By Simon Gray – The increase in global regulation of the alternative investment sector, notably the Private Fund Investment Advisers Registration Act in the United States and the European Union’s Alternative Investment Fund Managers Directive, have raised the hackles of many members of the fund industry, but the ongoing success of Ireland as a domicile and servicing centre for hedge funds and other alternative vehicles demonstrates that it’s an ill wind that blows nobody any good.
With the institutional investors that account for an every-increasing share of the industry’s assets broadly welcoming of more effective oversight of alternative funds and their managers, Ireland’s long experience of developing a regulated hedge fund industry is striking a chord with managers as they respond to their clients by offering onshore products that are more transparent and subject to greater supervision.
Over the past year or so macro developments such as sovereign debt problems in Europe and feeble to negative economic growth in many parts of the world have contributed to generally lacklustre performance on the part of most hedge fund managers and probably also dampened investor inflows, although many indicators suggest that allocations held up well considering the market environment. Traditional funds have also suffered from indifferent returns and a slowdown – or reversal – of capital flows.
However, last November the net assets of funds domiciled in Ireland, including traditional retail funds and ‘Newcits’ as well as alternative products falling under the Qualifying Investor Fund regime, passed the EUR1trn mark for the first time thanks to growth of 42 per cent over the previous 24 months, and reached EUR1,055bn by year-end. With the authorisation of 781 new funds and sub-funds in the course of 2011, the total number of Irish-domiciled funds set a new record of 5,069.
True, the numbers were boosted by a surge in investor demand for money-market funds, which account for a substantial proportion of the jurisdiction’s in Ucits assets (EUR375bn out of a total of EUR783bn). However, the aggregate figure also included EUR182bn invested in more than 1,300 QIFs, whose assets grew by 20 per cent in 2011 following an increase of 35 per cent the previous year.
“The industry has continued to grow because of the global nature of the Irish fund industry, and the fact that people recognise we have a regulator who understands the industry and areas of concern to promoters and investors,” says Shay Lydon, a partner in the asset management and investment funds group at Dublin-based law firm Matheson Ormsby Prentice.
He notes that Ireland also benefits from the absence of any tax on fund structures (unlike the taxe d’abonnement, or subscription tax, imposed by Luxembourg, the other major international fund centre in Europe), along with the country’s long and growing list of double taxation treaties. “We have managed to tick all the boxes and do so in a way that has made us more successful than many competitor jurisdictions,” Lydon adds.
Don McClean, head of Ireland and Jersey at UBS Fund Services, adds: “Ireland’s international financial services regime is attractive for investment managers as well as for sophisticated investors, who receive the necessary assurance from the industry’s strong regulation and corporate governance. Over the past 20 years, a support environment including lawyers, accountants, custodians, administrators, consultants and the regulator have developed the in-depth expertise to meet the requirements of the most demanding alternative fund industry participants.”
For State Street, whose hedge fund servicing business employs around 1,000 people in four locations across the country and accounts for a significant proportion of the group's USD550bn in assets under administration in Ireland, managed accounts are a significant growth area, according to senior vice-president Pat Hayes, who heads the Irish hedge business. “Last year we took a stake in InfraHedge, which is a pure managed account platform, in order to have a solution to meet the needs of our broad client base including institutions and sovereign wealth funds,” he says.
Paul Murray, an asset management and investment funds partner at law firm William Fry, points to the launch of an exchange-traded note by BlackRock as an example of another growth area – and one important to alternative managers looking to obtain positions in various markets. “The ETN, which is a debt instrument, was quite an innovation on the part of our firm, utilising changes brought into our securitisation tax code last year,” he says. “The product allows investors to gain exposure to precious metals – gold, silver, platinum and palladium – which cannot be done within a Ucits framework.”
Still, Ireland shares with the rest of the global fund industry the impact on new business of a more difficult economic environment both in general and for the fund industry in particular. “We are seeing a great deal of institutional business, large asset management firms and banks, that are developing new products, more so than new entrants to the sector or start-ups,” says Stephen Carty (pictured), a partner in the investment funds group at the Dublin office of international law firm Maples and Calder. “The other trend we're noticing is US managers offering their own Irish-domiciled funds or involved in products on a sub-advisory level.”
