Tangled up

The EU–UK Trade and Cooperation Agreement (TCA) is essentially a no-deal when it comes to financial services, and specifically private equity. After years of negotiation, the final deal focuses almost entirely on trading goods between the UK and the EU, with services being all but ignored.

After years of uncertainty caused by the Brexit negotiations, it was hoped that by this point - the start of 2021 - there would at least be some clarity over the way in which UK and European financial services firms would be able to interact with each other.

Unfortunately, that is far from the case. So what does this mean for private equity?

Of course, private equity firms will most keenly feel the impacts of Brexit on their portfolio companies. Beyond the intricacies of managing and adjusting underlying assets, Brexit impacts PE houses themselves in two key areas: managing cross border funds and fundraising.

The TCA says a Multilateral Memorandum of Understanding (MMoU) between the UK and EU is scheduled to be agreed by March 21 2021, which will pave the way to deciding whether or nor the UK is granted equivalence on key rules governing the private capital funds industry, namely MiFID and AIFMD.

The March deadline is by no means guaranteed, and judging by the way in which pre-Brexit negotiations played out, it is unlikely to be met. So, this leaves the industry facing another stretch of uncertainty. To navigate this strange and liminal period, it is necessary to assess the management of cross border funds and fundraising on the basis of where the UK currently stands, i.e. a third country, and the possible outcomes of further negotiations.

Equal opportunities

The big question hanging over UK private equity funds right now is whether or not equivalence will be granted.

According to Jan Gruter, legal director in Addleshaw Goddard’s Investment Management group, looking at AIFMD, it has a complicated third country passporting regime built in that in theory envisages third country managers being treated like EU managers, including marketing and management passports. “But it hasn’t ever been switched on. An equivalence determination would pave the way for third countries that have been assessed as ‘equivalent’ as being able to use the AIFMD third country passport,” he adds. “However, it’s not as easy as that because specific action is needed by the Commission to actually make the AIFMD third country passport regime operational and for the time being this is unlikely to happen. So even if the UK received a positive equivalence decision in March, it would not restore AIFMD passporting rights to UK managers under AIFMD for the time being.”

When it comes to MiFID, the third country regime is already operational. “So if there was equivalence, UK firms under MiFID could operate under the third country regime. It comes with conditions; it’s not easy, but, at least in parts, it is similar to the passporting arrangements,” adds Gruter.

Crossing the border

For managers operating cross border funds, in particular UK-based managers with structures domiciled in the EU, there were two main models adopted in preparation of a no-deal Brexit. Managers either set up offices in Europe (typically larger houses with the firepower to do so), or they plugged into third party AIFM services based in Europe (typically smaller firms).

Both of these solutions resolve the UK as a third country issue, but they are both dependent on being able to delegate portfolio management and risk management to a nonEU based manager (a third country). As it currently stands, the ability to delegate portfolio and risk management back to a third country manager depends on individual
member state rules. For example, Luxembourg’s interpretation of the AIFMD allows non-EU AIFMs to manage funds in the Grand Duchy. In April 2019, the jurisdiction strengthened its position via a CSSF circular, which set out applicable regulatory requirements for non-EU firms providing investment activities and ancillary services.

If equivalence isn’t granted, these two models remain the most obvious ways in which UK-based managers can continue to operate cross border funds based in Europe.

Market to marketing

The other side to this coin is fundraising and distribution. As things stand currently, UK managers can raise capital in Europe through National Private Placement Regimes (NPPRs), under Article 42 in the AIFMD, where permission needs to be sought on a country-bycountry basis. This is how funds based in the Channel Islands (also third countries in relation to the EU) have operated for many years.

While many managers have to date used UK based placement agents to augment their European distribution activities, Brexit is now posing further regulatory challenges in connection with any such arrangements. According to Andrew Brizell, co-founder of Corvus Advisers, placement agents are regulated under MiFID, and overnight have, in a number of member states, lost their ability to operate under MiFID as the passport has fallen away. “This issue is not insurmountable, and most agents will have enacted post Brexit contingency planning, but of the key European investor jurisdictions, France, Spain and Germany will present certain distribution challenges for most agents.”

Thankfully, unlike other pockets of the financial services industry, private equity firms raise capital infrequently and for short periods of time. With that, having a permanent or long term ability to access European investors is less important. This means the NPPR is a much more viable option for private equity compared with other financial products.

