Aligning UCITS funds with AIFMD

Fabulous Fab famously joked about selling structured credit instruments to widows and orphans he ran into at Brussels airport. Yet, for a brief but delicious interlude, the once unregulated hedge, private equity and real estate funds which are in reality sold to sophisticated institutional investors will be more heavily regulated in Europe than the mutual funds sold to widows and orphans by salesmen on fat commissions. This is a quirk occasioned by the fact that the Alternative Investment Fund Managers Directive was passed into law ahead of the fifth iteration of the Undertakings for Collective Investment in Transferable Securities Directive (UCITS V).This oddity will soon disappear. On 15 April 2014, the European Parliament adopted UCITS V after a long delay occasioned mainly by political disagreements over how unkind to be to mutual fund managers over their remuneration. The Economic and Monetary Affairs Committee (ECON) of the European Parliament favoured capping the bonuses paid to senior personnel at one times their salary. In the end, this idea did not survive. Instead, UCITS managers are likely to be subject to remuneration restrictions not dissimilar to those laid down in the AIFMD, including the principle that remuneration be proportional to the size and structure of the firm.

“Likely” is the operative word, since the UCITS V legislative process has some way to go. The European Council must approve the text endorsed by the European Parliament before the draft Directive can be published in the official journal of the European Union (EU), probably in the autumn of 2014. If that happens, member-states will then have 18 months to translate it into national law, implying that UCITS V will finally bring mutual funds into alignment with alternative funds in the second quarter of 2016.

In the meantime, the European Securities and Markets Authority (ESMA) will issue guidelines intended to help fund managers prepare for the three main changes envisaged by UCITS V: the scope of the staff to be caught under the new remuneration rules and the application of the new remuneration principles for UCITS management companies; the appointment of depositary banks to protect investors; and the harmonisation of the way in which UCITS rules, and especially sanctions for misbehaviour, are applied across the member-states of the EU (as well as bringing them into line with those of the AIFMD).

On remuneration, the prediction (based on existing remuneration rules set by ESMA) is that up to 50 per cent of variable remuneration for senior staff must be disbursed in units of the UCITS, with 40 per cent deferred for at least three years. 60 per cent of a bonus will have to be deferred when the sum involved is exceptionally high. The stated ambition, of course, is to discourage excessive risk-taking.Although UCITS fund managers have experience of depositary banks, it was not extensive outside France and Germany, because EU legislation merely required UCITS fund to appoint an independent one. UCITS V brings their responsibilities into line with the AIFMD by limiting the depositary role to banks, making them responsible for oversight and cash flow monitoring, and rendering them responsible for segregation of the assets, and strictly liable for any which go missing. Unlike AIFMD, however, UCITS depositaries will be prohibited from delegating their liabilities.Nor is there any room for a depositary “lite” offering (see “Depositary “lite” looks like a temporary fix,” page 32) by which the depositary bank can escape strict liability. “There are nuances between UCITS V and AIFMD in terms of depositaries,” says Brendon Bambury, director of sales for the UK and Ireland at KAS Bank. “Perhaps the biggest is the absence of depositary-lite in UCITS V whereby firms can be excused from the strict liability clauses. But by and large, the rules are fairly much aligned.”

The exclusion of a depositary “lite” option is one measure of the focus of UCITS V on protecting the retail investors who are the main investors in UCITS funds. “This is absolutely the intention of European regulators,” adds Bambury. “They are nervous about some of the strategies being run out of UCITS directed at retail.”

Regulators are certainly mindful that the UCITS III and IV Directives did lead to a number of unusual asset classes (notably derivatives) finding their way into UCITS structures,and UCITS vehicles even proving amenable to alternative investment management strategies. Despite the difficulties some hedge fund managers have encountered in replicating their strategies within the constraints of UCITS vehicles, Alix Capital, a Geneva-based investment boutique, reckons €231 billion is currently managed by alternative UCITS. That is a small fraction of an industry running roughly €10 trillion in all, but regulators are terrified of exposing retail investors to asset classes which stray beyond the obvious, especially if investors cannot retrieve their money at will. The UCITS VI Directive, which is already being discussed, is expected to narrow the range of assets eligible for investment by UCITS funds agreed in the UCITS III directive back in 2002. “Regulators are taking much more interest in the liquidity profile of some of the biggest UCITS managers,” says Bambury. “This is evident in their thinking in the UCITS VI consultations.”

ESMA has already stipulated that UCITS funds managed by commodity trading advisors (CTAs) be sufficiently diversified, fully transparent and easily replicated as well as being re-balanced periodically rather than daily or intra-daily. In both Ireland and Luxembourg, the two major UCITS domiciles and servicing centres in Europe, regulators have implemented these guidelines already. They are widely believed to be merely the precursor to tougher provisions in UCITS VI.The tougher stance by ESMA is said to have prompted the closure of at least one fund already. Cantab Capital Partners announced in May 2013 it was shutting its $320 million CCP Quantitative fund, a UCITS-compliant CTA vehicle. It could well be taste of things to come, since the focus on UCITS run by CTAs merely reflected their rapid growth since the financial crisis, with nine funds managing €1.57 billion in 2008 climbing to 55 running €6.09 billion by 2012.

One prospect is enticing. Once UCITS V has brought mutual funds into alignment with alternative funds regulated under AIFMD, the choice of regulated vehicle will be less important than it once was. Funds that would once have elected for a UCITS vehicle might conclude that an AIF is a more attractive option in terms of management discretion and attracting investors, and vice-versa. If UCITS VI imposes the more conservative investment rules currently anticipated, the traffic might even become one way: from UCITS to AIFs.