Welcome back after the summer. We trust that you have, if you wanted, managed some form of break, even in these unusual circumstances. These are strange times indeed - John has even attempted some gardening. Thank you to regular reader Stuart Wilks for the quote, "there comes a time in the life of every cyclist with a garden, when a heavy duty strimmer and a chain saw are needed”. Stuart’s updates are not the only circulars to grab our attention recently. Last week we were delighted to receive a helpful email from a City law firm, “Things to consider when buying a corporate jet for your business”. Having checked our budget, we are thinking more along the lines of a corporate tandem, but we are sure that the considerations are the same.
As is so often the case, this edition is a bit of a Brexit sandwich. We start with a Brexit update flimsier even than Britain’s likely trade deal with the EU and end, as ever, with a bit of historical trivia, this time our great nation’s previous flimsiest deal, the Truce of Tours of 1444. On this occasion, we do feel that our historical trivia has been somewhat upstaged by whichever Anglo-Saxon Ælf planted a wall on the site of the Kent Brexit lorry park. Top trolling from the past.
The seventh round of face-to-face negotiations finished on 21st August with the predictable outcome. Nothing happened. As after the sixth round, the EU once again said that the clock is ticking and the UK said that no deal is better than a bad deal. Although Michel Barnier commented that a deal is looking increasingly unlikely, a view repeated by many commentators, we remain of the view that there will be a deal, but it will be so flimsy as to be almost pointless. The next formal round of negotiations will start on 7th September although there may be informal discussions this week.
In addition to the general sense of gloom, there are two further pieces of bad news for the financial services sector.
On 17th August, the Financial Times reported (see here) that Valdis Dombrovskis, the executive vice-president of the European Commission responsible for financial services, had commented that the EU would not be in a position "in the coming months" to assess whether Britain qualifies for equivalence for financial services. As we have commented regularly in this newsletter, equivalence does not bring the same access that the UK has currently in the single market. Not having equivalence would be worse. Following the resignation of Irish commissioner Phil Hogan over “golfgate”, Valdis Dombrovskis is temporarily also taking over the broader trade role, so he will be coming at us from both flanks.
In our previous Brexit update, we included positive news about the financial services Memoranda of Understanding (MoUs) between the FCA and EU regulators. Unfortunately the European Securities and Markets Authority (ESMA) has rather taken the shine of this since then. This is discussed below.
AIFMD update from ESMA
In our previous full newsletter (see here), we covered the financial services Memoranda of Understanding (MoUs) between the FCA and EU regulators. As we outlined, the MoUs are positive news for the UK investment management industry as one of the areas covered is delegation to UK firms under the Alternative Investment Fund Managers Directive (AIFMD). Unfortunately, the certainty provided has been somewhat undermined by a subsequent letter from ESMA, as mentioned above and described below.
On 19th August ESMA announced that it had written to to the European Commission highlighting areas to consider during the forthcoming review of the AIFMD. You can find the letter here.
The key points covered are:
The letter raises a lot of points in a general sense, but these are all broad matters for the Commission to consider rather than specific proposals. Whether or not any of them see the light of day, and in what form, remains to be seen. We will keep a beady eye on developments.
- The letter proposes harmonisation of the AIFMD and UCITS regimes and harmonised reporting for UCITS. These are proposals for UCITS to be more like AIFMD, so nothing for real estate fund managers to worry about;
- It goes on to flag some areas of ambiguity and inconsistency between AIFMD, UCITS and MiFID. This is not a revelation and addressing this would be a positive provided that the eventual cure is not worse than the ailment;
- The section on delegation and substance is the most worrying part, and gives rise to the issue with the MoUs referred to above. The letter comments "ESMA sees merit in providing additional legislative clarifications in the AIFMD and UCITS frameworks with respect to delegation and substance requirements”. It goes on to refer specifically to the ESMA opinion from July 2017 on the UK leaving the EU, which you can find here. The ESMA letter suggests a review of delegation of portfolio management by EU AIFMs to firms outside the EU. This is specifically what is covered in the MoU so any change in this area creates uncertainty for UK based asset managers working on a delegated basis for AIFMS in the EU, typically in Luxembourg and Dublin. However, this is not a uniquely UK issue. It would potentially have a much wider impact. For example, US fund managers have long operated under delegated powers from EU AIFMs to facilitate marketing of funds in the EU. It affects UCITS funds as well as AIFs, and AIFs cover a much broader range of asset classes than just real estate.. The UK real estate investment management industry will not therefore be alone in lobbying against limitations in delegation. The letter also suggests a review of the role of host AIFMs, which will not be popular, particularly in Luxembourg. ESMA should expect a robust response. The distant clattering noise you can hear is the Luxembourgers gathering their pitchforks.
