Funds Annual Briefing 2020 - Headline grabbers

So we now have the outcome of the general election and, as many predicted, Boris Johnson has secured a large majority government. The agreement, made in October 2019, between the European Council and the UK to extend the Article 50 period by up to three months means that the UK will leave the EU at the end of the month in which ratification of the revised withdrawal agreement is concluded, up to 11.00 pm on 31 January 2020 (UK time).  On 31 January, therefore, the UK will leave the EU whether or not the withdrawal agreement has been concluded, unless a further extension is agreed, or the UK revokes its Article 50 notice.

Does this mean that fund managers, alternative investment funds and their advisers finally have a clear picture of how Brexit will impact on the various legislation, rules and guidance which affect the investment funds' industry? Not quite, but the election result has brought an end, at least, to the uncertainty caused by the possibility of a second referendum or revocation of Article 50. We have set out below some of the key considerations relating to investment funds in the short and long term. But if we have learnt anything about politics over the past 3 years, it is that is extremely difficult to predict what happens next and it is possible that the analysis in this briefing may be overtaken by events.

Transition period in the event of a deal

The new Conservative majority government will now be able to secure the passage of its Bill implementing the renegotiated draft Withdrawal Agreement. The UK then has a transition period until 31 December 2020 in which to agree a deal with the EU on the future relationship. It is of course possible that the government will seek an extension of the transition period, notwithstanding current claims.  See more on our views at Brexit Hub.

During the transition period, the revised withdrawal agreement provides that the UK will continue to be treated as an EU Member State. EEA full-scope alternative investment fund managers ("AIFMs") currently managing and/or marketing an EEA alternative investment fund ("AIF") under an AIFM passport will be able to continue to do so. Similarly, those AIFMs relying upon marketing using the national private placement regimes ("NPPR") will be unaffected.

No-deal Brexit 

Funds, and their advisers, should not abandon their efforts to prepare for a no deal Brexit outcome. There are several reasons for this:

• A no deal outcome at the end of January 2020 cannot be ruled out. The government has already hardened its stance on requesting an extension to the transition (indicating that it will not do so) and is may come under further pressure to commit to a so-called "clean Brexit" (which is effectively a no deal exit);
  
  
• Apart from the transition, the draft Withdrawal Agreement is primarily "backward-looking"; until agreement is reached on the future relationship, a no deal outcome on 1 January 2021 remains a possibility; and
  
  
• Even if a deal is reached with the EU on the future relationship, this is only likely to be possible by January 2021 if it is very much at the "harder" end of the Brexit spectrum. For certain sectors of the economy (such as financial services), this could be almost as disruptive as "no deal" and therefore "no deal" planning will still be of assistance in that scenario.

As the UK will immediately become a third country in the event of a no deal, UK full-scope AIFMs will no longer be able to use the AIFMD marketing passport and will instead only be able to market under NPPR. Sub-threshold AIFMs will not be affected to the same extent as full-scope AIFMs; having never had access to the AIFMD passport, they will continue to market under the NPPR. Similarly, non-EEA AIFMs would also continue to market under NPPR.

However, AIFMs marketing under the NPPR require, as a condition to access to the regimes, relevant co-operation agreements to be put in place between UK and Member State supervisors in relation to the exchange of information. In February 2019, the FCA and ESMA announced the agreement of a multi-lateral regulatory co-operation agreement("Mmou") between the FCA and EEA regulators. The text of the Mmou has not been published. The areas we would expect the Mmou to cover include (i) UK AIFMs marketing to EEA investors under NPPR; (ii) EU AIFMs delegating portfolio management to UK firms; and (iii) the cross-border management of funds. The FCA has confirmed that the Mmou is based on the existing memoranda of understanding which are currently in place in respect of the AIFMD, and that it meets the requirements set out in regulation 59 of the UK AIFM Regulations.

The AIFMD asset stripping provisions currently applicable to private equity funds' operations will no longer apply in respect of UK investments.

Private funds will have a number of additional considerations in relation to their portfolio companies, including (i) immigration, employment and travel; (ii) cross-border trade; (iii) reviewing licences and permits to ensure that there will be no disruption to the use of such; and (iv)) intellectual property.

Individual Member States' preparations remain in a state of flux and vary considerably from jurisdiction to jurisdiction.

Additional and up to date disclosures will be necessary in annual reports in relation to Brexit, given that under the AIFMD an AIFM must include on the annual report any material change to the information disclosed to investors. Similarly, any live placing programme prospectuses should be reviewed to ensure any Brexit-related disclosures are adequate.

