Dec 28 2009 | 9:47am ET
By Lawrie Chandler — More and more managers are using Europe’s UCITS III structure to create “new-CITS” hedge funds. Fund managers and promoters are attracted by UCITS III gold standard status and flexibility to accommodate the more liquid hedge fund strategies.
There has been massive activity around UCITS III in the EU and also beyond Europe’s borders, in recent years non-EU sales of UCITS have accounted for 40% of total sales and Asian and Latin American sales have grown fast than sales in the EU.
With more regulators accepting the UCITS brand its importance to fund promoters is clear. UCITS III could be the road to recovery for alternative fund managers burnt by the financial crisis, however the road is covered with potholes and road signs that must be adhered to.
The Rise of UCITS
The UCITS brand had approximately €6.8 trillion under management according to the European Fund and Asset Management Association (EFAMA) at the end of September 2009. UCITS was developed in Europe to harmonise domestic EU markets for collective investment schemes.
The financial crisis demonstrated how intertwined financial markets had become. The shortcomings of opaque structures contributed to investors feeling they had been misinformed. The buzzword at the start of 2009 was transparency.
When confidence was shaken to its core investors looked at hedge funds and were dissatisfied. The crisis showed inherent weaknesses in hedge fund structures, strategies and operations. In addition, failures from disastrous risk management, poor due diligence processes and counterparty risks caused more damage. Finally investors lost more faith when they were hit by side pockets, lock-ins and gates. The hedge fund world was left in pieces. An alternative structure was needed for hedge fund managers and UCITS has risen as that option.
Conveniently, UCITS had been popular in the long-only space and had built a positive reputation. An EU Directive in 2001, creating UCITS III, allowed fund managers to partially deploy alternative fund strategies within the UCITS III space. The greatest development was permission to use derivatives for investment purposes, as opposed to just hedging, making a range of hedge fund-type strategies possible within the UCITS framework. With little confidence in private placement regimes, fund managers have turned to UCITS as a flexible investment product, affording significant protection to a broad range of investors, while permitting sufficient investment latitude to allow managers to pursue their alternative investment strategies.
Modern Day Use
The flexibility of the UCITS regime and demands in the current environment for a better structure has propelled the creation of “Newcits” – hedge fund like UCITS III funds. These funds go by many names nowadays, for example hedge fund-lite structures, absolute return funds, newcits funds, etc. In Europe, according to Alternative Decisions’ research and tracking service there are over 400 UCITS III funds with hedge fund characteristics or investment objectives. Additionally, research from Hedge Fund Intelligence showed over 50% of all Europe’s hedge fund companies either plan to launch, or have already launched, UCITS-compliant funds. Use of UCITS III for hedge fund strategies is mainstream in Europe these days and is now a channel some consider ahead of private placement regimes.
The UCITS III structure has been around since 1985, but its use by hedge fund managers for alternative investment strategies has been a more recent phenomenon. One hurdle for fund managers and operators is to understand what types of assets (‘eligible assets’) are allowed under UCITS III. Alongside the technical aspects of eligible assets are certain requirements on liquidity, constraints on the use of leverage and concentration levels in securities. Knowing the rules is only a start, the operations and business impact for an alternative fund manager needs to be considered as well.
Planning an UCITS Fund? Things To Consider
Given the complexities of managing UCITS funds, and the complications it introduces, planning is important; here are some things to consider:
1.) Fund’s Proposition, Target Investors and Business Distribution
As with any new fund, reaching critical mass is essential to reduce costs and ensure effective execution of the investment strategy. Before launching, get a clear focus on whom the fund is targeting, the investors’ tax status, how the fund will be distributed, how intermediaries (if there are any) will be serviced and remunerated, and the appropriate fee structure. For example, changes under the UK’s retail distribution policy may alter the structure of rebates and fund managers need to consider the requirements under the new reporting status rules. Getting the marketing message right and knowing competing products will require some analysis and competitor benchmarking.
2.) Operational Issues and Considerations
These issues are not often a core competency for fund groups, especially boutiques whose skill sets are in managing funds rather than concerning themselves with various technical legal and operational issues, including: Where should the fund be domiciled? What legal identity is appropriate [open ended investment company (OEIC), SICAV (Société d’Investissement à Capital Variable), a French FCP (Fonds commune de placement), etc.]. It is also necessary to decide which core activities are handled internally and which are to be outsourced.
3.) Risk and Governance
Rules under the Directive exist to ensure investor protection and provide comfort for clients by reducing the operational risk passed to investors. The main item when using derivatives is that exposures can be met from the assets in the fund at all times. This requires fund managers to have appropriate risk measurement processes in place to “enable them to monitor, measure and manage at any time the risks of the positions and their contribution to the overall risk-profile of the portfolio.”
This list is not exhaustive and experts in structuring, developing and designing funds should be engaged early in the design work to ensure a successful development of any product.
The Torpedo Risk
Confidence is the single most important factor that fund promoters need to manage with investors. If events of the past are repeated, the industry needs to ensure the UCITS III brand is not tainted. A blow-up is likely but the industry needs to educate investors. An UCITS III blow-up would get wide media coverage and risk tainting the UCITS brand. We call this the torpedo risk because despite UCITS III providing greater regulation, protection and oversight misappropriate derivate use or financial engineering to make inappropriate assets “eligible assets” could take us down the rocky road we travelled in 2008. This again demonstrates that fund managers need to bring capable people and experts into the product development process early so any investment strategy is fully within the spirit of UCITS III, not just the rules.
UCITS is giving alternative fund mangers an opportunity to move into the mainstream. There has to be an overhaul of business processes, operational models and product design procedures. However, the design stage is the easy part in reality. Reaching investors and meeting their needs is something that comes once the product is designed and that entails a completely new set of rules and procedures.
Lawrie Chandler is a co-founder Alternative Decisions. Launched in the summer of 2009, Alternative Decisions serves the needs of alternative investment funds looking to increase their visibility and engage with institutional investors. The firm offers advice on manufacturing funds and marketing materials as well as managing an investor communications and sales platform. Fund managers pay an annual membership fee to join Alternative Decisions while qualified investors join for free. An industry first, all investor members have access to a private eLibrary hosting materials from alternative fund managers. Alternative Decisions, through an impartial service, helps fund managers and investors discover one another and share qualitative materials of a high professional standard.
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