The cost of regulation

Just a few years ago real estate fund managers did not need to discuss things like the US Foreign Account Tax Compliance Act (FATCA) or the EU Alternative Investment Fund Managers Directive (AIFMD) with their investors. But after the torrent of new rules and regulations which has come into effect across the globe, managers must work out how the costs of the corresponding legal and compliance work are allocated.

Although AIFMD and FATCA are two separate topics, there are similarities with respect to the costs of becoming compliant. These costs can broadly speaking be divided in two: firstly, the costs related to the analysis of AIFMD and FATCA; what this means for both a fund manager and its managed funds, and how the manager should set up its operations to cope with this adequately. Secondly; the recurring costs of compliance such as ongoing reporting, which will be incurred on an annual basis.

Getting ready for the new regulation
Analyzing the implications of AIFMD and FATCA on a fund manager’s operations is often carried out by internal resource teams – which may have been reinforced to be able to cope with these issues – and with the help of external advisors.

For many managers, the process to obtain their AIFM license from Europe’s regulators, is seen as complex and multi-faceted. In addition to that, whenever new funds are launched, managers also need to analyze which domicile to choose for their funds, including potentially blocker and/or feeder vehicles, and how that will work in practice from an AIFMD perspective. Even non-EU fund managers need to carefully analyze their fund structures when they want to market their non-EU fund to certain European investors, such as German or Danish LPs for example.

In the case of FATCA, compliance is no longer optional as most countries have now transposed the Intergovernmental Agreements (IGA) signed initially with the Internal Revenue Service (IRS), into local law. For many fund managers, FATCA compliance is also non-optional from a marketing perspective, as institutional investors start to require seeing the fund’s FATCA analysis and status before committing capital to new funds. Furthermore, most banks now request the funds’ and underlying SPVs’ FATCA status before opening new bank accounts, meaning that managers can therefore potentially also face transactional risks when investing or divesting, if cash is blocked because of non-compliance.

Consequently, all funds must at least determine their FATCA status and many of them will be required to submit annual reporting. It is also important to keep in mind that the FATCA analysis must be performed not only at fund level but also throughout the entire structure of underlying SPVS and property owning entities, often across multiple jurisdictions. While it is clear that most funds will be classified as Foreign Financial Institutions (FFIs), the analysis also needs to go further and determine the exact FFI status to be selected and to look at the impact for the entire group, should one opt for example for the sponsorship relation (i.e. who will be the sponsor and responsible reporting officer etc.).

The amount of time and money that managers have spent on these regulatory aspects varies between firms. In particular when managers started to look at AIFMD, some firms saw an advantage of being among first movers, deciding very early on to implement dedicated task forces, to seek external advice to perform the analysis and to ensure they would be completely ready when AIFMD came into force in Q3 2013. Others took a very different approach, and were sitting on the fence waiting to see which direction the industry would take, and hence benefited from a growing level of knowledge, experience and best practices in the market.

There are therefore significant differences in the level of costs that fund managers incurred in getting ready for AIFMD, and this is also true to a certain extent for FATCA.

What is probably common for all of them though, is that these set-up costs are very difficult to pass on to investors. For existing funds, management fees have already been negotiated with investors so there is little room, if any, to pass on these costs. Will it be easier to include these overheads in the management fees for future funds? Potentially yes, although it will likely be quite marginal as this is a sensitive subject for many investors and it can be difficult to convey that management fees are increasing because the cost of setting up a fund is on the rise. So the set-up costs of both AIFMD and FATCA will typically be borne by the managers, and it is generally accepted that these costs form part of the manager’s overheads, considered as being an investment that will provide them with advantages going forward, as it creates certain “check-the-box” benefits in the marketing of their new funds.

Picking up the bill for on-going compliance
After fund set-up, other regulatory provisions kick in across both FATCA and AIFMD. A feature often cited as the number one cost burden of AIFMD, is having to hire a depositary, the role of which is to safe keep the assets of the fund, monitor cash flows and provide oversight.

What is clear is that the depositary fees are charged to the fund, and are not borne by the manager. This should not be a surprise to many as standard fund documents will typically state that the fund bears all costs of its operations, the use of outside consultants and third party legal and accounting services employed on the fund’s behalf.
However, what is far less clear cut is how to allocate the costs of associated AIFMD reporting. For example, the directive’s Annex IV reporting requires data collection from the underlying asset, which seems like a fund expense, but also requires information on the manager’s firm-wide exposure to risk, or leverage, which seems like a management expense.

What we see from a practical perspective across several jurisdictions is that whenever the reporting is outsourced, it tends to be charged to the fund. Where fund managers do the reporting in-house, it will be part of the manager’s overheads, and so potentially going forward will be covered via the management fees if that is possible.

Working out who should foot the bill for FATCA compliance also needs to be considered. All FFIs will have to identify US reportable accounts within their investors and lenders. In most situations, this can only be done by obtaining a self-certification from each investor and lender, which is something that can range from something straightforward to far more complex depending on the process applied as well as the number and nature of investors. The good news for managers is that FATCA identification is usually grouped with the well-known Know Your Customer (KYC) process. In most jurisdictions, the costs related to this process are charged to the fund, and sometimes it is even part of the subscription fees directly paid by the investors.

Once the US reportable accounts are identified, they must be reported to the local tax authorities for Model 1 IGA countries and directly to the IRS for Model 2 IGA and non-IGA countries.

Again fund managers must work out with their investors the best way to divide the bill, although in practice what is happening is similar to the cost of AIFMD reporting; the invoice is picked up by the fund if the reporting is outsourced, and by the manager if it is done in-house.

So, while there is a general consensus in the market that the costs of the newest compliance burdens should be split between managers and investors, it is not always that easy to work out exactly how that should be done. Yet, common sense and market practice will no doubt dictate what can and cannot be charged to the fund.
Benoit Dewar is head of regulatory and compliance services and deputy head of depositary services for fund administration firm Alter Domus. Anita Lyse is Alter Domus’ head of real estate.