- ESMA believes that the availability of additional liquidity management tools (LMT) should be consistent throughout all EU jurisdictions and refers in particular to the ESRB’s public statement of 13th May 2020 on the use of liquidity management tools by investment funds with exposures to less liquid assets. As we have covered regularly, regulation of funds investing in illiquid assets is a key topic for the real estate investment management industry;
- There is a splendidly geeky point on the reporting of leverage levels in funds. This is of interest to regulators and people like John who appreciate these things as something of beauty in themselves. See also the ESMA consultation on leverage in funds as a separate item later in this newsletter;
- ESMA has conducted a separate ad-hoc analysis of the issues it sees merit in addressing regarding the AIFMD reporting regime and data use. This is set out in an annex to the letter;
- The section on harmonisation of supervision of cross-border entities is relevant for regulators;
- The letter suggests that there should be a definition of “semi-professional” investor in AIFMD, but that passporting should not be permitted to such investors. It would be up to each country whether to allow marketing to such “semi-professional” investors under National Private Placement Regimes (NPPRs);
- ESMA believes that there should be a specific framework for loan origination funds within the AIFMD. This is a subject on which ESMA has pontificated in the past and on which we disagree with some of the conclusions. We will write more on this in due course;
- There is a brief bit on central securities depositories which is not relevant for real estate;
- There is an equally brief bit on the proportionality principle for remuneration requirements in which ESMA reminds the Commission that they wrote to them in 2016 about this and presumably never received a reply;
- ESMA recommends that the Commission should consider further clarifying the power of Member States to apply additional requirements under their national law to sub-threshold AIFMs. Making the rules for sub-threshold AIFMs more demanding whilst limiting the capacity to use a host AIFM instead (see comment earlier) would be bad news for start-up fund managers;
- A topic covered that has been of ongoing concern to the real estate industry since the introduction of AIFMD has been valuer liability. Under AIFMD, “the external valuer shall be liable to the AIFM for any losses suffered by the AIFM as a result of the external valuer’s negligence or intentional failure to perform its tasks”. ESMA proposes to restrict this to gross negligence;
- Point 15 is a call for amendments to definitions. We have read it several times and are at a bit of a loss as to what ESMA is driving at;
- The letter states that there is merit in considering achieving greater clarity on the definition of reverse solicitation;
- Point 17 is a bit odd and is titled "convergence in treatment of significant influence’. A UCITS fund is not allowed to acquire any shares carrying voting rights which would enable it to exercise significant influence over the management of an issuing body. The letter notes that AIFMD does not include equivalent provisions. We would respectfully suggest that this is because this is exactly what AIFs are supposed to do. It is not clear what ESMA is suggesting, but a convergence of rules would be silly;
- ESMA believes that the AIFMD review is an opportunity for the Commission to allow more digital communication instead of paper form. We cannot see anyone disagreeing with that;
- The final point in the letter is that ESMA notes that there has long been a discussion in the EU on the merit of a depositary passport, since the UCITS II debate in 1993 at least. While not recommending the creation of such a passport in AIFMD and the UCITS Directive, ESMA believes the Commission may study the benefits and risks further in the context of the AIFMD Review.
John was quoted in CoStar on this. You can find the article here.
In addition to our last regular newsletter, we sent out a very brief update a couple of weeks ago about the FCA’s announcement of a further consultation on open-ended funds, which you can find here. The main proposal in the consultation is the introduction of notice periods for funds investing in illiquid assets. in addition to press coverage, John's comments were read by over 3,000 people on Linkedin, so we assume that this remains a topic of interest. As usual, we will contribute to industry bodies responses, but we will also be submitting our own responses.
The other major matter looming for open-ended property funds will be the impact of the uncertainty clauses on valuations being lifted. Authorised funds in the form of Non UCITS Retail Schemes (NURS) applied early the new regulations coming into effect at the end of September that require such funds with more than 20% of their portfolio subject to material valuation uncertainty are required to suspend subscriptions and redemptions. As the material uncertainty clauses are lifted on all property types, funds will need to reopen, at which point it will become apparent if there are redemption pressures that have built up during the suspensions.
