Gareth Henry Sees Opportunity for Investment Managers in UCITS Funds
Alternative investments expert Gareth Henry has recently written an article on Medium extolling the virtues of UCITS funds for investment managers looking for a cost-effective way to address the European markets. By standardising the regulatory procedures which investment managers must follow when marketing their funds, the UCITS legislation enables funds which qualify under its guidelines to be marketed throughout the EU without the need to complete new regulatory paperwork in each country.
In his article, Henry discusses the benefits this streamlined approach offers both for European money managers as well as those based in the U.S. who want to offer their funds to European investors.
Henry is a veteran observer of the alternative investments landscape. After earning a Bachelor of Science degree in actuarial mathematics from the University of Edinburgh in Scotland, he carved out a successful path in public relations and capital raising for prominent investment management firms. Henry is the former head of global investor relations for several of the largest hedge funds. In this role, he keeps a keen eye on developments in the investment markets, both from a regulatory and investment standpoint.
What is a UCIT Fund?
UCITS is an investment fund structure specifically designed to be sold to investors throughout the European market. UCITS stands for Undertaking for Collective Investments in Transferable Securities. While the UCITS acronym may not be the catchiest, the idea behind the fund structure stems from a desire to simplify the process of offering hedge fund investments to investors throughout Europe. Before UCITS was developed, hedge fund sponsors were faced with the time-consuming and expensive task of seeking approval in every country where they wanted to offer a fund to investors.
Using UCITS, hedge fund sponsors now have a standardized regulatory framework they can use to market their funds throughout the EU without concern as to in which country a potential investor resides. For investors, this new fund structure enables them access to a broader range of hedge fund offerings than would otherwise be the case while still requiring fund managers to provide the disclosure necessary to enable them to perform adequate due diligence on a fund before investing in it. The UCITS concept has proven to be so advantageous that UCITS funds are now available in Asia and Latin America as other countries see the advantages using such an investment structure can offer.
The Development of UCITS
The need for an overarching regulatory framework for investments funds such as UCITS has long been apparent. Given the costs involved in registering funds for sale in every country in the EU, offering such investments across the whole of Europe was simply unaffordable for all but the largest fund managers. A few decades back, hedge funds faced great difficulty in marketing their products and had to rely on selling strictly to “qualified investors,” generally defined as those with a net worth above $1,000,000 or making in excess of $250,000 per year. At the same time, these funds typically faced little regulation in terms of disclosure of how they operated and the strategies they pursued.
If a hedge fund was established in the United States, for example, and had U.S. clients who were happy with their returns and recommended the fund to their friends in England, or France, or anywhere outside the country, the chances were that the fund would be unable to accommodate these friends if they wished to invest given the cost of registering the fund in those countries. As Gareth Henry writes, “this made it nearly impossible to quickly raise multibillion-dollar funds.” This situation was not conducive to giving investors access to a broad swathe of investment options in the hedge fund arena.
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Benefits of UCITS
A primary benefit of the UCITS framework is the reduction in costs for hedge fund sponsors looking to offer their products in different countries across the EU. Now, instead of creating a different prospectus for every country they intend to offer a fund in, they can create a single document serving the same purpose.
The funds saved by the adoption of the UCITS system are by no means inconsiderable. According to Gareth Henry, if the cost of creating a prospectus is thought be $300,000, drawing up an individual document for each of the 28 countries in the European Union would cost over $8 million — before a single dollar or euro was spent marketing the fund.
The benefits of this type of cost reduction accrue straight to a fund’s bottom line. “That means more profit to the funds ROI,” Henry stated, “and in a world where fund performance over the past decade plus since the financial crisis has been a real challenge, keeping expenses down has become a big deal.”
The regulatory changes which created the UCITS framework began more than 30 years ago. Initially, the goal was to come up with unified rules applicable to the marketing of what are known as “open-ended” funds investing in securities that can be transferred. However, as the saying goes, the best laid plans often go awry, and European states ended up passing legislation that made it difficult to market UCITS funds across borders. Nevertheless, the effort to standardize the process continued and over the years amendments were passed and negotiations conducted until at last, in January 2009, UCITS IV Directive received approval from the European Parliament. In 2011 the Council of the European Union also approved the directive.
By following the UCITS Directives, fund management companies can acquire a “European passport” enabling them to offer the fund anywhere in the EU. Such a passport also expands the activities in which they can engage. Additionally, the Directives enable use of a simplified prospectus, which is designed to offer information to potential investors in an easier-to-digest format to make marketing across borders less difficult.
Growth of UCITS Funds
The amount of assets in UCITS funds has grown substantially from the time of the first UCITS directive in 1985. The industry gained assets slowly, and by the end of 2007 assets under management had risen to just $150.5 billion. After the global financial crisis in 2008–09, however, UCITS hedge funds experienced substantial asset growth, outdoing other types of funds in terms of relative growth rate.
Data provided by research firm Eurekahedge shows that after initially falling in the wake of the financial crisis, UCITS hedge funds began gaining assets in the following year. In the past decade these funds have seen their total AUM rise from approximately $50 billion to around $325 billion, reflecting a compound average annual growth rate of approximately 20%.
The growth in assets has not occurred in a straight line, Gareth Henry notes, writing that it has varied year to year. The industry’s assets under management reached $205.7 billion at the end of 2010, which almost doubled the number of the year before. However, the Eurozone crisis caused growth to slow in subsequent years, as many UCITS hedge funds primarily focused on investments in Europe.
