Why UCITS? Well, everybody is doing it, aren’t they? It represents a major change from five years ago when hardly anyone was looking at UCITS, so what has changed?
Firstly, the level of regulation affecting hedge funds, including the AIFM directive, is increasing, and the impact on you and your businesses will be potentially significant and material. It may mean you will have to re-think and possibly restructure some of your fund offerings if you want to sell into Europe but in the meantime, you can’t sit around doing nothing while the directive is being discussed in Brussels.
Also, your strategy can, almost without exception, be adapted to fit within the constraints of the directive. The ‘exception’ is largely the most illiquid strategies, but with some constraints, most other strategies can be made to work. The passport, which is at the heart of the UCITS directive to sell to the public in all markets around the union, allows you to access new markets and new sources of assets. Importantly, we’re seeing a lot of interest from the larger and more mature managers who see UCITS as the next stage in their own internal development.
Investors, and in particular institutional investors, are demanding greater levels of liquidity and transparency, and UCITS is clearly not the only way of delivering those. It is also becoming more of a feature of hedge funds and managed accounts. There is, however something to be said for selling a product that comes with these features built in “as standard”.
Institutional investors can allocate more easily to UCITS, and they can allocate more as they can invest from pools of assets they could not use for offshore hedge funds. The prize to play for is a very significant pool of assets, namely $7.2 trillion under management in UCITS vehicles at the end of last year.
Also, one should not think of UCITS as a purely European product – it has a reach far beyond Europe. A large proportion of Luxembourg fund sales last year – 35% - were to investors in Asia.
The strategies that can work are the usual suspects – long/short equity and its variants like market neutral and absolute return. The fund managers instructing us to launch UCITS versions of their hedge funds follow liquid equity and bond markets but there is also quite a lot of activity in global emerging markets, managed futures and macro. We are also seeing a significant increase in the level of interest from funds of funds and that helps to mature the market for UCITS hedge funds.
There is a broad cross-section of managers launching UCITS, evenly split in our experience between Ireland and Luxembourg and ranging from smaller managers with $200 million under management up to the Brevan Howards and Bluecrests of this world, with many in between. Although there is a bias towards the larger managers who have the resources to devote to UCITS, you don’t have to be in the bulge bracket to be able to contemplate UCITS as an option.
Platforms vs DIY
A platform in this context is a pre-built solution that has been established (usually but not always) by an investment bank that has invested time and resources in building a structure to which the hedge fund manager is contracted. They offer a simple solution to get into the UCITS market; there is inevitably less regulatory baggage involved and if you just want to manage assets, the platform provides you with that sort of solution. It does, however, mean less hands-on involvement in the process of launching your fund and in the management and maintenance of that vehicle.
There is less regulatory liability in you not being the manager or promoter of a UCITS, but liability comes in various forms. Inevitably, as an investment manager, you will have to manage the assets in accordance with the UCITS rules of the fund’s jurisdiction, and that will be enforced by the platform agreement. Inevitably, in the case of active breaches, you will have to make good the fund, and there is no way around that as the contract will require you to do so.
The platform approach arguably outsources risk. You are relying on a number of other regulated parties to perform their functions according to the rules, but again risk also comes in many forms. With less control over the structure and the vehicle, you are putting faith to some extent in the service providers to the vehicle whom you haven’t necessarily selected. Less control of the structure might arguably lead to increased risk in terms of business and reputational risk.
UCITS platforms are sold as distribution plays. If it is being put together by distributors with global reach, you should expect to see distribution as one of the big strengths of this approach. However that can be overplayed – UCITS are perfectly capable of being sold to traditional hedge fund investors, and buyers of your offshore fund might conceivably be persuaded to buy your UCITS hedge fund in greater numbers.
The platform offering is still an effective solution for many managers, particularly in the US where it can be regarded as a “toe-in-the-water” option. UCITS is unfamiliar for many US managers, and while they are interested in having a foothold in the European market, some might regard launching their own fund as a little bit too ambitious at this point. There will likely be an economic impact. They will have to give up some fees, and there will be exclusivity requirements. For example, they might not be able to launch the same strategy in another UCITS structure for a year or two.
We turn next to the use of indices in UCITS. A number of platforms are pitching to managers that they can offer a wrap solution using an index approach for many hedge fund strategies. It is worth remembering that derivatives cannot be used to circumvent the directive and that underlying assets of derivatives must be eligible, namely: transferable securities, money market instruments, other funds and other “assets” like interest rates, foreign exchange rates and currencies. All are acceptable as eligible assets. The UCITS directive is, however, about financial assets, not physical assets, which is why commodities have been left out of the party. If, though, you structure an index which complies with the relevant criteria, the index itself is regarded as the asset, and you don’t look through the index to the underlying components. The eligibility or otherwise of those components becomes irrelevant.
The index has to be sufficiently diversified, with no component comprising more than 20% of the index (35% on a very exceptional basis). The index must represent an adequate benchmark of the asset class or strategy involved, must be published in an appropriate manner, and be independently managed from the asset management function. There are undiversified indices as well, which can be used for risk diversification purposes only.
The index approach can be used for a number of hedge fund strategies, typically quantitative-type strategies around which rules can be easily constructed to accommodate an index. An example of this in practice is that of CTA/managed futures funds and, because you cannot invest in commodities or commodity derivatives (because you cannot invest through a derivative into what you cannot invest in directly), managed futures funds have a bit of a problem, because of the commodity element of any managed futures strategy. The ways you can get access to commodities is through exchange-traded commodities (ETCs), structured products, notes and also indices. There have been a number of quite high profile launches in this area over the last couple of years.
