Market commentary and discussion on the merits and limitations of alternative Ucits funds continue to generate considerable interest for hedge fund managers and their investors.
The interest is backed by recent statistics from the European Fund and Asset Management Association showing continued recovery and overall net inflows for Ucits since the turn of the year. At the end of May, total net assets within Ucits stood at EUR5.58trn, representing about 76 per cent of all European investment fund assets. While the alternative Ucits sector is currently a small fragment of the Ucits market, it is growing rapidly.
This trend is not new, and there is now widespread awareness of the opportunities for repacking traditional hedge fund strategies within Ucits funds. The ‘Newcits’ combination of regulation, diversification, liquidity and international distribution with the ability to replicate hedge fund strategies has proved a strong draw.
Product innovation continues apace with Ucits being structured, for example via indices or exchange-traded certificates, to provide investors with access to a multitude of sophisticated asset classes including hedge funds, life settlements, commodities and credit. This growth may in turn lead to an expansion in secondary investment as the universe for fund of funds-type investment into other Ucits hedge funds multiplies.
However, the liquidity constraints, investment restrictions, diversification rules, borrowing and leverage limits imposed by the Ucits directives will not fit the strategies of all alternative managers, nor do all have the resources to add the additional substance and risk-monitoring layers required to run a Ucits fund.
Nevertheless, overall market sentiment and interest remains positive and, for managers considering where to locate new Ucits funds or expand existing platforms, Ireland continues to be recognised as the domicile of choice for alternative Ucits. This stems not only from the country’s reputation for innovation on legal and regulatory issues but also its long history of providing administration, listing, legal and audit services to hedge funds located in the traditional domiciles of Cayman and the BVI. As a result, it is a natural fit for managers seeking to add a European regulated product to their existing hedge fund offerings.
Against this backdrop, industry members should take note of a number of significant recent developments for Ucits funds both in Ireland and the EU as a whole.
We expect some alternative managers with certain types of European investor to look at adding fund platforms in EU member states, particularly Ireland. Our experience to date is that most are seeking European-regulated products that complement rather than fully replace platforms in traditional hedge fund domiciles.
In this regard, the Irish Companies (Miscellaneous Provisions) Act 2009 provides a clear regime for managers who would like to move part of their existing corporate structures to Ireland by way of legal migration and apply for subsequent authorisation as a Ucits.
This new migration option is in addition to the existing feeder fund, amalgamation, merger and asset swap techniques. Non-corporates continue to be able to migrate depending on the terms of their documentation, and further clarification and developments for specific fund structures, such as unit trusts, is expected shortly.
There have also been significant developments in the rules governing both the receipt and passing of collateral to OTC counterparties. The Irish Financial Regulator has extended its list of permitted collateral that may be received by a Ucits to reduce its OTC counterparty risk exposure to include equity securities traded on defined stock exchanges. This extension is subject to an ‘add-on’ such that the market value of any such collateral represents 120 per cent of the related counterparty risk exposure (that is to say, a 20 per cent ‘haircut’) and is sufficiently liquid.
With regard to the passing of collateral, the terms on which collateral or margin may be passed by a Ucits to an OTC derivative counterparty or prime broker, without offending the general Ucits principle of depositary safe-keeping, have been clarified. This will aid Ucits managers wishing to use synthetic prime brokerage arrangements to support their strategies.
Ucits IV implementation
At EU level, the funds industry stands on the cusp of its next major evolution as the Ucits IV Directive enters the final stages of Committee of European Securities Regulators (Cesr) recommendations and industry consultation ahead of its scheduled implementation in EU member states by July 1, 2011.
As most readers will be aware, Ucits IV comprises a series of reforms aimed at enhancing the distribution and efficiency of Ucits funds rather than creating new strategy capabilities, which were addressed in Ucits III and the Eligible Asset Directive. The key legal and regulatory principles of Ucits IV already set down in the recast Ucits IV Directive (2009/765/EC) consist of a working management company passport, merger options, master-feeder structures, electronic cross-border notifications, key investor information documentation (KIID) and a framework for improving co-operation between EU supervisory authorities.
