The regulatory environment for Irish-domiciled management companies has been subject to review in recent years, with greater focus on ‘substance’ to ensure that current business models are fit for purpose now and in the future.

The Central Bank of Ireland (CBI) is acting to accelerate change and create a level playing field for all Irish-domiciled management companies – whether they be for Self-Managed Investment Companies (SMICs) or as stand-alone management companies (ManCos). Our ‘Five Questions’, with Aaron Overy, discusses the history of SMICs and why managers (and those advising them) who are seeking to access distribution through an Irish-based fund should be thinking about future challenges.

Q1: What historically led to the growth of SMICS and why in Ireland particularly?
 

Ireland has a long and well-established reputation as a fund-friendly domicile. Its pragmatic regulatory environment benefits from the passports available under the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive and the Alternative Investment Fund Manager Directive (AIFMD) rules, which allow funds to be sold and marketed into the EU and beyond, while being managed outside of Ireland in jurisdictions such as the UK, US and Asia. In the past, the SMIC model has been preferred for US and UK managers who were looking for UCITS to provide a gateway into Europe. The original UCITS Directive of 1985, implemented in 1989 in Ireland, offered a simple way of setting up a structure so that managers could carry on managing money both from the EU and outside of the EU, in jurisdictions such as the US, Asia or Australia.

Q2: How did the CBI’s CP86 review come about and what’s the impact on SMICs?
 

The most common form of UCITS structures established in Ireland up until 2014 were SMICs. Although the CBI had introduced the concept of designated persons and managerial functions as far back as 2009, the time commitments related to those managerial functions were not significant and so, typically, the independent non-executive directors (INEDs) undertook those managerial functions. Things began to change with the introduction of AIFMD in July 2013. Unlike the UCITS regime, which is largely a product directive but also enshrines principles around the management of UCITS, AIFMD focuses on the regulation and ongoing supervision of the Alternative Investment Fund Manager (AIFM). AIFMD is, in many respects, closer to the Markets in Financial Instruments Directive (MiFID) regime than the UCITS regime, notwithstanding that the UCITS regime also requires a UCITS management company function. 

Although AIFMD permits both an internally managed Alternative Investment Fund (AIF) structure, as well as the appointment of an external AIFM, the rules around governance, supervision and the extent to which an AIFM can delegate duties are far more prescriptive than the UCITS regime and made the concept of an internally managed AIF (similar to the SMIC model under the UCITS regime) far more challenging. This prompted the CBI to consider the effectiveness of the delegation structures by Irish management companies which, in turn, led to the introduction of the so-called CP86 regime. What was particularly important about this was that it applied to UCITS management companies, as well as AIFMs, even though the UCITS Directive did not include the same level of detail around UCITS management company delegation arrangements. It was felt that since both the UCITS and AIFM regimes permitted a single regulated entity to be licensed as both an AIFM and a UCITS management company (a so-called Super ManCo) the same standards around oversight, delegation and supervision needed to apply not only to AIFMs but also to UCITS management companies as well. 

Following the UK’s decision to leave the EU, the European Securities and Markets Authority (ESMA) issued a series of opinions in July 2017 which focused on the level of substance which management companies operating in the EU would be required to have. The ESMA opinions signposted a jump in terms of the regulation of ManCos and sought to ensure that a newly established ManCo would have real substance and ‘boots on the ground’ in the relevant EU jurisdiction in which it was established. Since the CBI had already introduced the CP86 regime, it was felt that Ireland was ahead of the curve compared to other leading fund management company domiciles. However, once the Brexit wave of applications was over, the CBI was keen to ensure that there was not an uneven playing field in terms of substance requirements between existing SMICs and ManCos and those recently approved ManCos who had been subjected to higher levels of substance and time commitments as part of their licence approval process. A further CP86 thematic review was commenced in September 2019 in order to assess the typical level of substance and time commitments within existing SMICs and ManCos. This CP86 thematic review concluded with the issuance of the ‘Dear Chair’ letter in October 2020 which mandated that SMICs and ManCos plan for and communicate how they will meet the standards.

Q3: The concept of ‘Substance’ is increasingly important – how can this be defined?

The decisions around substance are increasingly being centralised by ESMA – that has become a common EU theme with increased political pressure as a result of Brexit. ‘Appropriate’ substance will require management firms to have capital to support them and a reasonable level of staff. However, substance requirements are changing and there are reports of ESMA asking, during the application process, for real-time data on what local regulators are saying. Following guidance issued by ESMA, the CBI has been to the forefront of taking ESMAs guidance onboard and aims to be a ‘good EU citizen’ around ESMA decisions. 

