In the aftermath of the financial crisis, demand on the part of institutional investors for more regulated, transparent and liquid collective investment schemes, and continuing uncertainty over the impact of the Alternative Investment Fund Managers (AIFM) directive on their marketing activities in Europe, have led to increased interest on the part of Asian hedge fund managers in so-called "Newcits" – UCITS (Undertakings for Collective Investment in Transferable Securities) funds which pursue hedge fund type strategies and invest in derivatives for speculative purposes as opposed for efficient portfolio management. In this article, we consider what establishing a UCITS fund involves and ask whether the potential advantages of managing a product that can be widely distributed to retail investors, as well as being readily acceptable to institutional investors in many jurisdictions, outweigh the higher costs and more stringent compliance requirements associated with establishing and running a UCITS fund.
The majority of UCITS funds are established in Ireland or Luxembourg. The promoter of a UCITS fund which is established in Ireland is required to have paid up share capital of €635,000 (or the equivalent in another currency). In Luxembourg, the capitalisation requirement for a promoter of a UCITS fund is significantly higher. This causes problems for many Asian promoters who are often required to have significantly lower paid up and/or liquid share capital requirements by their home regulator.
Both Ireland and Luxembourg currently require that the administration and custody of the fund be carried out in the respective jurisdiction. A UCITS fund must provide its investors with at least fortnightly liquidity. There are onerous requirements in both Ireland and Luxembourg with respect to the submission of various reports to the local regulator on a monthly, quarterly and annual basis and to seek the local regulator's consent prior to making material changes to the UCITS fund.
UCITS have existed since the transposition into national member state legislation in the European Union of Council Directive 85/611/EEC (UCITS I). UCITS established under UCITS I were limited to investment in transferable securities and were distributable throughout the EU on the basis of a European passport. Cash and money market instruments could be invested in only as "ancillary liquid assets".
The development of Newcits products was made possible by the changes to the EU's UCITS legislation brought about in 2001 predominantly by Directive 2001/108/EC, which was one of the two directives which collectively became commonly known as UCITS III. The range and type of financial instruments in which UCITS can invest was expanded by UCITS III (as enhanced by the Eligible Assets Directive and guidelines issued by the Committee of European Securities Regulators) to include not only transferable securities (defined as shares in companies and other securities equivalent to shares in companies, bonds and other forms of securitised debt and any other negotiable securities which carry the right to acquire any such transferable securities by subscription or exchange) but also units in collective investment schemes, deposits, approved money market instruments, financial indices and derivatives. Derivatives could only be invested in for efficient portfolio management purposes under UCITS I.
A UCITS that invests in derivatives for investment purposes must design and implement a comprehensive risk management system relating to the use of such derivatives to ensure investor protection which must be approved by the regulator of the UCITS. Amendments to the plan must be approved in advance by the UCITS' regulator.
There are specific criteria that any financial indices used must comply with. Any derivatives traded in must be dealt in on a market that is regulated, operating regularly and open to the public. A UCITS fund may trade in OTC derivatives on a limited basis. No more than 5% of the net asset value of the UCITS fund may be exposed to any one counterparty when investing in OTC derivatives. This limit is increased to 10% where the counterparty is a credit institution in a regulated jurisdiction. OTC derivatives exposure must be independently valued on a daily basis. A UCITS must ensure that its global exposure to derivatives does not exceed 100% of its net asset value and it may not engage in physical short selling. A UCITS may borrow up to 10% of its net asset value on a short-term basis. In addition, synthetic leverage can be undertaken using repos and total return swaps. Securities held by a UCITS may not be re-hypothecated. Although UCITS are generally not permitted to invest directly in hedge funds or commodities, they may gain exposure to these asset classes by investing in hedge fund or commodities indices.
The greater flexibility accorded by UCITS III has allowed fund managers to replicate many different hedge fund strategies and to offer performance and risk diversification to investors, but UCITS are clearly more suitable for some strategies than others. Broadly put, equity long/short and 130/30 strategies are a good fit with the UCITS regime as are tactical strategies which rely on derivatives indices. Other strategies, however, such as an event driven strategy which exploits pricing inefficiencies caused by corporate events, investment in distressed assets or relative value strategies are less likely to fit within the UCITS framework, as they will often not offer sufficient liquidity.
UCITS IV (which is due to be transposed by EU member states by July 2011) will facilitate further the cross-border marketing of UCITS funds within the EU, replace the simplified prospectus currently used with a "key information document", facilitate mergers of UCITS funds, allow UCITS to be established as master-feeder structures and permit the management company of a UCITS to be established in one member state while the UCITS fund is established in another member state. (An attempt was made under UCITS III to achieve the latter objective but it was not successful.)
The increase in interest in UCITS funds is in large part investor-driven. Since the financial crisis, institutional investors have sought out more regulated investment vehicles. In this regard, the controls imposed on UCITS relating to diversification, leverage, eligible assets, liquidity and transparency mean that they are perceived as being less risky than less regulated offshore funds.
A UCITS fund established in one EU jurisdiction is freely marketable throughout the other 26 member states. UCITS also represent an international gold standard. UCITS funds are widely authorised for distribution to the retail public in Hong Kong, Singapore and Taiwan. They are also widely authorised for distribution to the public in South America and in the Middle East.
A further reason for the increased interest among Asian hedge fund managers in UCITS products was the uncertainty that surrounded AIFM (which impacts virtually any type of collective investment scheme offered in the EU that is not a UCITS fund). Some of this uncertainty has now dissipated in light of the finalisation of the text of AIFM in November 2010. Nevertheless, much remains to be determined by the European Commission relating to AIFM. Among its many provisions, AIFM seeks to impose more onerous obligations on custodians of alternative investment funds marketed in Europe than are currently applicable to UCITS funds. The EU Commission has recently commenced a consultation process with a view to imposing more onerous obligations on the custodians of UCITS funds to bring their responsibilities in line with those of custodians of alternative investment funds under AIFM.
One way in which Asia-based managers are trying out UCITS products is by being appointed as a sub-adviser – typically in respect of a sub-fund that pursues an Asia-focused strategy – on an existing UCITS platform in Europe where the manager, custodian and administrator and other service providers have already been approved. The platform will usually also facilitate the distribution of the sub-fund.
There is concern among European regulators that Newcits funds are being mis-sold and that investors in UCITS are not being adequately informed of the potential risks associated with investments in such products. In practice, however, many Newcits already exclude retail investors by imposing high minimum investment requirements. Regulators also question whether Newcits would be able to meet their liquidity obligations in a crisis like the one which followed the collapse of Lehman Brothers. UCITS V is currently under discussion and its primary objective is likely to be to enhance investor protection.
The possibility of establishing a Newcits fund offers Asian hedge fund managers exciting distribution opportunities in Europe and elsewhere. It also offers an opportunity to diversify their existing product offering particularly where such managers have grown to the extent that they can provide the compliance infrastructure required by the UCITS regime and where their investment strategy can be replicated without too much difficulty within the investment limitations, diversification and liquidity requirements imposed by the UCITS legislation.
Anne-Marie Godfrey is a Partner at Bingham McCutchen LLP.
This article first appeared in AIMA Journal (Q1 2011, Page 18). For more information, please visit www.aima.org