Read the Matthew Feargrieve blog. A joint KPMG and RBC Dexia report, “Alternative options: hedge fund redomiciliation trends in emerging markets” analyses the drivers motivating fund domicile selection by hedge fund managers. It used to be so easy. Between 1996 and 2006, when the alternative fund management industry went through huge growth, a Caribbean jurisdiction, like the Cayman Islands or the British Virgin Islands, was the natural choice. Since 2006, growing numbers of hedge funds have been domiciled in “onshore” jurisdictions, like Ireland and Luxembourg, a trend that has accelerated since the financial crisis of 2007/2008 and the Madoff affair.

The report makes for interesting reading, and confirms trends that those in the alternative fund management industry – managers and professional advisors alike – have been witnessing for some time. Several messages and trends emerge from the report’s findings, but five in particular are signal and may be summarized as  follows:

Background. 

Managers in the EU are facing up to the hard fact that the freedoms they enjoyed before the financial crisis are now being significantly circumscribed by governments and financial regulators. Ringing the changes, the AIFMD has significant implications for managers in the UK and across Europe.

Although the activities of hedge funds were found by the Turner Report, Matthew Feargrieve says that they do not have any systemic or causal effect in the financial turmoil 2007/2008, suspicion and mistrust lingered on in the minds of regulators, politicians and investors alike. The AIFMD was published in draft form in early 2009, and represents an attempt by Brussels to impose greater regulatory control on the hedge fund managers. In tandem with this, investor interest in “onshore”, EU domiciles was growing. Unfairly tainted by the Madoff fraud, and by some isolated, high profile fund failures, offshore fund domiciles found themselves on the defensive. Politically motivated, anti-tax haven rhetoric compounded matters. Almost overnight, offshore hedge funds came to be perceived, even by some institutional investors, as opaque and unregulated.

That was the prevailing, knee-jerk consensus in the immediate aftermath of the financial crisis. Normality has to a large degree returned, and offshore fund domiciles are still very much in business. But investor perception of “onshore” domiciles as being “better” regulated, and therefore “safer”, is dramatically boosting the market positioning of Ireland and Luxembourg. Many managers are setting up hedge funds in those jurisdictions. Domicile choice – offshore, onshore, or both- is now a big issue for managers and investors alike.

AIFM Directive. 

Fund managers like Matthew Feargrieve are familiar with spectre of over-regulation and freeze-out from EU markets threatened since early 2009 by the AIFM Directive. UCITS enjoy automatic rights of distribution and sale in the EU. Non-UCITS (whether domiciled in the EU or elsewhere) do not. The Directive strikes a short term compromise by preserving the existing national private placement regimes as the primary means of access to EU markets until around 2018. Around 2015 a "passport" may be introduced by the European Commission. Thereafter the two regimes - private placement and passport – will run in tandem until around 2018, at which point the private placement regimes can, on the recommendation of the newly established European Securities and Markets Authority (“ESMA”) be terminated.

So managers of non-UCITS will have a number of choices: continue to market the fund on a private placement basis (and comply with the new regulatory requirements imposed by the Directive); adopt full compliance with the Directive and obtain a "passport"; or go the UCITS route, either in alternative or addition to the traditional offshore products.

Managers wishing to take advantage of the passport mechanism will find themselves facing a regulatory burden similar to that currently applicable to UCITS. This will, over the next three years, give rise to a more discriminating evaluation of the perceived upsides of UCITS. Without having carried out full diligence of the regime, managers should resist hard sell from UCITS domiciles like Ireland and Luxembourg and remember that the Directive is aimed at regulating the manager - not the fund. The Directive imposes no regulatory requirements on the fund, whether onshore or offshore. True, for private placement or passport distribution, non-EU fund domiciles will be required to have in place “systemic information exchange” agreements with EU Member States. But Cayman and the other primary offshore domiciles are positioned to meet the EU’s requirements.

The hurdles to be met by the offshore centres will become clearer when the Level 2 implementing measures are made known by Brussels later this year. In the meantime, managers should be critical of EU fund products. They should, for example, consider that EU non-UCITS – like Luxembourg SIFs or Irish QIFs – are not materially easier to distribute in the EU than the Cayman equivalent, nor materially more advantageous when it comes to obtaining an EU passport.

Some hedge fund managers have adopted a “wait and see” approach regarding the final outcome of the AIFMD before making any decision on whether it would be necessary to move their funds to an onshore domicile. Many managers consider their offshore hedge funds to be a sustainable business model. Then there is a third group, that is considering co-domiciliation, in other words, setting up parallel structures both onshore and offshore that will enable them to cater for EU and non-EU investors.

Growth of EU Fund Domiciles. 

The report cited the following statistics:

• At the end of 2010, assets under management in Luxembourg funds reached EUR 2.19 trillion and for Irish funds EUR 964 billion, collectively representing over 41% of the net assets of the overall fund industry in the EU;
• In the non-UCITS segment, total assets in Luxembourg Specialized Investment Funds (SIFs) at the end of 2010 totalled EUR 215 billion, whilst assets in Ireland’s Qualifying Investor Funds (QIFs) were EUR 153 billion;
• At the end of 2010, Luxembourg has 31% of the UCITS market (EUR 1.88 trillion) and Ireland 12% of the market share (EUR 758 billion), with France having 20% (EUR 1.21 trillion), the UK 11% (EUR 675 billion) and Germany 4% (EUR 249 billion).