Material contracts should also be reviewed to determine whether any definitions of 'EU' or 'EEA' need to be updated so as to carve out the UK from such definitions.

AIFMs should consider whether any personal data is being transferred from the EEA to a third country (i.e. the UK post Brexit).  Under the EU General Data Protection Regulation ("GDPR"), unless one of a number of specified arrangements is in place to provide adequate safeguards for personal data, the transfer of personal data from inside the EEA to third countries outside the EEA is restricted. This includes storage on a server in the EU. If so, the AIFM will need to ascertain whether the necessary safeguards are in place in relation to the transfer of that personal data.

Funds which have shares admitted to a regulated market in the UK and a dual-listing in another EEA state will need to make additional notifications to regulators for certain matters, including in relation to the post-Brexit UK market abuse regime. These obligations are in addition to existing obligations under EU market abuse regime.

For listed funds, to be eligible for admission to trading on the Official List/ Specialist Fund Segment, applicants must comply with the 'free float' requirement. The current free float requirement (that issuers must ensure that 25% or more of their issued shares are held in public hands in EEA states) will be amended so as to require 25% or more shares to be held by investors in any jurisdiction.

Also of relevance to listed funds, the UK's Disclosure, Guidance and Transparency Rules ("UK DTRs") will apply to all issuers with transferable securities admitted to trading on a UK regulated market, irrespective of their place of incorporation. The ‘home/host’ concept, which currently determines which Member State’s rules apply, will not be relevant in the UK after Brexit. The UK HM Treasury has made an equivalence decision that determines EU-adopted IFRS to be equivalent to UK-adopted IAS for the purposes of the EU Prospectus Directive and Transparency Directive (HM Treasury are working on updating this to reflect the move to the Prospectus Regulation). On this basis, non-UK incorporated funds will be able to use EU-adopted IFRS when preparing consolidated accounts for financial years beginning on or after Brexit and will not have to translate the accounts into UK-IAS, so long as the FCA has granted such funds an exemption in relation to EU-adopted IFRS.

Recent years have seen record fundraising in the secondaries market, with the 10 top secondaries funds alone seeking to raise more than $70billion in 2020.  This has created a large pool of capital that GPs are increasingly looking to access in order to respond to their LPs' demand for liquidity, differentiated performance and sophisticated portfolio management.  This pool of capital is also being accessed by GPs to maintain exposure to high performing assets, enhance the performance metrics of their funds, ensure that their LP base receives liquidity concurrent with a new fundraise, generate a 'stapled' commitment from a secondary buyer and to accelerate carried interest. GPs are using a wide range of structures to differentiate themselves within the Market such as portfolio sales, strip sales, preferred equity and NAV based lending.

GP-led secondaries

In a typical GP-led secondary:

• The GP of a selling fund runs an auction process and, ultimately, arranges for a secondary fund to capitalise a continuation vehicle that is managed by the same GP that manages the selling fund.
  
  
• The continuation vehicle makes an offer to acquire some or all of the selling fund's portfolio with the price set by reference to NAV in the most recently available quarterly reports.
  
  
• The GP offers each LP the right to take liquidity at the offer price or to maintain its existing exposure to the portfolio.
  
  
• The GP is required to 'roll' some or all of the carried interest that it receives in respect of the transaction into the continuation vehicle as an investor commitment.
  
  
• The GP will receive a management fee and carried interest from the continuation vehicle.

Why are GPs looking at liquidity/financing options?

The Senior Managers and Certification Regime ("SMCR") was extended to all firms authorised under the Financial Services and Markets Act 2000, including fund managers, on 9 December 2019. Firms should now be compliant with the vast majority of the regime's requirements. Firms must have identified all of their Senior Managers and Certification Staff and ensured that they are trained on the new regime. The Conduct Rules applied to them as from 9 December 2019. However, there is a one-year transitional period as regards certain aspects so that firms have until 9 December 2020 at the latest:

• To complete the initial certification process – i.e. to complete their fitness and propriety assessments and issue the first annual certificate in respect of Certification Staff;
  
  
• To train their other staff (i.e. all those employees, other than ancillary staff, who are not Senior Managers or Certification Staff but who are within the scope of the Conduct Rules; and
  
  
• To upload via Connect all the data about individuals that they are required to provide for the purposes of the FCA's new Directory.

Fund managers will need to adapt to an increased focus on sustainable finance over the next few years, as regulatory measures are introduced at both at an EU and UK level.  This is set against a wider backdrop of global initiatives in the area of climate change.

