Ireland has been an increasingly popular domicile for Japanese, Asian and other fund promoters for a number of years. Ireland, being an EU and OECD member country, has earned a reputation as a strong yet flexibly-regulated jurisdiction which meets the standards of selection of foreign investment funds securities under the relevant Japanese regulations (as well as being a recognised jurisdiction in Hong Kong and other countries). These factors combined with relevant expertise of Japanese lawyers in working with Irish structures, a network of double tax treaties, pragmatic regulator, a variety of fund structures and a genuine commitment to meet the needs for continually-evolving industry, mean that Ireland's popularity in Japan and elsewhere seems set to continue in the area of hedge funds. Hedge funds were traditionally domiciled in unregulated jurisdictions, which meant that hedge funds were seen as a less-regulated product. In addition, hedge funds were often viewed as high risk because they were operated by investment managers who employed unusual investment techniques that demanded a lot by way of flexibility and little or nothing by way of regulations. However, with the growth of interest in alternative investments, Ireland has put itself forward as a reputable and regulated environment offering greater opportunities to make the hedge fund product available to Japanese investors.
Why are investors attracted to hedge funds?
Many investors are attracted to hedge funds as they are considered highly-speculative investments suitable only for the wealthy private or institutional investor. The risks can often be far greater than traditional long-only funds and consequently the returns are perceived to be high. Also, because hedge fund managers frequently have a significant personal stake in the fund, investors may feel that the hedge fund manager stands to lose along with the investor should the fund perform badly.
The use of a prime broker
Since hedge funds traditionally developed in "unregulated" jurisdictions, a requirement to employ the services of an independent custodian was not traditionally imposed. Instead, funds in these jurisdictions relied on one main broker through which they would buy and sell securities, and to provide custody facilities as part of its brokerage service. This broker became to be known as the prime broker. To the extent that the hedge fund required to borrow or to take short positions, the prime broker would be able to provide financing and lend securities to the fund. As the prime broker had custody of the fund's assets, it had security for the securities the fund had borrowed from it. This type of relationship was generally only possible in unregulated jurisdictions, since most regulators would not permit unlimited access by a prime broker to a fund's assets because of the risk of loss to the fund should the prime broker became insolvent. Loss could arise if the prime broker effectively treated the funds' assets as its own, rendering them indistinguishable from its own assets to a liquidator.
When considering the possibility of allowing hedge funds to be established in Ireland, the Irish Financial Services Regulatory Authority took the view that the taking of title to a hedge fund's assets by a prime broker was incompatible with a custody relationship. Where a prime broker is appointed, the trustee/custodian is essentially replacing its own sub-custody network with the prime broker and its network of agent banks. The assets transferred are no longer owned by the hedge fund and the hedge fund merely has a contractual right against the prime broker for the return of equivalent investments or, if the prime broker is insolvent, a debt owed to it equal to the value of the investments transferred. In addition, where only one prime broker is engaged by a hedge fund, the risks associated with single counterparty exposure arise.
The Irish Financial Services Regulatory Authority's difficulty with the use of a prime broker lay in the requirements imposed by the Irish Financial Services Regulatory Authority on Irish custodians in the interest of protecting investors. In summary, a trustee/custodian of a non-UCITS fund (UCITS vehicles are not allowed to be established as hedge funds) is required to exercise due care and diligence in the discharge of its duties and will be liable for any loss arising from the negligence, fraud, bad faith, wilful default or recklessness of the trustee/custodian in the performance of those duties. In addition, a custodian/trustee of an Irish fund must ensure that the assets of those funds are held within the custodian/trustee's custody network so that in the event of the insolvency of the safekeeping agent the assets are available to the fund. Furthermore, non-cash assets of the fund must be readily identifiable and segregated from the assets of the safekeeping agent.
The Irish Financial Services Regulatory Authority needed to be satisfied that the appointment of a prime broker still allowed the trustee/custodian of a hedge fund to meet those requirements. Much industry discussion culminated in an important move by the Irish Financial Services Regulatory Authority in permitting the use of prime brokers for funds authorised by the Irish Financial Services Regulatory Authority as "professional" and "qualifying" investor funds on certain conditions.
The rationale and requirements worked through by the Irish Financial Services Regulatory Authority and the industry in achieving this breakthrough have now been embodied in a draft guidance note issued by the Irish Financial Services Regulatory Authority in April 2000. A summary of the Irish Financial Services Regulatory Authority's current position as set out in the draft guidance note is as follows:
- any entity, including prime brokers, to whom the assets of a hedge fund are entrusted must be appointed as a sub-custodian by the trustee/custodian;
- the prime broker, or its parent company, must have a minimum credit rating of A1/P1;
- the prime broker must be regulated as a broker by a recognised regulatory authority and it, or its parent company, must have shareholders' funds in excess of Euro 200 million (or its equivalent in another currency);
- the Irish Financial Services Regulatory Authority accepts
that there are circumstances in which assets of the hedge
fund may be transferred out of the control of the trustee/custodian.
