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Dermot Butler, Custom House Group

Distribution bridge between Asia and Europe strengthens

By James Williams – One thing above all else is guaranteed when discussing developments in the alternative UCITS space: it polarises opinion. Much like the wider financial markets, where people argue their case with equal validity as to the likelihood of a sustained recovery or further descent into the abyss, the regulated alternatives market is much the same.

On the one hand people will point to sustained AUM growth over the last few years, which according to Alix Capital has seen assets increase from around EUR80billion to EUR129billion, as a clear sign that momentum is building. Furthermore, alternative investments research firm, Brighton House Associates, recently reported that at the end of Q1 2012, some 24.5 per cent of the hedge fund mandates collected by the firm specified an interest in UCITS funds.
On the other hand, others say that compared to the overall UCITS market these funds represent a tiny percentage and are still yet to take off.
Never the twain shall meet it seems.
Speaking with Hedgeweek, Dermot Butler, CEO of global fund administrator Custom House Group, says that none of the firm’s hedge fund managers have yet to open UCITS funds: “This is largely because hedge fund UCITS are often too restrictive with regard to replicating their strategies under the UCITS regulations and are noticeably more expensive to both set up and operate,” says Butler, who adds: 
“It is our opinion that for a UCITS to be an attractive to a hedge fund manager it must:
1.         Enable that manager to utilise his investment strategy without restriction;
2.         Have good distribution, which is why many managers contract with UCITS platforms because the operator of the platform has distribution capabilities;
3.         Ensure the net returns only differ marginally from the net returns on their non-UCITS European funds.”
What does seem apparent is that the types of hedge fund managers launching these vehicles are large global blue-chip names that have the operational weight needed to either launch internally, as Man GLG has done, or be attracted onto the leading bank platforms like Morgan Stanley’s FundLogic Alternatives or Deutsche Bank’s Platinum platform.
The Brevan Howard’s and CQS’s of this world are doing a great job raising assets, but there are plenty of managers, particularly those in the US, who are yet to adopt the UCITS wrapper as an alternative conduit for asset raising.
“For the biggest managers, if there’s no need to actually create such a structure then why even think about it? If you’re seeking assets from different investor types then it might be something to consider but if you are a well-performing manager with a robust infrastructure and sound strategy, then I would question the need to create a legal entity wrapper like UCITS,” comments Zeynep Meric-Smith, AIFMD leader for asset management at Ernst and Young.
Not that this is the sole preserve of the billion-dollar boys club. Some smaller managers are establishing funds and, going forward, will find it easier from a cost perspective as more platforms like the one being launched by David Robinson’s Prodigy Capital Partners look to support them by offering a turnkey solution. But it seems that, right now, it’s more a case of looking into things and asking questions as opposed to taking concrete action.
Adds Meric-Smith: “Their interest is to understand the opportunities, but once they’ve weighed up the costs and benefits, the number who take further action is actually very limited.”
Margaret Harwood-Jones, Head of Client Segments – Asset Managers & Alternative Investments at BNP Paribas Securities Services, takes a more bullish stance, overall. In her opinion, the growth in this space is evident and that alone should be greeted as good news given the challenging market environment in which the fund management industry, at large, continues to operate in.
“What I’m seeing – and what I hope the market is encouraged by – is a greater systematic use of UCITS in the alternatives space; that is a constructive and positive development. Growth is there, and it will remain in perpetuity; I think it’s fantastic for managers in the alternatives space to recognize that they’ve got another opportunity to structure investment performance for their clients,” asserts Harwood-Jones.
One of the concerns when the AIFMD was formulated was that the hedge fund industry would see an exodus of managers. Migration into the UCITS space might have been the first signs of this happening but whilst it’s undeniable that managers are taking a more holistic approach to the regulatory environment, there’s little evidence, if any, that managers are turning their backs on the Cayman Islands and moving completely onshore.
“Many people thought there would be a rush to bring funds to an EU domicile. That hasn’t happened anywhere near to the extent people thought. I don’t see it becoming a huge trend across the industry,” says Gavin Ralston, global head of product at Schroders.
In Meric-Smith’s view, it again boils down to the size of the manager and the ultimate aims of that manager long-term as to whether they decide to offer an onshore regulated vehicle. Large managers, who are better placed to tap into European institutional money, are widening their product range with UCITS and non-UCITS structures; they can afford to do it. Smaller managers may not need to take advantage of the fund passport and choose to remain with a national private placement regime. 
“There’s no clear trend that smaller and mid-sized managers are launching these onshore structures. Unless an investor specifically says ‘We can only invest in a UCITS structure’, there’s no impetus for them to go down that path. It’s just another additional cost,” says Meric-Smith.
Moreover, the fact that institutional money is by-and-large going to the blue-chip players, means there’s even less of an incentive for smaller managers.
Butler states that for many non-institutional investors the offshore fund is still a perfectly acceptable investment vehicle: “There are many investors who would prefer not to be vulnerable to EU inspection – not because they have criminal intent or are tax dodgers but because they fear and do no trust bureaucratic oversight.”
Meric-Smith says that dual onshore/offshore domiciliation is likely to develop going forward but that the decision on whether to launch a UCITS fund or a QIF/SIF will depend on investor needs: “Do they specifically want a UCITS structure and if so can the hedge fund strategy easily fit into that? If not, then a QIF makes more sense.”
Michael Ferguson, Chair of the ALFI Hedge Fund committee, notes that far from being sold to retail investors, alternative UCITS funds are being targeted at the European institutional, HNW markets. However, he notes that asset flows to this sector from European pension funds over the last 12 months have been “modest”. In his view, their primary focus is the quality of the fund manager not the type of fund structure.
