Matthew Feargrieve: European Hedge Funds Industry- An Overview

4:36 PM

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:

Managers will be increasingly interested in onshore fund domiciles over 2011-2012, in advance of the Alternative Investment Fund Managers Directive (“AIFMD”) becoming law in the EU in 2013

The “traditional” offshore fund domiciles, like the Cayman Islands, will continue to be considered the optimum choice for many hedge fund managers. They offer much greater investment flexibility and established expertise.

Whilst offshore fund domiciles will remain important, an increasing number of managers will domicile their hedge funds in onshore centres, notably Ireland and Luxembourg, in order to assuage concerns some investors have about offshore jurisdictions

Because of this duality, co-domiciliation will become a key trend, with managers setting up fund products in both offshore and onshore domiciles. A greater number of those managers with an interest in onshore fund domiciles will adopt this approach than those that will choose to redomicile their offshore funds completely.   

Whilst there have been large inflows of investor money into “alternative UCITS”, namely highly-regulated EU investment funds pursuing “alternative” investment strategies, there is some evidence that UCITS may have reached their zenith. There is a strong and growing preference for EU non-UCITS products as well regulated and flexible alternatives to offshore funds. Far from replacing offshore hedge fund products, UCITS are likely to come to be complementary to them.

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.
Matthew Feargrieve

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).
These statistics speak to the growing market share of the alternative asset management industry being claimed by “onshore” fund centres. Managers respond to the following perceived benefits of these domiciles:  

  • they enable investment by European institutional investors, whereas some of those investors (like pension funds) may find it harder to invest in “unregulated” offshore products;
  • they are home to UCITS, that offer managers the possibility of tapping into the EU retail market;
  • they are sometimes perceived as facilitating more liquid, transparent and better regulated products for investors;
  • they are more “AIFMD friendly” than their offshore counterparts;
  • they provide economic, fiscal and tax regime stability;
  • they benefit from large communities of experienced professional advisers.

UCITS: Losing their Lustre?

From an alternative manager’s viewpoint, the primary upside of UCITS can be summarised in a word: distribution. Being an EU regulated investment product, UCITS can be sold throughout the EU to both institutional and retail investors. This automatic passporting is particularly attractive given the barriers to EU entry erected under the AIFM Directive. More importantly, UCITS facilitate capital raising by hedge fund managers in the EU, by opening up a previously verboten client base: retail investors.

From an investor’s viewpoint, the benefit of UCITS is found in the built-in protections that are normally associated with investments sold to widows and orphans. So a manager of a UCITS product must observe strict rules about liquidity and portfolio diversification. Direct borrowing is not permitted, only synthetic leverage achieved with derivatives. Similarly, physical short selling is not permitted; instead, the manager must use derivatives to replicate short exposure.

Leverage, shorting, derivatives; these are some of the key tools at the disposal of a hedge fund manager in the pursuit of alpha. Restrictions and prohibitions on these techniques point to a serious downside of UCITS: lower investment returns. Achieving returns not correlated to any index is harder in a regime intended for long-only, retail products. This entails another serious drawback of UCITS: lower fees. Whilst good news for investors, a manager who is not achieving the kind of returns possible in a non-UCITS model will not be able to command the same level of fees. So, whilst the traditional “2 and 20” fee structure is theoretically possible in a UCITS, the reality is that a manager will be charging significantly lower fees.

The problem of lower returns and lower fees is compounded for investors and managers alike by the higher organizational costs involved. The total expense ratio entailed by a standalone, or ground- up, UCITS requires a radical shift in the mindset of the alternatives manager. A UCITS with a vanilla equity long/short strategy can cost up to EUR100k to set up. Other strategies, with the additional regulatory burden involved, can boost organizational costs to EUR200k. The same strategy could be launched using the traditional Cayman model at a fraction of the cost.

Sizeable costs are indicative of a slow and burdensome regulatory approval process. This is the enemy of the manager keen to exploit market opportunity. A UCITS product conservatively takes 2 to 6 months to launch.

Then there is the mandatory liquidity requirement of UCITS: daily or weekly liquidity may be beneficial for investors, but is debilitating for the manager trying to grow assets. There is a significant number of UCITS funds in existence with AUMs of <50m, limited prospects for growth and saddled with organizational costs of 100 to 200 bps.     

Ultimately, of course, UCITS is just one product in a universe of investment products. If investors and managers have an appetite for relatively lower returns, lower fees and higher costs, then so be it. But what is worrying is that these drawbacks are accepted as the price of “better” regulation. The higher level of regulatory oversight is considered by many investors as a guarantee of the safety of a UCITS investment. The paradox is that the UCITS regime is in fact an untested model for alternative investment strategies.

Whilst alternative strategies like equity long/short, CTA, emerging markets and (in lesser numbers) global macro and event driven are being replicated (at higher cost) in the UCITS framework, some core strategies – those focused on commodities, managed futures, distressed and fixed income arbitrage, for example -  are not permissible or possible of faithful replication in the UCITS framework. This stems partly from the prohibition on investing in commodities or commodity derivatives, which are not sufficiently liquid to satisfy the UCITS requirements or which contravene the exclusion of physical assets. Alternative, risky and potentially illiquid strategies are being shoehorned into the UCITS model. This is a far cry from the retail, long-only product that UCITS was originally intended to be.               