Where a hedge fund's assets are passed outside the custody
network to a prime broker (whether to secure borrowings
or for any other reason whatsoever), the Irish Financial
Services Regulatory Authority has set out requirements that
must be complied with;
(a) the value of assets passed to the prime broker must not exceed the level of the hedge fund's indebtedness to the prime broker;
(b) the arrangement must incorporate a procedure to mark positions to market daily in order to monitor the use of assets on an ongoing basis;
(c) the prime broker must agree to return the same or equivalent assets to the hedge fund;
(d) the arrangement must incorporate a legally-enforceable right of set-off enabling the hedge fund to set-off the value of assets held by the prime broker against the liabilities owed by the hedge fund to the prime broker. The rationale is that in the event of the prime broker's insolvency, the hedge fund should not be left in a position whereby it is in debt to the prime broker and is left to prove as an unsecured creditor for the return of assets used by the prime broker.
There must be clear disclosure in the hedge fund's promotional/fund-raising documentation of its proposed relationship with the prime broker. In addition, the Irish Financial Services Regulatory Authority has confirmed that the prime broker may take a charge over the assets of the hedge fund held by the prime broker in its capacity as sub-custodian to the hedge fund.
Retail, professional and qualifying investor categories
The "retail", "professional" and "qualifying investor" categories of non-UCITS schemes can be broken down as follows:-.
(a) Retail scheme
If a fund has no minimum subscription or, if it imposes a minimum subscription of less than Euro 125,000, it will be considered to be a "retail" scheme. This type of fund is regularly used where the principal target market is retail investors outside the EU, although it can of course be used within the EU but will not benefit from any European UCITS visa. Irish Financial Services Regulatory Authority has recently approved the creation of retail funds of hedge funds.
(b) Professional scheme
If a minimum subscription requirement of at least Euro 125,000 per investor is imposed, a fund will be considered to be a "professional" scheme. That means that the standard investment and borrowing restrictions just mentioned can be disapplied to the extent agreed with the Irish Financial Services Regulatory Authority.
(c) Qualifying investor scheme
To be a qualifying investor scheme, a fund must:
(i) impose a minimum subscription requirement of Euro 250,000
(ii) be marketed solely to the following qualifying investors:
- any institution which owns or invests on a discretionary basis at least Euro 25 million or;
- any individual with a minimum net worth in excess of Euro 1.25 million.
Institutions may not group amounts of less than Euro 250,000 for individual investors unless pursuant to a fully discretionary investment mandate. Qualifying investors must self-certify that they meet these minimum criteria, that they are aware of the risk involved in the proposed investment and of the fact that, inherent in such investments, is the potential to lose all of the sum invested.
This structure gives Japanese promoters the opportunity to use Irish vehicles for a complete range of different fund types depending on the requirements of their targeted investors. The Irish Financial Services Regulatory Authority disapplies its general investment restrictions and borrowing limits for qualifying investor funds.
What are the advantages of establishing a hedge fund in Ireland?
Given Ireland's position as a highly-regulated jurisdiction it is attracting those hedge funds which are suitable in terms of their investment strategies and investor base to establish themselves away from their traditional jurisdictions. A distinct benefit of establishing a hedge fund in Ireland is the strict approval and supervision process relative to those in less-regulated jurisdictions. Accordingly, fund promoters are attracted by the prospect of offering a regulated hedge fund product while fund managers, who are already established in Ireland, are familiar with the legislative framework, and have solid relationships with their service providers. Indeed, the established centres are re-inventing themselves. Custodians/trustees have had to deal with the issues arising out of the Irish Financial Services Regulatory Authority Guidance Note in relation to prime brokers, the appointment of prime brokers as sub-custodians and the charging of funds assets. Administrators have had to deal with more complex valuations, equalisation and performance fee calculations and multi-class structures with differing currency classifications. It is from this established footing rather than from any start-up operation that the growth in Irish authorised hedge funds will come.
Funds of hedge funds - the way forward?
As hedge funds move from the alternative to the mainstream, it is projected that the growth in directly invested hedge funds will, to a large extent, be matched by the growth in funds of hedge funds.
Fund of hedge fund schemes in Ireland
The Irish Financial Services Regulatory Authority's position in respect of the schemes in which fund of funds schemes can invest is set out in NU 1 of the non-UCITS Notices.
