On August 18, 2020, the European Securities and Markets Authority (“ESMA”) published a letter (the ‘Letter”) addressed to the European Commission (“EC”) on its recommendation for the upcoming review of the Alternative Investment Fund Managers Directive (“AIFMD”). Many of the recommendations made also require consideration of material changes to the Undertakings for the Collective Investment in Transferable Securities (“UCITS”) legislative framework as well.

Since AIFMD’s implementation in 2011, ESMA and various national competent authorities (“NCA”) have identified key areas of improvement to AIFMD in light of their practical experience in supervising firms in accordance with the AIFMD regulatory framework. Article 69 of AIFDM requires the EC to periodically review the application and scope of AIFMD. This involves the EC assessing the AIFMD’s impact on investors, alternative investments funds (“AIFs”), alternative investment fund managers (“AIFMs”) in the European Union (“EU”) and in third countries in order to establish how far AIFMD’s objectives have been achieved. The pending scheduled review by the EC of the AIFMD framework provides the perfect opportunity for ESMA’s recommendations of priority topics to be actioned in order to improve the effectiveness of the AIFMD.

Policy enhancements are proposed in Annex I to the Letter and reporting recommendations are made in Annex II. Although ESMA’s Letter includes recommendations for changes in 19 areas, the present article summarises the key changes which will be relevant for fund managers and asset managers.


Harmonisation of the AIFMD and the UCITS regimes

ESMA believes that as the EC is reviewing the AIFMD framework, it should also consider greater harmonisation between the AIFMD and UCITS framework.

ESMA highlighted in the Letter that the newer AIFMD (level 1 and/or level 2) provisions are more granular and specific compared to the UCITS requirements, for example in respect of risk management and liquidity management requirements. Although some difference is understandable, UCITS are also likely to face liquidity issues despite being invested in transferable securities or money market instruments. Harmonisation across these two frameworks would also reduce the administrative burden on management companies who manage both UCITS and AIFs.

Additionally, in line with the European systemic risk board (“ESRB”) recommendation in 2017 on the topic of harmonisation in its Recommendation D on UCITS reporting (the “ESRB Report”), ESMA has also included a recommendation on improving AIFMD Annex IV regulatory reporting and aligning UCITS regulatory reporting once such updates have been made (subject to specificities of UCITS).

Delegation and Substance

ESMA is calling for restrictions to the delegation of portfolio management functions to non-EU firms post-Brexit, recognising the reliance AIFMs place on delegation arrangements. This point was already highlighted in their Opinion published back in July 2017 following the UK’s withdrawal from the European Union. Because of the operational and supervisory risks associated with such delegation arrangements, ESMA is requesting clarification from the EC on the maximum extent of delegation to ensure that sufficient substance remains in the EU. The authority has suggested that a list is included in the AIFMD setting out functions which may and may not be delegated to third parties and which must be performed directly.

To address situations where either AIFMD or UCITS delegates do not fall directly under the scope of the AIFMD framework, ESMA recommends legislative amendments to ensure that both the management of AIFs and UCITS is subject to the regulatory standards as set out in the AIFMD and UCITS framework, regardless of the regulatory licence or location of a delegate.

It is important to highlight that ESMA has also requested the EC to codify its Q&A published on the topic of delegation. The Q&A set out that AIFMs are responsible for ensuring compliance with the delegation rules in respect of all functions under points 1 and 2 of Annex 1 of AIFMD. This includes not only investment management functions but also administration and marketing functions even in situations where delegates have been appointed directly by the relevant AIF rather than the AIFM to perform certain functions.

Supporting staff

ESMA recognised the popularity of secondment arrangements, in which staff from group entities or professional services firms are temporarily seconded to an AIFM or UCITS management company to perform specific functions. As this arrangement often takes place on a cross border basis, more often than not, the seconded individuals do not physically operate out of the same country as the AIFM/UCITS management company and remain based in their usual offices, often outside of the EU. Under the AIFMD, an AIFM needs to have sufficient ‘substance’ to its business dealings and functionality to prove that it is offshore. This means AIFMs cannot delegate functions to the extent that it becomes a “letterbox entity”.  So far there has been limited regulatory guidance to assess what exactly would constitute “substance”, with only a general understanding that the AIFM must be able to retain a certain level of substance, activity and expertise, particularly in the areas of risk management and/or portfolio management. Therefore, ESMA has queried the compliance of this arrangement with the substance and delegation rules and recommended that the legislation is updated to clarify how such arrangement sits within the AIFMD framework (as well as the UCITS frameworks).

Firms will need to keep tabs on this area especially where staff who are engaged in marketing activities are based outside the AIFM’s jurisdiction and how this relationship remains in compliance with the substance requirements.

Availability of additional liquidity management tools

ESMA has recommended to the EC to make additional liquidity management tools available to all AIFMs in all Member States, so a consistent approach is taken across the EU. Interestingly, ESMA highlighted this need in light of the market dislocation during the ongoing coronavirus pandemic and that a common union framework governing the liquidity management tools would support this.

ESMA’s view is for the EC to also consider including the availability of all liquidity management tools outlined in the ESRB’s Report within the AIFMD (as well as the UCITS Directive) and to introduce adequate legal backing for the use of such instruments.

