Nine months after the referendum that overturned half a century of British economic and foreign policy, the UK government has invoked Article 50.
Politically, there is no turning back
In the weeks and months following the unexpected outcome of the referendum, Parliament appeared minded to resist or at least water down Brexit. The City, like business in general, was keen on a soft Brexit that kept the UK in the single market. A few analysts even doubted if Article 50 would ever be invoked.
But the odds of a U-turn have faded as the new political calculus hardened. Two-thirds of MPs represent constituencies that voted to Leave. There is little evidence that Leave voters are suffering from buyer’s remorse. Labour under Jeremy Corbyn is divided on the EU, while Conservative ministers perceive that Labour is less of a threat to them than the Brexiteers on their own benches. The realignment was all but confirmed when Parliament voted earlier in March to authorize notice under Article 50, even though most members of the Commons and Lords had campaigned for Remain.
The (short term) macroeconomics favour Brexit
Perhaps the only thing that could shift voter sentiment against Brexit is an economic crisis, but that has not happened. After a bit of a hiccup in the aftermath of the referendum, alternative investment managers raising new funds found no real attenuation in investor appetite in the second half of 2016: Private Equity News has reported that three quarters of UK private equity funds closed at their hard caps.
True, sterling has suffered what appears to be a permanent devaluation, which is importing inflation and squeezing disposable income. But otherwise the economy has been remarkably resilient, aided by the Bank of England’s prompt intervention after the referendum to calm the markets and the Treasury loosening fiscal policy by abandoning George Osborne’s budget deficit reduction strategy. Even if the economy does start to feel a drag effect as the exit door looms ever closer, this will not be a uniformly bad thing if it offsets the imported inflation caused by sterling’s fall.
The UK will leave the single market
The government has made clear that Brexit will have to meet three tests: end the supremacy of European law in the UK, allow the UK to strike its own trade deals, and restore national control over immigration from the EU. Since freedom of movement is one of the “four freedoms” underpinning the single market, and the supremacy of European law is essential to making the single market work, it follows that the UK will have to leave the single market in order to satisfy these tests, an outcome that Theresa May acknowledged in January. This has significant implications for the alternative assets sector.
Access to capital
Currently, a fund manager established in any country within the single market can conduct its own services and market EU funds across the single market via the MiFID and AIFMD passport regimes. Indeed, many firms have structured their entire European operation on this basis, covering the Continent from their London office. But once the UK leaves the single market, it will become a ‘third country’ under MiFID and AIFMD. Thereafter, UK-based managers wishing to raise money from EU investors will have four basic options:
- Do not market in the EU at all, and only accept subscriptions from European investors by way of reverse solicitation. However, reverse solicitation is only genuinely available in very limited circumstances and cannot be used as a marketing strategy, so a manager that chooses this option is effectively deprioritizing the EU market.
- Market the fund separately in one or more EU member states under national private placement regimes (NPPRs). This is what third country managers based outside Europe (and sub-threshold European AIFMs) have been doing for years, but the route will only be available so long as the NPPRs remain in force. That is not guaranteed; indeed, the AIFMD envisages that NPPRs will eventually be phased out.
- Rely on Europe awarding Britain a third country AIFMD passport. Given that it is currently 100% AIFMD-compliant, Britain has a good case for a third country AIFMD passport as part of a deal with the EU on financial services. It would effectively extend the single market back into Britain, at least in this one regard.
- Set up a regulated management subsidiary in an EU member state. In the absence of a passport, this option may suit firms (particularly big ones that can absorb the extra costs) that currently manage or in future expect to raise a lot of EU-origin capital.
Relocate or stay?
Several Continental states are known to be shopping themselves to London-based managers. France, for instance, recently unveiled the ‘Agile Programme’ of reforms, including fast-track domiciliation applications, liberalised marketing rules and a new fund-friendly partnership structure. The press has reported that Blackstone and the Carlyle Group are considering setting up management subsidiaries in Luxembourg.
In reality, most managers will probably find it uneconomic or impractical to move roles and expend resources on a bifurcated EU/UK management model. The costs of relocation are high, not only in finding and kitting out adequate office space, but also in sourcing experienced professionals. No Continental financial centre currently compares to London for its depth and breadth of human expertise in a range of related businesses – banking, law, asset management, consulting, etc. Labour laws in places like France, Italy and Germany also tend to be more costly to comply with than the UK’s own flexible regime.
Even for those managers that do set up a European subsidiary, much of its work will still be handled by investment professionals based in London. The AIFMD currently allows portfolio management functions for EU-domiciled funds to be delegated outside the EU, although the question of ‘substance’ is a live one and may be revisited by regulators in the future.
To passport or not to passport
It is arguably in the EU27’s own interest to maintain the UK’s passport, given the importance of UK financial services within Europe. According to FCA data, around 5,500 UK firms rely on passporting to do business across Europe, while more than 8,000 European firms use the passport to do business in the UK. TheCityUK, a financial services lobby group, estimates that Britain accounts for 85% of the EU’s hedge fund assets and 64% of private equity funds raised. It is thought that around 20-25% of capital managed by UK-based alternative fund managers originates from EU investors. On a worldwide scale, Britain is second only to the United States in the alternative assets sector.
It’s not a sure bet, however. The passport process so far has been strewn with obstacles and delays. After a comprehensive review, ESMA last year recommended several highly-regarded foreign jurisdictions (including Canada, Guernsey, Jersey, Switzerland and Japan) for passports. But the power to grant passports lies with the European Commission, and it has not yet prepared the necessary secondary legislation.
Twin track rules
If the UK does receive a third country passport, it would need to maintain equivalence with the AIFMD rules as they change over time. Although this might seem to undercut one of the key promises of Brexit, “taking back control”, it can be finessed by putting in place twin track rules – an AIFMD-equivalent regime for UK managers wanting to target EU investors using the passport and, alongside it, a lighter-touch alternative regime for UK managers with an international focus. The twin track strategy has been advocated by, among others, the New City Initiative, a think tank representing independent asset managers. It is the route adopted by Jersey and Guernsey, so there is good precedent for this.
One significant aspect of fundraising that cannot be addressed by passports or an EU subsidiary is the European Investment Fund (EIF). The EIF is a major player in venture capital funds, estimated to have contributed over one-third of the capital ultimately invested in British start-ups. Its presence as an LP often draws in private investors. But the EIF is an EU institution with an investment mandate that explicitly confines it to investing in the EEA and countries in the EU membership queue. British-based funds and start-ups will fall outside the EIF’s investment mandate once the UK leaves the EU. Absent a change in the mandate, it will fall to private investors and publicly-financed institutions like the British Business Bank to make up for any loss of access to EIF capital.
Access to people
Since the 1990s, freedom of movement within Europe and the UK’s relative openness to well-educated foreign professionals has helped to support the City’s extraordinary success in becoming the world’s leading international financial centre. If the UK puts up the barriers after Brexit, there is a risk that the ‘cluster effect’ will unravel. That said, the UK’s international work permit schemes would automatically apply to citizens of EU member states after exit. Having taken back control, it will then be up to British ministers to determine how restrictive or flexible the controls on mobility should be, depending on whether demand for overseas labour remains strong post-Brexit in industries as diverse as investment banking, construction, hospitality and social care.
This document is written as a general guide only. It is not intended to contain definitive legal advice, which should be sought as appropriate in relation to a particular matter.