Traditionally Luxembourg hedge funds and funds of hedge funds have been set up under part II of the law of December 20, 2002 on UCIs and, more recently, Specialised Investment Funds governed by the law of February 13, 2007. However, today many hedge fund managers are considering launching Ucits structures that can be freely marketed within the European Union and enjoy widespread acceptance elsewhere in the world.
The Ucits framework is attracting hedge fund managers mainly because of increased demand from investors for regulated products, transparency and liquidity - especially in the aftermath of the Madoff scandal – as well as broader eligible asset rules for Ucits, the strong risk management framework and the future benefits of Ucits IV after 2011. In addition, many institutional investors are restricted in the proportion of assets they can invest in less regulated funds but may invest relatively freely in Ucits vehicles.
The European passport makes distribution easier for fund promoters since they no longer have to be reviewed for substance in other EU member states but only with respect to formal compliance. The new simplified notification procedure under Ucits IV should speed up the cross-border distribution of funds.
An important factor in the emergence of ‘Newcits’ is the Eligible Assets Directive of March 19, 2007, which provided EU member states with a common understanding as to which assets are eligible for Ucits investment, together with the Eligible Assets Guidelines issued by the Committee of European Securities Regulators (Cesr). These rules were transposed in Luxembourg by the Grand-Ducal Regulation of February 8, 2008 and the CSSF circular 08/339.
Previously, alternative Ucits were limited to long/short equity strategies. The main innovation was to extend the range of eligible assets to enable Ucits III funds to invest in OTC derivatives such as total return swaps and contracts for difference, to adopt synthetic shorting strategies and to permit investments in hedge fund indices.
These strategies are, however, subject to counterparty exposure restrictions, in that global exposure through the use of derivatives should in principle not exceed 100 per cent of the net asset value of the assets, limiting the funds’ overall risk exposure on a permanent basis to 200 per cent of their net asset value.
According to article 42 (1) of the 2002 Law, Ucits must implement a risk management strategy that enables them to monitor and measure the risk of the positions and their contribution to the overall risk profile at any time. The Luxembourg regulator, the CSSF, has classified Ucits on the basis of their risk profile into sophisticated Ucits and non-sophisticated Ucits.
A sophisticated Ucits – generally those set up by hedge fund managers – is defined as mainly using derivatives and/or making use of more complex strategies or instruments. According to the CSSF, a sophisticated Ucits must entrust to a risk management unit independent of the investment management function the task of identifying, measuring, monitoring and controlling the risks associated with the portfolio’s positions.
In addition, several European regulators are pondering whether Newcits should be treated differently from long-only Ucits in other ways – for example, by insisting that they can be sold only with advice, whereas currently all Ucits can be sold on an execution-only basis. Cesr has not yet taken any formal action but the issue remains firmly on its agenda.
Olivier Sciales and Rémi Chevalier are partners with Chevalier & Sciales