NU 1 (Paragraph 1) provides inter alia that a scheme in which an Irish fund of funds scheme can invest must be:
- authorised in Ireland or in another jurisdiction by a supervisory authority established in order to ensure the protection of unit-holders and which in the opinion of the Irish Financial Services Regulatory Authority, provides an equivalent level of investor protection to that provided under Irish laws, regulations and conditions governing Irish funds; or alternatively
- the management/trustee and custodial arrangements, constitution and investment objectives of any scheme in which it is intended that an investment should be made must provide an equivalent level of investor protection as that provided by schemes authorised under Irish laws and regulations governing Irish funds.
Retail schemes are obliged to comply with the requirements of NU 1 (Paragraph 1) but professional investor funds ("PIF") may be granted a derogation on application to the Irish Financial Services Regulatory Authority. In the case of qualifying investor funds ("QIF") on the other hand, the requirements of NU 1 (paragraph 1) are automatically disapplied.
From a fund of hedge funds perspective, this means that an Irish-domiciled PIF/QIF fund of hedge funds can invest in hedge funds which are unregulated. Certain conditions apply however, which include the requirement that where the PIF or QIF proposes to invest in underlying funds which are unregulated this fact should be clearly disclosed in the prospectus and, where appropriate, should include a warning to the effect that the scheme may invest in underlying funds which are unregulated and which will not provide an equivalent level of investor protection to schemes authorised by the Irish Financial Services Regulatory Authority.
In order to address concerns in relation to inappropriate investment by Irish fund of funds (and feeder) schemes in unregulated schemes, the CBI has made a number of amendments to its NU series of notices and in particular, NU 1. The amendments are set out in the CBI's Guidance Note 1/01 entitled "Collective investment schemes other than UCITS - Feeder Schemes and Fund of Fund Schemes: Acceptable Investments and Related Issues" which was issued by the CBI in December, 2001. The main amendment for our purposes is that a PIF fund of funds scheme is now allowed to invest up to 100% in unregulated schemes, subject to a maximum of 20% in any one such unregulated scheme whereas a QIF fund of funds scheme may now invest up to 100% in unregulated schemes, subject to a maximum of 40% in any one such unregulated scheme.
The diversification requirement of 20% in any one such unregulated scheme in respect of PIFs seems to correspond to most hedge fund managers' diversification needs. This seems, therefore, to herald the way forward for PIF fund of funds schemes being the vehicles that hedge fund managers will adopt in the future for funds of hedge funds in Ireland. Similarly, QIF fund of hedge funds schemes may also become popular with hedge fund managers but it is likely that to achieve sufficient diversification only a maximum of 20% will be invested in any one scheme despite the fact that a maximum of 40% is permitted by the Irish Financial Services Regulatory Authority.
Other points of interest to note in respect of Guidance Note 1/01 are as follows:
- Fund of funds schemes investing in other fund of funds schemes (NU 1, paragraph 4) - This paragraph prohibits a retail fund of funds scheme from investing in another fund of funds scheme. A PIF scheme is permitted to derogate from the requirement provided investment in other fund of funds does not exceed 10% of net assets. The requirement is disapplied in the case of a QIF. Therefore, a PIF or QIF fund of hedge funds investing in another fund of hedge funds may be permitted although the Irish Financial Services Regulatory Authority requires that any such proposed investment should be clearly disclosed. In this regard, disclosure should focus on the implications of the policy regarding increased costs to investors (i.e. the fact that fees will arise at three levels the Irish scheme, the underlying fund of funds and the underlying funds in which the fund of funds invests) and the resultant lack of transparency in investments.
- Fund of funds schemes investing in feeder fund schemes - Guidance Note 1/01 stipulates that a Retail/PIF fund of funds proposing to invest in a feeder fund is not permitted but is so permitted in the case of a QIF. Accordingly, a QIF fund of hedge funds may invest in a feeder scheme where suitable disclosure regarding increased costs and lack of transparency is provided.
Retail Funds of Hedge Funds
In December 2002 the Irish Financial Services Regulatory Authority issued a new non-UCITS Notice (NU 25) on "Funds of unregulated fund schemes" which followed consultation with members of the funds industry. This notice permits the authorisation of so-called "funds of hedge funds" which can be sold to retail investors. It is anticipated that the introduction of this new fund variation will serve to further boost Ireland's growing hedge fund industry. It is expected that the new Irish funds of hedge funds will be popular with retail investors, particularly those in Japan seeking higher returns than those generated by traditional long-only funds.
Funds of regulated funds schemes will continue to be authorised under NU 1 and are permitted to invest up to 10 per cent. of net asset value in unregulated underlying collective investment schemes. Such unregulated funds schemes are those which fall outside the scope of Annex 2 to the Irish Financial Services Regulatory Authority's Guidance Note 1/01 which sets out acceptable investments in respect of fund of regulated funds schemes.
NU 25 now provides that a scheme may invest more than 10
per cent. of net asset value in unregulated schemes, such
as hedge funds and other alternative investment funds, subject
to certain rules.
