Why are fund costs in the spotlight?

An ESMA investigation was launched in 2021 with national competent authorities. It revealed divergent market practices as to what the management industry reported as “due” or “undue” costs charged to funds and investors. As a result, ESMA is considering how to harmonise the concept of undue costs among Member States in order to avoid investors from being charged undue costs. 

What is being proposed? 

• ESMA (the European Securities and Markets Authority) published an Opinion, on 17 May 2023, that examines undue costs of undertakings for alternative investment funds (AIFs) under the AIFMD (as well as a regime for costs charged by UCITS).  
• The Opinion sets out proposed amendments to Article 12 of the AIFMD that would introduce the concept of ‘undue costs’ into law.
• Management companies and AIFMs would be required to act in such a way as to prevent undue costs being charged to a fund and its investors. 
• AIFMs would be required to develop and review regularly a fund-specific pricing process for each AIF under its management.

What would a sponsor (/ manager / AIFM) be able to lawfully charge the fund and its investors if these changes are adopted?

• The cost must be 'eligible': draft amendments to Article 12 of the AIFMD would require an AIFM to assess the eligibility of costs by way of referring to the categories of costs set out under Annex VI Part 1.I of the Commission Delegated Regulation (EU) 2017/653), but taking into account the AIF's specific investment policy. 
• Due to the stated concern that investors are often "overcharged" by a manager particularly in the case of related-party transactions (but acknowledging that ESMA wants to avoid national regulators becoming price regulators), not only should the cost be eligible, but charged at prices or at conditions equal to or better than market standards.
• The assessment to determine eligibility of costs ought to take into account the type of fund. 
• Fund managers should consider costs on a case by case basis as part of pricing due diligence, depending on the type of fund and its investment policy; rather than, for example, simply charging the same costs as the predecessor fund.
• AIFMs will be required to develop a fund-by-fund pricing policy that it periodically reviews for each specific fund strategy.
• The proposed new amendments to Article 12 of the AIFMD would stipulate the following as necessary as part of the pricing policy / review:
  • due diligence is performed on charges to the fund and, upon request, made available to investors to ensure that all charged costs are equal to or better than market standards; 
  • in the case of related-party transactions, conflicts of interest are appropriately identified and managed given the risk of the related party charging costs higher than market standards; and
  • costs do not exceed the figures disclosed to investors in the pre-contractual documentation.

How might this impact market practice with managers / AIFMs? 

• The inevitable result will be a requirement for AIFs (/sponsors) to be more transparent on costs incurred and charged to any fund vehicle under its management. 
• Costs will need to be considered upfront by managers as part of the fund structuring process because AIFMs will be expected to disclose a fund specific pricing policy for each AIF it launches and not subsequently exceed those disclosed costs (*managers might need to consider adding new LPA rights to require investor prior approval for charging previously undisclosed costs to the fund). 
• This could likely end the practice of manager's charging a lump sum for fund set-up costs (i.e., all fund set-up costs up to an upper limit amount) without having to justify how those costs are incurred. Investors will be able to interrogate and review those costs. 
• On an ongoing basis, costs will most likely need to be itemised and disclosed periodically (perhaps going so far as seeking prior investor approval (via a limited partner advisory committee) over a certain threshold or if not previously disclosed to investors). 
• In practice, managers will need to accept they need to be more upfront and more transparent with fees and expenses charged to a fund and its investors (this will filter through to what a manager's legal counsel will be able to charge for acting for a sponsor on a fund launch of an AIF). 

The AIFMD no longer applies to UK managers so this is not relevant?

• The AIFMD no longer binds the UK in its implementation (because the UK put in place a domestic regime regulating the management and marketing of AIFs in the UK, which maintained similar rules to those set out in AIFMD as implemented at the end of the Brexit 'Transition Period'). 
• However, if the AIFMD's article 12 were now amended (as set out above), while the UK would not be bound to strictly follow the EU AIFMD, the 'market' (i.e.,    large institutional investors) may demand costs are charged and disclosed on a basis equivalent to those by EU AIFMs so, in practice, UK managers of AIFs will need to consider keeping current with these proposed new rules (if adopted into law). 

Why is it important to take these proposals seriously as a AIFM?

• As part of ESMA's proposed amendments to the AIFMD, it would require an AIFM to proactively reimburse (or indemnify) any costs identified as being 'undue costs'. 
• The obligation would require timely reimbursement or indemnification of investors.
• This, in turn, could have a softer, more serious consequence for managers of AIFs – loss of confidence from their investors – if a manager is forced to admit that it has 'overcharged' its investors. 

Where to go for more information? See the published ESMA Opinion on undue costs of UCITS and AIFs