Funds authorised as UCITS1 currently hold in excess of 7 Trillion Euro and as international recognition of this form of fund regulatory authorisation grows the related opportunities are being examined by an increasingly broad spectrum of investment managers.
These opportunities include both a legal right to avail of pan European Union (“EU”) market access, but also potentially expedited registration and facilitated distribution in third countries where the UCITS brand is readily identified and accepted. Recent statistics illustrate that in excess of 40% of all UCITS sales have come from such third countries, primarily those in the Far East.
For alternative managers UCITS became of greater interest following the broadening of the investment opportunities available to them and clarification in this regard further to the “UCITS III” regulatory reforms2 and the Eligible Assets Directive3. Steady growth of alternative UCITS, typically called “Newcits”, has been evident in the years since then and the number of such UCITS hedge funds now exceeds 1,000. As the majority of such funds launched post the financial crisis of 2008 it is evident that the growth trend in the alternative sector of the UCITS market is accelerating and this is being driven by investor demands for regulated products that afford greater liquidity and transparency, as well as the potential for higher returns and access to alternative strategies offered by traditional hedge funds.
As a result alternative managers, many of whom traditionally only operated funds in the offshore sector4, are increasingly considering launching UCITS and this article seeks to highlight a range of the key issues for such managers when they determine to launch UCITS.
New Establishment or Conversion?
It is generally possible to simply convert an existing alternative fund structure into a UCITS (a “Conversion”). However, in addition to undergoing the relevant UCITS authorisation procedures of the appropriate local EU regulator, such as the Central Bank of Ireland (the “Central Bank”), this may require the redomiciliation of the structure in accordance with relevant legislation such as Ireland’s Companies (Miscellaneous Provisions) Act 2009 where the fund was originally domiciled offshore. Managers contemplating entering the UCITS space who already have a range of existing hedge funds must therefore initially determine whether to engage in a Conversion or to simply establish a new separate standalone entity and to maintain their existing, possibly offshore, structures intact - typically referred to as operating a “side by side” or co-domiciliation strategy.
In practice, the predominant pattern to date has been for separate standalone entities to be newly established where alternative managers enter the UCITS market, particularly in cases where a redomiciliation would be required. Key reasons many managers have determined to adopt this approach include the fact that the range of investment restrictions applicable to UCITS will typically require extensive amendments to the fund’s investment policy and contractual arrangements and result in a new cost structure which may reduce or distort the performance of an existing fund. Accordingly, it is often deemed preferable not to subject existing investors to such radical changes in case this triggers a wave of redemptions.
However, it can be noted that a Conversion (whether carried out in conjunction with a redomiciliation or not) does have various advantages, including the retention of the existing corporate identity of the fund, the maintenance of existing contractual relationships and the avoidance of the costs of establishing a new legal entity or a potentially tax inefficient transfer of assets between funds. It would also permit a fund to retain its existing track record and listing history. In addition to highlighting key issues for offshore alternative managers when they determine to launch UCITS, therefore, this article will identify the issues which may create differences in performance, structure and risk profile between an alternative UCITS and the same investment manager’s sister non-UCITS products in a side-byside fund range.
Implications for the Investment Manager
Investment managers are typically subject to regulation in the country in which they are located. Accordingly in many cases investment managers may be able to avail of exemptions applicable under local law from any requirement to be regulated where they are only providing management services to unregulated offshore funds. On the other hand, a UCITS home state regulator will generally require entities that wish to provide discretionary investment management services to such products to be regulated regardless of the jurisdiction in which they are located so alternative managers wishing to enter this market may find that they themselves need to obtain some form of regulatory authorisation. Switzerland is an example of a country which specifically introduced certain regulations some years ago in order to address this issue for local investment managers wishing to service UCITS which were not previously required to be regulated locally. One option where obtaining regulatory approval presents an issue may be for the existing manager to only act in an advisory capacity to a regulated entity which in turn is appointed as the actual investment manager of the UCITS, but in the majority of cases this will not be a tenable strategy.
We turn now to look at the attributes of the proposed alternative UCITS itself, initially focusing on potential differences when compared to an offshore fund by reference to its domicile, legal and capital structure, documentation, governance and service providers.
