The European Hedge Fund Industry

Recent growth has been remarkable

Peter Astleford and Susan Lark, Dechert LLP

The rapid growth of the European hedge fund industry in recent years has been remarkable. Whether or not the exciting returns of past years are still achievable, the industry is still seen to deliver positive absolute returns in an environment of falling or unreliable equity markets. This has attracted the interest, not just of sophisticated high net worth investors, but also of pension funds and firms wishing to sell these products to retail investors.

Although the overwhelming majority of hedge funds are established in the Caribbean, some European jurisdictions, such as Germany, Ireland, Italy and Luxembourg, now allow domestic hedge funds and/or funds of hedge funds. These varying regulatory regimes have created a fragmented marketplace with a lack of consistent platforms and discriminatory tax treatment.

Against this background, both the European Commission and the UK Financial Services Authority ("FSA") have reviewed, and indeed are reviewing, the regulatory and marketing regimes for this product type.

In June last year the President of the European Parliament announced that the Committee on Economic and Monetary Affairs had been authorised to draw up a report (the Report) on the future of hedge funds and derivatives. The resulting proposals, led by MEP John Purvis, were passed by the Parliament in January 2004. The Report referred to a new type of vehicle, the "sophisticated alternative investment vehicle" (SAIV).

The Report's main recommendations were that legislation should be introduced to make lending by EU financial institutions to offshore hedge funds more transparent; access to SAIVs should be facilitated for moderately affluent investors and, eventually, for retail investors; a light-handed and appropriate EU-wide regulatory regime for SAIVs should be developed to help attract them to locate in the EU and provide the benefit of a common European passport by means of mutual recognition.

The Report went on to point out that the regime for SAIVs must be liberal enough not to negate their role as an alternative investment medium of choice or to impede the freedom of investment managers (inter alia) to employ innovative and even exotic techniques and instruments; to take "strong" positions, including by use of shorting, leverage and derivatives; and to be remunerated relative to their performance. However, managers' investment and operating methods should be disclosed appropriately to direct or indirect investors.

Local regulators would have the task of verifying that promoters, directors and managers of SAIVs are "fit and proper", and adequately expert and well-informed in the investment techniques and instruments employed. Risk must be clearly advertised, communicated, monitored and controlled.

The Report also recommended that distributors be specifically authorised on a renewable basis dependent on their probity and level of knowledge of SAIV products. In addition the industry should be encouraged to develop a self-regulatory code of conduct covering in particular appropriate sales and distribution methods.

The Report stated that it expects the Commission to report on the fiscal and regulatory differences between Member States and to consult with other relevant jurisdictions such as the USA, Japan and Switzerland with the aim of developing a consistent international approach.

The Commission was also asked to consider whether the SAIV regime should form part of a revised UCITS directive or a separate directive and to consider the proposals within the Financial Services Action Plan (FSAP).

The Report concluded that hedge funds contribute to the efficiency and self-balancing of financial markets. A light-touch regulatory regime in a free-flowing global market with near-harmonised basic rules would be the best option.

Speaking at a debate of the European Parliament on 15 January 2004, Commissioner Bolkestein welcomed the Report as helpful guidance for the Commission. The Commissioner identified two key questions: firstly, how to attract hedge fund investments on-shore, and secondly, what level of protection do investors need for this type of product? He also noted that the Commission would take into consideration the conclusions of the Asset Management Expert Group which the Commission set up to consider post-FSAPpriorities.

This Group's final report in May concluded that a flexible, principle-based approach offered the best prospects for an appropriate SAIV framework. The Group recommended that the Commission should review the EU regulatory framework to allow hedge funds on an EU-wide basis (subject to appropriate safeguards). It went on to say that the current UCITS legislation could be used as a reference if adapted and that flexible principle-based standards should be used instead of over-prescriptive rules. Alternatively or additionally private placement rules should be harmonised together with a clear and uniform definition of private placement.

While AIMA, the Alternative Investment Management Association, appears sceptical about the proposed pan-European hedge fund regulation, a simplified unified system could be of great advantage to industry participants and investors alike.

