European passport for hedge funds

Growth of the European alternative investment industry

Paul Farrell, Matheson Ormsby Prentice, Ireland

Paul Farrell of Dublin law firm Matheson Ormsby Prentice writes on future developments for European domiciled hedge funds and in particular a European passport for European domiciled hedge funds similar to the European passport for UCITS funds.

Having evolved into a global business in the 1990's, the growth of the hedge fund industry has continued at a phenomenal rate with alternative investments today being rightly viewed as a critical component of portfolio diversification.

Arguably the most explosive growth in the hedge fund industry has taken place in Europe. The European hedge fund market has grown exponentially in recent years and now represents around 15% of the global hedge fund market. In liberalising their regulations, Ireland and Luxembourg have played a significant role in this rapid European growth, opening up hedge funds and fund of hedge funds to a wider variety of investors. In this regard, Ireland has possibly been the most proactive in improving access to hedge funds.

In the late 1990's, the Irish Central Bank, now the Irish Financial Services Regulatory Authority, recognised that there were opportunities for Ireland in this area that could be achieved while protecting Ireland's reputation for probity and regulation. Following submissions from the Irish Funds Industry and firms like Matheson Ormsby Prentice, the Irish Financial Services Regulatory Authority introduced rules, which facilitated the appointment of prime brokers to Irish domiciled funds. Largely in response to Ireland's success in the regulated hedge fund industry, Luxembourg subsequently introduced its own rules applicable to hedge funds and funds of hedge funds.

In light of the developments in Ireland and Luxembourg and more recently the moves in Germany and Spain and the increased interest that institutional and private investors in Europe have shown in hedge funds the European Parliament has stated that it considers it time to develop a European regime for hedge funds or "sophisticated alternative investment vehicles" ("SAIVs"). This initiative is likely to significantly affect a promoter's choice of hedge fund domicile with regulated European jurisdictions likely to benefit at the expense of less regulated or unregulated jurisdictions outside the European Union.

Sophisticated Alternative Investment Vehicles

In the European Parliament's resolution on the future of hedge funds and derivatives, the European Parliament has expressed a concern that the success of the hedge fund industry and rate of growth of the hedge fund industry has the potential to adversely affect financial markets if hedge funds were to continue to proliferate without adequate control. In particular it has focused on the risk of systemic damage to the global financial system and the lack of internal risk control systems of less experienced participants in the hedge fund industry.

The European Parliament is of the view that these risks can be addressed through provision of a European passport for hedge funds similar to that currently in place for UCITS funds. It is hoped that in addition to reducing risk, the implementation of such a regime would also mean that investors would be more inclined to invest in a SAIV than to invest in hedge funds established in offshore, zero-rated tax jurisdictions enjoying laissez-faire regulatory regimes.

It is considered that a separate lightly-regulated regime of SAIVs with a European passport is the most suitable route for the proposed European regime for hedge funds. Hedge funds could then elect to be regulated under this regime, in which case they would be required to adhere to particular rules. It would be possible for hedge funds to remain unregulated but in this case they would not be able to avail of the European passport. In this regard the European Parliament has noted that success in attracting hedge funds onshore will depend on establishing a lighter regulatory regime than for conventional UCITS, with such a regime concentrating on provision of sufficient and intelligible information to the investor rather than on over-prescriptive rules and regulations

It was noted that for such a regulatory regime to succeed for hedge funds it would have to be sufficiently light-handed so as not to compromise hedge funds alternative investment properties or hinder the ability of investment managers to:
 

  • employ unconventional investment techniques and instruments;
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  • take strong positions, including positions held through the use of shorting, leverage and derivatives; and
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  • be remunerated relative to their performance.
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Once in place, the SAIVs regime could apply to other alternative investment funds, which do not necessarily pursue absolute returns, for example in areas such as property, currencies or commodities, which are prevalent in the European market but currently unable to take advantage of a single EU-wide regime.

The European Parliament has acknowledged that there is a perception that there will be a need to inform less sophisticated investors about the various strategies and risks of alternative investment. To address this it has been suggested that limits might be imposed on investment into such funds while public understanding is poor but that these restrictions should be progressively reduced and ultimately eliminated as awareness improves. In tandem with this process, the European Parliament has expressed the view that the hedge fund industryitself and national regulators would be expected to play a significant role in educating potential investors about hedge funds and the associated risks. The Irish Financial Services Regulatory Authority addressed this issue in implementing its retail fund of hedge funds notice by requiring funds to include a simplified glossary of terms in their prospectuses.

The Proposed Regulatory Regime for SAIVs

In its proposals the European Parliament has focused on a number of key criteria that it considers have to be addressed to protect investors in SAIVs.

