The EU’s new PRIIPs regulation will come into force on 1 January 2018, requiring many firms to prepare a “key information document” for certain financial products that are sold to EU retail investors. Given that most hedge funds are not aimed at the retail market – and with the PRIIPs regulation arriving just two days before MiFID 2 – the industry’s attention has understandably been focused elsewhere. But the PRIIPs regulation will catch many hedge fund managers, and it is worth taking a moment to understand how it works.
What is a PRIIP?
PRIIPs are “packaged retail and insurance-based investment products”. The term encompasses, among other things, any investment where the amount repayable fluctuates with the performance of underlying assets. It therefore includes interests in open-ended investment funds, such as a typical hedge fund.
What does the PRIIPs regulation require?
The PRIIPs regulation is short (by some standards), and has two primary obligations:
The rest of the PRIIPs regulation, along with detailed regulatory technical standards, is mainly concerned with the contents of the KID.
While a UCITS is a PRIIP, there is a transitional period for UCITS extending to 1 January 2020. Until that date a UCITS will continue to use its own key investor information document (KIID).
Why is this relevant to a fund aimed at professional investors?
Because the main PRIIPs obligations relate to investments by EU retail investors, a firm can avoid the PRIIPs regulation by ensuring that EU retail investors cannot invest. This is simple in principle, but there are some important details to understand.
If we opt up individuals to professional client status, are they out of scope?
Many UK hedge fund managers use the “opt-up” process in the FCA’s Conduct of Business rules (COBS 3.5.3R) to treat certain individuals as professional clients rather than retail clients. The key point to understand is that the PRIIPs regulation relies on the MiFID 2 definition of “retail client”, whereas the FCA permits certain persons to be opted-up for financial promotion purposes who are not eligible to be opted up for MiFID purposes. Managers therefore cannot assume that opted-up individuals can be treated as professional clients for MiFID purposes, and in fact many such persons will be considered retail investors for the PRIIPs regulation.
The difference between the opt-up criteria for non-MiFID purposes (such as financial promotion) and those for MiFID purposes is the test set out in COBS 3.5.3R(2), which the FCA dubs the “quantitative test”. This requires two of three criteria to be met:
The “relevant market” concept in the first limb is not well-defined, but in this context it is likely to refer to investments in hedge funds. As it is unlikely that an individual will satisfy this, the only persons who can opt up for MiFID purposes will be those who have been in a relevant position in the financial sector for a year, and who have €500,000 of assets – excluding their home.
The application of the quantitative test will therefore mean that most high net worth investors and many of the manager’s staff will be treated as retail investors for PRIIPs purposes.
Can we give interests in our funds to our staff?
One of the requirements of the FCA’s AIFM Remuneration Code is that part of the variable remuneration payable to certain staff should consist of interests in any relevant AIFs. While some firms apply the principle of proportionality so as not to apply this rule, a number of hedge fund managers are unable to do so.
Whether interests in an AIF are being “made available” to relevant staff where their issuance is obligatory, thereby triggering a requirement to prepare a KID, remains an open question. A prudent interpretation suggests that the arrangement is caught, even though this would undermine the aims of the AIFM Remuneration Code.
Can we opt up local authorities?
Under MiFID 2, local authorities will generally be classed as retail clients, although they can also opt up to professional status. The issues set out above do not arise in the same way, though, because any opt-up criteria used by national regulators will define the status of a local authority for MiFID 2 purposes.
What about retail clients who invest indirectly?
Some hedge funds, while not having any direct contact with retail investors, have distribution channels through wealth managers and private banks. The end-clients in such arrangements can include EU retail clients.
Where those firms are investing on a discretionary basis for the end-clients, the relevant “investor” for this purpose is the discretionary manager and so the PRIIPs regulation shouldn’t apply. But if those firms have an advisory relationship with the end-client, the wealth manager or private bank itself will have a direct obligation under the PRIIPs regulation to provide a KID to an EU retail client.
Is there anything else to look out for?
It is possible to be caught indirectly. If a fund is invested in by another PRIIP (such as a fund of funds), and that other PRIIP is available to EU retail investors, then a KID will need to be created for that other PRIIP. To do so, its manufacturer might request detailed information about its underlying funds.
Can we rely on reverse enquiry?
Unfortunately not. The EU Commission has made clear that a PRIIP can be both “sold” and “made available” to a person on the basis of a reverse enquiry.
What does preparing a KID involve?
If a manager determines that its funds are currently available to EU retail investors, it will need to decide whether to prepare KIDs or to close the funds to such persons from 1 January 2018. To make that decision, it will need to understand what the production of a KID involves.
For those familiar with the UCITS KIID, which was introduced in 2011, the PRIIPs KID is similar in concept – and is based on the UCITS KIID – but the idea has been taken further.
The PRIIPs KID will be a three-page document setting out certain features of the product. The content is highly prescribed. Because the document is aimed at retail investors, it is intended to be simple on its face. However, complex calculations are required behind the scenes to generate a “summary risk indicator” (a number from 1 to 7), performance scenarios under specified conditions, and certain cost figures.
Because each class of interests is considered a separate PRIIP, a separate KID will usually be needed for each class.
If a KID is produced, a manager is required to publish it on its website. As with UCITS KIIDs, it should be permissible to have the KIDs password-protected.
What to do now?
The PRIIPs regime comes into effect on 1 January 2018, so managers should have measures in place by then.
If a firm decides not to accept any EU retail investors into some or all classes of interests in its funds, then it is sensible to include an appropriate statement in the fund’s offering documents and a representation in the fund’s subscription documents. This reduces the chances of an EU retail investor finding his or her way into the fund, and provides a reasonable basis on which to assert that the fund is not being “made available” to EU retail investors. If a fund is updating its documents for MiFID 2, this can be done at the same time.
Firms should also consider whether they should liaise with any third-party distributors, or with investors acting as intermediaries, to ensure that they will not bring a fund within the scope of the PRIIPs regulation through their distribution or advisory activities.
Funds don’t need to eject any existing EU retail investors, but they should identify who those persons are and block any top-up investments.
If a firm decides to take the plunge and prepare KIDs for some or all classes of interest, it should engage with that process as soon as possible if it has not yet done so. Managers may wish to consult with their legal advisers and other external service providers to support them in the process.