US-based Hedge Funds Should Consider Offering UCITs Funds

US hedge fund managers are largely unaware of the EU-domiciled UCITs III hedge fund structure, which is revolutionizing the ways assets will be managed for non-US clients both in the EU and elsewhere.

 

By setting up UCITs III-compliant funds, US managers may be able to distribute to constituencies that had never invested in hedge funds previously.

 

There are few UCITs III hedge funds in the US, hence there is a first mover advantage for those willing to set up such a structure.  

We believe that every large and established US-based Hedge Fund management company will offer UCITS III compliant products within five years, if not sooner. This may be a bold statement seeing that until very recently, few if any US-based managers were aware of the existence of UCITs III, let alone its benefits.

 

Many of the major London-based Hedge Funds have either launched such funds or are planning to do so soon. US managers are only starting to become aware of the UCITs structure, but are not yet fully cognizant of its immense distribution power, and the central role it will play in the years to come in the global alternative investment arena.

 

Simply put, this is the regulated framework through which liquid hedge fund strategies may be distributed locally throughout the EU. This includes both institutional and local retail clients. Many of these client bases are off limits to regular offshore hedge funds.

 

The fund must be set up in a EU domicile, with Luxembourg and Ireland being the two most popular. There are some local registration requirements for each market one wants to distribute in, but these are not too onerous.

 

There are some investment restrictions, diversification rules and liquidity requirements. For example, no physical shorting is allowed, but one may get short exposure via swaps. There is also a prohibition on investing in commodities (although certain commodity indices are permissable). Individual security positions may normally not exceed 5% of NAV (up to 40% of a portfolio may have positions of 5-10% each). Liquidity is fortnightly at least, but most managers offer daily or weekly dealing. 

 

Strategies suitable for UCITs III include classic equity long-short, market neutral, event-driven and CTA's.

 

The reasons for considering UCITs structures now are as follows:

 

1. Increased demands from investors for more transparency and liquidity.

 

2. The regulatory framework in Europe provides comfort to investors, especially given various well-publicized cases of hedge fund fraud.

 

3. The recent EU Hedge Fund Directive, if adopted may make offshore funds more difficult to market in Europe. The more Cayman or BVI-domiciled funds become subject to EU regulatory scrutiny, the more attractive European-domiciled fund structures become.

 

4. Increased acceptance of UCITs funds worldwide (ex-US) 40% of UCITs sales have been outside the European union.

 

5. Investor preference for liquid hedge fund strategies.

 

Disadvantages:

1. There are large upfront costs involved in order to set up local fund management companies and establish one's counterparties who are key to the process, such as custodians, local directors, transfer agents, administrators, swap counterparties, auditors and so on.

 

2. One needs connectivity to distribution channels  - there are many distribution platforms, but being on such a platform along with many other managers does not necessarily guarantee that one's product will be sold.

 

While over 80% of long-only investment management assets in the EU are UCITs compliant, there are still only a handful of UCITs Hedge Funds. Hence there is still the opportunity for first mover advantage for US hedge funds interested in exploring the space.   

This author consults with leading institutions through GLG