Attracting Retail and Institutional Investors in Europe - UCITS III

Entrepreneurial U.S. hedge fund managers should consider offering products under the European Union's Undertakings for Collective Investment in Transferable Securities ("UCITS III") framework. UCITS III is the latest version of the Europe-wide regulation that allows for the creation and distribution of investment fund products throughout the European Union to retail and institutional investors. The primary advantage to a UCITS III fund is that it may be offered to retail and institutional investors in all EU member states after its initial organization, which generally takes place in Dublin or Luxembourg. According to HedgeFund Intelligence, half of all hedge fund managers are either planning or have already launched a UCITS III compliant vehicle. UCITS III compliant vehicles are also becoming popular in Asian and Latin American countries as investors and regulators become more comfortable with the UCITS III framework. According to JP Morgan Chase, over 40% of new UCITS sales are outside of the European Union. Even though these figures appear to support a convergence between hedge funds and UCITS III vehicles, due to the UCITS III framework, not every hedge fund can be "reformatted" into a UCITS III compliant vehicle. More liquid strategies such as absolute return, managed futures, trend followers and long-short equity can work well within a UCITS III structure; however, strategies (i) with an event driven focus, (ii) that invest in illiquid and difficult to value securities, and (iii) that rely heavily on leverage (like certain arbitrage funds) may have difficulties in operating under a UCITS III compliant structure. Additionally, managers should be aware that under the UCITS III framework, they (i) may only invest in a prescribed list of eligible assets, (ii) are prohibited from shorting securities, (iii) are subject to limitations on the use of leverage, (iv) are subject to certain portfolio diversification mandates (e.g., no more than 10% of the fund's net asset value ("NAV") may be invested in any one transferable security), and (v) must provide investors with at least bi-monthly liquidity. However, through the use of financial derivative instruments ("FDIs") (one of the permitted assets), UCITS III compliant vehicles may employ synthetic leverage (up to 100% of NAV) and shorting, as long as the assets underlying the FDIs are considered as being eligible under the UCITS III framework.

Currently, nearly all derivatives (e.g., CFDs, repos, total return swaps and CDSs) can be used by "sophisticated" UCITS III compliant vehicles (i.e., those that employ FDIs for strategic/investment purposes) to replicate many hedge fund strategies. All "sophisticated" UCITS III compliant vehicles are required to employ robust risk management procedures (e.g., managers must apply value-at-risk (VaR) analysis in order to assess the global exposure the UCITS compliant vehicle is undertaking and such analysis must be combined with portfolio stress-testing and back-testing). The UCITS III framework will remain in place until July 2011 when the individual European Union member states are required to implement the UCITS IV Directive, adopted by the European Commission on January 13, 2009, which repeals the current UCITS III framework. Our expectation is that the cross-border and operational benefits from UCITS IV will attract increased interest from fund managers over the coming years. UCITS III compliant vehicles can offer U.S. hedge fund managers a vastly expanded pool of potential investors and distribution channels, specifically retail investors in Europe, who may not otherwise invest directly in a hedge fund, and institutional investors in Europe, who are attracted to the regulated risk management, liquidity and high transparency of UCITS III compliant vehicles.

 

Please contact Lance Friedler at 212.573.8030 (or lfriedler@sglawyers.com) or Micah Nessan at 212.573.8034 (or mnessan@sglawyers.com) for more information on launching a UCITS III fund.

Cheryl Spratt