Mark White, a partner with another local law firm, McCann FitzGerald, says that most managers found it difficult to raise capital in 2011. “People who had fundraising plans last year often finished up with less money than they anticipated, especially if they launched in the second half of the year when fund performance was coming under pressure,” he says. “In that kind of climate it’s so much more difficult to raise money. New launches still took place, but the funds have definitely been smaller. Investors were sitting on cash because of the economic uncertainty, including concern about exposure to the euro.”
Lydon points out that in an environment in which many institutional investors are more comfortable with regulated alternative funds, Ireland benefits from the fact that the QIF regime has been in place for some two decades. “It has regulated service providers, is approved and authorised by the Central Bank of Ireland, and meets the regulator’s policy requirements in terms of what it can and cannot do, yet the QIF has the flexibility to pursue virtually any alternative investment strategy, with only limited diversification requirements,” he says.
“The regulator's policy has evolved over the years along with its ability to oversee alternative investments effectively and to understand hedge fund strategies. Today Ireland accounts for almost 63 percent of the assets of hedge fund assets domiciled in Europe. This gives us a head start when managers that up to now have used offshore jurisdictions start thinking about whether they should have a regulated fund and where.”
This is a particular advantage with the AIFM Directive set to come into effect for EU-based managers in less than 18 months, on July 22, 2013, while non-EU managers and funds will not be eligible to market their funds with a pan-European distribution ‘passport’ – assuming they meet the terms of the directive – for at least two years after that.
Members of the industry in Ireland believe that the QIF is effectively an ‘AIFMD-ready’ product, especially with the minimum investment level having been reduced from EUR250,000 to EUR100,000 in line with the standards for sophisticated investors set out in the EU’s Markets in Financial Instruments Directives, with whose terms the AIFM Directive has been drafted to dovetail.
“Regulated versus unregulated products is a trade-off between cost and marketing/distribution strategy,” McClean says. “Business under the AIFMD regime will become more regulated and entail higher costs through reporting and service arrangements, particularly custody services. Many of the requirements laid out by the directive have always been built into the governance structure of Irish-domiciled funds, so it has only strengthened our case as the domicile of choice for alternative fund mangers.”
Another recent step was the introduction of an industry code of conduct on fund governance. “It's really about introducing more formality to governance arrangements, ensuring that proper procedures are put in place and are documented,” Murray says. “For some clients it may involve substantial changes, particularly regarding the constitution of boards on which there may not currently be independent directors. But for the majority of boards of funds for which we act, it will be formalising what is already in place.”
Says Lydon: “The evolution over the 20 years we have been offering QIFs is partly down to industry interaction with the regulator, including a faster authorisation process stemming from requests for better speed to market, and the reduction in the minimum investment level under the qualifying investor test to EUR100,000.
“We see the QIF as already encapsulating the mandatory requirements of the directive, including an independent custodian and administrator, as well as disclosure requirements and the information that must be given to investors. The industry is working with the regulator to ensure that when the AIFM Directive comes into effect, the QIF has all the necessary structures and procedures built into it.”
Chris DiNigris, marketing and sales manager at fund software specialist Koger, says the directive is the major regulatory issue facing the firm’s third-party administrator clients. “Administrators and other service providers are preparing for the anticipated surge in demand for reporting. They will have to be more flexible, and as the best always do already, adapt to their clients’ requirements.
“Ireland is well positioned to benefit from the directive because many of the provisions are covered by the QIF regime. This should encourage more alternative managers to set up Irish-domiciled funds, something that is happening already. Meanwhile, the increased regulatory and investor scrutiny will push managers to bring more middle- and back-office processes back in-house, at least in part, to speed reconciliation processes with their administrator and tighten controls.”
Mark Mannion, a managing director with BNY Mellon, says uptake of the QIF regime has also benefited from use of what is known as a section 110 company, after Section 110 of the Taxes Consolidation Act 1997, which offers particularly advantageous treatment of withholding tax on interest payments for funds trading in debt securities. “In the current financial environment, credit strategies have become increasingly popular,” he says. “If you place a section 110 company within a QIF, you have a tax-efficient structure that can be distributed to investors globally.”
Members of the fund industry acknowledge that the much-publicised passage of legislation a couple of years ago allowing corporate funds established in other jurisdictions to be redomiciled to Ireland has not been met by a flood of managers seeking to move their offshore funds lock, stock and barrel – partly because the procedure is in some respects a cumbersome and costly one, but also because non-European investors may see additional expense but no great advantage for themselves in the change.
