UCITS Hedge Funds: Custom Tailored For The European Market
What Are UCITS Anyway?
If there is one thing governments around the world do well it is creating acronyms for complicated regulatory programs. Somehow a cute sounding name is suppose to make confusing regulatory jargon understandable to everyone. If that were only the case. UCITS are no exception. However if you have an interest in hedge funds there are some important distinctions so let’s start with a close look at exactly what UCITS are in the first place.
UCITS stands for Undertakings for Collective Investments in Transferable Securities. UCITS provide a single European regulatory framework for an investment vehicle which means it is possible to market the vehicle across the EU without worrying which country it is domiciled in. This is what makes UCITS an exception. European regulators are making life easier for investors without sacrificing safety and security.
Europe regulators are not alone. UCITS funds have also become successful in Asia and Latin America because the UCITS ‘label’ means investors can have some assurance that regulatory and investor protection requirements have been met.
This and other similar regulations represent a tectonic shift. As recently as the 1980’s hedge funds were severely restricted no matter where in the world they operated. During these years hedge funds were virtually unregulated. In return fund marketing was limited exclusively to so called “qualified investors” which was financial code for people worth more than $ 1 million or with more than $250,000 of annual income. And then if a hedge fund, domiciled in New York for example wanted to open access to a qualified investor in France, a prospectus conforming to French law had to be created (and translated) before any money could change hands. But what if the French client had friends in Italy, Germany and Spain? Well, you get the picture. This made it nearly impossible to quickly raise the multibillion-dollar funds. In the final analysis, this was not good for anyone.
The Advantages Are Obvious
It is easy to see how the creation of the UCITS system offers real benefits. The biggest of course is how quickly costs come down for fund providers. In a single regulatory stroke, it means they no longer had to create a new investment prospectus and marketing materials for each country in which they intended to sell the product.
Imagine for a moment the legal cost alone to create a single prospectus is $300,000. There are 28 members in the European Union. Before the first marketing call or the first dollar of income a hedge fund manager would have to consider sinking over $8 million just to gain market access and then the pure marketing costs come on top of that.
That means more profit to the funds ROI and in a world where fund performance over the past decade plus since the financial crisis has been a real challenge, every keeping expenses down has become a big deal.
The regulatory effort at creating UCITS got started over thirty years ago. The original intent was to unify the rules for marketing so called open-ended funds that invest in “transferable securities”. But regulations seldom workout the way they were intended. Each of Europe’s member states quickly created legislation that placed obstacles on cross border marketing of UCITS.
Finally after several amendments, lots of negotiations and many years UCITS IV Directive was approved by the European Parliament in January 2009 and later in July 2011 by the Council of the European Union.
UCITS Directives seek to give management companies a “European passport” to operate throughout the EU, and widens the activities which they are allowed to undertake. It also introduces the concept of a simplified prospectus, which is intended to provide more accessible and comprehensive information in a simplified format to assist the cross-border marketing of UCITS throughout Europe.
When the original UCITS directive was put in place back in 1985 the UCITS hedge fund industry started relatively small. By the end of 2007 assets under management totaled just $105.5 billion. It wasn’t until after the global financial crisis that UCITS hedge funds gained traction and outpaced their non-UCITS peers in terms of relative growth.
The two dates: 2009 and 2011 mark key inflection points for UCITS as data shown below, provided by the well respected research firm of Eurekahedge.
Shaken By The Financial Crisis
Despite taking a beating during the financial crisis, UCITS hedge funds recovered starting the following year. Over the last decade Assets Under Management have grown from around $50 billion to about $325 billion or a compound average annual rate of about 20%. However impressive the overall growth, it has been marked by year-to-year variations.
The industry assets under management grew to $205.7 billion by the end of 2010, nearly doubling the previous year’s number, indicating the increase of interest among investors who demanded higher transparency and liquidity from fund managers. Industry growth slowed down over the next few years due to the Eurozone crisis, which is not unexpected as a sizeable population of the UCITS hedge funds were solely focused in investing within the European region.
