First of all, we should consider the change in situation from late 2008. After the collapse of Lehman Brothers, moves from the US dried up as investors and managers took a cautious approach to all kinds of activity. However, after good performances in both the traditional and alternative fund spheres in late 2009, US managers are looking to Europe. This, teamed with the looming AIFM directive, means that managers are having to plan for what may be an extremely regulated future in their cross-border strategies. For some, the obvious solution is UCITS adoption.
So the timing is right, but what about the clear advantages for hedge funds globally thinking about adopting UCITS?
Following the financial crisis the call for more regulated funds has allowed the UCITS brand to gain traction with investors. “Hedge fund” has become a dirty word for some as investors seek comfort from regulated funds that deliver greater transparency, liquidity and risk management.
In this time of prudency and scrutiny, it is extremely beneficial for hedge fund managers to be able to use the UCITS global brand to market their funds. It provokes connotations of liquid strategies, security against operational losses, as well as increased distribution channels for EU-based managers with the promise of an EU passport for fund activity.
Whilst most of these benefits resonate with US managers, there are further reasons for this increased interest on the other side of the Atlantic. US adoption of UCITS will certainly be spurred on by the impending AIFM directive which could go as far as preventing marketing within the EU of non-UCITS structured funds from outside the EU. At a time when investors are regaining confidence and managers are revving up activity, the last thing anyone wants is to have a limited market through restrictive European legislation. UCITS is widely-known as being the way for US funds to “side-step” forthcoming regulations and pre-empt further EU legislation.
For US hedge funds, setting up UCITS in the EU creates an opportunity for greater asset gathering and a chance to infiltrate clusters of investor wealth and cross-border deals. In addition, the proposition of UCITS IV in 2011 will result in even more strategies being applicable to UCITS funds. With this in mind it can be argued that UCITS is fast becoming the norm, and US managers may feel pressure to adapt. However managers must have strategies for dealing with some of the potential pitfalls; how to deal with retail investors who choose to invest in the fund and outscourcing the compliance monitoring and risk reporting requirements are two such pitfalls.
Why only a handful?
It is also being reported that only a handful of US managers have set up UCITS funds, in spite of the surge in interest. In a recent report by Preqin, only 28% of US-based managers surveyed were in the process of setting up UCITS funds. So why the reluctance when you consider all the many advantages set out above?
US hedge funds share many of the same issues in setting up UCITS structures as do hedge funds in Europe. There are high costs in establishing a new structure or fund strategy – some companies might not be in a position to prioritise this process. In addition, it is not always that obvious whether a fund strategy is compatible with UCITS and managers are sometimes given inconsistent advice about this. Managers also fear that UCITS is too limiting. Although this is being adressed by UCITS IV, there are still concerns that the limits on types of funds that can be held and the amount of leverage that can be employed will have a negative effect on the success of the fund. Essentially, in Europe and globally, this is where any reluctance stems from, and one could argue that all these problems are already being addressed by the call for clarity and increased functionality proposed by UCITS IV. But even when the cost and the limits of the basic structure are overlooked, US managers still face, if not an uphill struggle, then an undulating plain.
The US challenge
US Treasury Secretary Tim Geithner has accused EU plans for legislation and regulation of fund activity as being discriminatory against countries outside Europe. He is referring to the fact that the AIFM directive will restrict cross-border marketing for funds based outside the EU. And yes, the way to avoid this clamp-down is to set up a UCITS fund in Europe, which will go some way in adhering to many of the new rules. But it isn’t so straight-forward for US hedge funds.
One of the main challenges is the practicality of setting up a fund in the EU. The cost of establishing UCITS is high enough for European managers, but there are additional costs of setting up a fund management company abroad and appointing counterparties in the domicile, such as transfer agents, local directors and administrators. And then you have to pass the UCITS test of the local regulatory authority there before you can even open for business. If you are transferring to notoriously stringent Germany, this might be the greatest part of your challenge. Choose Luxembourg or Dublin, and acceptance might be that little bit easier.
Following on from these practical challenges inevitably comes the question, what do you do once you have got there? The local authority will not be happy if you set up shop and scarper. US managers, on a personal level, might not want to stay in Europe and run their fund from a new home. One thing that is rarely addressed in the business plan for these projects is the family situation. If you move with your family, will there be good schools for your children? Will your partner find a job and a group of friends? There are ways around this, such as partnering with a European firm but, from a US stand-point, this could easily explain why there is a trickle of UCITS funds springing up, rather than a wave.
Another popular theory for the slow uptake is that UCITS simply has not made a name for itself in the US. Many investors may thus not yet have EU regulatory issues on their radar and UCITS does not resonate with them as much as it should. Those investors that are aware of the need for UCITS are concerned by a different fear – that moving strategies across to UCITS funds might have a negative effect. It is feasible that an imposed sale in a UCITS fund could decrease the value of the same asset in a hedge fund. Investors who query managers on this kind of issue will want assurances that some US managers are not equipped to provide.
Fundamentally though, I believe that the US has not jumped on the UCITS band-wagon just yet, because they have a different regulatory culture. Managers and investors alike aren’t used to hedge funds being so tightly regulated, and it is viewed as a restrictive and limited strategy. The restrictions on leverage and eligible assets, and the greater liquidity and reporting requirements demanded by UCITS rules, whilst seen in a positive light by many investors, can therefore be seen as negative by US managers and investors.
A gradual process...
In spite of all the reasons why US hedge funds might not implement UCITS – and some experts even believe that they are right to be cautious – in my view, it is simply a matter of time. UCITS has been underestimated in terms of its necessity and distrubtion powers. US managers who leave it until the last minute will miss out on first mover advantage and sacrifice huge asset gathering advantages. Any fund manager taking on the UCITS structure will need to be fully educated about the functions and pitfalls. There is a danger that managers who adopt UCITS without the correct infrastructure or advice may land their funds in trouble.