Gruter explains, NPPR remains important for some managers, depending on how often they were accessing European investors and where in Europe they are based. “If a UK-based GP has numerous European LPs, or is looking to expand their investor base in Europe they are more likely to look into setting up their own European AIFM or plug into a third party AIFM services provider to allow access to the AIFMD marketing passport,” he says. “Other managers may however see the private placement regimes as a viable option. It’s a case of which member states they need to access as the conditions differ by country.”

Indeed, some countries are much easier to access via the NPPR including the Netherlands and the Nordic countries, whereas France and Southern Europe are less accessible under the regime.

If equivalence is granted, that would return passporting rights to UK based managers, and allow them to freely access European managers, regardless of individual country rules.

Power brokering

Now that the transition period has come to an end, and some kind of deal has been agreed, how likely is equivalence when it comes to financial services?

There are two inherent issues with equivalence. One is that either party can withdraw it with only 30 days’ notice. The risk here is one rogue play could see equivalence removed. The other is that it requires the third country to track EU regulation.

Says David Rochford, managing director, head of hedge, private equity & real asset funds at MUFG Investor Services, “If you’re trying to access capital in another market, you can only do so on equivalence; the EU needs to be comfortable that their rules apply. With that in mind, the whole sovereignty question surrounding Brexit is difficult to square when it comes to equivalence.”

It is interesting to note that the UK has downgraded its ask when outlining its future relationship with the EU. It first sought ‘enhanced equivalence’, focusing on an outcome based on more than rules based assessments, but this has been reduced to just ‘equivalence’.

“We’ll have to see how those talks progress,” says Rochford. “Ultimately, if equivalence can’t be achieved then access is restricted, and the UK could do the same in return, which might be a concern but ultimately the EU is a bigger market. This all comes down to power brokerage.”

Indeed, there is a touch of the David and Goliaths when thinking about the UK’s standing in achieving access to the EU. In the five-year period to 2019, European investors allocated more than half of the total capital raised by UK private equity firms. However, as much as the EU operates as a trading bloc, individual member states have varying needs. “Individual countries will be concerned; this is not a simple decision,” notes Rochford.

Go your own way

Returning to the question of sovereignty for the UK, there appear to be signals of this already emerging.

In November 2020, the FCA released details of a working group that, “...will build upon work already undertaken to investigate the challenges and potential barriers to investment in productive finance assets in the UK, including the Treasury’s Patient Capital Review in 2016 and the Asset Management Taskforce’s UK Funds Regime Working Group’s Long-Term Asset Fund (LTAF) proposal in 2019.

“The working group’s mandate will be to agree the necessary foundations that could be implemented by firms and investment platforms, to facilitate investment in long-term assets by a wide range of investors.”

Explains Gruter, “The UK is a leading centre for fund management but less so for fund domiciliation, and so when it comes to domiciles it will probably want to find ways of making its domestic fund regime more attractive and more competitive.”

Alongside the FCA’s working group, the UK Treasury recently entered the second stage of its consultation on Alternative Holding Companies (AHCs).

Says Brizell, “The Treasury is currently consulting on the tax treatment of asset holding companies and has confirmed its intention to reform the law in this area. They have stated that there is both a clear policy justification and a strong economic and fiscal case for reform.”

According to Brizell, a reformed or improved regime could fit quite naturally alongside the re-emergence of the English (or Scottish) LP. “While a cross border marketing passport under AIFMD would not be available for this structure, a wide range of European investors would remain accessible under the existing article 42 marketing regime.”

In terms of how much appetite there is for a more competitive fund domicile in the UK, demand is likely to fall at either end of the spectrum; for large global companies or for smaller, local UK organisations. Brizell points out that first time fund managers who are looking at establishment of both their substantive advisory entity as well as their fund, without the benefit of an ongoing management fee stream, are likely to be attracted by the relatively low cost and ease with which UK based structures could be established. “As long as the UK government doesn’t chip away at the capital treatment of private equity funds, any cross border holding structures (and associated capital transfers) continue to function and there is a viable distribution route, this could be an interesting option, in particular for smaller and/or first time managers,” he says.

Performance review

Staying with regulatory reviews, it’s important not to forget where we are with AIFMD, with the latest consultation ending as this article goes to print.

Gruter explains the current AIFMD review may well result in proposals from the European Commission that could tighten things like delegation rules. “Another important question for the review is whether or not they will keep the NPPR, or make accessing NPPRs more difficult,” he says. “The idea was always that NPPRs may ultimately be turned off but only if and when there is a fully functioning AIFMD third country passport and we are some way from that still. Thankfully, both GP and LP focused industry associations in the UK and across the EU are supportive of retaining existing NPPRs to allow sophisticated PE investors continued access to a wide range of PE funds. It’s important that those voices are heard by the Commission.”