UCITS are required to be constituted under the laws of a member state of the European Union (the “EU”) so where a new entity is to be established this will have to be in an appropriate jurisdiction. In practice Ireland and Luxembourg are the two most prominent domiciles for the establishment of internationally distributed UCITS. It can be noted that the article makes specific reference to UCITS domiciled in Ireland due to their overall popularity, the fact that according to the latest statistics Ireland appears to be emerging as the domicile of choice under the current UCITS regime and Ireland’s dominance as the domicile of choice for alternative European fund products. For example, the European Fund and Asset Management Association (“EFAMA”) latest annual statistical report5 showed that Irish UCITS experienced the highest net inflows of any fund domicile during 2011, attracting net inflows amounting to €62 billion in 2011, some €50 billion more than the next most successful domicile. In the fourth quarter of 2011 alone, Irish UCITS attracted nearly five times more new monies than those of all other jurisdictions combined. In addition, Irish funds contain 63% of European hedge fund assets according to surveys by HFM Week and Hedge Funds Research, Inc.
Where it is proposed to proceed with the UCITS authorisation by means of a Conversion, this will need to adhere to both the applicable requirements of the local regulatory requirements for such authorisation in the relevant EU member state as well as the re-domiciliation legislation of the target jurisdiction (if the fund was originally established outside the EU)6.
Legal and Capital Structure of UCITS
UCITS may be formed as investment companies, unit trusts or contractual vehicles only and accordingly if an existing fund was constituted as an investment limited partnership a new form of legal structure will be necessary and a Conversion would not be possible, as such. As a result, the legal structure of the respective funds may constitute a differentiating characteristic in the side-by-side model in addition to the regulatory classification.
The form of articles of association of any investment company will usually be largely driven by local company law so it would be preferable, if not absolutely necessary, for a completely revised form of articles which complies with both local law and the UCITS requirements to be adopted. This may also necessitate an amendment to the existing capital structure, particularly as share capital in off-shore investment companies is typically divided between non-voting participating shares held by investors and a small number of non-participating management shares with voting rights being held by the investment manager or promoter. By contrast all of the shares or units in UCITS will have voting rights and this often poses a concern for traditional alternative managers regarding potential loss of control.
One possible way of addressing such concerns within the applicable requirements is for the UCITS to be created with a separate nonparticipating subscriber share class with voting rights which are held by the investment manager (although investors will also still have voting rights) which not only facilitates a winding up at the end of the life of a fund but also, in the event of a serious disagreement with investors in a sub-fund, creates a potential practical solution where closing or spinning off the relevant sub-fund is proposed, to ensure the fund platform or corporate shell remains under the control of the sponsoring investment manager. It can be noted that UCITS are prohibited from making loans so the practice sometimes employed by offshore funds for issuing debt as well as equity will not be appropriate.
In the case of UCITS structured as self-managed investment companies one (minor) advantage of a Conversion rather than establishing an entirely new UCITS, particularly for smaller managers who may have difficulty in raising, or providing, seed capital, is that the fund will typically already be of sufficient size to eliminate any need for the manager to invest capital to ensure that it meets the minimum capital requirement for UCITS.
Issues regarding Fund Documentation
Naturally, regardless of the legal structure selected, the offering memorandum will contain appropriate disclosures addressing this, but certain additional documentation is required to be prepared for UCITS. In relation to offering documentation this includes a requirement to also issue a Key Investor Information Document, or “KIID”, in the prescribed format. Other documentation, such as a Business Plan and Risk Management Process will also be required to document internal governance procedures. It is also worth noting that specific additional disclosures will be required in the main offering memorandum or prospectus in the case of UCITS. In accordance with UCITS IV7 these mandatory disclosures will include details of the voting policy, organisational or administrative arrangements for the management of conflicts of interest and complaints procedures which investors may follow. Consideration should therefore be given when determining to launch side by side structures as to whether to adopt a uniform approach in this regard across a manager’s international range of products.
Fund governance is an area of increased attention in recent years. In particular, the recent Weavering case8, where two “independent” directors were subject to civil litigation for their conduct as directors of a Cayman fund structured as an investment company, has focussed increased attention on the nature and composition of fund boards.
The issue of director capabilities and experience has greater significance in the context of UCITS. This arises as, in addition to general director’s duties, the boards for such funds, or their management companies, are specifically required to take responsibility for ten key management functions under the UCITS IV regime, including risk management, supervision of delegates and monitoring of investment policy, investment strategies and performance, to cite a handful of examples. Each management company or selfmanaged fund is required to prepare a “Business Plan” which details the manner in which these requirements are met on an on-going basis and the UCITS’ “Statement of Responsibility” will specify which specific responsibilities adhere to each director. It can also be noted that the concept of collective board responsibility must be replaced with individual designated responsibility, in accordance with UCITS IV, for directors of UCITS by 1 July 2013 at the latest so this will accentuate concerns in this regard.