And, as Tara Doyle, also an asset management and investment fund partners at Matheson Ormsby Prentice, acknowledges wryly, the ability for an offshore fund to take its track record onshore through redomiciliation is not necessarily an incentive – given the recent hedge fund industry performance, some managers are probably content to leave their track record offshore and start again with a clean slate.
“In our experience, factors such as previous performance history, the current position of the fund versus its high water mark and the desire to consolidate funds under a single umbrella often lead clients to decide either to establish clone funds in Ireland rather than redomiciling an existing fund, or to effect the redomiciliation through the traditional method, which allows for the creation of a single umbrella housing all funds rather than the continuation methodology provided for in Irish company law,” she says.
As a domicile both for QIFs aimed at sophisticated investors and ‘alternative Ucits’ that use the EU retail fund regime to obtain passporting rights throughout Europe as well as access to other countries in Asia, Latin America and the Middle East where Ucits are welcomed, Ireland is well placed to benefit even without actual redomiciliation of offshore funds.
“If managers are being pushed into AIFMD compliance and setting up a parallel European fund to complement their flagship Cayman fund, there is no doubt that they are looking toward Ireland,” White says. “At one point it was forecast that we would see a lot of redomiciling of funds from centres such as Cayman and the Channel Islands to EU countries such as Luxembourg and Ireland, but I’m not sure how much of that has actually taken place. If you're a US investor and perfectly happy in a Cayman fund, why would you want to pay for the cost of moving onshore to Europe?
“Instead managers looking to access European capital may set up a parallel fund as a QIF or Ucits in Dublin. For instance, there may be European institutional investors such as pension schemes and insurance companies that appreciate the track record of the offshore fund but that are restricted in their ability to invest in a Cayman vehicle, or investors that want a regulated fund with an independent depositary such as a big US bank holding the fund assets.”
Gavin Byrnes, head of UK business development at UBS Fund Services, believes it may be too early to tell whether redomiciliation, or the parallel approach, which seems to have been dubbed ‘co-domiciliation’, is the better option. “The trend toward redomiciliation has not been at the pace originally envisaged by the industry,” he says. “Many details of the AIFM Directive have still yet to be finalised, and most fund managers will wait for clarity before planning business strategy for the future.
“Some leading managers have already taken the decision to redomicile their product range, but the marketing strategy and scale of a fund business will be the defining factors in determining the blend of onshore versus offshore within their product mix. Once the directive is finalised, managers will be better positioned to determine the structure of their business and their marketing strategy for the future.”
While ‘Newcits’ have been in many cases a response to the lingering uncertainty over the scope and details of the AIFM Directive, White points out that it is no panacea, because of higher set-up and ongoing operating costs and the heavy regulatory burden to which they are subject, especially after the implementation of the Ucits IV Directive in July last year. “There has been an increase in conduct of business rules, codes of conduct, and risk management processes that need to be in place,” he says.
“Although Ucits enable investors to gain access to alternative strategies through derivatives and financial indices, it can be difficult to replicate Cayman funds exactly because of the diversification requirements ands leverage restrictions, while disclosure and other costs may also detract from returns. This leads to tracking error between the Ucits and the offshore fund, but there is no alternative to complying with the rules if you want to use the Ucits label.”
Instead, White believes, as the AIFM Directive and its passport for marketing to professional investors in Europe draw closer, funds that fall under the directive – such as QIFs – may gain even more traction among managers targeting European markets. “Alternative managers are not looking to sell Ucits product with very complex strategies to retail investors,” he says. “For institutions and other sophisticated investors prepared to invest a minimum of EUR100,000, the QIF ticks the box.”
Carty agrees that uncertainty over the directive has fuelled the growth of alternative Ucits. “For the first year or so after the first draft of the directive was published promoters were going into Ucits because they offer both the potential for product sophistication and access to Europe and beyond,” he says. “But once they got further down the line, they saw that the QIF has all the pieces that the directive will require. Overall, QIF assets have grown by more than 40 per cent since the AIFMD was first unveiled in April 2009.”
But Mannion points out that Ucits offer a wide range of transparency and liquidity advantages for investors that traditional hedge fund structures don’t necessarily offer. “Investors can fully see what portfolios are invested in and have the comfort that they will be able to redeem their capital at least as frequently as twice monthly,” he says. “Ireland has attracted its fair share of the alternative Ucits business. We are a very big player in that, because it requires the full range of custody and trustee capabilities to service an alternative Ucits fund fully, and it’s an industry that has now grown to more than USD200bn.”