How They Work
UCITS funds were designed for retail investors in Europe, and the overwhelming majority of fund investments made by smaller European investors are made in UCITS funds. 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. The reasons that fueled UCITS funds’ global popularity are attractive to U.S. institutional investors, particularly U.S. tax-exempt investors.
UCITS Funds Help U.S. Based Investment Advisor’s Global Reach
The widespread global appeal of the UCITS brand make UCITS funds an interesting vehicle for U.S. fund managers who wish to market their investment strategies to investors outside of the U.S. Because UCITS funds can be marketed to U.S. institutional investors, seed funding for such a global strategy can be raised in the U.S., primarily from tax-exempt investors such as endowments or foundations that will not subject the UCITS fund to ERISA. For the effective use of UCITS funds as part of a strategy to expand a U.S. fund manager’s global reach, a thorough understanding of their foreign and domestic regulatory framework and their U.S. tax implication is required.
Key Features Of UCITS Funds
UCITS funds are mutual funds with significant investor protection features mandated by the UCITS Directive, including investment and leverage limitations, and risk concentration, management, and transparency standards. A key benefit of a UCITS fund from an investor perspective is the requirement to provide liquidity within two weeks of receiving a withdraw notice.. Despite the highly regulated environment in which they operate, there is flexibility in structuring UCITS funds. Notably, UCITS funds can accommodate master-feeder structures familiar to U.S. fund managers.
Under the UCITS Directive, a UCITS fund is required to be domiciled in an EU member country. Because each individual EU country has its own domestic rules and regulations regarding funds and fund management, UCITS funds and UCITS management companies are governed both by the UCITS Directive (as implemented into the domestic laws of the applicable member state) and the member states existing internal law.
The first step for a U.S. fund manager wishing to manage and/or advise a UCITS fund is to either set up a EU-based management company or enter into a partnership with an EU domiciled management company that will serve as the management company to the UCITS fund. Under such an arrangement the U.S. fund manager may serve as an adviser to the EU-based management company or, possibly, the UCITS fund, or manage one or more portfolios within an existing UCITS fund.
UCITS Funds: U.S. Regulations
UCITS make life as a hedge fund manager simpler and less costly. However this does not eliminate everything. U.S. fund managers who are managing or advising UCITS funds also must comply with applicable U.S. federal and state regulation.
For example, a U.S. fund manager must comply with the requirements of Regulation S under the Securities Act of 1933 when marketing investments in a UCITS fund to European and other non-U.S. investors. While a UCITS fund may be marketed to European retail investors, a UCITS fund may not be marketed to U.S. retail investors without registration of the offering under the Securities Act, and registration of the UCITS fund under the Investment Company Act of 1940.
If all this still sounds overly complicated; well it is. But here is one simple way around the problem. In order to avoid these registration requirements, the securities of a UCITS fund may limited to U.S. investors to a private offering in accordance with Regulation D or Section 4(2) of the Securities Act. Under this approach 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.
U.S. fund managers sponsoring UCITS funds that are marketed to U.S. investors will also want to evaluate the eligibility of the European based management company for an exemption from registration as an investment adviser under the Investment Advisers Act of 1940.
UCITS fund management companies with their principal place of business in an EU member state can qualify for the private fund adviser exemption from the registration requirement under the Advisers Act if they (i) have no clients that are U.S. persons other than private funds, and (ii) manage only private fund assets from a place of business in the U.S. with a total value of less than $150 million.
One favorable aspect of the UCITS structure is that a UCITS fund is not a “covered fund” as defined in §619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act as long as Americans investors represent no more than 15% of the securities. Even if U.S. investors who are as much as 25% in the aggregate under the Employee Retirement Income Security Act of 1974, it will be necessary to comply with ERISA.
