As the participants log in for the Europe roundtable discussion, one thing is certain – there is plenty of regulation to talk about. The years since the global financial crisis have seen a flood of new rules brought in across the financial industry, with asset management one of the latest sectors to be affected.
A range of ongoing initiatives by the Organisation for Economic Co-operation and Development (OECD) and EU aimed at protecting investors, increasing transparency, collecting more tax and promoting regulatory convergence have inundated managers and fund administrators with demanding new compliance requirements. Set against a backdrop featuring the imminent legislative shakeup likely to result from Brexit, and the still largely unfathomed impacts of covid-19, compliance professionals in the European private real estate investment industry have plenty to keep them occupied.
Elliot Refson, director of funds at Jersey Finance, opens the discussion by listing the key issues affecting domicile choices revealed in a survey of real estate fund managers and investors commissioned by his organisation at the turn of the year: “Brexit, BEPS (base erosion profit shifting), substance requirements and transparency.” He adds: “It also indicated that managers are concerned about higher regulatory costs in many jurisdictions, increased reporting requirements, primarily in Europe, and more regulatory uncertainty resulting from a number of jurisdictions being ‘blacklisted’ under EU economic substance requirements.”
Eric Brilman, a lawyer who acts as EMEA counsel for manager CBRE Global Investors, observes that a great deal of new regulation is being introduced each year, particularly in Europe. “For managers, that adds cost and execution risk, especially where investment structures are international and rules differ from country to country. Investor clients are asking us: what structures can reduce that risk, and how are you as a manager making sure that you comply with all those regulations?”
But tighter regulation has not reduced investor appetite for European real estate, suggests Simon Vardon, global head of real assets at fund administrator SANNE. “We are currently in an ultra-low interest rate environment, so the fundamentals are strong,” he says. “The amount of technical regulation to be complied with is to a degree a necessary evil, because it is there to encourage good behaviours and to set minimum standards, but the cost of compliance is something that has to be navigated to achieve the best outcome for the investor.”
The Alternative Investment Fund Managers Directive (AIFMD) has facilitated investment in the region by levelling the playing field and allowing ‘passporting’ to facilitate cross-border capital raising within the EU, adds Edward Tran, a partner at law firm Katten. However, he says national variations in the interpretation and application of cross-border rules have sometimes been unhelpful to international investors. “Most non-European institutional and sovereign investors are well able to protect their own interests by making bilateral agreements with managers. For them the nuances of regulation probably just decrease the ease with which they can access investment opportunities, making investments more complex and costly as a result. I have seen a number of transactions go much more slowly or be paused as a result of those challenges.”
Brilman says: “There are still quite a lot of low-hanging fruit that regulators can address, so we get even more convergence in the interests of a properly functioning pan-European market.”
He suggests that not only alignment, but also simplification should be a goal for regulators. “For example, we see questions around how MIFID [the Markets in Financial Instruments Directive] interacts with AIFMD sometimes. Especially for markets with professional investors only, we need a back-to-basics approach where regulators really look at what exactly is the interest of the investor being protected, and create simpler, principle-based rules.”
In February, the Cayman Islands, together with Panama and the Seychelles, was added to the EU’s ‘blacklist’ of jurisdictions perceived to encourage abusive tax practices, principally by providing low tax rates aimed at attracting profits without reflecting real economic activity, or ‘substance.’
Cayman Islands is among the most popular jurisdictions in which to domicile real estate funds, alongside Luxembourg, Delaware and the Channel Islands, but blacklisting has already damaged its appeal. “We have had managers switch literally last minute because they can no longer use Cayman, for example as a feeder fund into a master fund structure,” says Vardon. “If they want to bring in EU capital, those investors will say they cannot use Cayman while it is on a blacklist.”
At present, blacklisting has limited implications for existing fund structures that utilise Cayman, but that may change from 2021 when EU members states will be required to take action against jurisdictions on the list, says Tran. “One of those actions would be the imposition of withholding tax on funds with a Cayman entity or partnership in their structure. However, Cayman has taken some steps and hopes to get off the blacklist when it is reviewed in October this year, which would be welcome news.”
Substance rules, alongside increased costs and uncertainty over future reporting requirements, are having a significant effect on domicile choices, argues Jersey Finance’s Refson. “We have seen a flight away from blacklisted jurisdictions toward those that can offer tax neutrality, which remains difficult to achieve onshore in a cross-border context. Based on the research we commissioned, investors – and it is investors that primarily determine domiciliation – want a jurisdiction that can offer expertise and political and fiscal stability with a no change outlook from a regulatory, legal or economic perspective. That outlook is gaining traction, particularly among US investors exploring ways of accessing European capital.”
Jersey was removed from the EU ‘grey list’ of countries required to show more rigor in proving that they meet substance requirements in March 2019. “We codified what was best practice in Jersey anyway, and we have subsequently been praised by European regulators for how those regulations were implemented,” claims Refson.
Vardon observes: “For Jersey and Guernsey, the new economic substance requirements shone a light on something that they can prove exists. Other offshore jurisdictions that did not already have a model built around management and control are likely to find it a slightly tougher gig to demonstrate true economic substance in the same way. That will help to differentiate them in the eyes of some investors.”
Meanwhile, Luxembourg retains its attractions as a jurisdiction for many European funds. Brilman says: “For many investors, two things really drive the choice of domicile: flexibility of structuring, and tax treatment that is favourable. That, plus a mature and stable regulatory environment causes people to end up in Luxembourg more often than not these days. When you are going into a jurisdiction having the know-how on the ground and a competent supervisory body is absolutely key.”
