Institutionalisation of Hedge Funds

A new dawn for the Irish regulated hedge fund?

Sheila Duignan, RSM Robson Rhodes

In October 2006 The Bank of New York in conjunction with Casey, Quirk & Associates published its second report into 'Institutional Demand for Hedge Funds'. Updating its earlier report of 2004, which had focused on the drivers of US institutional interest in hedge funds, the 2006 report analysed trends emerging in the global institutional space. Ratifying much of the anecdotal evidence and the commentary in industry press, the report concluded that hedge funds are definitely here to stay. They are no longer the playthings of the high net worth individual as institutional interest has grown in line with the latter's appreciation for absolute return and appetite for greater flexibility in investment techniques. As today's hedge fund techniques become tomorrow's mainstream investing, it is predicted that hedge fund in-flows will be approximately $510 billion from 2007 to 2010 and that institutional investors will account for more than 50% of this total flow into hedge funds. The majority of this money will come from pension and retirement plans. Evidence is already emerging of growing interest in the UK from both corporate and local authority pensions.

Shifting market focus

How will this institutionalisation shift impact on some of European market's existing structural norms? In recent years discussion about the emergence of a regulated European hedge fund market has focused on the creation of distribution channels for the retail sector. The framework adopted by the various European regulators is based upon the fund of funds and multi-manager model. This is the structure supported by the industry's representative body AIMA as the most appropriate regulated hedge fund product for the retail market. The UK's FSA indicated it was also of the same mind with its introduction in 2005 of Qualified Investor Schemes.

But what of the institutional market place? Many of the mainstream or traditional fund groups in the UK have entered the hedge fund space in the last decade. Notable success stories are Gartmore, Henderson, Jupiter and Threadneedle. In the past they have successfully utilised the tried and tested formula for distributing hedge fund product in Europe; setting up unregulated Cayman hedge funds, administered and serviced in Dublin. All 15 of Gartmore's Alphagen range of funds, comprising $5 billion of assets are set up in Cayman and listed and administered in Dublin. However there is an increasing interest amongst Gartmore and other mainstream groups to include regulated hedge fund products in their portfolio going forward. For firms with the scale, depth, operational infrastructure and appetite to develop durable multi-product hedge fund businesses, it should be a relatively simple matter to plug in a regulated hedge fund to their existing suite of investment products.

This view is also ratified by the Bank of New York's report, which predicts that the demands of institutional investors will ensure that 'institutional quality' competitors will dominate, with operational excellence, and comprehensive risk oversight being amongst the key drivers to their success. The emergence of a regulated hedge fund platform seems an inevitable consequence for the more scaleable and complex hedge fund firms.

Operating closer to home

This is not to predict the demise of the Cayman domiciled hedge fund model. This is a formula that is cost effective, highly efficient and has worked extremely well for many hedge fund managers over the years and is excellent for start up managers who do not have the resources to deal with the requirements of an on-shore regulated market. Luxembourg has also raised its profile in this market place of late with the introduction of new rules for specialised funds. But as the establishment of regulated or onshore hedge fund product begins to gather pace, Ireland is once again touted by many managers as a jurisdiction particularly well placed to service this market place.

The Irish Financial Services Regulatory Authority (the Financial Regulator) was the first European regulator to introduce a framework for hedge funds in 2000 for onshore hedge funds authorised as either a 'professional investor fund' (PIF) or 'qualifying investor fund' (QIF) subject to certain restrictions. However after an initial flurry of interest from hedge fund managers, appetite for the product flattened largely due to constraints imposed on prime brokerage arrangements and inefficiencies in the authorisation process. In response to pressure from industry, changes were subsequently introduced to the regime in June 2004 to allow for greater flexibility in the use of leverage, and the treatment of prime brokerage arrangements.

In addition the Financial Regulator streamlined the hedge fund approval process; hedge funds do not have to obtain the pre-approval of prime brokerage documentation, provided that the fund's legal advisers certify compliance with requirements for such documentation. This reduced the length of the approval process significantly reducing the total set up time for a QIFs in Ireland (which has a minimum subscription level of €250,000) to approximately 6 weeks from start to finish which compares favourably with the Cayman Islands.

Improvements to the current regime

At time of writing the Financial Regulator has just announced further very significant changes to their authorisation regime for QIFs. With effect from February 2007, subject to the promoter, directors and relevant service providers (primarily the investment manager, administrator and custodian) to a QIF having the appropriate authorisation/approval of the Financial Regulator, the QIF fund product itself will be capable of being authorised by the Financial Regulator on a filing-only basis. This will also apply to the addition of new sub-funds and to revised prospectus/supplements for existing QIFs etc.

All of the normal requirements of the Financial Regulator in relation to a QIF, including the contents of the prospectus and the material contracts will still have to be adhered to and a detailed application form and confirmation letter from the legal advisers will still have to be completed and filed. However as the current review process can be quite time consuming and typically involves at least two sets of submissions following comments from the Financial Regulator, it is believed that this change to the authorisation process will facilitate greater speed to market for fully hedge fund regulated product.

A step in the right direction

Thischange has been welcomed by industry practitioners and managers alike. One of the stumbling blocks to building a significant Irish domiciled hedge fund business has clearly been speed to market. However further structural changes to the Irish regulated QIF product will be required before it can go toe to toe with a Cayman fund. Currently the Irish rules stipulate that an Irish domiciled fund must appoint a local custodian, which in turn appoints the prime broker. With a Cayman fund the prime broker is appointed directly by the fund. This is seen as a pointless extra layer of administration and cost with no measurable investor protection benefits. If this requirement is removed as many believe it should be, there would be little difference in cost and process between an Irish regulated hedge fund product from an offshore unregulated hedge fund.

Ireland's success as a centre servicing over 37% ($474 billion) of the world's $1300 billion of offshore domiciled hedge fund assets is well documented. Currently there are close to 500 Irish domiciled hedge funds comprising some $100 billion of assets. As the global hedge fund market place matures and institutionalisation takes hold, it is clear that traditional firms will move into hedge funds and established firms will seek to build scaleable multi-product offerings. Much of the new money will come from pension fund assets and the public sectors.

Clearly Ireland will wish to position itself as the jurisdiction of choice for regulated hedge funds and given its success in building a credible servicing centre for traditional and hedge fund assets in the last 20 years there is every reason to believe it can do so.