Date Published 20/11/2024
By Mark Browne, Partner, Clerkin Lynch LLP
The use of established third-party fund platforms by asset managers wishing to launch a European fund product for global distribution in the form of a sub-fund on an existing “umbrella” vehicle is now well established. This applies to both UCITS and alternative investment funds (“AIFs”) under the EU’s Alternative Investment Fund Managers Directive (“AIFMD”). In fact an article which I wrote highlighting key considerations when negotiating to “on-board” onto an existing third-party platform was published in the AIMA Journal over ten years ago !.
However, while the points made in that article (which is available at this link) remain valid, the market has evolved considerably since then as new commercial and regulatory impacts have brought new considerations to bear. This article explores some of these new factors which managers would be advised to include in their due diligence exercise when assessing potential platforms.
Market Developments
The number of potential providers has grown considerably in recent years, and this affords those seeking a European host platform with a wealth of choice. In the Irish context this has been driven in part by the “CP86” reform initiative. This essentially shut down the previously dominant model of self-managed investment companies, or “SMICs”, by requiring additional substance in management companies including full time employees. For smaller managers, it will rarely be worthwhile capitalising a management company as well as employing local staff. Third party management companies can meet this need by acting as the delegate to a fund board and then sub-delegating portfolio management activity to an external overseas asset manager. In many cases they will also offer a host fund vehicle where a new sub-fund can be launched for new underlying portfolio managers. This applies both under UCITS and AIFMD, with individual management companies being capable of being authorised to manage both categories of vehicle (so called “supermancos”). However, it’s well worth conducting extensive due diligence to find the right partner vehicle.
Even if a third-party management company is used, it is not necessary (at least from a regulatory perspective) to use an existing platform vehicle so consideration should initially be given to establishing a new separate fund entity. This will afford choice of service providers and ensure flexibility in case of replacement. Seeking to move a fund from a third-party platform will generally be considerably more onerous than replacing a management company.
Regulatory Impacts Other considerations
The European Securities and Markets Authority (“ESMA”), the lead supervisory authority across the European Union, has been increasingly focussed on the role of the management company under UCITS and AIFMD. It constitutes the “responsible person” under the terms of much of the applicable legislation – also in terms of liability. The fact that ESMA’s related guidelines highlight the need for consistency in the treatment of related issues mean that the existing approach by a management company regarding their platform is highly important as this should be applied to any new funds. Different treatment for other funds on a platform could only normally be justified if an objective basis for this can be identified. I have included details below of some specific relevant points to consider when assessing the suitability of a platform.
Valuation policy
In January 2022 ESMA announced the launch of a common supervisory action (“CSA”) with national competent authorities (“NCAs”) across Europe addressing valuation provisions under UCITS and AIFMD. It focussed in particular on the valuation of less-liquid assets held by UCITS and open-ended AIFs including unlisted equities, unrated bonds, corporate debt, real estate, high yield bonds, listed equities not actively traded and bank loans. A Final Report from ESMA issued in May 2023 included analysis of adherence to valuation principles and methodologies with a view to reflecting a true and fair view of their financial positions in line with applicable rules.
The Central Bank of Ireland (the “CBI”) issued a “Dear CEO” letter on the topic in December 2023 clarifying that all firms should have documented, comprehensive and entity specific asset valuation policies and procedures clearly outlining the operational roles and responsibilities for all parties involved in the asset valuation process.
Asset managers should assess the extent to which these existing valuation policies and procedures are compatible with their own approach. This issue will be particularly relevant where they wish their European fund to be held out as an equivalent to an existing vehicle under a “side by side” distribution strategy – since different valuation policies may result in markedly diverse results.
Errors Policy
In addition to the above, the CBI letter of December 2023 clarified that all Firms should have a formalised and comprehensive errors procedure in place to ensure remedial action is implemented when valuation errors or incorrect calculations of the NAV occur. Similarly, asset managers should check that the standard approach of the management company as applied on their fund platform does not diverge from their own approach to minimise the potential for unpleasant surprizes.
Costs and charges policy
Another set of policies that has been the subject of a CSA by ESMA and subsequent guidance by the NCAs including the CBI relates to costs and charges. Again, I have previously had a detailed article on this topic published in the AIMA Journal (this article is available at this link), however in summary this interprets the relevant legislation prohibiting the charging of undue costs to mean that fund costs charged should: (a) be consistent with the investment objective of a fund and not prevent it from achieving this objective, and (b) be clearly identifiable and quantifiable. Management companies are expected to develop and periodically review a structured pricing process addressing key elements including disclosure, consistency, sustainability, equal treatment, proportionality and necessity of costs. Such policies should be reviewed and discussed to ensure that they are aligned with the expectations of asset managers intending on launching on a relevant platform.
Policies generally
Some specific examples of relevant issues based on recent communications from both ESMA and the CBI have been included above. It is evident from these that a general analysis of the policies of the management company to a proposed third-party fund platform would be appropriate prior to on-boarding onto a platform they manage.
Risk framework
ESMA also launched a CSA to investigate UCITS liquidity risk management in early 2020 following highly publicised issues relating to the Woodford Equity Income Fund. In Ireland the CBI released a “Dear Chair” letter highlighting 9 specific areas of concern and indicating its related expectations for Irish UCITS Management companies in May 2021.
Asset managers should review the underlying liquidity risk management framework (the “LRM Framework”) including both the Risk Management Policy and Risk Management Process pertaining to any relevant fund platform for potential compliance issues.
ESG
In the European funds context the “Environmental, Social and Governance” or “ESG” policy of entities has been an area of increased focus due to legislation such as the Sustainable Finance Disclosures Regulation (“SFDR”). Under the SFDR funds must categorise themselves under one of three headings, with Article 9 funds being aimed at related issues. Asset managers seeking to pursue an ESG aligned objective should consider the appropriateness of launching on the same platform as funds with an unaligned view on ESG issues.
Pricing
While costs are one of the drivers towards the third-party model and indeed specific providers within that model, attention should be paid to both the platform cost structure and its constituent elements, as well as any term limits or restrictions on fee raises or new charges. While the market is highly competitive, with additional regulatory pressure coming to bear, as well as their own potential investor demands, management companies are inevitably trying to find ways to increase revenue. Although direct fee raises are generally rare to date, other ways of increasing revenue may include, adjustments of minimum fees, additional fees for any services deemed to be additional or ancillary and a stricter defining of the service offering, expiration of “teaser” introductory rates etc. The ownership structure of the platform may be a factor to bear in mind when assessing the likelihood of such hard or soft fee raises.
Service providers
An existing fund platform has incumbent service providers which will typically be non-negotiable. While the incoming asset manager may be satisfied with these, care should be taken that any additional service providers that it wishes to use specifically for its fund, such as prime brokers etc. will be willing to work with the existing service providers (and visa-versa). Ideally examples of existing sub-funds that have appointed them should be apparent or related assurances be sought.
Summary
The market for third-party fund platforms has grown exponentially in recent years. However, while the basic key considerations when assessing such options, such as costs, service providers, directors etc. remain unchanged, regulatory and market factors have caused an evolution in the range of issues to be assessed when conducting prior due diligence to ensure a good fit.