By Olivier Sciales (pictured) and Rémi Chevalier – Continued uncertainty regarding the provisions of the European Union’s Alternative Investment Fund Managers Directive, despite its formal finalisation on June 8, remains an important growth driver for the growth of Ucits funds offering alternative strategies. With the drafting of Level 2 measures to implement the directive in detail still months away at best, the lack of clarity is strengthening the appeal of Ucits to institutions as regulated vehicles.
An increasing number of alternative managers are rolling out Ucits-compliant funds to complement their offshore offerings. They provide a clear, transparent way not only to attract investors across Europe through the regime’s passporting feature, but thanks to their recognition among global regulators managers can capitalise on the popularity of Ucits in regions such as East Asia, Latin America and the Middle East.
Luxembourg remains unquestionably the leading European centre for Ucits funds. Many of the biggest European and global fund groups have Luxembourg-domiciled management companies and well-established local fund services relationships, making the grand duchy a logical domicile and service centre for alternative Ucits; anecdotal evidence suggests that the jurisdiction is home to as much as 60 per cent of this market.
The country’s muscle in the fund sector is reinforced by a highly qualified and skilled workforce, famously international and multilingual, in all areas of fund services from custodians and administrators to auditors and lawyers. And the sector continues to grow, with the trend toward new administrators setting up shop in Luxembourg continuing into 2011, while existing service provides are adding to their staff.
But a key opportunity for the grand duchy lies in the increasingly international distribution of Ucits, which has made the French term Sicav – open-ended investment company – a familiar expression among retail investors across broad swathes of South-East Asia.
The signature in 2008 of a Memorandum of Understanding between regulators in China (CBRC) and Luxembourg (CSSF) offering access to Chinese institutional investors to invest in Luxembourg domiciled UCITS, as well as the registration of Lux-domiciled UCITS in Latin American countries (i.e. Chile, Columbia) underscores the way Ucits has grown into a global brand, suggesting that over the coming years non-European investment will continue to increase as a share of aggregate assets under management.
Alternative Ucits remain a relatively modest proportion of this huge global pool of assets – some USD128bn as of the end of September 2010, according to one report (although other estimates range from USD100bn to USD400bn). These figures suggest that at most Ucits account for 10 per cent of total hedge fund assets and probably rather less, and an even smaller proportion of the total USD5.8trn in Ucits assets under management.
Figures are understandably sketchy given the difficulty in establishing a precise and uncontroversial definition of alternative Ucits – or ‘Newcits’ – a term much of the industry hates but seems condemned to live with.
Participants are also having to deal with media comment about the development of an alternative Ucits bubble, although the steady rather than spectacular growth in assets gives this theory little support; so far at least. And while hedge fund managers may look to replicate aggressive offshore investment strategies within these onshore vehicles, the Ucits regulatory overlay is robust enough to provide broad protection against catastrophic blow-ups.
However, there is certainly a danger that retail investors may become confused about the risk-reward profiles of funds that use complex derivatives such as swaps to evade some of the investment restrictions inherent in the Ucits framework. The difficulty for retail investors in grasping all the implications of such structures – for instance, the creditworthiness of swap counterparties – is if anything a greater concern than the actual level of risk involved in these transactions.
Improved communication can certainly help allay these fears, something that the latest revision of the regime, Ucits IV which came into effect on July 1, seeks to address with its replacement of the voluminous and inappropriately- named ‘simplified’ prospectus with the stripped-down Key Investor Information Document.
Inevitably national supervisors and the new European Securities and Markets Authority (Esma) will continue to examine closely how managers are using Ucits funds as vehicles for alternative strategies. However, the proposal by the French regulator, the Financial Markets Authority (AMF), to divide the category into complex and non-complex Ucits, as part of the second Markets in Financial Instruments Directive (MiFID), could damage the brand, in particular by impeding cross-border distribution in Asia.
The biggest risk facing alternative Ucits is reputational rather than financial. With assets under management still modest and monthly inflows relatively small, the publicised risks of bubble developing seem exaggerated. To put matters in perspective, bubbles normally occur because of illiquidity and excessive leverage, as with the 1990s dot.com boom of the late 1990s where many companies had small capitalisation and shallow liquidity.
A more relevant criticism is the relatively weak performance of alternative Ucits in 2010 compared with offshore hedge funds. For example, the Absolute Hedge UCITS Index underperformed the Dow Jones Crédit Suisse Hedge Fund Index by 6.84 percent in 2010. This could be influenced by start-up and first-year operating costs, since much of the sector is relatively new, but also by tracking errors relative to the managers’ comparable offshore funds because of Ucits investment restrictions and liquidity requirements.
The obvious question is whether a hedge fund manager running between USD15m and USD20m in an offshore fund really needs an onshore vehicle too. Unquestionably, managers for which the benefit is marginal are jumping on the Ucits bandwagon. Given the extra costs and the burden of retail-class risk management procedures, some of them might be better off establishing a Luxembourg Specialised Investment Fund (SIF) instead.
Managers launching alternative Ucits with the aim of targeting institutional investors should reflect on various questions before taking the plunge. First, a Ucits requires at least twice-monthly liquidity, and hence redemptions; can the investment strategy accommodate this? Does the manager have the operational staff and infrastructure to handle Ucits-style transparency and reporting? And do they really need a European passport; what extra benefits will it bring?
The Ucits structure suits some strategies better than others; equity long/short strategies fit the investment constraints better than most. There are certainly advantages in an onshore vehicle, but they’re not a catch-all solution for everyone. Managers need to assess all the factors carefully.
One positive point could be Ucits IV, the latest update of the directive, which came into effect across the EU at the beginning of July. The most obvious improvement is that streamlined procedures for authorisation of cross-border marketing offer fund managers quicker time to market. They may also benefit from efficiency measures such as the EU passport allowing management companies to provide services to funds in other member states and cross-border fund merger provisions, although time will tell how much.
Managers should also note a number of other regulatory developments. According to article 186 of Luxembourg’s legislation of December 17, 2010, which transposed Ucits IV into national law as well as introducing other updates to the country’s fund regime, Ucits established before the January 1, 2011 have until July 1, 2012 to replace their simplified prospectuses with the Key Investor Information Document (KIID).
During the next update of their fund prospectuses, and at the latest by 31 December this year, Ucits must also comply with Esma’s guidelines on risk management. Finally, May 2010 guidelines from Esma’s predecessor Cesr, the Committee of European Securities Regulators, make a distinction between money market funds and short-term money market funds, which will require the updating of the prospectuses of Ucits funds falling into those categories.
Olivier Sciales and Rémi Chevalier are founding partners of the Luxembourg law firm Chevalier & Sciales. You may find more information at www.cs-avocats.lu " target="_blank">www.cs-avocats.lu