As we close out the last decade, many in the hedge fund industry will prefer to look forward rather than back to the tail end of the noughties. While some economic indicators show strong rebounds in performance by the end of 2009, the impact of the financial crisis was severe enough at the start of that year for the future of the entire industry to be called into question. Most hedge funds saw substantial falls in performance coupled with continuing investor redemptions. However, the outlook significantly changed over the course of 2009 and most would agree that we move into 2010 with a cautious sense of optimism.
In the Irish market, we saw a shift away from the restructuring and/or termination of existing funds and continued momentum towards the establishment of new products. Notably, these funds differ greatly from their pre-financial crisis counterparts and the trend is currently towards greater regulation (UCITS), greater investor control (hybrid hedge/private equity funds), managed account platforms and in redomiciling offshore funds to Ireland.
With regard to redomiciliation, it is probably too early to determine whether this development represents the beginning of a fundamental shift onshore or whether managers will continue to operate in both spheres and divide their fund structures and business accordingly. There are many factors behind a decision to redomicile and there are a multitude of legal, tax and regulatory issues to be considered before any move. The key factor is usually investor demand, but it is not the only consideration. Some managers are attracted by the package on offer from regulated jurisdictions or by the product choice (for example, UCITS are not available offshore) while others are preempting the implementation of the AIFM directive. The trend towards establishment in a regulated jurisdiction is also backed by statistics from the Irish Funds Industry Association released in December 2009. These figures show that while the total of AuA in Ireland fell from over €1.6 trillion at the close of 2008 to €1.35 trillion in 3Q2009, the figures for the Irish-domiciled market during the same period reveal a slight increase in both the numbers of registered funds (5,025 to 5,073) and in total assets (€647 billion to €708 billion).
December also saw the Irish government release draft legislation which will permit offshore corporate investment vehicles to redomicile in Ireland by way of straightforward legal migration process and subsequent authorisation as either a UCITS or non-UCITS fund. This new process will become available in addition to previous legal methods, including asset transfers, and is expected to accelerate the onshore drift. Unit trusts, limited partnerships and contractual funds will continue to be able to redomicile depending on their constitutive documents.
A Desired Product
On the regulatory side, UCITS funds continued to feature prominently on the desired product list for traditional hedge fund managers. UCITS has become a powerful international brand and is recognised as providing a high degree of investor protection, the limited reputational damage from the Madoff scandal excepted. UCITS funds can be distributed from Ireland throughout the EU using the harmonised UCITS passport and further marketed on a global basis to over 100 other countries, usually on the basis of recognition of minimum investor standards which are equivalent to local rules. As a result, for fund promoters and managers faced with investor demands for greater regulation, liquidity, transparency and strong governance, a popular solution has been the repackaging of traditional hedge fund strategies into UCITS-compliant funds. Alternative UCITS (or ‘Newcits’) have continued to grow as some of Europe’s top alternative managers and largest institutions took the decision to repackage or relocate alternative strategies into Irish UCITS funds. In order to do so, these managers continue to push the boundaries of eligible asset classification within the UCITS framework.
However, the liquidity constraints, investment restrictions, diversification rules, borrowing and leverage limits imposed by the UCITS directive will not fit the strategies of all managers nor do all have the resources to add the additional substance and risk-monitoring layers required to run a UCITS fund. As a result, those examining the UCITS structure or considering redomiciling would be well-advised to also consider whether regulated onshore alternative funds, such as Irish Qualifying Investor funds (QIFs) are better suited to their current strategies.
QIFs combine many of the features of UCITS (regulation, independent administration, segregated custody and transparency) but have none of the investment or borrowing restrictions and are quicker to launch (one business day following filing with the Irish Financial Regulator). As a result, QIFs and structured QIFs or ‘Super QIFs’ (QIFs combined with tax-efficient SPVs) continue to be extremely popular with managers and widely recognised when marketed to investors.
