Removing Regulatory Hurdles

Is UCITS the new frontier for hedge funds?

Originally published in the May/June 2009 issue

UCITS III came into force in February 2004 and was designed to facilitate the development of investment strategies to keep pace with market evolution and investor demand. Increased investment powers, the ability to invest across asset classes and access to returns using derivatives means that the UCITS model is flexible for fund managers to use, incorporating wide ranging investment powers.

Historically the tendency has been to regard UCITS funds as targeted at the retail market and therefore as a more ‘conservative’ or mainstream product. However, this assumption does not do justice to what has become a popular investment vehicle for sophisticated investors, high net worth individuals and large-scale institutions. Traditional asset managers have come a long way from simply long-only asset management, using a greater range of complex derivatives within the UCITS wrapper. In addition, UCITS products that aim to replicate hedge fund performance, or even index-linked products that give fund of hedge fund exposure, have become increasingly popular of late. As a result, UCITS funds have a global appeal, being successfully marketed throughout Asia as well as within the EU.

Recent events have seen the hedge fund industry facing significant challenges: plummeting AUM, depressed returns, and large scale redemption requests have resulted in a number of hedge funds and their managers simply ceasing to exist. Although forecasts indicate that recovery is coming and the industry should rise again, it is clear that the landscape will have changed dramatically. Recognising the need to adapt to the changing environment many hedge fund managers have begun to look to the opportunities in the regulated fund world, often teaming up with mainstream asset managers, to adjust hedge fund strategies to those permitted in a UCITS fund, thus facilitating capital raising in these difficult times.

There are a number of advantages to operating in a regulated market rather than in an unregulated jurisdiction such as Cayman. In addition, the growth in the number of UCITS funds in Luxembourg and Ireland in particular reflect the attractiveness of the product. These jurisdictions have streamlined their regulatory and tax systems, seizing upon the opportunities offered by the UCITS framework.

Whilst the currently preferred domiciles for UCITS funds, by a large margin, are Dublin and Luxembourg, the management of these funds often sits largely in the UK where the investment professionals are located. More recently the UK authorities have tried to improve the competitiveness of the UK funds market by giving UK funds greater clarity on the distinction between what constitutes ‘trading’ as opposed to ‘investment’. Draft legislation has been published, providing a white list of transactions for UK authorised investment funds (AIFs) which mirrors the list of ‘investment transactions’ that qualify for the UK Investment Manager Exemption, a set of tests long familiar to the hedge fund industry.

Despite these favourable measures, it will no doubt be some time before the UK is in a position to match Dublin and Luxembourg as regards the size and scale of domestic UCITS. Therefore the issue at hand for hedge fund managers setting up remains that of how to ensure that these non-UK funds are an attractive investment for UK resident investors, not least the investment professionals themselves. This must be done by ensuring that the non-resident funds comply with the UK offshore fund rules and obtain UK Distributor Status in order to give UK resident investors capital gains tax treatment on disposal of their investment.

Hedge fund managers have an opportunity to capitalise upon the extended investment permissions afforded by UCITS III at exactly the right time, and indeed some have already acted. With the gap between income tax and capital gains tax rates widening further, it has become more important than ever to secure capital gains tax treatment for UK-resident individuals investing in offshore funds (in order to pay 18% capital gains tax on disposal of their investment, compared with income tax rates of up to 50% from next year).

Historically the hedge fund world has faced two key issues with obtaining capital gains tax treatment: (i) the ‘roll up’ nature of their funds which typically do not pay annual distributions of income, and (ii) the perception that the prevailing assumption would be that a hedge fund is ‘trading’ in nature due to the high frequency of trades and systematic portfolio churn. Now the UK has introduced two measures which effectively remove these difficulties going forward.

Firstly, the current UK Offshore Fund rules which require an offshore fund to be certified as a ‘distributing fund’ (referred to as obtaining UK distributor status) are to be replaced by a ‘Reporting Regime’ from 1 December 2009. Inter alia, this removes the need to pay physical cash distributions and instead offshore funds must publish details of their ‘reportable income’ for the benefit of their UK resident investors, in a manner acceptable to HM Revenue & Customs. As a result, many managers will be considering whether to apply for reporting fund status for accumulation share classes and furthermore whether distributing share classes are even required.

Secondly, the recent confirmation that the ‘white list’ of ‘investment transactions’ will be afforded to UK residents in offshore funds which are ’equivalent’ to a UK AIF, means that a UCITS ‘hedge fund’ should now be able to achieve a level of certainty as regards “investment” status that many doubted would be possible.

What constitutes “equivalent” will be confirmed in the long awaited updated Offshore Fund Regulations that will implement the new “reporting regime” that we expect to be issued shortly. At the present time, it seems reasonable to anticipate that an EU domiciled UCITS fund which is widely marketed to the general public ought to fall within the term “equivalent”.

The introduction of the reporting regime, the “white list” of investment transactions and the changing regulatory landscape look to create an environment in which hedge fund managers can be at the forefront of an opportunity for mass marketing of their investment management skills in a regulated product, one that can be marketed to the general public at large, in a tax efficient manner. Furthermore, following the 2009 G20, and the publication of the draft EC Directive on Alternative Investment Fund Managers, political agendas across the globe are weighing heavily on hedge funds. This has created an increased focus on tax havens and a consequential call for there to be full tax information exchange. Although we understand that Cayman, Channel Islands and certain other offshore territories will sign up to these agreements which ought to afford them “white list” status and should therefore mean that their status as an offshore location for fund domicile is maintained, it would seem that for many the answer may lie in adapting sister investment strategies to fit within the UCITS requirements.

Withthe prospect of master/feeder structures being brought within the UCITS product range under the current UCITS IV proposals due to be enacted in July 2011 it would appear to be the case that the majority of hedge fund managers should be considering whether the UCITS product is one which they themselves should be offering.


Lachlan Roos leads the PwC UK hedge fund tax team and Suzanne Ashwell is a Senior Manager in PwC’s Investment Management Tax Consulting Team. Both have extensive experience of structuring new funds, management houses, fund reorganisations and offshore funds issues, covering both traditional and alternative asset classes.