By most standards London’s position as an international centre of the hedge fund industry appears to be in pretty good shape. The industry is climbing back fairly strongly from the pit into which it fell in 2008, when profits turned into losses and investors scrambled to reclaim their cash; last year’s rebound in fund returns has left the majority of managers that survived the downturn mostly heading back toward their high water marks and the resumption of performance fee payments, if they have not reached them already.
With interest rates still geared to warding off economic recession, hedge fund-style returns are looking particularly good to institutional investors, and money is flowing back into the sector, including investments from some of those who pulled money out a year or so earlier. And the slump may even have had its benefits for the alternative fund industry and London’s financial sector generally, by taking some of the heat out of the inflated costs for everything from Mayfair office space to experienced financial analysts.
If the aftermath of 2008 resulted in creative destruction in the hedge fund industry, it is now seeing the arrival in the marketplace of new talent spinning out of existing hedge fund management firms as well as the proprietary trading desks of investment banks – with more to follow if the ‘Volker rule’ proposed by US President Barack Obama requiring a separation of traditional banking business from more risky activities is widely adopted.
All this stands to benefit London, the second largest global centre for hedge fund managers (after New York) with 18 per cent of the world’s hedge fund assets managed there at the end of 2008, according to the City’s promotional organisation IFSL. London’s primacy within Europe seems beyond challenge, with UK-based managers accounting about two-thirds of the continent’s total of some 1,300 funds and 80 per cent of its aggregate assets under management (USD300bn) in December 2008, or as much as 90 per cent if funds of funds and investments from the US managed in Europe are taken into account.
Analysts such as IFSL’s note that London possesses a range of structural advantages that make it particularly attractive as a centre for hedge fund management, including its accumulated skills and knowledge base, the proximity of institutional and high net worth clients and markets, and a strong asset management industry. The City also offers services including custody and audit as well as prime brokerage, being the leading European centre for investment banking business.
Yet the beginning of 2010 sees increasing anxiety about how durable London’s dominance within the industry will prove. For more than a year the media has been full of stories about an exodus of hedge fund management firms toward other European jurisdictions, notably Switzerland and the Channel Islands. Although the actual number of managers that have taken concrete steps to move their businesses wholly or partially elsewhere still seems to be relatively small, the merits of London as a management base are being called into question as never before.
These concerns have nothing to do with the City, its people and infrastructure and everything to do with the regulatory and fiscal environment both in the UK and the European Union as a whole. The impact of the credit crunch, which led to the emergency bail-out of many of the largest British financial institutions, has led the government to introduce a range of tax measures including the raising of the top rate for individuals to 50 per cent on income above GBP150,000 as of April this year.
The tax hike comes on top of previous measures affecting high earners including a one-off tax on banks paying large bonuses this financial year, and earlier curbs on the tax benefits for individuals resident in the UK but with non-domiciled status. Protests that the measures will affect the competitiveness of the country’s financial industry, its most important source of international earnings, have fallen on deaf ears amid widespread public outrage at what is perceived to be the outsized remuneration enjoyed by members of the industry at a time when the population at large is still suffering the effects of the recession.
The fact that the hedge fund industry has not benefited – directly at least – from the government bailout has not preserved it from the general opprobrium toward the financial industry; hedge fund managers have long been a handy target for populist ire. They have also been unsettled by uncertainty over the past few years surrounding the investment management exemption, which sets out the rules under which an offshore fund run by a British-based manager is exempt from UK tax.
Repeated tinkering with tax rules is a recurrent complaint against the UK government by the hedge fund industry and other investment managers, and is an important factor in the unwillingness of managers to domicile anything but domestically-oriented funds in the country. But that uncertainty pales against the confusion spread by the EU’s chaotic attempts to lay down uniform regulatory conditions upon the alternatives sector through its proposed Directive on Alternative Investment Fund Managers.
With the third draft of the directive now on the table and a reported 1,700 amendments to the legislation tabled in the European Parliament, the ultimate shape of the rules it will bring in remains shrouded in mystery. But concerned by the slant of the proposals toward significant restrictions on funds from EU-based managers, some members of the industry are wondering aloud whether it might not be more advantageous to be located beyond the directive’s reach – in Switzerland, for instance. Big industry players Brevan Howard and BlueCrest Capital Management are the latest to announce plans to open offices in Geneva.
Nevertheless, hedge fund managers and service providers believe that fears of a large-scale exodus are overblown. Melissa Hill, managing principal of Sabre Fund Management, argues that while the initial reaction of many members of the industry was to look up the flight times to Geneva amid outrage at the government’s steadily climbing tax demands, careful reflection is likely to give managers pause.
Hill, who admits that Sabre has examined the possibility of a presence in Jersey, says: “This is a reasonably significant threat for people who are mobile, but those with children already in school might find it a bit harder. It’s nice to go skiing in the winter at weekends, but not everyone can fit into Geneva – I understand there’s very little office space available and limited housing.”