One of the chief limitations of the QIF versus a UCITS is distribution. However, a UCITS-style passport for QIF-type products (as adapted to fit new EU rules) will become a reality if the AIFM directive, in one of its current forms, is voted into EU law in 2010. As most readers will be aware, the initial draft of the AIFM directive was issued on 30 April 2009 by the European Commission and attracted widespread criticism and comments from the hedge fund industry.
Some of these comments were taken on board in revised compromise drafts issued by the Swedish Presidency of the EU, firstly on 12 November 2009 and subsequently amended on 25 November 2009 and 15 December 2009. However, the compromise texts themselves provoked fresh controversy and they introduced new concepts into the debate, including a restrictive framework on remuneration for hedge fund managers. To add a further layer of confusion to the process, a report from the main rapporteur of the European Parliament (Jean-Paul Gauzes) on 23 November 2009 proposed a total of 138 amendments to the initial draft of the AIFM directive, many of which differ from the Presidency’s compromise proposals or raised new points.
As a result, conflicting views of the European Commission, Council and Parliament are currently in circulation and diverge on major policy issues, including the scope of the AIFM directive, eligibility and liability of the depositary, independence of the valuator, delegation, private placements outside of the AIFM directive framework and remuneration restrictions. It remains to been seen whether all of these points can be reconciled or a final compromise reached in time for the vote in the European Parliament plenary sittings, which is scheduled to take place in July 2010.
New Opportunities on the Horizon
Looking forward to 2010, finalised laws on redomiciliation feature prominently on the horizon in the first quarter for the Irish market and its participants. The Irish Financial Regulator continues to engage with the industry in a positive manner on domestic issues and clarification on the private placement regime, new prime brokerage rules, further guidance of the allocation of specific assets to share classes and a number of other derogation requests are expected to result in new opportunities for fund promoters and their managers.
Ireland will also be affected by developments at the EU level and as noted above, the AIFM directive is scheduled for final adoption while UCITS will reach an important milestone. The new UCITS directive (Directive 2009/65/EC), which incorporates UCITS IV, has been published in the Official Journal of the EU and as a next step towards legal implementation in the member states, technical implementing measures (‘Level 2 Measures’) are to be finalised by June 2010. These will confirm how the increased efficiencies under UCITS IV – management company passport, master-feeder structures, cross-border mergers, cross-border marketing registrations and KII – are to work.
However, early 2010 will not be without its headaches. While fund restructuring, liquidity issues and terminations have largely given way to new product launches they have not disappeared completely. Many of the fund products which were previously suspended, gated and side-pocketed are beginning to reopen. Managers will face strategic decisions where substantive parts of the portfolio are still illiquid or how to reorganise their portfolios and fee structures in an efficient manner while retaining investors. Many of these investors will be reluctant to accept the previous terms and will want commitments on liquidity harmonisation between the redemption timeframes and underlying assets or the introduction of private equity features and segregated or managed accounts features.
Managers will also have to balance the demands of investors and the benefits in widening their distribution bases versus higher regulatory compliance standards under UCITS or AIFM directive. In addition to the regulation of managers, the AIFM directive proposes to increase the liability standards for depositary banks (custodians) and the responsibility for valuators (administrators) appointed to alternative investment funds. The Lehman administration and Madoff scandal (which is still the subject of ongoing litigation in several member states) have also prompted the European Commission to look at the current standard of liability for UCITS depositaries. In both of these areas, varying standards, including forms of strict liability, are being considered and the initial reaction from service providers is that, if these higher standards are implemented, higher fees will be required to offset the increased risks.
Peter Stapleton is a partner in Dillon Eustace. He has particular expertise in the establishment, structuring, financing, public and private distribution and ongoing operation of traditional and alternative investment funds, including UCITS, hedge funds and fund of funds. Peter also advises in the areas of derivatives, investment services and securities law.
This article first appeared in the HFMWeek Ireland 2010 special report (Pg 12, Ireland 2010 issue). For more information, please visit www.hfmweek.com.