These two things may come together (and not in a good way). As we have previously covered, and was discussed in detail in John’s report for AREF on fund behaviour following the EU referendum (see here if you are interested), there are very significant structural challenges to changing the retail distribution of funds, in particular the platform architecture. As we have also covered, this is an issue for DC pension investment in real estate as well. The NURS rules already allow funds investing in immovable property to have redemptions less frequently than daily. Funds have not moved to less frequent redemption models because many of the platforms through which retail investors generally enter such funds do not accommodate this. There are also significant issues from the mismatch between the fund rules and the ISA rules. In the report on fund behaviour, John outlined that it was essential that there was a comprehensive reform that addressed:
The FCA consultation recognise that these are issues, but we think reassurance needs to be provided to the retail distribution network that changes will not be introduced until a solution to these problems has been developed.
- Ambiguities and inconstancies in the current NURS rules;
- Challenges arising from the platform and retail distribution architecture;
- Changes to other regulation, where there is a knock-on impact, specifically the ISA rules.
As mentioned previously, we also have a broader concern about “one size fits all solutions”. We do not believe that the introduction of notice periods is the only relevant liquidity tool. Liquidity tools should match the liquidity of the underlying assets. Individual apartments will typically be more liquid assets than, say, airports, so an approach with a single length of notice period or only the use of notice periods would not appear to us to be the most sensible way forward. Our view has always been that the best way of taking this forward is to address the issues identified above and then allow the market to offer a variety of fund products. Investors can then vote with their feet.
It is concerning that those who are most enthusiastic about the proposed new rules are those who want to see an end to open-ended funds. Chief executive of First Property and odious former Brexit Party MEP, Ben Habib has written with barely concealed glee, "If the FCA’s proposals are realised they will effectively spell the end of “open-ended” funds”. We doubt that the objective of the FCA is to bring open-ended funds crashing down for the benefit of Ben. Without a more nuanced approach and significant changes to the overall investment architecture, this could nevertheless be the result.
The other point that is in focus again this week that we have flagged in the past, is that the bigger issue in open-ended funds is not those that invest in real estate which investors know is an illiquid asset, but funds that are investing in things that are in theory liquid that turn out not to be, these days widely referred to as a “Woodford scenario”. The Financial Times has been flagging unusual aspects of valuation and liquidity management at H2O Asset Management since before Woodford. Although the manager is based in London, the funds in question are regulated by the French regulator, which required eight of its funds to suspend last Friday due to circumstances not dissimilar to Woodford.
Anyway, we are sure that there will be a lot more on this topic over the next few weeks. For one thing, John is chairing an Investment Property Forum webinar “Open ended property funds under the spotlight” on 15th September. Details later in this newsletter.
Stamp Duty Land Tax Surcharge
Draft legislation for new rates of Stamp Duty Land Tax for non-UK residents from 1 April 2021 was published on 21st July. As previously announced, the rules introduce a surcharge that will apply to acquisitions of residential property, including certain leases, by non-residents. The rate will be 2%. We had not originally planned to cover this as various law and accountancy firms have produced summaries and the HMRC explanatory materials are comprehensive. However, we have concluded as a result of some of the discussions that we have had with clients that it would be useful to share some thoughts as to how the changes apply to funds.
In the context of funds, it will apply to:
The surcharge will apply to “dwellings" acquired eligible to Multiple Dwellings Relief so if 6 or more dwellings are acquired, this is likely to mean that the fund will treat this as a commercial transaction subject to SDLT at 5% rather than using the Multiple Dwellings Relief.
- Non UK equivalents of a UK Co-ACS, including the Luxembourg FCP;
- Non UK unit trusts such as a JPUT;
- Non UK funds in the form of a company, such as a Luxembourg SICAV;
- Partnerships, including UK partnerships, if any of the partners is non-resident. The SDLT surcharge will effectively apply to all the partners if there is a single non UK partner;
- UK companies that are controlled by non-residents unless the company is a REIT or UK OEIC, such as a PAIF.
It increases the importance of looking at the SDLT impact of different ways of structuring acquisitions, e.g.:
- Forward funding contracts where the SDLT is only on the land element;
- Buying and selling assets already held in an SDLT opaque SPV. The tax rationale for the using income transparent FCP or JPUT fund structures is preserved if the SPV itself is transparent for taxation of income purposes (e.g, a JPUT)
You can find the HMRC explanatory materials and draft legislation here.