Vardon adds: “AIFMD considerations mean investors typically gravitate toward an EU-based manager, and most likely an EU-based fund, and then most of the time Luxembourg is the preferred domicile choice for both.”
On 1 January, the UK officially left the EU, although a 12-month transitional arrangement where EU law applies as before will continue until 31 December. The participants agree that a comprehensive trade deal seems unlikely, and that as such passporting arrangements hat currently allow UK-regulated managers to raise funds across the EU will probably also come to an end.
“Brexit is going to make life a lot more difficult for all of us in the fund industry,” predicts Tran. “It means increased regulatory uncertainty and cost. It has not helped investors and managers from the perspective of choice, certainty and investor protection. My personal view is that it has been a drag on investment.”
Like most managers, CBRE Global Investors has adjusted its management structure to accommodate the expected change. Brilman says: “Where we had a Europe-domiciled fund with a UK manager, that meant moving the regulated management from the UK to the continent. You can make plans to address the issues, but Brexit uncertainty remains a significant threat to the wider market.”
New funds seeking to raise capital within the EU are no longer using UK-based managers, says Vardon. “The UK is such a significant player when it comes to the flows of capital within Europe, both as a recipient and originator, that it will be interesting to see how the UK government plays this. There does not seem to be an appetite for signing up to equivalence on many fronts when you listen to their rhetoric.
“At the moment, that leaves everyone with quite a lot of uncertainty, which has been to the detriment of the UK for the last few years, and to the benefit of EU jurisdictions that have been pretty good at beating the drum to attract new business.”
While some managers have moved AIFM structures to Luxembourg or Ireland, Refson believes that Jersey will also benefit. “In the event of a no-deal Brexit, the opportunity is there for offshore jurisdictions like Jersey to assist in bridging the gap. Jersey is a Crown Dependency with its own government, regulator and bilateral private placement agreements with the individual member states of the EU and guaranteed private placement into the UK, which was recently augmented in the event that EU law no longer applies in the UK because of a no-deal Brexit.”
While most of the topics the participants discuss have been on investors’ radar for months, or even years, the regulatory ramifications of coronavirus have not yet become apparent.
“As we went through lockdown in Western Europe and the US it became clear that regulators were very concerned about the resilience of firms under their supervision. Not everyone had an adequate plan for working remotely for extended periods,” says Tran. “Aside from the larger macro- commercial piece there is certainly more emphasis on making sure that we
can continue working and investing.”
“Covid has shone a pretty bright light on the importance of non-financial risk factors,” notes Vardon. “There was already momentum, but if there were managers out there that weren’t really up to speed on ESG before, then this has been the kick start to play catch up. Investors will be wanting to know how the broader non-financial risks like climate change are being assessed.”
The last global crisis brought with it a tsunami of related regulation that has changed the shape of the asset management industry in Europe. This one might yet do the same.
Which one piece of regulation or regulatory trend should be on the radar of investors and managers?
Refson: Brexit. In a post-Brexit world, assuming no deal between the UK and EU, which is the likely outcome, and assuming a lack of equivalence, which is equally likely at this point, UK managers will not be able to access European capital, and European managers will not be able to access UK capital.
Vardon: Because of BEPS, tax regulation is still coming thick and fast. ATAD (Anti-Tax Avoidance Directive) I and II are now being implemented. The first includes interest-deductibility rules, which can have quite a bearing on real estate structures because it has the potential to impact on IRRs if there is a big swing in the amount of interest that can be deducted in tax returns. Sitting alongside that, you also have the introduction of the mandatory disclosure rules. There are a lot of people in the industry still trying to grapple with the practicalities of compliance with such a broad piece of tax legislation.
Brilman: Data and information security is going to be a hot topic with regulators. Managers are under increasing pressure to manage all of the different regulatory requirements, so they need to develop systems to do that, and those systems need to be secure.
Tran: If Brexit, tax, and data security are all taken, which are all excellent themes that we will be seeing more of, I would come back to ESG. There are no widely agreed common standards yet and there will be debate as they develop. We may also see enforcement actions taken by regulators against companies that are caught ‘greenwashing’ and unable to back up
claims about their ESG achievements.
The participants consider the direction of travel in ESG, diversity and sustainability regulation:
Brilman: Managers and investors are really driving this agenda more than regulators at the moment. Investors’ requirements are increasingly consistent and those are converging with managers’ policies at a level above where regulation sits right now. We see more and more private and NGO initiatives which create benchmarks, labels and certificates. The market
is relying on that right now rather than regulation, but regulators are catching up.
Refson: Regulators in many jurisdictions are grappling with those issues and they need to collaborate and create a global standard, without which regulation will be very piecemeal and fragmented.
Tran: The difficulty is in defining how you achieve success in ESG categories. What does it mean to have a properly diverse real estate fund? Are we talking about the managers, the buildings, the localities? How do you take the concept and actualize it? We are still very much in the phase of developing ways of measuring the achievements of funds and investors
by this new yardstick.
Vardon: There is regulation coming through. The EU’s sustainability-related disclosures are fast coming down the track, and that will be a pretty significant piece of legislation. There is still discussion around the detail of what is fair disclosure and what fund managers will have to demonstrate to prove their ESG achievements.