U.S. Tax Considerations: Best For Tax Exempt Investors
Most forms of UCITS funds, such as public limited companies, are deemed corporations under U.S. tax laws. This means that they are not eligible be treated as a partnership for U.S. income tax purposes. Generally, a UCITS funds earnings as a corporation will be classified as “passive foreign investment company” or “PFIC.” This little known provision makes UCITS unfavorable to U.S. taxable investors and thus far better suited for U.S. tax-exempt investors such as endowments or foundations U.S. taxable investors could be accommodated by structuring the UCITS fund as a legal entity that is eligible to elect partnership tax treatment in the U.S. such as an Irish SICAV.
When adding up all this information, one thing is clear. Even with all the benefits of UCITS, there is still plenty of work for securities lawyers and tax accounts. The point however is the process is better defined, simpler and less costly. This is a good thing.
Current Status: Open The Flood Gates
Henrik Koning, founder of KDK describes today’s market pulse most clearly in the publication Hedge Fund Digest:
“The market has recently been flooded by a great number of UCITS funds managed by hedge fund managers. 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. Market observers also saw the emergence of specialised UCITS Hedge Fund indices: three such index families were launched. Many funds of hedge funds are also widely considering UCITS as a potential instrument to regain assets from private banking clients and high net worth individuals who have not returned to alternative investments yet. These so-called ‘New CITS’ have therefore become one of the key topics in the hedge fund industry.”
UCITS have come to represent the “gold standard” in the international marketing of investment products. The attractiveness of UCITS funds to institutional investors comes from the increased transparency and disclosure of investments, limited leverage and attractive liquidity terms.
Managers outside Europe have also been looking towards the UCITS platform as a passport to access European clients and market their funds to investors across EU market that is not qualified to invest in sophisticated products. The latest regime for the directive, UCITS V, includes enhancements in areas of remuneration policies for UCITS-compliant managers, risk-taking behaviors and the duties and liabilities of depositories — to some extent, aligning certain aspects of the UCITS and AIFMD directives together.
Compliance Has Been Favorable
UCITS appear to be earning their “gold standard” reputation as evidenced by a so-called Thematic Review of performance fees by The Central Bank of Ireland released in September 2018. The purpose of the review was to establish whether the procedures used to calculate and pay performance fees in UCITS, ensure that investors’ interests are protected at all times.
The review investigated the methodologies and parameters selected and applied in the calculation of UCITS performance fees to examine if they are in line with UCITS Performance Fees Guidance (the “Guidance”) issued by the Central Bank. This review was carried out in parallel to a Consultation on amendments to the Central Bank UCITS Regulations, which proposes to introduce requirements in relation to performance fees.
The review identified approximately 350 UCITS that accrued performance fees in 2017. Of these, authorized officers reviewed a sample of circa 30%. During the course of the review, the Central Bank identified a number of good practices across the majority of the sample of UCITS sub-funds reviewed. Good practices included:
- UCITS that had clear and unambiguous prospectus disclosure in respect of the performance fee methodology;
- UCITS that clearly disclosed the version of the index to which the performance fee methodology related;
Transparent, comprehensive and frequent review of performance fee calculations by Fund Service Providers; and Fund Service Providers with dedicated performance fee teams. The Central Bank identified approximately 90% of the sample of in strict compliance.
What About Investment Performance?
The near 20% growth in AUM during the last decade has been impressive but looking at the performance of UCITS funds yields a less glowing picture. There are several different several different sources to measure performance starting with Eurekahedge, Barclays and HFT. There are slight differences in scope for each but each are highly respected and all paint a similar picture.
Eurekahedge UCITS Hedge Fund Index Bloomberg Ticker EHFI547 over the last decade investors have experienced an average 4.7% annual return on their investment. This compares with the HFRI Hedge Fund Index of 3.4%. So UCITS hedge funds have delivered on their primary mission: to provide superior investment returns to justify their lofty performance fees.