Gradual opening for Spain's hedge fund market
Barely a year after the full implementation of the first legislation to give legal recognition to hedge funds in Spain, the industry is starting to move into gear as the first wave of licensed managers begin to unveil products and the authorities fine-tune the rule book for single-manager funds and funds of hedge funds. But for managers of foreign-domiciled funds, there seems little prospect of direct market access for the foreseeable future. Spain joined other European countries that have put hedge funds on a regulated basis with the entry into force of the Regulations on Collective Investment Schemes on November 9, 2005, a royal decree that put into effect provisions of the 2003 Law on Collective Investment Institutions, which also transposed the European Union's Ucits III directive into Spanish law.
The decree established a regulatory framework completed by a ministerial order in April 2006 and a circular from Spain's securities and stock market regulator, the Comisión Nacional del Mercado de Valores (CNMV, or Spanish Securities Exchange Commission), the following month. Before May last year, the Spanish financial regulatory structure did not make any specific reference to hedge funds. The standard fund regulations, which barred leverage and greatly restricted use of derivatives, effectively ruled out domestic single-manager funds, while would-be managers of funds of hedge funds were hamstrung by a requirement that no more than 10 per cent of the assets of a fund of funds could be in unlisted securities. Sales to Spanish investors of foreign domiciled funds were theoretically possible through private placements but hard to achieve in practice.
The November 2005 decree established a regulatory framework for hedge funds, described in the regulations as 'free investment funds', and funds of hedge funds ('funds of free investment funds'). Hedge funds can only be sold to qualified investors, as defined by the provisions through which Spain has implemented the terms of the EU Prospectus Directive, according to law firm Simmons & Simmons.
Qualified investors encompass authorised financial market participants including banks, insurance companies, investment funds and their managers, pension schemes and other specialist investment businesses, state and international financial and government institutions, and large companies, as well as smaller firms that opt to be treated as qualified investors. For individuals to qualify, they must meet two of three criteria: to be regular and substantial traders in securities markets, have a securities portfolio of more than EUR500,000, or have worked in the financial industry with experience of
By contrast, domestic funds of hedge funds are not subject to marketing restrictions, which means they can be actively sold to retail investors. And in a package of amendments to the hedge fund regulations published in March, it was confirmed that even single-manager funds are free to accept subscriptions from retail investors who make unsolicited applications, as long as the EUR50,000 minimum investment level is respected.
Single-manager hedge funds are required to meet the liquidity, diversification and transparency requirements that the legislation enshrines as basic principles of collective investment, but otherwise they are free to invest in all categories of financial assets. Leverage is limited to five times the fund's net asset value, although the use of derivatives to achieve leverage and some other techniques are exempt from the restriction as long as this is disclosed in the prospectus. Hedge funds authorised under the regulations must have reached a minimum of 25 shareholders within a year of registration with the CNMV, and if it falls below this level the shortfall must be remedied within a year to avoid loss of authorisation or compulsory dissolution of the fund. The regulations require implementation of risk management systems and regular stress testing.
Funds are required to publish quarterly, semi-annual and annual reports, publish NAV at least quarterly unless their strategy involves investments that justify less frequent NAV publication, and must report financial statements, statistical information and details of the investment portfolio monthly to the CNMV. The CNMV circular published in May 2006 also offers more flexible regulation of prime brokerage activity than was provided in earlier drafts, according to Simmons & Simmons, on the basis that collateralisation of a fund's assets with the right to dispose of them is carried out with prime brokers that are subject to supervision in an OECD jurisdiction. Measures require that the fund's custodian, and if applicable its administrator, are informed about the status of collateral provided to prime brokers and liabilities secured against it. Funds of hedge funds must invest at least 60 per cent of their assets in domestic hedge funds, in foreign funds that are themselves domiciled in an OECD jurisdiction or whose manager is subject to supervised in an OECD jurisdictions, or in investment companies, portfolio companies or structures such as managed accounts whose investment principles and rules are similar to those of Spanish hedge funds. The March 2007 amendments made clear that Spanish funds of hedge funds could not invest in other funds of funds.
The regulations also allow synthetic exposure to hedge funds through index products or derivatives with a hedge fund or similar structure as its underlying basis in calculating compliance with the 60 per cent threshold. The maximum level of investment in a single underlying fund or structure is 10 per cent. Funds of hedge funds are subject to similar disclosure and reporting rules as single-manager funds.
The most recent amendments to the regulations have clarified various areas of uncertainty in the original rules for hedge funds and funds of hedge funds, including the explicit authorisation of lock-up periods, extended notice periods for subscriptions and redemptions, redemption gates limiting the total amount of capital investors can withdraw at any one time, and the payment of redemptions over an extended period. In addition, Spanish-domiciled funds are now authorised to act as master funds in a multifund structure.