By way of example, the Aliquot Commodities (UCITS) Fund uses different types of instruments for different sectors of the commodities and futures markets including index swaps, ETCs and ETFs. The BlueTrend fund, launched on the Merrill Lynch platform a couple of years ago on the other hand, uses swaps on specifically developed commodity indices, using single commodity indices for specific commodity plays (single commodity indices can be used but only for risk diversification purposes).
The CESR guidelines within the UCITS rules apply what is called the 5/10/40 rule to single commodities indices, treating them as if they were issuers of securities. Thus you could not invest more than 10% in any single commodity index, and any positions beyond 5% cannot in aggregate exceed 40%.
The Man AHL Diversity product involves the development of a single index (the AHL Trend Index) rather than bespoke separate indices within which the strategy operates. Man has developed the index for use within the UCITS, and the UCITS has entered into a swap on that index. The strategy can be housed within a Cayman hedge fund or a managed account, the index just lies on top of it: the trades are what are important, and the trades effectively comprise the index. Being a compliant financial index, you don’t look beyond the index to the host vehicle.
The challenges and differences
It is perhaps not surprising that, with the growth of interest in hedge fund strategies being offered within UCITS, regulators have been vocal in their concerns about potential abuse of the UCITS brand, particularly where vehicles are sold to retail investors. They are concerned about their complexity, the way in which the products are sold, and in France the AMF (Autorité des Marchés Financiers) has suggested that high minimum investment limits ought to be applied. The FSA has never regarded high minimum entry levels as a viable proxy for measuring sophistication and is more concerned about systems and controls, making it clear that you will require resources to be able to cope with the compliance requirements within the UCITS environment.
Regulatory engagement is also a two way street: as a UCITS manager you will have to engage with the regulator and, particularly if you take the role of the fund promoter, the regulator will want to know you and your business in a way that the Cayman Islands regulator does not when you are managing a Cayman fund.
Key differences between UCITS and Cayman funds
1. Cannibalisation: the concern is that by creating a UCITS hedge fund, managers effectively create a reason for their investors to move over to the UCITS version of their strategy that might offer lower fees and better liquidity. Managers are concerned they might be creating a business risk for themselves. There is no easy answer to that, apart from perhaps via some form of product differentiation. The UCITS may be offered at less leverage or less volatility, or to different markets – for example only offering the UCITS version to institutions who would not buy the strategy in a Cayman fund.
2. Registration: All managers with discretion over UCITS assets must be regulated and there needs to be a cooperation agreement between the regulator of the home state of the fund and the jurisdiction in which the assets are being managed. US managers will, therefore, have to be SEC (or CFTC) registered.
3. Master feeder: Although UCITS are not yet often sold to US taxable investors there is no current ability to offer master-feeder facilities (this will change with UCITS IV). There is currently no scope for a UCITS to feed into a corporate master fund although you could, of course, have a Delaware LP feeding all its assets into a UCITS master. Because of the nature of the Irish corporate fund vehicle, however, an Irish PLC can’t “check the box” to be treated as tax transparent for US tax purposes. An Irish unit trust could be used as it is transparent although this is less attractive as a structure and a Luxembourg SICAV may be preferable as it is able to check the box.
4. Risk management: The Risk Management Process (RMP) is a document that seeks to capture the risks inherent in your derivatives strategy and the processes that you apply to manage and monitor risks, including the approach you take to the use of VaR, which for most hedge fund strategies is what you will probably use. It is not difficult to draft but it does represent a new procedure to go through and it does have to be filed with the regulator.
5. Performance fees: Clearly most hedge fund managers will want a form of performance fee. If your fund is dealing daily or weekly, then the use of series accounting is problematic – you are creating a new class every time you deal. Equalisation is also quite a challenge for some administrators, particularly traditional hedge fund administrators on daily dealing funds. We are doing funds at the moment that use either series or equalisation but, particularly with Luxembourg funds that want to use equalisation, administrators are having to outsource that to Ireland. If it is within the same group, it is potentially feasible, but it can be a challenge.
6. Compliance: pre-trade compliance is advisable if you can achieve it and have the resources to do it, but the rules do not specify whether you apply pre or post-trade compliance, so long as you comply.
7. FINRA: new issues and IPOs will typically lead to a proportion of the portfolio being carved down and attributed to non-restricted investors. This does not work for Irish and Luxembourg UCITS, where, on current rules, you need to offer the same exposure for all investors in the same fund.
8. Frequent liquidity: you will have to deal twice monthly, there is really no way around this and your notice periods will be shorter. In Ireland and Luxembourg it is 10 days notice in practice and in Ireland that is from receipt of redemption notice to payment of proceeds. There is a lot less flexibility than you would be traditionally used to in your hedge funds.
9. Dilution: something that affects all single priced funds but which is largely ignored in the hedge fund world. The dealing costs incurred in buying or selling assets to meet a large subscription or redemption (respectively) can have a significant impact on existing (or remaining) investors. A dilution levy or use of a swinging price are two ways of compensating the fund that are commonly used in UCITS.
10. Prime brokers: the position of prime brokers is quite different in UCITS due to the inability to physically short and the constraints on counterparty exposure. Although some are now developing UCITS compliant “synthetic” prime brokerage models, most often UCITS trade with multiple counterparties or take collateral to reduce their exposure to their main counterparty.
11. And finally….Regulation: It exists, UCITS is a product of regulation, and the approval process that is attached to getting a UCITS up and running is real, it takes time, and you need to allow for that.
Neil Simmonds specialises in investment funds (both onshore and offshore) with emphasis on open-ended products, including the launch and reconstruction of unit trusts, ICVCs and UCITS, as well as hedge funds and funds of hedge funds. Neil joined Simmons & Simmons as a partner in 2003 from another City law firm and has advised a significant number of the firm’s hedge fund clients on their establishment of UCITS versions of their strategies. This article is for general guidance only. It does not contain definitive advice.