Operational Details of UCITS Funds
The design of UCITS funds was intended for European retail investors. The vast majority of hedge fund investments from smaller European investors are in UCITS funds. According to Henry, “Because of their transparency, liquidity and regulations governing their structure, investment activities and supervision, UCITS funds have also become popular with institutional investors both in Europe and globally outside of the United States.”
He also cites U.S. institutional investors as being interested in these funds, for the same reasons that make them attractive to European investors, namely transparency, liquidity and regulations covering how the funds are organized and operate.
“Because of their transparency, liquidity and regulations governing their structure, investment activities and supervision, UCITS funds have also become popular with institutional investors both in Europe and globally outside of the United States.”
Extending U.S. Investment Manager’s Global Reach
In his article, Henry also mentions the use of UCITS funds by U.S.-based investment managers to help expand their global reach. Due to their worldwide appeal, U.S. fund managers can use these funds to market themselves to non-U.S. investors. The funds can also be sold to institutional investors in the U.S., which makes it possible to raise initial startup capital for funds of this type in the U.S. Such capital is typically initially raised from tax-exempt investors, including foundations or endowments, so as not bring the UCITS fund under the purview of the ERISSA rules. For U.S. fund managers considering the use of UCITS funds to widen their global investment offerings, “a thorough understanding of their foreign and domestic regulatory framework and their U.S. tax implication is required,” according to Henry.
UCITS Funds Details
A UCITS fund is a mutual fund that features measures for investor protection as specified in the UCITS Directive. These include:
- Limits on investments and the use of leverage
- Risk concentration parameters
- Management and transparency standards
A major benefit investors gain from UCITS funds is that such funds must provide an investor with liquidity no greater than two weeks after the fund receives a withdrawal notice. While UCITS funds operate in a highly regulated market, they can be structured in a variety of ways depending on the approach of the fund. For instance, a UCITS fund can be established using a master-feeder structure such as is used by many fund managers in the U.S.
The UCITS Directive requires UCITS funds to have their domicile in a country that is a member of the EU. Each country within the EU has its own particular rules governing funds and how they are managed. Thus, UCITS funds are subject to the rules of the member states in which their fund is domiciled as well as the UCITS Directive.
If a fund manager based in the U.S. wants to set up or manage a UCITS fund, according to Henry, the initial step when doing so would be to partner with a management company domiciled in the EU or to establish an EU-based management company.
U.S. Investment Managers and UCITS
While UCITS funds simplify the registration and marketing processes for hedge fund managers, those based in the U.S. are still subject to all applicable U.S. federal and state regulations. This includes complying with the rules under Regulation S of the Securities Act of 1933 when it comes to marketing a UCITS fund to investors outside the U.S.
A UCITS fund can be marketed to retail investors in Europe, but not to U.S. retail investors unless the offering has been registered in accordance with the Securities Act and the Investment Company Act of 1940.
A method to avoid the requirement of registering under these regulations is to limit a UCITS fund’s securities to U.S. investors who purchase the fund in a private offering using Regulation D or Section 4(2) of the Securities Act. If this approach is used, Gareth Henry says, “the UCITS fund must also satisfy the conditions of the exemptions from the Investment Company Act registration under either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.”
Because UCITS funds are typically considered to be corporations by U.S. tax laws, they are not able to file for the favorable tax treatment accorded to partnerships under U.S. income tax laws. Earnings from UCITS funds will typically be categorized as coming from a “passive foreign investment company” (PFIC). As a result, UCITS funds are not well-suited to taxable investors in the U.S. and are more appropriate for tax-exempt entities such as endowments or foundations.
As Henry writes, “Even with all the benefits of UCITS, there is still plenty of work for securities lawyers and tax accounts.” That being said, “The point however is the process is better defined, simpler and less costly. This is a good thing.”
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UCITS Funds Gain in Popularity
Gareth Henry quotes Henrik Koning, founder of KDK, when describing the rapid growth the UCITS sector is experiencing currently. “The market has recently been flooded by a great number of UCITS funds managed by hedge fund managers, Koning stated in Hedge Fund Digest. “Hedge funds using UCITS are said to manage an estimated $35 billion and more than 200 of these funds have debuted in the last 18–24 months, according to Hedge Fund Research.”
According to Henry, “UCITS have come to represent the ‘gold standard’ in the international marketing of investment products.” He cites their improved transparency and disclosure, limited leverage, and generous liquidity provisions as supporting their widespread popularity.
He also sees managers located outside Europe as investigating the UCITS platform as a way to work with European clients and offer their funds to investors in the EU who are not qualified for more sophisticated investment products.
Compliance and Performance Results of UCITS Funds
The Thematic Review of performance fees performed by the Central Bank of Ireland in September 2018 was designed to check whether the process utilized in calculating performance fees in UCITS funds was sufficient to make sure that the interests of investors were being protected. In the course of the review, 350 UCITS that received performance fees in 2017 were identified. During the review, the Central Bank specified several good practices used by the majority of the sample of UCITS funds. Of the sample of funds surveyed, around 90% were identified by the Central Bank as being in strict compliance with these good practices.
For more information on Gareth Henry, visit his website at www.garethhenry.com.
Originally published at geeksnews.co.uk on January 18, 2019.