Ucits and Alternative Strategies: Not Necessarily a Match Made in Heaven

20 May, 2011

Managers in the EU and US 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 AIFM Directive in the EU and the HIRE Act and Dodd-Frank in the US have serious implications for managers on both sides of the Atlantic. Enter Ucits. The EU regime for Undertakings for Collective Investment in Transferable Securities has been around for years, but Ucits (in their “Newcits” reincarnation) are suddenly what everyone now talks about over dinner. Ucits has, we are told, been transformed from a boring retail brand to the vehicle of choice for managers pursuing the most “alternative” of investment strategies. True that Ucits is a brand that has attracted billions of investment. True that some alternative strategies can be replicated (more or less) with Ucits. But the drawbacks of Ucits must be weighed with the merits.

Ucits: upsides & downsides

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 organisational 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 €100 thousand to set up. Other strategies, with the additional regulatory burden involved, can boost organisational costs to €200 thousand. 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 are a significant number of Ucits funds in existence with AUMs of <50m, limited prospects for growth and saddled with organisational costs of 100 to 200 bps.

Better regulated?

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.

AIFM Directive

Managers are familiar with the 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 ESMA’s recommendation) be switched off.

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 the 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.

Why Cayman?

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 categorised as “hedge” funds) were regulated by the Cayman Islands Monetary Authority (CIMA). This 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 some 100 new funds per month are being registered with CIMA.

These statistics speak both to Cayman’s dominance of the offshore alternatives market and to a significant upturn in start-up funds over the last twelve months. Whilst there has been some increase in the use made by alternatives managers of EU domiciles like Ireland, Luxembourg and Malta, Cayman has maintained its position as the default jurisdiction for hedge fund products. 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 re-domiciled their funds from Cayman to EU jurisdictions. Proportionately 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, and often overstated by those domiciles who would stand to gain the most from any contraction in Cayman’s market dominance. 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, capitalisation of fund or manager, use of leverage, shorting or derivatives. All the tools of alpha generation remain at the manager’s disposal.

The following dynamics are central to Cayman’s ongoing attractiveness to managers:

1. 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 Member States.

2. Cayman is a stable offshore financial centre. Contrast Ireland, Luxembourg and Malta, which have larger populations to look after and so are susceptible to economic downturns and the spectre of EU tax hikes and harmonisation.

3. Cayman is well regulated, but not over-regulated. CIMA understands that risk lies with the onshore manager more than the offshore fund. Contrast Ireland, Luxembourg and Malta, where non-Ucits products are subject to retail-type
restrictions. And CIMA’s policy on fund audit kept Madoff out of Cayman (contrast Luxembourg).

4. Cayman has been home to hedge funds for more than thirty years. CIMA has more experience as a hedge fund regulator than its counterparts in Ireland, Luxembourg and Malta.

5. Cayman’s courts are more experienced in hedge fund matters than the courts in Ireland, Malta and Luxembourg.

6. Cayman is synonymous with hedge funds. Its selection by a manager is instantly intelligible to investors and other managers.

7. Cayman enables managers to establish a flexible “regulated” product at low cost. Contrast Ireland, Luxembourg and Malta where more regulation and national economic drivers result in a higher total expense ratio and higher taxes and duties.

Importantly, Cayman is not a Ucits domicile. A Ucits blow-up in Luxembourg, Ireland or Malta will result in the exodus of billions from all three jurisdictions, and irreversibly taint them as “regulated” domiciles. Cayman will be immune from the toxic fallout.

What next?

Some alternatives managers capable of absorbing the cost of EU regulation have utilised Ucits to distribute products and raise retail monies. Others have dipped their toes in the Ucits waters by using distribution platforms. Inflows into Ucits continue to increase. But the cycle will be adjusted when managers whose assets have reached a plateau at small levels pull the plug and move back into offshore products. The ability to automatically passport Ucits may be attractive, but the lower returns, together with growing concern about its suitability for the replication of alternative strategies, will be significant countervailing factors. These concerns will increasingly be played out against the backdrop of a challenging economic situation and a renewed search by institutional investors and pension funds for managers capable of generating
above-average returns.

At Appleby, where we provide alternatives managers worldwide with access to offshore legal solutions throughout the lifecycle of their fund products, we see that domicile choice is driven by the manager, who has to tread a fine line between products conducive to capital raising and returns, and the predilections of institutional
investors. The divergence between pro-Ucits and anti-Ucits managers (ignoring the domicile agnostic managers) will ultimately be corrected when (a) investors renew their search for uncorrelated returns, and (b) those managers who have failed to grow assets and achieve returns with Ucits products wind them down and move their funds back offshore.

Matthew Feargrieve is a member of the Funds & Investment Services team at offshore law firm Appleby.