Fri, 02/09/2005 - 07:13
Crédit Agricole-Caisse d'Epargne Investor Services (CACEIS) examines the issue of structuring for hedge funds distributed in Europe.
Luxembourg and other hedge fund domiciles offer a range of structures for hedge funds.
The choice of the promoter will often be guided by the type of investor targeted, whether there is a need for flexibility regarding the investment of additional capital, and whether shareholders may wish to buy or sell holdings at short notice.
Three main types of structure used to establish hedge funds are available in Luxembourg, including two corporate structures: closed-ended (Sicaf) and open-ended (Sicav) investment companies. Each of these can be set up as public companies, limited liability companies or partnerships limited by shares.
Hedge funds can also be set up as either open-ended or closed-ended Fonds Commun de Placement, a contractual structure in which a pool of assets is run by a management company. Closed-ended structures are more commonly used by venture capital and commercial property funds, while Sicavs and open-ended FCPs are usually favoured by alternative funds that invest in securities and derivatives.
The choice between an FCP and a Sicav often depends on the tax implications for investors, the promoter, the fund itself and its underlying investments. In addition, the promoter enjoys greater control over the fund with an FCP, in which unit-holders tend to have no voting rights, whereas in theory the directors (and thus the manager) of a Sicav can be changed by shareholders at a general meeting.
An issue for funds domiciled in Luxembourg is the subscription tax on assets, which is levied quarterly and amounts to five basis points where the fund is available to private and retail investors, or one basis point where the fund is sold to institutional shareholders. A separate share class can be created for institutions and taxed at one basis point if the fund is also offered to individual investors.
The flexibility of the rules in Luxembourg has led to considerable diversity of legal structures used for hedge funds, but the mainstream vehicle chosen for the vast majority of vehicles is Sicavs created under Part II of the Luxembourg legislation on investment funds (Part I covers funds that comply with the EU's Ucits legislation).
There are also a number of complex funds with fixed-income arbitrage strategies that invest in bonds and carry out swaps. These products used to be set up exclusively as managed accounts, but since the entry into force of the revised Ucits legislation, some promoters are converting these funds into Ucits III products.
This is because the legislation allows use of derivatives and because Ucits III provides much greater flexibility in term of distribution. Under the Ucits III structure, funds can be distributed in any other country within the European Economic Area, which represents a considerable advantage over a Part II Sicav fund, which is quite restricted in terms of marketing.
Basically, this involves a trade-off between the flexibility in terms of investment management and regarding distribution. A promoter that is targeting high net worth investors may prefer the flexibility that can be enjoyed with a fund domiciled in an offshore centre. But those who are targeting big institutional investors may have to provide some guarantees in relation to the vehicles they are providing. That's why Ucits III funds, which are supervised by the Luxembourg financial regulator, the CSSF, are more targeted toward institutions.
The growth in popularity of structured products has also extended to hedge funds, especially in the light of growing retail interest in the sector. A number of jurisdictions offer less stringent requirements in areas such as minimum investments for funds of hedge funds or, occasionally, single manager funds, that are backed by a guarantee.
Usually this is structured in the form of a medium-term note that invests in a managed account. Part of the account is invested in a zero-coupon bond to protect the initial capital and provide the guarantee, in the same way as a traditional structured product, while the remainder of the capital is invested directly into one or more hedge funds.
Structured products can be set up in Germany and are tax-exempted if they are sold in the form of certificates. In fact, most hedge funds are currently sold with this structuring in Germany because of this tax advantage.
Gains from derivatives are now tax-free for institutional investors if they are accumulated in the fund, while any gains from derivatives, whether distributed or accumulated, are tax-free for private investors, as long as the funds meet the German regulator's transparency requirements.
This article was prepared by Crédit Agricole-Caisse d'Epargne Investor Services (CACEIS) in Luxembourg
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