UCITS report | Can a Leopard Change its Spots?

The European UCITS brand is a seal of quality recognised in financial centres the world over, spanning from Asia to the Americas. The widespread appeal of UCITS-compliant funds exists notwithstanding the significant additional compliance burden that is pinned unto UCITS-compliant managers. This is a success story that began in 1985 and has undergone three subsequent and significant amendments, with another one, possibly two, in the regulatory pipeline.

Each amending directive brought more flavour to the initial and somewhat restrictive UCITS framework. What initially started off as a framework for retail collective investment schemes pursuing plain-vanilla equity and bond strategies gradually evolved into a platform for the development of investment strategies that are more akin to those sought by hedge funds. The Product Directive (Directive 2001/108/EC of 21 January 2002) broadened the scope of “eligible assets” to include Financial Derivative Instruments, resulting in a corresponding widening of appeal to managers looking for more flexible investment parameters.

The UCITS brand continues to attract the interest of hedge fund managers who are eager to avail themselves of pan-European passporting and international recognition as a serious, solid vehicle affording high levels of investor protection which, in turn, attracts investors from across the world. Investors’ recognition in markets such as the Middle East, Asia and Latin America of the high level of investor protection afforded by the EU’s UCITS funds has gone a long way towards establishing this form of regulated retail fund as a staple offering by many managers.

The accommodating of hedge fund type strategies within the Ucits framework led to variants referred to as “Newcits”, “sophisticated Ucits”, and “complex Ucits”. Ucits IV has preserved this state of affairs and it is expected that this flexibility will not be materially affected by Ucits V.

However with the current raging debate within the EU in respect of the appropriateness of selling complex investment strategies to retail investors, the European Commission has published a consultation on Ucits VI in July 2012 which, amongst other things, seeks to evaluate the appropriateness of retail funds adopting complex or highly sophisticated investment strategies.

This consultation process has been received by the industry with a mixed sensation of curiosity and consternation, primarily due to the fact thatUCITS V hasn’t even rolled off the regulatory production line in Brussels. In any case,UCITS VI may mark the start of a process of change for the long-standingUCITS regime policymakers may seek to curtail the extent to which hedge fund strategies can be wrapped inUCITS packaging. If the AIFMD timelines are anything to go by, it may be anything between two and four years until the final cut ofUCITS VI sees the light of day.

But does this mean that hedge fund managers would be denied from having access to the EU market and benefitting from the advantages of theUCITS brand distribution network?

Enter the AIFM Directive, the EU directive which has yet to win the favour of fund managers across the European continent and beyond, and which provides a pan-European market to fund managers having alternative strategies, underpinned by tighter monitoring of such managers’ risk management procedures.

The AIFM Directive is essentially a service-related directive, targeting the operations of investment managers. But it also indirectly has elements of a product related directive to the extent that the rules imposed on the manager directly affect the structuring and operation of AIFs, the funds managed by AIFMD-compliant managers, or AIFMs.

This Directive has created a dual regulatory regime in Europe for the management and marketing of investment funds, namely the Ucits funds on one hand and all other investment funds (referred to as “alternative investment funds” or “AIFs”) on the other. “AIF” is the new “non-Ucits” and is certain to become the vehicle of choice for all managers seeking a quality fund structure without Ucits restrictions. Hedge funds, private equity funds, real estate funds and venture capital funds, to name a few, would all fall within the scope of the AIFM Directive.

Against this backdrop, it is expected and logical that Ucits VI will push complex investment strategies towards the AIFMD fund framework, whilst on the demand side, non-retail investors seeking a combination of exciting investment strategies within structures affording high levels of investor protection within will find themselves suitably accommodated by AIFs. The investor’s peace of mind rests in the fact that AIFMs will be subject to various levels of disclosure to the relevant EU regulatory authorities, adding a much-desired level of transparency and oversight both on a micro level (the manager’s internal systems) and a macro level (ensuring the avoidance of build-up of systemic risk).

It is noteworthy that managers are permitted to operate as Ucits managers and AIF managers contemporaneously, giving managers the ability to reorganise their various strategies within the appropriate vehicles whilst retaining the pan-European distribution channels- Ucits for retail investors and AIFs for professional investors.

In light of these considerations, the development of the AIFM Directive as a regulatory framework for alternative investment fund managers represents a positive move for investors and will also prove valuable to managers in providing an attractive alternative toUCITS funds which were always intended to be retail in nature. The UCITS leopard will not change its spots- but it could certainly lose a few to AIF structures which are more than likely to set a new yardstick for the proper and transparent regulation of alternative, professional and esoteric funds. Whilst this change will most likely pick up momentum with the eventual implementation ofUCITS VI, assuming that the expected curtailment of the eligible assets list to limit the use of FDIs does in fact happen, many managers are already taking positive steps towards establishing AIFs to accommodate alternative investment strategies.

The Malta Financial Services Authority has undertaken a firm, proactive commitment towards the timely implementation of the AIFM Directive, ensuring that all regulatory instruments were in place well in anticipation of the 21 July deadline. The Authority’s commitment is being maintained by ensuring that all AIF applications are processed thoroughly and efficiently and it is this approach, coupled with the on-going regulation of AIFs that will bring the AIF to benefit from the wide brand-recognition hitherto enjoyed by UCITS funds.