Using a third-party alternative investment fund manager for access to the EU market

26 October 2022
Alternative investment funds have become increasingly popular as a way for investors to diversify their portfolios. Fund managers who want to raise capital for alternative investment funds in Europe are subject to the Alternative Investment Fund Managers Directive, passed in the wake of the 2008 financial crash to regulate investments in such assets.

Complying with AIFMD requirements can be expensive and time-consuming, particularly for small and medium-sized organisations based outside the EU that aren’t familiar with its rules. There are, however, options, some of which can prove more effective than others. Using a Luxembourg-based third-party alternative investment fund manager (AIFM) is often the most efficient choice for fund managers to raise capital anywhere in the EU.

How the EU regulates investments in alternative assets

Alternative investments are assets that fall outside the most common categories of equity, income and cash. They include private equity, real estate funds, private debt, infrastructure, hedge funds and others.

In the past couple of decades, institutional investors have found alternative assets increasingly appealing, as have high-net-worth individuals with a tolerance for risk. These investments can be attractive in part because they are less correlated to traditional asset classes and can help balance a portfolio.

Following the 2008 financial crisis, EU regulators identified alternative investments, particularly those based on subprime mortgages, as a key source of the systemic risk that led to the crash.

In response, the EU implemented the AIFMD in 2013, providing a framework that regulates previously unregulated alternative funds. The goals were to: ensure investors have access to information so they can make informed decisions; oversee fund managers; minimise systemic risk; and create a single EU-wide market for alternative investment funds (AIFs). (An AIF is a collective investment in alternative assets that pools investor capital, much like stock or bond funds.)

Why alternative investment fund managers are important

An alternative investment fund manager is an entity that manages one or more AIFs. An AIFM is responsible for investment, portfolio and risk management decisions, asset valuation, distribution, compliance and oversight of delegates.

Rather than regulating the AIFs themselves, the AIFMD regulates the managers of the funds. Any manager operating a fund in the EU is subject to the regulation, no matter where they are located. Alternative investment fund managers are required to report detailed information to local regulators on the AIFs they manage.

An EU AIFM can conduct marketing and management activities across the entire EU to raise capital from European investors. The ability to do this is called a marketing passport. Such EU-wide marketing was previously limited to conventional stock, bond and income funds.

Raising capital for alternative asset funds in the EU

Managers who want to raise capital for alternative assets in the European Economic Area (EEA) must be compliant with the AIFMD. As with any complex regulation, AIFMD compliance demands significant expertise, time and resources.

Since an AIFM is the regulated entity that raises capital for an AIF, in order to operate, fund managers must either understand and become fully compliant with the AIFMD themselves or appoint a third-party AIFM.

For some large institutions with a global footprint, developing an internal AIFM function may well make sense. But for most small and medium-sized funds, an outsourced solution is best. Compliance issues require a detailed level of expertise, especially to keep abreast of regulatory changes. Sometimes what may seem like a minor change can have significant effects on a fund’s operations and risk levels.

Given the complexities of alternative fund compliance, developing an AIFM capability internally is expensive, and it can take several months or more. For those seeking to domicile and market their AIF in Europe, outsourcing AIFM functions to a third-party management company, or AIFM ManCo, can be a fast, cost-effective route to compliance.

A typical scenario: A US firm hires an AIFM in Luxembourg

To understand the process of outsourcing to a third-party AIFM ManCo in the EU, let’s look at a typical scenario. In our example, a US real estate investment firm wants to raise capital in the EU for the first time and hires an AIFM ManCo based in Luxembourg.

While there are other location options (such as Ireland and Cyprus), Luxembourg is a particularly popular jurisdiction for AIFs targeting EU investors. Luxembourg has the greatest number of established funds in Europe and a significant number of local experts familiar with EU regulations.

The Commission de Surveillance du Secteur Financier (CSSF) supervises Luxembourg’s financial sector. In our scenario, the AIFM ManCo registers the AIF with the CSSF for pre-marketing or marketing activities through its marketing passport. The CSSF will in turn notify the host member states’ regulators about the intention to market the AIF in their jurisdiction. Once it obtains approval from all relevant host member states, the AIFM ManCo and/or placement agents may market the AIF in the EU member states where the US firm intends to operate.

The AIFM ManCo may distribute the AIF across the EEA using a regulated placement agent, or it can act as a placement agent itself, a process sometimes referred to as “chaperoning.”

Choosing an AIFM

Determining the need for third-party support is typically straightforward, but choosing an appropriate AIFM ManCo requires careful analysis.

The AIFM ManCo must interoperate with the management functions of the fund manager, while also providing AIFMD expertise, particularly in the areas of risk management, valuation, marketing, local compliance and Annex IV reporting.

The AIFM ManCo should not require any operational changes on the part of the fund managers, allowing them to continue running their portfolios as usual while the AIFM ManCo provides all the EU-related administrative, legal and risk support required.

Finally, it makes sense to choose an AIFM ManCo with specialists in the AIF’s sector, such as real estate, so that investment processes are aligned.

The advantages of third-party AIFM services

Here’s a summary of important advantages a Luxembourg-based AIFM ManCo can provide:

  • A faster EU fund launch, typically between two and four weeks, through an established entity that has existing relationships with service providers.
  • Easier access to capital through the AIFM Manco’s marketing passport and compliance with the EU distribution regulations.
  • A reduced workload for the fund managers, allowing them to focus on their core portfolio responsibilities.
  • Outsourcing of liabilities, since AIFMs take on the liability and must meet regulatory capital requirements linked to their assets under management.
  • Access to regulatory expertise and established relationships with the local regulator, including setup of marketing.
  • Reduced operating expenses, as the AIFM ManCo provides HR, IT and office infrastructure.
A summing-up

Global economic and political realities are evolving quickly, and investors are more than ever looking for stability as well as value. The EU has been on the vanguard of introducing and maintaining strict financial controls aimed at protecting investors and maintaining a stable, transparent investment environment. The EU market is particularly attractive for US fund managers now as they look for alternatives to domestic targets.

The use of a third-party AIFM ManCo makes it possible to enter the EU alternative asset investment market without the significant outlay required to develop an internal AIFM capability. Once the AIF is established, the AIFM ManCo can provide the ongoing expertise needed to navigate EU markets in the face of regulatory change.