The CBI’s decision to align itself fully with ESMA requirements means that it is difficult to envisage a scenario where existing SMICs and ManCos remain subject to a different level of substance and time commitments than more recently licensed ManCos. It is therefore unlikely that firms who previously provided designated persons to SMICs and ManCos under a different level of time commitment will be able to fully support the new model through a SMIC on the same basis as before. Currently, two designated persons discharge all six managerial functions in the context of a SMIC. Under the new regime the minimum requirement is three full time equivalents (FTE). Furthermore, it will be essential that the designated persons undertaking the managerial functions (particularly those around investment management and the two risk functions) are sufficiently senior and qualified to undertake these roles. Six functions have been designated, with a requirement of typically 660 days, or 110 days per role, with days allocated based on AUM, complexity of the funds and funds under management:

• Investment Management – monitors the portfolio managers to ensure that the investment strategy is adhered to and tracks performance.
• Fund Risk Management¹ – monitors key investment risks and ensures that appropriate mitigating controls are in place.
• Operational Fund Risk¹ – monitors key operational risks and ensures that appropriate mitigating controls are in place.
• Regulatory Compliance – oversees compliance with the relevant legal and regulatory requirements.
• Capital and Financial Management – monitors the preparation of the audited and semi-annual financial statements, ensures appropriate capital is in place and that appropriate books and records are maintained.
• Distribution – ensures that the funds’ distribution strategy is approved by the board and that marketing is in line with the regulations. Monitors any complaints.

¹ In larger ManCos these roles could feasibly be undertaken by one person provided that the person in question undertakes these functions on a full-time basis and is also designated as the head of risk for that ManCo.

Q4: What are the options for existing SMICs?
 

With regulations becoming more stringent, existing SMICs need to review their business strategy. Two key options exist:

1. Direct application to the CBI for authorisation to set up a ManCo requires the fund manager to staff up and build infrastructure and operations in Ireland. While this approach retains control in-house, the trade-off is that it can be time-consuming and costly, with significant capital requirements, and approval by the CBI is not guaranteed. For non-EU asset managers, such as US managers, gaining sufficient familiarity with the UCITS regime around asset eligibility and the diversification requirements of the UCITS Directive is demanding enough to deal with, let alone dealing with the ManCo requirements on top of this.
2. Managers can contract a third-party ManCo to leverage that infrastructure. Outsourcing ManCo activity and designated person responsibilities to a third party is a lower-cost approach that can ensure regulatory compliance. However, the trade-off here is that the governance and oversight of the fund becomes the responsibility of a third party with a potential loss of some control by the manager.

Q5: What are the key challenges likely to be faced by a fund manager considering setting up a SMIC in future?
 

The CBI now having examined how CP86 has been implemented or lack thereof, has within the Dear Chair letter required significant changes in the way SMICs can continue to operate. In fact, there has already been a dramatic reduction in SMICs being authorised over the past few years – with fund managers either appointing a third-party UCITS ManCo or else setting up their own ManCo, particularly if the establishment of a new EU ManCo may assist in post-Brexit preparations for servicing EU customers. In future, SMICs are likely to have to hire more employees than expected – which will cost them more than is currently the case under their existing SMIC model. They will find both the CBI’s and their own head office’s requirements challenging to comply with, with little chance these will lessen over time. Reporting requirements are already making SMIC board meetings longer and more complex. There is no guarantee that rules around governance and substance requirements of UCITS management companies, or other management companies, may not change again in the future. Retaining a SMIC model makes it difficult to future-proof against any further increases in substance requirements in the future. This need for substance will result in a requirement to manage chargeable days and levels of responsibility against a scarcity of talent and experience. In summary, establishing and running a SMIC model may prove to be a very high and complex cost in an enhanced regulatory environment in which management companies are now being asked to operate. Against a backdrop of increasing regulation and, in particular, the CBI’s CP86 review, a thorough review of your existing SMIC model is necessary in order to determine whether it is adding value and is fit for purpose in the long term.

Photo credit: Christopher Head 

*Damocles was an obsequious courtier in the court of Dionysius II of Syracuse, a fourth-century BC tyrant of Syracuse. Damocles exclaimed that, as a great man of power and authority, Dionysius was truly fortunate. Dionysius offered to switch places with him for a day, so he could taste that fortune first-hand. In the evening, a banquet was held, where Damocles very much enjoyed being waited upon like a king. Only at the end of the meal did he look up and notice a sharpened sword hanging directly above his head, held only by a single horse-hair. Immediately, he lost all taste for the festivities and asked leave of the tyrant, saying he no longer wanted to be so fortunate. Dionysius had successfully conveyed a sense of the constant threat under which a powerful man lives.

For Cicero, the tale of Dionysius and Damocles represented the idea that those in power always labour under the spectre of anxiety and death, and that “there can be no happiness for one who is under constant apprehensions”. The parable later became a common motif in medieval literature, and the phrase “sword of Damocles” is now commonly used as a catch-all term to describe a looming danger.