'All these items will need to be disclosed to investors in the prospectus, but they will provide funds with much more flexibility to help them carry out their investment policies,' says Juan Sosa Pons-Sorolla, a senior lawyer with Simmons & Simmons in Madrid. 'Overall, the new features will generally provide more flexibility and should allow a wider range of products to be launched in the next few months.' As it currently stands, the Spanish regime holds out little or no hope to foreign hedge und managers of obtaining direct access to the market. They are left with a choice between selling to Spanish funds of hedge funds, offering structured or index-linked hedge fund products, marketing listed closedended funds that benefit from an EU 'passport', or opting for a presence in Spain on a standalone basis - an avenue seemingly of little appeal do far - or through a joint venture with a local financial services provider. The absence of measures to allow market access to foreign funds appears to be part of a conscious strategy on the part of the Spanish authorities to focus on development of the domestic market, according to Juan Sosa. Simmons & Simmons in Madrid has advised a number of managers based in the US and the UK on the new regime, but to date no independent manager has taken the plunge of setting up a presence that would allow them to offer Spanish domestic products.
'It seems that for the time being, the regulations are aimed at developing the domestic market for hedge funds,' he says. 'Although theoretically possible, it is very difficult for any foreign schemes with no local presence on the part of the fund manager to obtain authorisation from the regulator to be marketed in Spain. This is down to both the regulations themselves and the position of the regulator.' Foreign funds are eligible for registration with the CNMV if they comply with the same requirements as Spanish domestic hedge funds in areas such as leverage limits, minimum subscription and disclosure requirements. However, Simmons & Simmons says, the regulator can still deny funds authorisation if it deems that the jurisdiction where the fund is incorporated or in which the manager is based does not offer investors a level of protection equivalent to that in Spain. Sosa notes that even if foreign funds did obtain authorisation, they would still be handicapped by the tax treatment this would entail for Spanish investors. 'Usually investors in Spanish funds and passported Ucits funds can defer taxation until redemption, but if they invest in funds domiciled in jurisdictions that Spain defines as tax havens, they would be taxed annually on income presumed to be a minimum of 15 per cent of the fund's net asset value, unless the investor can prove otherwise. That makes it uneconomic for investors at this stage.
'According to the law it should be possible for foreign hedge funds not domiciled in offshore territories, but for instance in OECD jurisdictions, to obtain authorisation to be marketed in Spain. However, at the moment the regulator is focusing its efforts on authorising local fund managers and local hedge fund products. At this stage they do not have the resources to deal with applications for authorisation from foreign managers. I think they will ask any such applicants to wait until they are at a more advanced stage with domestic schemes.' There is no indication that the tax discrimination against foreign hedge funds will be remedied any time soon, especially as the authorities chose not to make any changes in this area when implementing a comprehensive tax reform package that took effect at the beginning of this year. Previously the tax rate on capital gains on the redemption of fund shares or units was levied at the investor's marginal rate of up to 45 per cent if the holding period was less than one year, or at 15 per cent if the investment was held longer than a year. Now all capital gains on redemption on funds, regardless of the holding period, are taxed at a flat rate of 18 per cent, as part of a move to put taxation of all savings income from products as bank deposits, bond issues and fund units or shares on the same level. Says Sosa: 'However, this huge tax reform did not take the opportunity to modify the status of other unlisted or non-Ucits fund products, so it is clear that Spain is willing to keep using taxation as a barrier, at least for individual investors.'
Demand from institutional investors for alternative investment products has been constrained up to now by statutory limitations. However, this is set to change somewhat following moves to liberalise the regimes for eligible assets of insurers and pension schemes. A decree and ministerial order setting out new rules on eligible assets for the technical provisions of insurance companies were published in February and approval of similar changes for pension funds is due in the first half of this year. According to law firm Cuatrecasas, the categories of funds that Spanish insurance companies may now hold to cover their technical provisions include Spanish-domiciled hedge funds, since all Spanish funds regulated under the 2003 Collective Investment Institutions legislation are admissible whether or not they comply with the Ucits III Directive. Foreign Ucits funds are also eligible.
The new rules deem real estate funds to be eligible as long as they are authorised or supervised by a European Economic Area regulator. In addition to shares or units in Spanish venture capital and private equity investment vehicles, the regulations now allow Spanish insurers to invest in foreign venture capital or private equity funds as long as they are domiciled in an OECD jurisdiction, their shares are freely transmissible, and the vehicles are audited.
The new regulations for insurers also loosen the eligibility rules for structured products linked to non-eligible assets such as hedge funds, which are now permissible as long as they are admitted to trading in a regulated market and are tradable. Tradable products are defined by being electronically traded or included in a traded index representative of the market, by the ability to obtain prices for the security in any of the three sessions preceding the drafting of financial statements, or by prices being offered by a market-maker. Non-traded structured products are not covered by the changes and will continue to be assessed for eligibility on the basis of their underlying assets. According to Sosa, institutional investors are also set to benefit from a European move to adopt a common set of rules for institutional investment in funds of all types through private placements. He says: 'The CNMV, as a member of the Committee of European Securities Regulators, has expressed its willingness to adopt a single private placement definition for institutional
'This should hopefully make it possible to avoid having to register funds when they are being offered to a restricted circle of qualified investors. However, we will need to see the scope of such a new unified regime in terms of what types of scheme might be covered. Certainly it would cover Ucits funds, but it remains to be seen whether it would cover hedge funds. But in the mid-term it might be good news.'
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