In the context of financial services "Sustainable finance" generally refers to the process of taking environmental, social and governance (ESG) considerations into account when making investment decisions. The three components break down as follows:

• Environmental considerations – these refer to climate change mitigation and adaptations – and to the environment more broadly and the associated risks (such as natural disasters);
  
  
• Social considerations – these refer to (among others) issues of inequality, inclusiveness, labour relations, investment in human capital and communities;
  
  
• Governance considerations – these refer to management structures, employee relations and executive remuneration and their role in ensuring that environmental and social considerations are included in the investment decision-making process.

At an EU level, as part of the European Commission's Sustainable Finance Action Plan, the EU institutions have been working on a range of measures including a new taxonomy or classification system of environmentally sustainable activities, new disclosure requirements relating to sustainable investments and provisions designed to integrate sustainability risks and factors into the way that financial services firms do business and deal with clients. These EU initiatives will not be effective until after the UK has left the EU and the expiry of the EU Withdrawal Agreement transitional period. However, depending on UK policy with regards to implementing EU-derived legislation following Brexit, it is likely that they will have a direct impact on UK firms; and, in any event, the UK is also pursuing its own domestic agenda on these issues.

EU Regulation on sustainability-related disclosures in the financial services sector

The EU Regulation on sustainability-related disclosures in the financial services sector ("EU Disclosure Regulation") was published in the Official Journal of 9 December 2019 and came into force on 29 December 2019. The majority of its provisions will apply from 10 March 2021. The EU Disclosure Regulation applies to portfolio managers, AIFMs, UCITS management companies, EuVECA managers and EuSEF managers as well as investment advisers.  

The EU Disclosure Regulation is intended to complement the other work being carried out on sustainability including ESMA's work on the integration of sustainability risks and factors into firms' policies and procedures (see below). 

The European Supervisory Authorities are required to develop regulatory and implementing technical standards in respect of many of the provisions of the EU Disclosure Regulation which will, among other things, further specify the details of the presentation and content of the information on sustainablity investment targets to be disclosed in pre-contractual documents, periodic reports and on websites. Some of these technical standards will come into force 12 months after the EU Disclosure Regulation comes into force; others will come into force 24 months after the EU Disclosure Regulation comes into force. 

Broadly, under the EU Disclosure Regulation fund managers will be required to make a number of disclosures as follows:

ESMA advice on integration of sustainability risks and factors

In response to a request from the European Commission for technical advice on potential amendments to, or the introduction of, certain delegated legislation, ESMA consulted on potential amendments to Level 2 measures adopted under AIFMD and the UCITS Directive and also under MiFID II. In May 2019, ESMA issued its two final reports containing its technical advice in respect of potential legislation on the integration of sustainability risks and factors into firms' policies and procedures. 

The proposals will apply to AIFMs and UCITS management companies and to MiFID investment firms (including portfolio managers and adviser/arrangers).  In some cases, the proposed requirements in respect of the MiFID II Level 2 measures would also apply indirectly to the manufacturers of funds (including non-EEA funds), particularly where making use of an EU distributor which is subject to MIFID.

Under the proposals, such firms would be required to take sustainability into account when complying with organisational requirements, including (where relevant) risk management, conflicts of interest and product governance requirements.

AIFMs and UCITS management companies would also need to integrate sustainability into the responsibilities of senior management and consider sustainability risks and factors when selecting and monitoring investments and when carrying out investment decisions.

Amendments to the relevant Level 2 measures under AIFMD, the UCITS Directive and MiFID II are likely to follow.

EU Taxonomy Regulation

The European Parliament and the Council have reached agreement on the Regulation for the establishment of a framework to facilitate sustainable investment ("Taxonomy Regulation").  This will introduce an EU-wide taxonomy or classification system of environmentally sustainable activities.  It will establish the framework criteria for determining whether and to what extent an economic activity can be considered environmentally sustainable, with detailed criteria to follow (see below).  In other words, by itself, the Regulation will not have any provisions which directly impose obligations on fund managers, but the taxonomy will have an impact on what can be considered environmentally sustainable and will therefore have a relevance in relation to those disclosures and other obligations which will apply to them directly (see above).

The Taxonomy Regulation will apply to:

• financial market participants who offer financial products; and
  
  
• financial and non-financial undertakings which fall under the Non-Financial Reporting Directive (i.e. which are required to disclose how/to what extent their activities are associated with environmentally sustainable economic activities).

The six environmental objectives underpinning the criteria are as follows:

• climate change mitigation;
  
  
• climate change adaptation;
  
  
• sustainable use and protection of water and marine resources;
  
  
• transition to a circular economy;
  
  
• pollution prevention and control; and
  
  
• protection and restoration of biodiversity and ecosystems.