UCITS is not a tried-and-tested regime. There is a growing feeling that a UCITS failure is likely. Such a failure could trigger the exodus of billions out of the brand. The regulators in the main UCITS jurisdictions, Ireland and Luxembourg, are relatively inexperienced in matters pertaining to hedge funds. A UCITS blow up of any size will severely test their ability to respond. And with 700 pieces of Madoff-related litigation eating up court time in Luxembourg, the capacity of the judicial system there to deal with a large fund failure is questionable. Contrast the traditional home of the hedge fund, the Cayman Islands, with some thirty years of regulatory experience and a legal system underpinned by the courts in England. Ultimately, investors and managers will need to decide in whose legal system they wish to place their trust.

Cayman Islands still Dominant. 

The Cayman Islands continues to be the leading offshore domicile for hedge funds. As at 31 March, 9,261 open-ended funds (around 90% of which can be categorized as “hedge” funds) were regulated by the Cayman Islands Monetary Authority (“CIMA”). This figure (a) represents some 67% of the market share of offshore hedge funds, and (b) is not far removed from the all-time high of 10,271 funds recorded by CIMA in 2008. There are currently more funds registered with CIMA than there were in the years 2003 to 2007, respectively. And thousands more funds with long lock-ups (typically five years or longer) or fewer than 15 investors are registered in Cayman without needing to be regulated or monitored by CIMA.

From a jurisdictional perspective Cayman enjoys a dominant position in the global hedge fund market. The Cayman Islands are home to the largest percentage of offshore-domiciled hedge funds.
The funds registered in Cayman are not in any sense “unregulated”. However, there are no constraints in Cayman on asset type or portfolio diversification, investor eligibility, capitalization of fund or manager, use of leverage, shorting or derivatives. All the tools of alpha generation remain at the manager’s disposal.

Many professional investors are familiar with Cayman hedge funds and the way they operate and the Cayman fund structure has a particularly strong reputation in the US and in Asia. A significant number of Cayman funds are already administered by regulated firms in either Luxembourg or Ireland, which gives comfort to investors in terms of governance. The reason for Cayman’s continuing dominance is clear: it scores equally if not more highly than the new kids on the EU block on all issues identified by the report as being important to managers. One consensus to emerge from the report is that investor perception is still positive for the Cayman Islands hedge fund. It has a reputation as a tried, tested and appropriately regulated investment product. The Cayman Islands has a modern and flexible statutory regime for companies and the laws of the Cayman Islands are substantially based upon English common law, which is the law recognized by investors.

The following dynamics are central to Cayman’s ongoing attractiveness:
  • Cayman has good political standing. It is OECD white listed, and compliant with IOSCO and FATF initiatives. It has an AML regime comparable with that of the UK and France (per the FATF). Cayman is well placed to implement systemic information exchange agreements with EU states (required by the AIFM Directive).
  • Cayman is a stable offshore financial centre.
  • Cayman is well regulated, but not over-regulated. 
  • Cayman has been home to hedge funds for more than thirty years. The Cayman financial regulator arguably has more experience with hedge funds than its counterparts in Ireland and Luxembourg.   
  • Cayman’s courts are more experienced in hedge fund matters than the courts in Ireland, Malta and Luxembourg.    
  • Cayman is synonymous with hedge funds. Its selection by a manager is instantly intelligible to investors and other managers. 
  • Cayman enables managers to establish a flexible “regulated” product at low cost. Costs and duties are higher in “onshore” domiciles.
  • Cayman is not a UCITS domicile. A UCITS blow-up will result in the exodus of billions of investor monies from EU domiciles, and taint them as “regulated” domiciles. Cayman will be immune from the toxic fall-out.          
Post-2008, political paranoia and media hype suggested that investors demanded “better regulated” funds. Some managers made a knee-jerk reaction and set up funds in EU domiciles. Others redomiciled their funds from Cayman to EU jurisdictions. Proportionate to the universe of 9,000- odd funds registered in Cayman, the number of funds to have migrated out of Cayman to EU domiciles is tiny. 

Co-Domiciliation: the Future?

The KPMG and RBC Dexia report observed that their respondents widely considered “traditional” offshore hedge fund centres, like the Cayman Islands, as the “right choice”. Offshore hedge funds continue to work well for a large number of investors. Only a small number of the report’s respondents professed any intention to  close their offshore fund range and fully redomicile their activity to the EU.

But there are clearly very strong factors in favour of onshore fund domiciles. The report concluded that the optimum solution for hedge fund managers may be to co-domicile, i.e. to retain offshore funds for investors who prefer and benefit from them, whilst setting up EU-domiciled funds to address issues from investors who prefer a greater degree of regulation and security. The report opined that it also seems likely that offshore hedge funds will remain, but onshore funds will continue to grow in order to satisfy the needs of investors who have concerns about offshore jurisdictions.Find out more about him on the Matthew Feargrieve website here.



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