Amending leverage calculation methodologies

ESMA recommended the international organization of securities commissions (“IOSCO”) “gross” method for assessing fund leverage, set out in IOSCO’s final report published in December 2019 on its own recommendations for a framework to assess leverage in investment firms. Under the current legislation, AIFMs must calculate and report on leverage on two measurements: the “gross” method and the exposure and commitment method. IOSCO’s more refined two step “gross” method involves as a first step for regulators to determine which funds pose a financial stability based broadly on the basis of “gross national exposure” and secondly for such regulators to define specific ways of assessing leverage for riskier funds.

ESMA considers this the best approach to identify funds that pose greater risks to a financial system with greater ease and clarity.

Sub-thresholds AIFMs (otherwise known as ‘small AIFMs’)

AIFMD exempts small AIFMs (AuM of Euro 100million or less) from most of the directive, leaving Member States to decide what to require from small AIFMs. ESMA has recommended, in light of some NCAs preference to have explicit EU legal basis, to extend AIFMD supervision to sub-threshold AIFMs.

AIFMD reporting regime and data use

In the Letter, ESMA includes a separate annex of suggestions for improvements across a range of reporting requirements. In particular, as mentioned above, relating to AIFMD Annex IV (regulatory reporting). ESMA is recommending significant changes in the AIFMD reporting regime and data use, including requiring all AIFMs and the funds that they manage to have their own Legal Entity Identifier (LEI, ISO 17442), as well as incorporating environmental, social and governance (“ESG”) metrics into mandatory reporting.

According to Recital 78 of the AIFMD, private equity funds do not have to report at the level of the structure they invest in (i.e. the special purpose vehicle). ESMA considers that in practice, this may imply that gross exposures and NAV are only based on an equity approach and not consolidated approach used for accounting purposes, which means the actual leverage of PE funds may be under-reported. A proposed solution is to remove the reference to the fact that PE funds do not have to report at the SPV level to ensure better harmonised reporting for all AIFs.

External Valuers

AIFMD allows the use of external valuation services. An external valuer under the AIFMD is considered as a delegate of an AIFM and the AIFM’s liability to the AIF is not affected by the appointment of an external valuer. AIFMD currently requires the external valuer to be liable to the AIFM for losses that arise from its “negligence”.  This liability threshold has discouraged the appointment of external valuers in some jurisdictions as the reference to “negligence” has been interpreted as covering not just “gross” but also “simple” negligence. Additionally, it has also been reported that insurers are also often unwilling to insure against such exposure and if they do, this typically comes at a steep price. Therefore, in a welcome proposal, ESMA suggests amending the liability standard for external valuers in the AIFMD to a “gross negligence” standard.

Scope of additional MiFID services and application of rules

As indicated in previous recommendations, ESMA has again addressed the need for further clarification on the scope of permissible business activities listed in Article 6(4) of the AIFMD and Article 6(3) of the UCITS Directive, in conjunction with Annex I of the AIFMD and Annex II of the UCITS Directive. This is because NCAs have divergent views on whether AIFMs (and UCITS management companies) could be permitted to perform business activities other than those explicitly listed under the AIFMD and UCITS.

ESMA has also suggested for greater clarification and harmony around the exact application of rules across the AIFMD, UCITS and the Markets in Financial Instruments Directive (“MiFID”) rules and how these should apply. ESMA pointed out that the references in Article 6(6) AIFMD and 6(4) of the UCITS Directive are references to MiFID I, and that this should be updated to reflect the requirements introduced by MiFID II. An example of this is that the transaction reporting obligation from Article 26 of MiFIR is not included in the list of MiFID provisions which also apply to AIFMs/UCITS management companies. This means that AIFMs/UCITS management companies providing MiFID services are not subject to the requirement to report transactions in accordance with Article 26 of MiFIR.

Additionally, ESMA also highlighted the uncertainty on whether and to which extent aforementioned rules could be applied to discretionary portfolio management or investment advice on assets that do not qualify as ‘financial instruments’ pursuant to Section C of Annex I of MiFID such as real estate, taking into account that the relevant MiFID provisions do not apply to them.

Therefore, ESMA has suggested defining and clarifying the position of AIFMs which also perform services (such as segregated portfolio management) under a “top-up” authorisation under MiFID as well as clarifying the AIFMD, UCITS and MiFID frameworks to ensure the same standard are applied to all three types of entity when providing the same type of services.


The EC is expected to publish a proposal for the AIFMD review, later this year, and ESMA’s views are likely to carry significant weight. For AIFMs that currently rely on delegation to firms based outside the EU, this is a key area of change to consider in adequately future proofing their delegation arrangements.  Additionally, ESMA’s suggestion that private equity funds report leverage at the level of the holding company structure may have potentially very significant impacts for such funds. This is because this may result in removal of the current exemption for private equity funds to disregard such leverage, so any purported changes put forward by the EC will need to be carefully monitored.

In order to mitigate the consequences of the upcoming changes, firms are encouraged to start thinking about their various arrangements across the board.

For more information, and any guidance or advice on understanding your requirements under AIFM or the UCITS regime, Cleveland & Co External in-house counselTM, your specialist outsourced legal team, are here to help.