Parts of the Taxonomy Regulation are currently expected to take effect as from 31 December 2021 with the remainder coming into effect as from 31 December 2022. 

Further details as to what specific types of economic activities or investments are objectively defined as being environmentally sustainable (the technical screening criteria) will appear in yet-to-be drafted delegated legislation (RTS/ITS).  Therefore the full impact of the Taxonomy Regulation will only apply once the relevant delegated acts under the Regulation, which will set out the relevant technical screening criteria for each of the relevant environmental objectives, have been established.

Open-ended funds and their holding of illiquid assets continued to dominate headlines in 2019.  In September 2019, the FCA published its Policy Statement (PS 19/24) on illiquid assets and open-ended funds.  This follows the publication of the FCA's Discussion Paper in 2017 (following the suspension of a number of property funds after the EU referendum) and the suspension in dealing in June 2019 of the LF Woodford Equity Income Fund.  Both issues have led to renewed focus on illiquid assets held in open-ended funds.  In particular, how fund managers use different liquidity risk management tools and how to strike a fair balance between the interests of investors wishing to redeem their holdings and those wishing to remain invested in the fund under difficult market conditions.

The new rules will introduce:

• A new category of ‘funds investing in inherently illiquid assets’ ("FIIA"). NURSs that fall into this category will be subject to additional requirements, including enhanced depositary oversight, standard risk warnings on financial promotions, increased disclosure of liquidity management tools and liquidity risk contingency plans;
  
  
• A new requirement that NURSs must suspend dealing in fund units where the standing independent valuer ("SIV") expresses material uncertainty regarding the value of 20% of the scheme property. In stressed market conditions, less liquid assets can suffer from a high degree of valuation uncertainty and become harder to sell at the value which would be expected in normal market conditions. The FCA will, however, allow an authorised fund manager ("AFM") to continue to deal where they have agreed with the fund’s depositary that this is in the fund investors’ best interests. This change is being introduced to ensure that AFMs (in conjunction with depositaries) have the ultimate say in whether a fund suspends. This will reduce reliance upon the SIV, and protect consumers by avoiding suspension where this would not be in investors’ interests;
  
  
• A new rules where AFMs managing NURSs choose not to manage the liquidity mismatch directly, for example by adapting the redemption arrangements to be more similar to the liquidity of the underlying assets, the fund will have to be classified as a FIIA and become subject to the additional requirements this brings.

The FCA will not proceed with two of its original proposals, being (i) the requirement for a manager of a FIIA to add an ‘identifier’ to the name of the fund; and (ii)  guidance relating to limiting the accumulation of large cash buffers within NURSs and UCITS funds.

In December 2019, the Bank of England published its Financial Stability Report, which set out the Bank’s concerns regarding open-ended funds that invest in illiquid assets.   The report states that there should be a greater consistency between the liquidity of a fund's assets and its redemption terms.  In that regard, the Bank made a number of recommendations, including that (i) redeeming investors should receive a price for their units  that reflects the discount needed to sell the required portion of a fund's assets in the specified redemption notice period; and (ii) that redemption notice periods should reflect the time needed to sell the required portion of fund assets without discounts beyond those captured in the price received by redeeming investors.

From 1 January 2020, the Swiss Financial Services Act ("FinSA") and the Swiss Financial Institutions Act ("FinIA") came into force (with various transitional periods applicable). Under the new regime, the requirement to appoint a Swiss representative and a Swiss paying agent (only applicable to non-regulated qualified investors in Switzerland) will fall away. As our clients more commonly see distributions to regulated qualified investors, this is not a significant change. There are, however, many other changes being introduced which may have an impact on future distributions. Furthermore, there will be further implementing provisions, the drafts of which having not yet been published.

Our understanding is that the new regime will abolish the entire current concept of "distribution" (which will be replaced by the one of "offer"). The current investor segmentation (regulated qualified investor/non-regulated qualified investor/retail investor) will be maintained but new client classifications are also being brought in (institutional/professional/retail).  There has been uncertainty as to what extent and under what circumstances, fund distribution activities will be characterised as "financial services" under the new regime. Should such distribution of collective investment schemes be viewed as being not only an "offer", but also a "financial service", it will imply those marketing the fund having to comply with new obligations for client advisors of financial service providers to become registered in a Client Advisors Register and to comply with new conduct and organisational requirements. 

As this is an ongoing development, it would be prudent to consult with Swiss counsel on potential distributions in a timely manner. 

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