By Olivier Sciales – The European Union’s Alternative Investment Fund Managers Directive is finally on the way to become law next July, at least in Luxembourg and other EU countries with ambitions to attract a larger share of the continent’s alternative investment business. However, the grand duchy is already benefiting for the preference among some hedge fund managers for a regulated structure that is already in place and benefits not only from free distribution throughout Europe but widespread acceptance elsewhere in the world – UCITS.
The drive toward use of the UCITS regime for alternative funds, despite its constraints regarding diversification of assets, restrictions on the use of leverage and the obligation to replicate the economic effect of short-selling through derivatives, has certainly been spurred by the glacial pace toward completion of the AIFM Directive since it was first proposed in spring 2009, but it has now taken on a life of its own.
Even after the formal adoption of the directive last June, numerous uncertainties remain regarding the number of EU member states that will adopt it by the deadline of June 22, 2013, and how this will impact the ability of managers and funds located in countries that have transposed the legislation to take advantage of the single market it is supposed to create for funds aimed at sophisticated investors.
Fund promoters, managers, service providers and investors are still in the dark, too, about the detailed rules that will spell out how the directive’s broad outlines will be implemented in practice, due in the form of a directly-applicable regulation whose finalisation by the European Commission has been delayed. Further additional rules, recommendations, standards and guidelines are due from the European Securities and Markets Authority and national regulators.
Against this backdrop, what the UCITS regime offers is certainty – with the proviso that consultation is already underway on the next iteration of the regime, to be known as UCITS V, even though the previous version only came into effect last year. And as the leading domicile and servicing centre for traditional retail funds, Luxembourg has become a natural choice for many providers of alternative UCITS.
Global political and regulatory developments over the past three years, as well as the evolving attitudes of institutional investors, have convinced many managers of alternative funds that for European investors at least, they need to be able to offer an onshore alternative to the traditional offshore fund structure domiciled mostly in the Cayman Islands, but also in the British Virgin Islands, Bermuda or the Channel Islands.
While there has been some incidence of redomiciliation of offshore funds in onshore jurisdictions through the actual transfer of an existing legal structure, for the most part promoters or managers see onshore funds as a complement rather than an alternative to their existing offering. The successful implementation of the AIFM Directive might provide a suitable regulatory framework for this at some point in the future, but for now UCITS funds tick enough of the boxes to appear the best choice.
For a start, they offer a well-established passporting mechanism developed over more than two decades to enable funds established in one EU jurisdiction to be marketed in another with a minimum of legal formalities and red tape. The implementation of the UCITS IV Directive in July 2011 streamlined the cross-border authorisation process further by imposing a maximum waiting period of 10 days after a manager’s submission of an application for cross-border marketing and curbing the ability of EU countries to delay or reject the distribution for funds from other member states.
A further advantage is the widespread familiarity with the UCITS framework of regulators and investors, both institutional and retail, in countries well beyond Europe, especially in East and South-East Asia, South America and the Middle East. While concerns have been raised about whether regulators in these jurisdictions might be less comfortable with funds offering alternative strategies, to date the appetite for UCITS has remained strong.
To a large extent this global awareness of the UCITS brand is associated with Luxembourg, which is home to 72 per cent of all funds worldwide authorised for distribution in other countries. So familiar has the French expression Sicav – open-ended investment company – become among investors in Europe and beyond that many funds in English speaking Malta have ‘Sicav’ in their name, and Ireland has drawn up plans to offer Sicavs as an alternative corporate structure to public limited companies.
The crisis of the past four years has affected the fund industry through performance volatility and increased investor caution, but it has not shaken Luxembourg’s position as the dominant centre for UCITS funds. At the end of June 2012 UCITS made up almost half of the distinct legal fund entities domiciled in Luxembourg, with 1,841 (most of them umbrella structures) out of 3,867, while UCITS assets of €1,762.87bn accounted for just under 80 per cent of the total of €2,224.48bn for all Luxembourg funds.
The grand duchy is home to management companies with local fund services relationships for most fund groups, whether from Europe, the US or Asia, with international ambitions. Its position as a marketing and distribution hub is bolstered by its experienced, skilled and multilingual workforce, service providers ranging from administrators and custodians to auditors, as well as law firms with expertise and network connections in key distribution markets.
It’s logical that managers using Luxembourg as a centre for the structuring, servicing and marketing of traditional funds should draw on its capabilities for alternative UCITS too. Hard and fast statistics are hard to come by, largely because there is no standard definition of what constitutes an alternative UCITS, but most estimates suggest that the country is the leading domicile for the sector.
Alternative UCITS have been growing rapidly over the past three years, although they still account for well under 10 per cent of the assets of the hedge fund industry as a whole, and probably less than 3 per cent of the total value of all UCITS funds, which amounted to €5,849bn at the end of May, according to the European Fund and Asset Management Association.