“I don’t envisage the likes of Schroders offering their alternative UCITS to a retail audience. Their target audience is the wholesale market. This is also true of markets like Asia and the Middle East – these products are being sold to wealth managers, not the broader retail space. Some global hedge fund managers have been very successful. They’ve raised significant assets in markets like Switzerland, mainly in the wealth management space,” comments Ferguson.
One of the major benefits of the UCITS brand is its global recognition. For hedge fund managers looking to diversify their investor base, not just in Europe, but globally, there are clear benefits to offering such a vehicle. And as Harwood-Jones is quick to point out, this is not just a case of European managers flooding, say, the Asian market to raise assets; increasingly, Asian managers are setting up structures in Europe to tap into European assets as well.
“The bridge is fully open and the direction of travel is two-way. If you look at who’s launching structures in Luxembourg, it isn’t just Europeans or Americans. There is now an increasing incidence of Asian players coming to talk to firms like BNP Paribas to help them overcome some of the distribution challenges they face. So the traffic is definitely flowing both ways and although the industry in Asia is still small compared to Europe and the US, that is changing and I think in the months and years ahead that pace of change will quicken,” says Harwood-Jones.
In June this year, Hong Kong-based Value Partners Group – one of the region’s largest asset managers with USD7.2billion in AUM – rolled out its first UCITS-compliant fund: the Value Partners Greater China Classic Fund. There is a strong belief among managers that this is space worth infiltrating.
Indeed, one Singaporean hedge fund manager was quoted in the press as saying that by not offering a UCITS structure a manager would “miss out on a lot of the action”. The UCITS wrapper was, he said, a seal of approval and compared it to a restaurant receiving a Michelin star.
Stephane Diederich is the founder of Alpha UCITS, one of the oldest independent hedge fund UCITS distribution and structuring platforms. The firm has two distinct business models: asset raising and fund structuring. Diederich says that from an asset raising perspective it’s been a good year, confirming that assets YTD are “double what we saw last year”.
An awful lot of due diligence goes into identifying the right managers. As Diederich points out: “You live and die by the quality of your products. Since we started we’ve probably met 40 managers a year but I don’t think we could ever raise assets for more than six managers at any given time.”
Having a UCITS fund, then, is not a guaranteed golden ticket. Managers have to demonstrate operational and performance excellence, just as they do when raising assets offshore.
On the structuring side, Alpha UCITS launched its first external manager earlier this year – New York-based GSB Podium Advisors, an equity statistical arbitrage fund. The fund is already at USD50million. Says Diederich: “On the structuring side, we would like to have a larger critical mass but now that we’ve launched our first manager I believe a lot of the hard work has been done. We are now actively looking to launch further sub-funds and currently in discussions with about 10 managers.”
One of the big dilemmas facing managers is how the AIFMD will play out. What will its final format be? There is a distinct possibility that QIFs and SIFs, already enjoying substantial growth, will become the preferred choice of onshore vehicle because of their greater inherent flexibility and suitability for hedge fund strategies. Quite what impact this will have on the alternative UCITS space is open to debate.
Says Ferguson: “We’ve seen significant growth in QIFs/SIFs. They’re being used for every alternative asset class, in particular debt and infrastructure over the last nine months. I personally think the alternative UCITS space is going to reach a certain level and plateau out.” He says that with AIFMD on the horizon, managers might choose to wait before launching UCITS vehicles and that those managers who have already launched funds might decide to migrate to an AIFMD wrapper i.e. QIF.
“It is possible that the AIFMD will establish a brand quality for the alternatives world similar to what UCITS established for the traditional world. If it does, then onshore investors will likely take comfort investing in QIFs/SIFs which will be AIFMD-compliant,” adds Ferguson.
UCITS V is expected to overlap with AIFMD in certain areas as the EU Commission attempts to create a level playing field for UCITS and non-UCITS funds. The carrot being dangled in front of managers that choose to become AIFMD-compliant, either by moving completely onshore of by establishing a dual vehicle, is that, like UCITS, they will be able to passport their fund across all 27 EU Member States.
Yet again, though, it will become a trade-off and will require managers to think carefully about their end objectives: should they go down the AIFMD-compliant QIF route, or stick to the established UCITS route?
“When you look at the entire provisions under the AIFMD it’s quite a small carrot in comparison to the number of sticks that the directive brings with it. For example, consider the depositary liability point: if you decide to take advantage of the passport it means you as a manager will have to comply fully with the Directive and that includes the appointment of an independent depositary whereas previously you might not have needed one. There are cost implications to this, which will ultimately trickle down to investors,” says Meric-Smith.
However, under UCITS V, managers will be subjected to the same depositary liability costs as managers under AIFMD. This could seriously impact performance of existing UCITS – particularly in emerging markets where there aren’t affiliated sub-custodians – and potentially put managers off launching funds.
Meric-Smith caveats this, by adding: “How liquid are the instruments being traded in those markets? If the answer is ‘Not very much’, then it’s highly unlikely a manager would be trading them in a UCITS fund in the first place.”
For now, alternative UCITS are an additional distribution tool for blue chip hedge fund managers but under AIFMD, the QIF structure could well start to become the preferred choice.
Concludes Diederich: “The environment is challenging, that’s clear, but we are quite confident that hedge fund UCITS are the future core allocation model into hedge funds for most European and Asian investors and we want to position ourselves as the specialist for asset raising and structuring in this space.”

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