In the first instance, the European Parliament considers that the regulators in European Union member states will have to satisfy themselves that the directors, investment managers and promoters of SAIVs must be fit and proper persons with sufficient experience in the investment techniques and instruments to be employed in their SAIV. This requirement reflects the current approach adopted in jurisdictions such as Ireland, where the Irish Financial Services Regulatory Authority undertakes a due diligence on directors, investment managers and promoters of Irish funds to determine their suitability to act as directors of, provide investment management services to and promote Irish domiciled funds.

It is proposed that the SAIV regime concentrate on the distribution and sales methods employed to ensure that sales and marketing teams acting on behalf of a particular SAIV would not target persons for whom an investment in a SAIV would not be appropriate. In particular, it is considered desirable that distributors be specifically authorised to distribute SAIVs and that such authorisation should depend on their probity and expertise in hedge funds. It was recommended that such authorisation be renewable on a regular basis.

In addition it was further recommended that the advertised style of investment and level of risk of a particular SAIV be properly monitored and controlled. In this regard and as with UCITS funds this could perhaps be achieved through the appointment of an independent custodian or trustee to undertake this monitoring role. Initially the European Parliament has suggested that for the purposes of the SAIVs, they would be required to run rigorous daily risk controls so as to ensure that they stay within the relevant risk parameters.

Finally in light of the increasing interest from the public and from institutional investors to gain access to such investment options while being reassured as to their good management, it has been proposed that prospective investors be provided with clear details of investment strategy and operating methods. This, it was proposed, would be set out in the form of clear and simple risk descriptions in the offering memorandum with warnings in the subscription forms to be acknowledged by investors as representing their understanding of the risks involved. Again, this would reflect the approach taken by jurisdictions such as Ireland, particularly in the context of Ireland's professional investor and qualifying investor funds.

The Role of the European Commission

The European Commission will play a key role in the implementation of a SAIV regime, particularly in the drafting of appropriate legislation and in this regard the European Parliament has called on the European Commission to exercise its powers of legislative initiative to consider whether a regime for hedge funds should potentially be enacted as a distinct part of a revised UCITS directive (perhaps as early as 2005) or in a separate directive that specifically addresses a regime covering hedge funds and other alternative investment funds, such as property funds, currency funds or commodities funds. The European Commission sanctioned such a report in early 2004.

The European Parliament has also requested the European Commission to report on the possible implementation of the SAIV regime in the different European Union member states and in this regard it expects the European Commission to report on fiscaland regulatory differences between the European Union member states, pointing out fiscal and regulatory dumping measures currently in place and measures that discriminate against hedge funds domiciled in other European Union member states.

In undertaking these considerations, the European Parliament has urged the European Commission to consult with the legislative and regulatory authorities in the USA, Japan, Switzerland and other relevant jurisdictions with the aim of developing harmonisation of the legal and regulatory regimes currently in existence in the arena of hedge funds.

The European Parliament considers the Worldwide harmonisation of the legal and regulatory regimes applicable to hedge funds to be extremely important and has urged the World's supervisory authorities to develop an effective means, possibly including a centralised credit register at for example the Bank for International Settlements, to monitor and control the extent of credit, management and operational risk which the hedge fund industry brings to the World's financial system. This reflects a recommendation of the Financial Stability Forum in April 2000 and the European Parliament has urged the European Commission to instigate such a mechanism, which would lead to more effective enforcement of existing provisions, in the context of its consultations with other jurisdictions outside of the European Union.

Conclusion

Today retail investors appear to be leaning towards alternative investment and it is the European Parliament's view that it would be preferable for these investors to invest in hedge funds domiciled in Europe where there is better supervision than in jurisdictions where there is little or no such supervision.

With continuing initiatives and developments being proposed by regulators such as the Irish Financial Services Regulatory Authority and in light of the actions of the European Parliament and its proposals for SAIVs, there is no reason to believe that future growth cannot be achieved both in Ireland and Europe with an increased number of Irish and European domiciled hedge funds being established.

It is Matheson Ormsby Prentice's view that the European Parliament's initiatives in this regard are to be welcomed.

The investment funds group of Matheson Ormsby Prentice currently comprises 5 partners and 14 fee-earners. The group advises some of the largest investment funds established in Ireland and is actively involved in representing the Irish funds industry both in Ireland and abroad. For further information or specific legal advice in relation to any of the matters summarised in this article please contact:-

Paul Farrell – Paul.Farrell@mop.ie 353-1-644 2021; or
Tara Doyle – Tara.Doyle@mop.ie 353-1-644 2221