If they are not prepared to comply with the obligations of the AIFMD, managers based outside the European Union are better advised to avoid Europe altogether than to rely on the legal no man’s land of reverse solicitation.
European prime brokers, fund administrators and fund managers are often surprised by the insouciance of their American counterparts towards the Alternative Investment Fund Managers Directive (AIFMD). Even now, a surprisingly high proportion intends to sidestep the AIFMD restrictions on marketing to European investors by unlicensed fund managers through reliance on “reverse solicitation.” As a marketing strategy, this nebulous concept translates, loosely, as “Call us; we will not call you.” In other words, if investors approach the manager, rather than the manager the investors, AIFMD does not apply. The problem, as those ever-interested parties (the lawyers) never tire of pointing out, is proving that this is what actually happened.
The Directive defines marketing as “any direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM of units or shares in an AIF it manages to or with investors domiciled in the [European] Union (EU).” In avoiding an inadvertent breach of that stipulation, reverse solicitation is far from the soundest choice. The cleanest and most durable way to ensure compliance is of course to become a fully-compliant EU AIFM of an EU AIF subject to the full rigour of the Directive, including its control of remuneration, reporting to regulators of activities through the templates described in Annex IV of the AIFMD, and insistence that the interests of investors are protected by a depositary bank. That authorisation frees a manager to distribute its investment vehicles throughout the EU via a single European passport.
There is a second option, open to an EU AIFM of a non-EU AIF, which is to market funds to sophisticated investors only. This is what most offshore managers are in practice doing already. Unhappily, however, there is no passport: a manager marketing an offshore fund has to comply with the national private placement regimes of every member-state of the EU in which the funds will be marketed. Private placement regimes vary markedly country-by-country. The United Kingdom and the Netherlands are relatively open, while France and Germany are relatively closed. There is still a slim hope that firms marketing by private placement will be offered an EU-wide passport in 2015, but national implementations of the AIFMD are in some cases actually closing the private placement option. Most observers now expect the private placement regime to be abolished in either 2015 or 2018, and every manager subjected to full compliance with AIFMD. In the light of these expectations, reliance on reverse solicitation is what Sir Humphrey Appleby would describe as a “courageous” decision, especially by the established brand names. They are much more likely to be approached than their smaller brethren. True, reverse solicitation is permitted under Articles 36 and 42 of the Directive (see Boxes), but it is worth remembering that initial drafts of AIFMD explicitly banned reverse solicitation. It was only sustained lobbying by the hedge fund industry that preserved private placement, let alone reverse solicitation, and the concessions were based less on a spirit of openness than concern that bans would be judged to be protectionist under international agreements. The result in the final legislation is a case study in vagueness, which has fund managers fretting about the content of web sites, brochures, pitch books and business cards, especially if they fall into the hands of European investors inadvertently, and who they might meet and where, and how.
Capital introductions events – long the most desired but least satisfactory aspect of prime brokerage – are a case in point. Although prime brokers have always had to manage the obvious conflict of interest in the capital introductions business, AIFMD is imposing a formal regulatory structure on this familiar issue. It is forcing capital introductions teams to re-think how they go about hosting events and introducing hedge fund clients to prospective investors within the EU. “Prime brokers have always had to tread a careful line and emphasise that capital introduction events are simply networking or educational exercises rather than formal introductions,” says Martin Cornish, a partner at MJ Hudson, a law firm in London that specialises in alternative asset management. “This was partly due to regulatory concerns and partly the commercial risk of comeback if investors lost money. AIFMD puts cap intro further under the microscope as a result of the decreasing number of countries which now allow private placement and the narrow interpretation of reverse solicitation in many countries. Cap intro teams are likely to insist on even more health warnings when hosting events or otherwise making introductions as a result.” One global head of capital introductions at a major prime broker in New York admits his job is becoming more challenging as AIFMD comes into effect. “We are evaluating what we need to do and have been consulting with our legal counsel,” he says. “We are going to have to watch what is happening in terms of regulation very carefully at an individual member-state level. Furthermore, it appears we will need to enhance our documentation of the work we do, so as not to fall foul of the regulators.” Bill Prew, founder of INDOS Financial, an independent depositary “lite,” agrees that capital introductions teams will have to tread a fine line. “AIFMD is raising marketing practices up the regulatory radar,” he says. “There is a lack of regulatory guidance and what regulators view as marketing will remain a grey area for a while yet. There is a risk prime broker capital introduction programmes could be viewed by some regulators as ‘indirect’ marketing by the AIFM. Given that managers are responsible for compliance with the Directive, they should approach with care and, practically speaking, seek to understand how prime brokers approach cap intro and the controls in place to manage this risk.”
Third party marketers operating in the EU on behalf of non-EU managers could also find themselves subject to unaccustomed restrictions. “Managers must be very careful when employing third party or external marketers to push their products towards European investors as this is likely to be considered by regulators as indirect marketing,” says Roger Fishwick, a director at Thomas Murray Data Services. “Managers should review their relationships with and use of third-party marketers in the light of AIFMD.” The unresolved dilemma for managers, he adds, is the difficulty of distinguishing between active marketing and the opposite. “European regulators have not provided managers or investors with much guidance on their interpretation of what constitutes reverse solicitation,” says Fishwick. “It is still a grey area for non-EU managers.” Bobby Johal, a managing consultant at Cordium, agrees. “There is very limited guidance about what is acceptable and what is not acceptable under reverse solicitation,” he says. “It is likely to depend on circumstances and regulators will scrutinise it on a case-by-case basis.”
