis that it is not in final form thus preventing a manager from negotiating (i.e. marketing) with investors on the basis that this would be marketing. Therefore getting to "final" documents is impossible! For instance, the FCA currently rejects documents that have draft watermarks. This could be problematic in the future where managers clearly do not want to provide "final" documents that are not final.
Another problem referenced above is in fact in the initial stages managers may not know exactly what structure the fund will be – will there be one partnership? A series of parallel partnerships? A master-feeder structure? In order to obtain the marketing passport, the fund must first be established and the manager obtained permission to manage the AIF. This is done on a per-vehicle basis. This means that as the fund structure develops there could be multiple filings to the regulator for each iteration of the structure along with the one month wait period before any change can take effect.
As managers will potentially be required to file more, costs will rise as some jurisdictions where the passport is applied for will charge fees for AIFs even if there is no subsequent investment. Ironically, this might mean fund managers decide not to register in jurisdictions where costs are known to be high – thus having the opposite effect of the intention of the CMU. There will also be potentially numerous (and pointless) material change notifications every time the documents shift even where these changes are in favour of the investor if it triggers an 'automatic' material change (the list of which ironically includes almost nothing that investors care about).
What does this mean for Article 42 (non-EU) fund managers
As for European managers, costs may rise for non-EU managers marketing into Europe and unnecessary filings will be made. Applications to market in jurisdictions will technically need to be made earlier as investor appetite cannot be softly assessed prior to applications being made. Given the cost of filing in some jurisdictions, managers may simply withdraw from other European jurisdictions. Whilst some European regulators have always been sceptical of non-EEA funds, these funds have an important role to play in ensuring that European investors have a diverse and risk weighted portfolio.
What does this mean for regulators
The new definition will provide the regulators with a lot more pointless data. Managers will be constantly registering and then deregistering AIFs (either because the interest in the market is not there or because specific vehicles designed for specific investors are no longer required). The number of filings made in respect of vehicles that never make an investment nor attract an investor could be significant.
Regulators, already coming to terms with the amount of additional information provided to them under the raft of regulatory changes in the last few years such as EMIR, MiFID II etc., will be provided with a lot more irrelevant detail.
Anatomy of a private fund fundraise – a different beast to a UCITS
What this legislation fails to comprehend is the completely different approach to developing and selling AIFs compared to UCITS. UCITS are generally evergreen, highly liquid funds with thousands of generally retail investors who (with some relatively small exceptions) are offered the UCITS on a take it or leave it basis. Individual investors have almost no power to amend the terms of the UCITS and their sole way of expressing displeasure is not to invest or to divest. Investors are generally 'mass' retail, often unadvised and don't always make rational decisions. In this scenario you can understand the consumer protection necessity.
But AIFs are not UCITS! AIF documents are heavily negotiated with sophisticated institutional investors who have significant power to amend the terms of the agreement. Anyone who has been involved in the process has seen a relatively manager-friendly LPA distributed to investors that is then commented on and amended (sometimes quite significantly). Additional vehicles may be established to take into account a whole host of bespoke commercial, tax and regulatory issues that arise from the investor base. This never happens with UCITS.
Fundraising for the next fund in a fund brand starts almost the day after the final close of the current fund and therefore may take a few years. The difference between reporting back on the current fund and discussions about the next fund cannot always be easily disentangled.
The degree of protection that each investor requires is clearly substantially different but the new rules will, again, seek to harmonise AIFMD and UCITS further despite the different investors, their sophistication and their relevant degree of power. AIFMD should treat professional investors as just that – professionals. UCITS is not the template that AIFMD should continue to be built on.
It is also difficult to see what regulatory harm is cured by requiring notifications so early. Requiring fund managers to register funds at an early stage that may never get an investment serves very little regulatory benefit; we would say no benefit. It also entrenches the position of established fund managers who have more certainty about getting their products sold. Fund managers will be less inclined to offer new and innovative products if they have to front load cost of registrations for a fund that may never get off the ground.
How to solve the problem
Reverse solicitation is not affected by these changes. If investors approach funds on a reverse solicitation basis the marketing rules do not apply and no registrations are required. This has been the regime typically employed by Article 42 fund managers (although caution is always required) in certain jurisdictions where it is (effectively or actually) impossible to market. It may be that all fund managers and investors who want to invest in these funds attempt to rely on reverse solicitation. Ironically more reliance on reverse solicitation, whereby investors do not benefit from the regulatory regime and its protections at all, weakens AIFMD rather than strengthens it. Fund managers may also need to more carefully assess what documents may trigger a notification and amend accordingly.
The better solution is to discuss this with regulators, policymakers and legislators at the earliest possible opportunity and to try and establish a better definition of "marketing" that links in with the current obligations of fund managers. It is a shame that this proposal has come before the responses from industry bodies and participants have been reviewed in the context of the KPMG Survey.
We would strongly advise investors and managers to lobby European regulators against the proposal in this draft legislation. One should be pushing for the approach that the UK FCA takes to "marketing" (we know you are chuckling and thinking – "Brexit"). This enables fund managers to speak to cornerstone investors negotiate terms of the deal and to finalise the fund structure before making a notification. In no circumstances can investors subscribe in the fund until the relevant AIFMD notifications have been made. Therefore, we question what investor detriment arises as a result of leaving the AIFMD notifications to a later point in the fund raising process. Investors are not bound to subscribe for units in the fund until the manager has complied with the AIFMD notifications, they are not bound to invest in the fund or commit any capital. Detriment is therefore significantly reduced. We would suggest that the proposals and draft legislation are akin to using a sledgehammer to crack a nut.
Author: Greg Patton, Associate
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