Alternative funds: What does the future hold?
The first European regulation on alternative investment funds was introduced 8 years ago. Its positive effect is remarkable today. What should be expected in the near future in terms of liquidity and investor protection in this field? What about the role of custodians? And the arrival of green finance? Changes lie ahead.
As a result of the 2008 financial crisis, a series of directives and regulations were established within the European Union (EU). In 2011, the first European regulation concerning the alternative investment sector and the investment fund sector in particular was introduced: the AIFM Directive. The AIFMD* came into effect in July 2013 and served as a major inspiration for UCITS V*.
The terms “alternative investment” and “alternative investment fund” have historically referred to hedge funds. However, the areas not covered by the UCITS Directive were integrated into the AIFMD by the European regulator. The list or range of alternative funds subject to this first AIFM Directive was expanded to include real estate funds and private equity funds.
Eight years after the creation of a single European regulation for these UCIs and six years after its transposition into local law, there has been a noteworthy positive effect on the UCI industry.
Although criticised during initial negotiations, the AIFMD has been a real success. It has created new business lines and provided growth opportunities. Following the example of Societe Generale Securities Services, many banks and their securities business lines have become actively involved in the alternative investment sector. They have seen growth in their assets under administration and on deposit as well as their staff and infrastructure.
In Europe, the assets of these alternative funds have increased by nearly 70% since 20131, surpassing the €6 trillion mark. They have been so successful that some of these UCIs from the alternative sector are catching up with UCITS very quickly in terms of net assets.
More liquidity for alternative funds?
Real estate and private equity funds offer a diversified, more attractive, dynamic investment in terms of performance compared with their counterparts in the UCITS sector. Up until now, these UCIs have been—and still are—exclusively reserved for institutional investors. As private investors, the general public has no access to private equity funds or real estate funds subject to the AIFM Directive. Provided that these products and the market are adapted, these investments could be made accessible to individuals.
That being said, there is still another step. It concerns liquidity or, more specifically, the possibility of offering investors the ability to redeem units/shares at a net asset value frequency similar to that of UCITS funds, even though this remains more complicated for a real estate fund or a fund holding unlisted assets.
Another point of comparison with the UCITS Directive is that the AIFMD is a directive for managers of alternative funds and not one that regulates the financial product. The manager or the management company must be authorised to market its investment fund to each appropriate local authority.
Dating back to 1985, the UCITS passport has made the cross-border distribution of UCITS easier over the years. It would be interesting to see an identical distribution passport for alternative funds, with more flexibility in terms of registration with the domestic regulator.
What should be expected in the near future?
Since 2012, the EU has launched a number of regulations needed to strengthen investor protection and better regulate all players and activities of the financial industry. The main objective of the Capital Markets Union project was to create more growth and jobs in Europe. Unfortunately, the results have been mixed, since the expected growth still has not been seen. In recent years, we have witnessed a period of interest rates that are close to zero or even negative. Even so, European citizens have not increased their investments in financial products since the 2008 financial crisis. Investors are still afraid of risk, and the measures taken have not yet reassured them completely.
In addition, there are new and future tax regulations such as ATAD II*, which came into force on 1 January 2019, and DAC6*, scheduled to be implemented in local law in August 2020. They could reshape the EU’s economic map and penalise growth because of the additional costs of compliance.
After the AIFMD, the alternative sector must now deal with the combination of regulatory issues and tax consideration.
Who will gain from these new tax transparency rules? Will Luxembourg be able to remain competitive and maintain its position as a leading European fund, or, without its knowledge, could the epicentre of the European alternative investment fund industry move beyond the EU’s borders?
One of Luxembourg’s major strengths remains its ability to distribute its investment funds both inside and outside Europe. This is likely to continue.
The custodian of tomorrow
While the AIFMD has required European alternative investment funds to appoint a custodian in the country where the fund is domiciled, one could wonder how the role of custodians will change. Large custodian banks have invested significantly in human and technical expertise to act as custodians of these other assets that are not financial instruments and are held outside the custodian bank.
On the other hand, the AIFMD has led to the emergence in Europe, and especially in Luxembourg, of custodians lacking credit institution status but considered financial sector professionals able to take action to monitor, oversee, and reflect these other asset categories in their own books under certain conditions.
The increase in implementation and ongoing management costs – necessary to comply with past, present, and future regulations – suggests that there will likely be a decrease in the number of custodian banks in Luxembourg from the current 642.
A new basis for dividing up UCI business could also emerge, with custodian banks of alternative funds with credit institution status on one side and players with the status of Financial Sector Professional in Luxembourg able to serve as custodians on the other side. In any case, these Financial Sector Professionals must use a bank to serve as custodian of liquid assets and financial instruments and for the financing of credit. It remains unclear when and how this transition would take place.
Today, the custodian of an alternative investment fund or a UCITS fund is established in the country where the fund is domiciled. It has a local physical structure enabling it to exercise its profession, role and responsibilities. The manager and the management company are in the same situation regarding risk management and/or portfolio management. The difference lies in the fact that the manager is not required to be domiciled in the fund’s jurisdiction.
Without waiting for UCITS VI, the custodian passport would lose all meaning if a new factor such as blockchain or a similar technology were taken into consideration.
This rapid evolution of new technologies is already impacting and will increasingly impact the custodian function. Will we see a (r)evolution of the very core of the custodian function?
Green finance is here
Lastly, while alternative investment funds are attracting more and more European investors, the arrival of green finance should also shake up traditional finance.
In this area, Brussels has decided to create a classification for sustainable and responsible investment and to encourage managers of UCITS and alternative funds, among others, to give greater consideration to this ESG criterion in their investment strategies.
Discussions so far have been difficult and are progressing slowly. The European Commission is aiming for the effective implementation of this regulatory taxonomy dedicated to sustainable finance and its ESG criteria by the end of 2021.
In the meantime, agreements should be reached on a list of eligible financial products and sectors, and a reliable index adapted to green finance should be proposed and/or created.
Where do we stand four years after COP 21 and the climate agreement in Paris? While there is clearly still a long way to go, the hope is that the enormous demand from individuals or institutional investors who are increasingly sensitive to this green finance and global warming will push asset managers to develop green products alongside alternative investment.
AIFM: Alternative Investment Fund Managers
ATAD: Anti-Tax Avoidance Directive
COP 21: Climate Conference
DAC6: Directive on Administrative Contribution 6
ESG: Environmental, Social, Governance
UCI: Undertaking for Collective Investment
UCITS V: Undertakings for Collective Investments in Transferable Securities V