In relation to a fund of unregulated funds scheme, it may not invest more than 5 per cent. of net asset value in any one unregulated scheme or more than 10 per cent. of net asset value in schemes managed by the same management company, which definition includes related companies or institutions. Further, these limits may be raised to 10 per cent. and 20 per cent. respectively, if the management company of the underlying scheme(s) is authorised to provide investment management services in an OECD jurisdiction.
The underlying unregulated schemes must be subject to independent audit and must have arrangements in place whereby all assets are held by a party/parties independent of the manager of the underlying schemes.
Although NU 25 relates to "retail" collective investment schemes, there is a minimum subscription requirement of Euro 12,500. However, this requirement may be disapplied where acceptable arrangements are in place to provide full protection to the capital subscribed by investors.
Specific additional disclosure in a scheme's prospectus is the main thrust of NU 25. The notice sets out additional risk warning wording which must be included in a prominent position in the offering document. The prospectus must also provide information on:-
- the investment policies of underlying schemes in which the scheme proposes to invest and any risks associated therewith;
- the levels of leverage employed by the underlying schemes;
- the expected impact of all fees charged on overall performance;
- the cumulative effect of any performance fees;
- potential liquidity problems;
- potential valuation difficulties.
There is also a requirement that the periodic reports of the fund of funds provide certain additional information on the underlying schemes.
The prospectus must provide a clear explanation of the alternative investment strategies that the underlying schemes may employ. It must also describe the diversification policies of the scheme and provide information on the extent to which the scheme may invest in underlying schemes that have demonstrated a high volatility of return.
Before the Irish Financial Services Regulatory Authority will authorise a scheme under NU 25 it must be satisfied that the management of the scheme and its delegates, where applicable, demonstrate appropriate experience and expertise in relation to alternative investment schemes. To satisfy the Irish Financial Services Regulatory Authority's requirement, detailed information must be submitted to show that appropriate controls and systems are in place to monitor the activities and overall leverage of the underlying schemes, their managers and any risk assessment procedures, on a continuing basis. Any submission should include information on the extent to which the management of the scheme (and its delegates) will review the background, expertise and experience of the underlying managers, the risks of the underlying schemes and the strategies being employed by them.
As provided for in NU 1, a fund of unregulated funds scheme may not invest in units of another fund of funds scheme, whether authorised under NU 1 or NU 25 or established outside Ireland. Similarly, where a scheme invests in units of a collective investment scheme managed by the same management company or by an associated or related company, the manager of the scheme in which the investment is being made must waive any preliminary/initial/redemption fee that it would normally charge. Further, where a commission is received by the manager of a scheme by virtue of an investment in units of another collective investment scheme, this commission must be paid into the property of the fund of funds scheme.
Where the fund of unregulated funds scheme is open-ended it must provide at least one dealing day per month to facilitate redemptions. The scheme may, however, retain up to 10% of redemption proceeds, where this reflects the redemption policy of the underlying scheme, until such time as the full redemption proceeds from the underlying scheme are received. The Irish Financial Services Regulatory Authority recognise that there may be circumstances where the underlying scheme may not permit holdings to be redeemed on as frequent a basis as that applying to the fund of unregulated funds and as a result the fund of unregulated funds cannot accurately determine it's net asset value. In such circumstances the scheme could calculate an estimated net asset value that would be subject to adjustment once the redemption proceeds from the underlying scheme had been received and a final net asset value is calculated. If the scheme adopts such a redemption policy there must be full disclosure in the prospectus with the time limits for payment of redemption proceeds clearly set out. The maximum interval permitted between submission of a redemption request and payment of settlement proceeds must not, however, exceed 95 calendar days.
The publication of NU 25 has been welcomed by the industry as a reflection of the Irish Financial Services Regulatory Authority's willingness to respond quickly to market requirements and indeed is a sign of the Irish Financial Services Regulatory Authority's growing sense of comfort with the hedge fund product generally. Ireland's position as a regulated jurisdiction has now been established and it is attracting hedge funds away from their traditional jurisdictions. It is projected that the growth in directly invested hedge funds will, to a large extent, be matched by the growth in funds of hedge funds.
The regulatory environment in Ireland, in the context of hedge funds and funds of hedge funds generally, is central to the future development of the funds industry as a whole. Pragmatic regulation of hedge funds is essential if alternative investment products are to thrive in the flexible environment in which they must operate to attain their objectives. The Irish Financial Services Regulatory Authority, as regulator, has facilitated the development of the Irish funds industry and its success has undoubtedly been due primarily to the legal and regulatory framework that is in place and the reputation and integrity of the Irish Financial Services Regulatory Authority. With this in mind, it must be remembered that the secret of good regulation is to strike a balance between protecting the investor and giving fund managers sufficient discretion and flexibility to do their job effectively.