However, the Ucits IV Directive only sets out the general framework and legal principles behind the Ucits IV concepts. As a result, since its publication there has been an extensive process of industry consultation and the provision of technical advice from Cesr to cover the details, that is level 2 measures and level 3 guidelines covering the practical implementation of Ucits IV.
This process resulted in the adoption on July 1 this year of further detailed requirements by the European Commission in the form of two directives and two regulations, which cover key investor information and publication issues, electronic notification procedures, mergers and master-feeders and management companies.
Commission Regulation (EU) No 583/2010 focuses on the KIID and the conditions to be met when providing key investor information or the prospectus of a Ucits in a durable medium other than paper or by means of a web site.
Commission Regulation (EU) No 584/2010 details the form and content of the standard notification letter and Ucits attestation, the use of electronic communication between competent authorities for the purpose of notification, and procedures for on-the-spot verifications and investigations and the exchange of information between competent authorities.
Commission Directive 2010/42/EU provides further clarification on the requirements for Ucits mergers and master-feeder structures, such as the content of the merger notification document and procedures between EU member state regulators and the relevant service providers.
Commission Directive 2010/43/EU expands on the procedural requirements for the management of Ucits, particularly cross-border activities, and organisational requirements, conflicts of interest, conduct of business, risk management and content of the agreement between a Ucits depositary and a management company in that context.
In addition, Cesr has published its final guidelines on risk measurement and the calculation of global exposure and counterparty risk for Ucits, which will be of particular interest to hedge fund managers using derivative instruments as an integral part of their strategy.
Now that the final measures are in place at EU level, attention is turning to the reform of existing rules in EU member states in advance of the July 2011 deadline.
Ireland has consistently been among the first EU member states to adopt new Ucits measures and the process of domestic change ahead of Ucits IV is already underway. In this regard, both the Irish government and the Financial Regulator have committed to Ireland's position as a leading centre for international investment funds.
For example, taxation measures announced in the Irish Finance Bill 2010 have already brought welcome clarity to the fraught issues of cross-border taxation for Ucits management companies – an Irish management company will not bring the profits of a foreign Ucits within the charge to Irish tax – and stamp duty relief for asset transfers under Ucits mergers or reorganisations.
In a recent address to the Irish industry, Matthew Elderfield, head of financial regulation at the Irish Central Bank, highlighted the “potential benefits of this legislative initiative”, while making clear that the changes must be achieved from an operational point of view with minimal risk to investors. He confirmed that the Irish Financial Regulator will continue working closely with industry to ensure the smooth transition of Ucits IV into the Irish regulatory sphere.
It is expected that revised Irish Ucits notices, guidance notes and policy papers will be issued before the end of 2010.
Cesr guidelines on money-market funds
Also of significant interest to the Irish market considering its share of European money-market funds are Cesr’s latest guidelines, which propose a common definition for Ucits and non-Ucits money-market funds. The move follows criticism of the labelling of certain funds resulting in investors suffering unforeseen losses. They were found not to appreciate fully the risks and asset classes these funds could invest in, which differed from the generally accepted concept of money-market funds as investing in relatively liquid, short-term investments.
The Cesr guidelines aim to improve investor protection by establishing a definition that will provide a more detailed understanding of the distinction between money-market funds that operate in a very restricted fashion and those that follow a more ‘enhanced’ approach. The guidelines create two categories, Short-Term Money-Market Funds and Money-Market Funds.
The Cesr approach recognises a distinction between Short-Term Money-Market Funds, which operate a very short weighted average maturity and weighted average life, and Money-Market Funds, which operate with a longer weighted average maturity and weighted average life.
The guidelines come into effect on July 1, 2011, the same date as the transposition deadline for Ucits IV, with an additional six-month period for existing money-market funds to comply. While other money market-style funds outside the two categories can continue to be authorised as Ucits, they will not be able to use the Money-Market Fund label following the introduction of the guidelines. In addition, only Short-Term Money-Market Funds will be permitted to use a constant NAV.
Peter Stapleton is a partner and Pádraig Brosnan an associate in the investment funds group at the Dublin office of international law firm Maples and Calder