Additional local legal and regulatory requirements may also be relevant. For example, Irish UCITS are required to have a minimum of two Irish resident directors who will be required to obtain approval from the Central Bank and to meet its new “fitness and probity” standards. The new Irish voluntary Corporate Governance Code for funds may also be relevant in relation to determining board composition as it provides, for example, for the appointment of at least one entirely independent director and one representative of the investment manager. It can also be noted that in addition to fund regulatory concerns, under Irish company law directors may be subject to a higher liability standard in carrying out their duties than is generally the case in offshore jurisdictions.
In light of all these considerations any Conversion will typically involve a re-evaluation of the existing board and potential changes to its composition to ensure members have the relevant expertise to address the UCITS requirements. As a result, in the case of side-by-side structures it may be appropriate for board composition’s to differ for the separate onshore and offshore structures, or if a common board is to be appointed it may be necessary to reconstitute the boards of the existing offshore structures in the product range to ensure those directors can also meet the requirements of the UCITS.
UCITS Service Providers
Apart from the investment manager, there will typically be a requirement to appoint certain local third party service providers for functions such as fund administration. In a Conversion scenario, given the high proportion of both offshore and European hedge funds already administered from Ireland, this may not entail any change of administrator. However, given the nature and higher level of reporting required for UCITS, for example the obligation to ensure that any OTC derivatives held are reliably valued on a daily basis, in practice it will be necessary to ensure that the existing administrator has the appropriate capacity and expertise and as a result it will still be necessary to examine whether a change of administrator is actually required in addition to revisiting the terms of the service contract.
It can be noted that under the relatively new outsourcing regime permitted by the Central Bank activities other than “core administration activities” (being the final checking and release of NAV for dealing purposes and the maintenance of the shareholder register) may be carried out, subject to the applicable requirements, elsewhere, for example in the US. Some managers may value the added convenience of having such outsourced operations performed locally in a more easily contactable timezone and this may also lessen any practical communication issues involved in appointing a local Irish administrator where this differs from the model employed in relation to the manager’s existing funds.
While offshore funds are generally free to choose whether or not to appoint a third party custodian, UCITS are required to appoint one, which must be located in the same jurisdiction they are domiciled in. In addition, in the case of a UCITS the minimum range of services to be provided is prescribed by regulations and the liability standard applicable to the custodian is required to cover situations where loss arises for the “unjustifiable failure to perform its obligations or its improper performance of them”. It is highly unlikely that this standard would be made applicable for any non- UCITS structure as, apart from other considerations, the exact meaning of this liability standard remains unresolved. The appointment of a custodian may therefore be a differentiating factor for the UCITS, which will certainly have a cost implication, and in any event the liability provisions, even if a custodian is appointed in both cases, will differ.
The appointment of a prime broker has been a standard hallmark of offshore hedge funds and indeed is often viewed as one of their defining characteristics. However, this was traditionally not possible for UCITS, primarily due to the prohibition on the re-hypothecation of assets typically provided for in standard prime brokerage agreements and the limitation of 10% on counterparty exposure which UCITS are subject to. Increasingly however, in order to target the multi-trillion Euro market which UCITS represent, prime brokers are now using modified form standard agreements specifically adapted to address the UCITS requirements and accepting a sub-custody role to facilitate their provision of services to UCITS. This is a growing market for prime brokers and increasingly the standard model for alternative UCITS.
A key area of divergence between an alternative UCITS and a traditional hedge fund relates to the potential portfolio of investments and related attributes. In this regard the investment restrictions, potential counterpart exposure, as well as the funds’ liquidity and capacity to employ leverage are all relevant considerations.
UCITS are subject to a range of strict investment restrictions imposed with the general aim of ensuring risk diversification. While it is beyond the scope of this article to examine these in detail it is appropriate to note here that these include a series of “hard” limits relating to concentration, exposure etc. all of which must be adopted at a minimum with no discretion on the part of the investment manager or fund board to waive them. On the other hand, the investment restrictions of a traditional hedge fund, even in the occasional cases where similar limits might be applied under the terms of the investment policy and investment restrictions of the offering document, are likely to be termed in more indicative language or to include opt-out provisions at the discretion of the board where circumstances are deemed to warrant it. If this is the case then in times of severe market stress, such as those as have been witnessed since the financial crises of 2008, the portfolios of the onshore and offshore vehicles in a “side by side” offering may diverge to a significant extent.