Helping the regulators put the AIFMD marketing rules to the test on a case-by-case basis is not a realistic approach for managers, as one New York-based chief operating officer (COO) at a hedge fund explains. “We do not intend to actively market into Europe because we do not want to find ourselves bound by the Directive,” he says. “We intend to rely on reverse solicitation. This will probably involve a European investor calling us up or scheduling a meeting with us on their own initiative. I am sure a non-EU manager could potentially stretch the rules by calling a European investor and talking to them about their business. Would European regulators take action against that manager for breaching the rules? Probably not, given the finite resources they have at present and the enormous regulatory mandate they are dealing with. But it is not a risk our firm or many others like us would want to take.”
Needless to say, the European Securities and Markets Authority (ESMA) is being urged to provide greater clarity to purge the industry of such anxieties. Robert Mirsky, global head of hedge funds at KPMG in New York, is firm on this point. “It is very important that regulators issue firm guidance as to what is permitted under reverse solicitation because it is a very grey area at present for managers,” he says. “The definition of active marketing has now become very much part of European regulation due to the introduction of the AIFMD.”
The Alternative Investment Management Association (AIMA), the London-headquartered trade association, has argued that AIFMs be allowed to provide general information to European investors about their organisational structure, history, expertise and investment strategies without referring to their track record. “We also believe that, if a prospective investor, following its receipt of such general information about the AIFM, requests offering materials in relation to an AIF managed by the AIFM, the request of the prospective investor should be considered a reverse solicitation and should not be considered marketing at the initiative of the AIFM,” read a letter submitted to an H.M. Treasury consultation on the subject.
In the event, the H.M. Treasury regulations that accompanied the implementation of the AIFMD in the United Kingdom were notable mainly for the criminal law sanctions that will be applied if marketing guidelines are contravened, and the rights given to investors to recover in full any monies invested as a result of unlawful marketing. It follows that any manager who relies on a liberal interpretation of reverse solicitation will be taking a substantial risk, even in the European country regarded as most welcoming to alternative investment managers. Under the circumstances, the only sensible advice to a manager is to consult a lawyer on every aspect of marketing in Europe, no matter how apparently trivial. Documents outlining performance and investment outlooks, supplied routinely to existing investors, could be construed as marketing even if an existing client simply upped their investment as a result.
Bobby Johal of Cordium argues that all contact with prospective investors within the EU will now have to be documented religiously. “Every communication with European investors has to be documented,” he says. “Firms should identify how they met that investor and the nature of the communication. It is essential to have an internal record for compliance’s sake.” Web sites will have to become even more discreet than they are already. Some lawyers are advising managers to ensure there are no references to performance at all on their web sites, while others are going even further and urging managers to make sure their websites cannot be viewed in countries which discourage even private placement.
“The United States has recently enacted the JOBS Act, which allows hedge funds to publicly market and advertise their investment vehicles to accredited investors,” notes Robert Mirsky of KPMG. “Many managers have talked about improving transparency on their web sites, which is now permissible, courtesy of the JOBS Act. However, those managers must be careful that these new look web sites cannot be viewed in countries such as Germany, where they could be accused of direct marketing. Likewise, some United States managers have said they might be more amenable to speaking to the media, but if those publications are available in those EU member-states adopting tough private placement criteria, it could lead to issues.”
One American manager says his legal advisers warned him against speaking at industry conferences in Europe, or handing out business cards to European allocators Databases, which chronicle the performance of hedge funds, are also on notice that they could face sanctions for promoting managers to European investors. An extreme view holds that European regulators will monitor European investors increasing their allocations to a hedge fund, but David Moss, head of business advisory for Europe, Middle East, Africa (EMEA) at Citi in London, thinks that unlikely. “We are hearing that because investors are paying for and pro-actively seeking specific fund information on their own accord, this would be viewed as reverse solicitation,” he says. “I do not believe regulators would view an increased capital allocation from an existing client to the same fund as reverse solicitation. However, managers do need to be thoughtful in how they present themselves to European investors and may want to seek legal guidance when marketing into Europe.”
Although the likelihood of regulators pursuing managers over minor transgressions is not high, given their current workload, managers are understandably reluctant to take risks on the issue. They cannot control the behaviour of an aggrieved investor, for example, who accuses them of marketing without the proper licence, goading regulators into taking enforcement action. So it is not surprising to find some non-EU managers deciding to avoid Europe altogether. A number of them with limited numbers of European investors have actually returned the capital rather than put up with the restrictions of the AIFMD. A Deutsche Bank Markets Prime Finance survey of 44 chief operating officers at American hedge funds managing $325 billion between them found less than half (43 per cent) would continue to market into the EU. It is not an irrational decision to avoid the EU. Every fund manager in every market raises the bulk of the capital they manage from investors in their domestic market. North America is also a much larger market than Europe. According to Barclays Prime Services, it accounts for 58 per cent of an estimated $2.7 trillion managed by hedge funds alone, or more than twice the proportion (24 per cent) that originates in Europe. American hedge funds in particular, having believed until the AIFMD was quite advanced that it would apply to EU funds only, are disinclined to put up with the obligation to delay and disclose their remuneration and report in detail on their activities to European regulators. As a way of avoiding a postponed bonus payment and completing an Annex IV report, staying away is a less risky solution than relying on reverse solicitation.