A person of substance

Assessing the various outcomes of the current negotiations between the EU and the UK, when it comes to both managing cross border structures, as well as accessing European investors, any outcome requires more people in the EU, even on a temporary basis. And this is largely because the EU’s focus is increasingly on substance. “It’s about having the right people and not a letter box entity if funds are delegating to an area where the EU has no control. For managers coming in now wanting to access EU capital, they will need an EU presence to do that. Because of this, we may see more jobs moving to the EU,” says Rochford.

Gruter adds that for an EU-based AIFM, looking at substance, including for example how many people it must have on the ground, there is different guidance from different member states. “Separately, because the marketing passport is attached to the AIFM, some UK fund managers may look to second staff to their EU AIFM but it isn’t easy,” he says. “In Luxembourg, for example, there has been some new guidance from the CSSF that such staff must actually be physically in Luxembourg and of course once staff are moved to another country even on a seconded basis, there are local labour law and tax issues to think of.”

Rochford points out that this is a far bigger problem for smaller UK managers. “Larger firms have the scale to do it, but for smaller firms this is an additional cost and it’s a shame that they may no longer be able to access EU capital.”

Third eye

Wherever the talks, negotiations, and various regulatory reviews end up, for now the industry needs to work on the basis that the UK is a third country when it comes to the EU. And that means UK managers accessing Europe on a country-by-country basis.

“Third country fund managers have always had to take a country-by-country approach when it comes to marketing their funds in the EU or managing EU-based funds and that is the situation that many UK managers now find themselves in,” says Gruter. “There are various solutions here that seek to mitigate this but no single golden bullet.” One example, Gruter explains, for marketing purposes, is a tied agent solution where a UK fund manager may work with a third party service provider that has an EU MiFID investment firm, which then in turn appoints an unregulated subsidiary of the UK manager as a so-called tied agent. “This may then allow the tied agent to use the MiFID passports of the EU MiFID firm to support its marketing efforts,” he adds. “Typically, the tied agent would be established in the EU but be subject to very limited local substance requirements. Portugal and Malta are emerging as jurisdictions where the regulators appear to allow that model. It’s gaining a lot of interest but over time is certain to attract more scrutiny from ESMA and the Commission.”

According to Brizell, as there isn’t currently equivalence under MiFID, every member state can set its own rules when it comes to third country access, and lots of countries do. “This is why there are third country regimes and/or extended transitional relief rules in Luxembourg, Finland, Belgium and Denmark for example, but nothing exists in Germany, France or Spain,” he adds. “It’s possible that, over time, we might see other countries who want their LPs to have access to the best managers setting up their own third country regimes, but in the immediate aftermath of Brexit this will likely remain a highly politicised issue and is unlikely to materialise.”

Everything’s political

Brexit is Cartesian geometry; everything exists in three dimensions. A web of ties between the UK and the EU would be far easier to cut and reattach. However, each tie between the UK and the EU is connected to many others - and not just the individual states, but all of the rules and regulations that connect or isolate 28 different markets. All with varying political agendas.

As ever, what to do about all of this depends on each firm’s needs. For UK-based managers with European investors, a lot rides on the individual jurisdictions of where those investors are based. For UK-based managers with widespread EU investors, equivalence under AIFMD and MIFID becomes more important. If it’s not granted, or if it were to be withdrawn, then using a third party ManCo is the way forward.

With that, PE firms must apply their own complex structure onto this knotted foundation in order to determine the impact, the potential challenges and opportunities, and ultimately, what to do next.

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In the five-year period to 2019

53%

The UK share of total European fundraising was 53% and 53% of the investments of UK-based firms went into the EU27

12%

12% of what is invested in private equity-backed companies in the UK comes from European investors

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Withholding tax

Eli Hillman, tax director at Grant Thornton UK, explains the impact of Brexit when it comes to tax.

“Previously the UK benefited from withholding tax directives that benefited PE funds’ UK holding entities holding EU investments, which reduced withholding tax to zero.

“Now the Brexit transition period has ended, and based on the agreement between the EU and the UK, those withholding tax directives no longer apply to these companies, so they fall back to treaties between individual countries.

“For example, Germany and Italy impose dividend withholding taxes, even after applying double tax treaties.

“As a result, leaving the EU may mean that certain future UK tax developments that could have made the UK equally attractive to Luxembourg as a holding platform for EU investments may still leave Luxembourg with an advantage.”