FCA AHC consultation
We have been covering HM Treasury’s consultation on the tax treatment of UK asset holding companies (AHCs), which closed on 19th August. John drafted the response from the Investment Property Forum. Let me know if you would like a copy. John also coordinated with AREF, INREV and the Law Society to share the IPF’s work with these other organisations responding to the consultation.
EU ESG consultation
We have been covering over recent editions of this newsletter the EU ESA’s consultation on the Reporting Technical Standard (RTS) for reporting under the EU Sustainable Finance Disclosure Regulation (SFDR). This is potentially a major issue for the real estate investment management industry. Real estate fund managers are caught by the regulation as it catches anyone within AIFMD, but the structure of the reporting framework makes it impossible for funds investing in direct property to comply. Even managers who are not caught may have to comply (in theory but impossible in practice) as their investors may be caught as it applies to European insurers (under Solvency II) and pension funds (institutions for occupational retirement provision - IORP II). The position in the UK is potentially even more complex as the UK has imported the SFDR into UK law but not the RTS.
John has coordinated an industry response arguing that real estate as an asset class should be excluded until a workable framework for reporting direct property can be developed, drafting the AREF and IPF responses to the consultation, and coordinating with INREV, GRESB and the BVCA.
Again, let me know if you would like a copy of the submission.
ESMA AIFMD / leverage consultation
AREF submitted a response last week to the ESMA consultation on the guidelines on AIFMD Article 25 (leverage) which closes today. We made a tiny contribution. Again, let me know if you would like any information about this.
Urban Splash Residential Fund
The Urban Splash Residential Fund, for which John is the chair, has been in the press regarding its latest capital raise. You can find the recent Estates Gazette article here.
Details of forthcoming webinars at which John is speaking are below.
London Stock Exchange Investment Fund Conference 2020
John will be speaking about real estate funds at this conference on Friday, which is being run as a webinar this year. You can find details and register here. As it is online, there is no limit on the number of people that can attend this year!
Investment Property Forum webinar “Open ended property funds under the spotlight"
John will be chairing this panel discussion. Details and registration here.
Historical trivia - the Truce of Tours
As we lurch towards a flimsily useless post Brexit trade deal, we thought it would be interesting to cover for you another contender for “our nation's worst deal ever". Our selection is the Truce of Tours between England and France of 1444. By way of background, the English king at the time, Henry VI, had come to the throne in 1422, when he was only nine months old. This is not an ideal age to be an effective monarch, so the country was ruled by regents until 1437. Henry’s main challenge was that he had inherited the Hundred Years' War with France which had been running since 1337. In 1437, the centenary of the start of the war, Henry was deemed to be fit to do the kinging himself. This rapidly proved to be an over-optimistic assessment. By the early 1440s, the war, which had already been going badly (from the English perspective), was going noticeably worse and the country was pretty much bankrupt. Hence the need for a deal.
So, to the terms of the deal. England’s chief negotiator, William de la Pole, 1st Duke of Suffolk, and the king himself seem to have genuinely thought that the French needed a deal more than the English did and that a two year transitional arrangement would automatically mean a permanent deal to follow. Not all aspects are direct parallels with the present. It being the fifteenth century, a key element was a French princess for Henry VI to marry. However, on closer inspection, the princess turned out not to be a top of the range model. Rather than being a daughter of Charles VII of France, she was his niece, the fourth child of an impoverished Duke and thus came without a dowry. She nevertheless had high expectations and relocating a princess was not a cheap exercise. As with government procurement projects to this day, it came in massively over budget and the king had to borrow heavily to fund it. Worse still, Charles VII announced that the English had agreed to hand over Maine (the province of France, at the time held by the English) as part of the deal, but that this had been kept secret by Suffolk and Henry to avoid uproar at home. So how did it all work out? Although the truce was extended briefly, the French attacked the English again in 1449, William de la Pole was impeached and then beheaded and Henry had a mental breakdown. By 1453, the French had captured all of the English possessions in France except Calais (bringing the Hundred Years’ War to a close after 116 years), and by 1455 civil war had broken out in England (the start of the Wars of the Roses). By 1471, Henry VI had "lost his wits, his two kingdoms, and his only son”.
Henry’s other main claim to fame is that he founded Eton College (as a charity school to provide free education to 70 poor boys), so you could claim that he also carries ultimate responsibility for the current mess, although, to be fair, his original mission of providing schooling for the poor seems to have become somewhat corrupted since his death.