Geneva-based Alix Capital, which compiles the UCITS Alternative Index, says the assets under management of 776 single-manager UCITS hedge funds and 78 funds of alternative UCITS funds surveyed by the firm amounted to €129bn at the end of June, an increase of 7.5 per cent from €120bn in the previous quarter and of 18.3% since mid-2011 (funds of funds represent a very small proportion of the sectors assets at some €3bn). Alix Capital says Luxembourg has a 45.7 per cent share of the market, ahead of France with 18.5 per cent and Ireland with 17.4 per cent.
Naisscent Capital, another Swiss-based research provider and funds of funds manager, says there were 1,018 single-manager alternative UCITS funds and 120 funds of funds at the end of June. In October last year the firm said a “best guess” at the sector’s assets was somewhere between €80bn and €120bn, because not all the funds it surveyed reported assets under management. At that time, Naisscent said that of approximately 1,000 single manager funds, 555 were domiciled in Luxembourg, 225 in Ireland and 130 in France.
PerTrac, a data and research technology provider, reported that the combined assets of 1,210 alternative UCITS funds – a sample compiled from various fund databases widely used in the industry – stood at €149.94bn at the end of October 2011, with Luxembourg the domicile of 49.92 per cent of funds, Ireland of 18.84% and France of 11.90 per cent. The variation between these figures indicates the difficulties in obtaining a precise statistical profile of the sector, but all point to Luxembourg’s central role in the development of an industry that is still in a stage of early and vigorous growth.
The grand duchy’s leading position as a centre for both traditional and alternative UCITS funds has been bolstered by its determination to transpose European legislation into its national law early, in order to give fund providers the maximum amount of time to prepare. For example, the UCITS IV Directive was adopted by Luxembourg’s Parliament in mid-December 2010, the first EU member state to do so and more than six months before the July 1, 2011 deadline.
The legislation was also used as a housekeeping exercise to update other areas of Luxembourg’s funds regime. At the end of June, the grand duchy was also the domicile of 581 non-UCITS funds established under Part II of the 2010 legislation, with assets of €202.4bn, as well as 1,445 Specialised Investment Funds with €259.2bn in assets – largely alternative investment vehicles set up under a lighter-touch regulatory regime introduced in February 2007.
The SIF legislation was revised in March this year, incorporating changes that already bring the regime into line with various provisions that the AIFM Directive will impose from July 2013. The full transposition of the directive into Luxembourg law is scheduled for the third quarter of 2012, as part of a fresh package of funds legislation that will also create a vehicle equivalent to the Anglo-Saxon limited partnership within the country’s civil law framework.
The grand duchy’s readiness to respond early to the requirements of international lawmakers as well as the needs of the industry will doubtless be seen again when UCITS V comes forward for adoption. In the new legislation, the European Commission has raised the question of whether the directive should make changes to the framework that has enabled managers to offer alternative strategies through UCITS funds.
Concerns have been raised that funds following complex strategies and investing in exotic derivative instruments may be offered to investors that do not understand them and for which they are not suitable, although alternative UCITS often impose minimum investment requirements significantly higher than those customary for mainstream long-only funds in order to discourage retail investors.
Some industry members worry that unfavourable publicity for alternative UCITS could damage the regime’s reputation as an assurance of best practice and risk control for funds aimed at the general public. In addition, it could hamper the ability of managers to distribute their products in other parts of the world (in many of which fund markets are much more dynamic than Europe’s) where regulators have up to now been happy to accept the EU seal of approval as a quality guarantee.
So far there has been little evidence of mis-selling, and the risks of a fund ‘blowing up’ are mitigated by the UCITS regulatory overlay, notably limits on leverage, diversification rules and the requirement that funds must offer investors liquidity at least bi-monthly. In fact, Alix Capital reports that among the funds it surveys, 83 per cent offer daily liquidity and almost all the rest weekly liquidity.
Even before the UCITS V proposals have been finalised, the Commission is already examining issues that may be covered by a future UCITS VI directive. One key area on which it has requested industry feedback is eligible assets, the liberalisation of which in the early to mid-2000s led to the alternative UCITS boom. A July 27 consultation paper asks whether there is a need to review the scope of eligible assets and exposures, whether all strategies currently offered are in line with investor expectations of a UCITS-regulated product, and whether further rules are needed on the liquidity of eligible assets.
The Commission is inviting comment on the possible consequences of preventing funds obtaining exposure to non-eligible assets, for example by adopting a look-through approach for securities, investments in financial indices (notably hedge fund indices) or closed-ended funds. It is also asking about the impact of defining specific exposure limits and diversification rules at the level of a fund’s underlying assets.
These questions are likely to be the centre of extensive debate in the coming months. In the meantime, the continuing expansion of the number, range and diversity of alternative UCITS testifies to managers’ confidence in their suitability for a broad range of sophisticated investors – and indirectly, in Luxembourg’s ability to deliver a regulatory environment and servicing capability that inspires the confidence investors need.
Olivier Sciales is a founding partner of law firm Chevalier & Sciales