Helen Bramley, product director for collateral at Lombard Risk Management, notes: “Around 80 per cent of the European hedge fund industry is UK-based. There’s been a lot in the press about fund managers moving to places like Geneva, but I don’t know whether that will actually happen or not. The firms we have been speaking to do intend to stay here, which means the business will grow. The intellectual capital around collateral is in London.”
Simon Dinning, managing partner of the London office of offshore law firm Ogier concurs, saying: “When a few significant fund managers depart Mayfair for Switzerland it creates headlines. I’m not saying it’s a knee-jerk reaction – I think it’s a considered move on their part – but there is something of a rush in the early days and things will slow down. There will certainly be a Swiss club, but London will still retain a significant community of hedge fund managers.”
In any case, being based outside the EU might well make it harder, or even impossible, to access investors inside the 27-country bloc, depending on the final form of the directive. In addition Switzerland and other non-EU jurisdictions seem willing to consider adopting similar legislation in order to avoid being shut out of any ‘fortress Europe’ that the legislation might erect. Nevertheless, the AIFM Directive is an added complication for those who would like to see London’s hedge fund industry expand its scope rather than shrink.
For to say that London is on the defensive over its hedge fund manager community does not tell the whole story. There is also a belief shared by industry members and government officials that the UK is capable of attracting at least a share of a part of the business it has never enjoyed – the domiciliation of hedge funds run by London-based managers, along with the provision to them of administration and other services.
For the time being the vast majority of UK-managed funds are established in ‘traditional’ offshore jurisdictions such as the Cayman Islands, British Virgin Islands and Bermuda, and to a lesser extent in the three crown dependencies, Jersey, Guernsey and the Isle of Man. Should the AIFM Directive make offshore centres less attractive as a domicile for funds targeting European investors, the EU centres that already dominate the cross-border retail funds market – Luxembourg and Dublin – appear well placed to take up the slack.
“The AIFM directive will force people to rethink fundamentally their business model and the traditional Ireland-Cayman master-feeder structures in the hedge fund world,” says Stephen Burke, director and head of compliance at IMS Consulting. “That model will be challenged – it may well come through that challenge relatively unscathed, but equally new models could emerge. A few people are now considering Luxembourg as a jurisdiction, although Cayman still seems to be where most people are being advised to go.”
But in theory at least, there is nothing that Luxembourg or Dublin offer that London could not, given the political will to ensure that the UK can offer a regulatory and tax environment as attractive as its rivals. This has not always been a government priority, but important steps toward putting appropriate measures in place have been taken over the past few years.
These include the establishment of a ‘white list’ of investment transactions that defines which activities constitute trading and distinguishes between capital and income items; the Qualified Investor Scheme that allows the creation of authorised schemes offering flexibility in terms of borrowing and investment strategies; and the Tax Elected Fund regime that allows tax liability to be passed down through a fund to its underlying investors.
The present moment is particularly propitious for an all-out effort to boost London’s attractiveness as a fund domicile because it coincides with the implementation into the national law of member states of the EU’s Ucits IV Directive, the latest update of the regime covering the cross-border marketing and distribution of retail funds. The significance lies in the fact that a growing number of managers are looking to launch Ucits funds that follow hedge fund-style strategies, exploiting the regime’s flexibility on the use of leverage and of derivatives that can be used to mimic investment techniques such as short selling.
For asset managers, the appeal is not only to broaden their investor base but to develop regulated vehicles using a tried and tested structure with an international profile, perhaps as an alternative to what may be a cumbersome and constraining regulatory system if and when the AIFM Directive is in place. For London to develop its role as a Ucits domicile would give it an additional argument for hedge fund managers – to be able to manage, domicile and service a full range of funds in a single location, with all the attended business activity and employment that would bring.
But there are many reasons not to get carried away with excitement. The UK has made sporadic efforts in the past to attract Ucits funds, with very limited success. In the meantime the key service providers such as administrators, custodians, accountants and auditors have focused their fund-related activities, for both retail and alternative vehicles, in Luxembourg and Dublin, and will require convincing arguments to replicate that infrastructure in London. And like all large countries, the UK struggles to accommodate what are essentially offshore legal and regulatory arrangements alongside the requirements of its domestic market.
Still, market participants say an important difference now is that the authorities are paying attention to the issue, and have a clear view of the benefits that a coherent policy to attract fund domicile business could deliver. “All those issues would have to be brought completely to a head before anyone would be interested in trying to sell it to anyone else,” says Lachlan Roos, UK tax hedge fund leader at PricewaterhouseCoopers.
“It is in its infancy at the moment – the policy ideas about how to make it work are really new. For example, the Qualified Investor Scheme has been around for years, but hardly anyone has ever used it. There’s only a dozen or so in place at the moment. But that people are actually trying to change policy, regulation and tax to make it work is actually a very new thing.”