There are also restrictions on the types of investments which may be undertaken. For example commodities, a number of which have seen substantial appreciation in recent years, do not constitute eligible investments for UCITS and therefore such funds are obliged to seek access to exposure to them by indirect means.
One particular investment restriction of specific relevance for hedge funds relates to short selling. Taking short positions to protect against negative price movements is arguably one of the defining characteristics of a hedge fund. However, UCITS are specifically prohibited from carrying out uncovered sales of transferable securities, money market instruments or other financial instruments. Therefore, in order to take advantage of negative price movements UCITS utilise synthetic shorts, typically through use of derivatives.
When considering portfolio construction it is also appropriate to note that UCITS are subject to a limit of 5% NAV exposure limit to a counterparty to an OTC derivative, although this limit can be raised to 10% in certain cases (for example where the counterparty is a credit institution authorised in the EEA or certain other countries. In addition other requirements applicable to UCITS include that it have the ability to close out transactions at any time at fair value so OTC contracts will need to include an appropriate optional termination provision. The net effect of these requirements on portfolio construction is that there will generally be a requirement for the UCITS to enter into transactions with a broader range of counterparties, who are eligible under the relevant criteria and for the agreements they enter into to be separately negotiated to those for the manager’s offshore fund range9.
The use of significant leverage is another hallmark of traditional offshore hedge funds. However, UCITS are subject to a maximum borrowing limit of 10% (which may only be used for temporary purposes) and the assumption of leverage through the use of financial derivative instruments (“FDI”) is also strictly regulated. There are specific rules applicable to the global exposure a UCITS may assume through its dealing in FDI, in relation to the collateral which may be accepted in conjunction with FDI and how this collateral may be treated. These restrictions should generally tend to result in lower volatility but also to produce a lower range of returns when compared to offshore funds not subject to such requirements. In addition certain fund strategies may not be tenable without a high level of leverage and hence will not be suitable for the UCITS environment. The required liquidity (discussed below) may also affect portfolio composition and selection of counterparties.
Redemptions rights and Liquidity
The lack of liquidity of many of the instruments held by offshore funds, and in particular those pursing alternative strategies, quickly became evident in the recent financial crises. However this merely highlighted the general tendency for such schemes to hold illiquid asset classes and as a result to typically impose, or retain the right to impose, restrictions on the frequency with which redemptions can be exercised as well as on the maximum extent thereof, such as gates. By contrast, UCITS, by their very definition, are expected to hold a diversified portfolio of transferable securities and are required to permit investors to redeem on a minimum of two dealing days per month. It is also worth noting that redemption proceeds must be paid in full within a strict maximum settlement period from dealing deadline to settlement date so the practice commonly adopted by hedge funds of holding off on payment of a certain percentage of redemption proceeds until after the audit or some other key date has passed is not permissible for them.
At the same time, in order to discourage excessive trading and consequent costs to other investors UCITS may apply an anti-dilution levy to cover dealing costs and preserve the value of underlying assets of a fund and UCITS may gate redemptions to 10% of NAV on each dealing day. In addition, subject to notification of the relevant regulator, they may even temporarily suspend redemptions in certain circumstances, for example during a period when circumstances outside the control of the directors exist as a result of which any disposal or valuation of investments of a fund is not reasonably practicable. However, any such ability to impose a suspension would be narrowly interpreted. Even where an offshore fund has comparable provisions in its offering memorandum it will generally subject any such suspension to the general discretion of the board and accordingly in practice in a crises liquidity may evaporate. It is the consequent greater liquidity of UCITS which has been one of the key drivers of their growth post the financial crises of 2008.
Conclusions and Summary
The market for alternative UCITS is expanding rapidly due to increased investor demand for well regulated, transparent and liquid investment structures. In determining whether to enter this market investment managers with existing funds need to initially determine whether to set up a completely new structure or to adapt and convert an existing product to ensure compliance with this regime and seek the appropriate authorisation. In either case the UCITS will differ from traditional alternative fund structures in a range of ways, a number of examples of which are set out above, typically including the fund’s form and capital structure, the parties to the scheme, including the contractual terms appointing them, and the attributes of the investment portfolio itself.