The Group's report closed for consultation on 10 September 2004. The EU Commissioners are expected to consider the results soon after taking office in November. The Commission will then produce a green paper with a likely directive in 20052006.

This development assumes Commission interest and/or pressure from the European Parliament Committee on Economic and Monetary Affairs (ECON) and by the Report's guiding spirit, John Purvis. It remains to be seen whether the newly elected ECON members will give the same priority to this development.

In the UK, the FSA has a slightly longer history of considering hedge fund regulation: it issued a discussion paper as far back as August 2002. The main subjects for consideration were the marketing and selling of hedge funds in the UK and the regulation of UK-based hedge fund managers. Alongside these two subjects, the FSA also questioned whether hedge funds, with their opaque structures, international character and lack of direct regulation, could be conduits for the proceeds of crime.

The FSA recognised the potential benefits to be gained from liberalising the regime for selling hedge fund products to retail investors, i.e., an increase in product choice for consumers and an increase in the product range and competition in the industry. It identified two steps that were within its power to take to achieve this: either to bring certain hedge funds within the scope of funds it can currently authorise; or to revise the Listing Rules to allow individual funds to list in the UK.

On the first point, the FSA considered that while in principle it would be possible to bring hedge funds within the scope of authorised funds; in practice some of the requirements for authorisation, such as limitations on borrowing, etc., could require considerable changes to the way hedge funds currently operate. As for the Listing Rules, the UK Listing Authority, a division of the FSA, took the view (which is certainly open to question) that, among other things, their general requirement of an adequate spread of risk would be generally difficult for hedge funds to achieve.

UK-based hedge fund managers carrying on regulated activities (as defined in the Financial Services and Markets Act 2000) will normally be regulated by the FSA. However, the employment of a UK-authorised hedge fund manager to provide services to an offshore hedge fund does not imply any direct regulatory oversight over the offshore fund itself.

On the subject of financial crime, the authority did not believe that there was any great threat from hedge funds; it said that little (if any) hard evidence that hedge funds could be conduits for the proceeds of crime had been presented. In addition, any UK-based manager or operator is subject to the Money Laundering Regulations 2003, even though the assets it manages are held overseas.

The FSA received some 40 responses to the consultation and published its resulting Feedback Statement at the end of March 2003.

There was a general consensus that the regulatory regime as applied to hedge fund managers was appropriate and workable. However, none of the types of currently authorised collective investment schemes would allow for hedge fund strategies to be operated. To bring such products into the regime for authorised retail collective investment schemes would require a radical rethink of the authorisation regime for retail schemes generally. The conclusion was that no such mechanism would be created at that time.

Of the possibility of listing hedge funds on the London Stock Exchange, the FSA concluded that because hedge funds were unable to offer an adequate spread of risk, a significant change to the listing regime for investment companies would be required. The authority concluded that it should not officially list them but noted that funds of hedge funds, investment companies investing in underlying hedge funds, were already admitted to the Official List and would continue to be so.

Gay Huey Evans, FSA Director of Markets and Exchanges summed up by saying that "Generally, the feedback we received did not indicate a great desire on the part of hedge funds or investment advisers to provide or sell hedge funds as retail products. Nor was there evidence of significant demand from retail investors." The original discussion paper did, however, indicate that the FSA would monitor the outcome of work being undertaken on hedge funds by the European Commission.

Notwithstanding its refusal to authorise hedge funds in the UK, the FSA, in its review of the collective investment scheme regime, introduced a new type of fund called the qualified investor scheme ("QIS"). This scheme introduced in April this year, has wider investment and borrowing powers than previous collective investment schemes and thus allows for some hedge fund features to be employed. However the QIS regime is only available to expert investors or institutions. There remain significant tax obstacles to the use of this type of vehicle.

Increasingly institutions such as pension schemes which seem to becoming eager to invest in hedge funds. Earlier this year it was reported that Railpen, the Rail Pension Scheme planned to put more than £600m into these funds; the BT Pension Scheme also announced plans to invest £500m and there were reports of J Sainsbury, Pearson and ICI following suit. Such is the interest evinced by pension funds that in June this year, the National Association of Pension Funds hosted its first hedge fund seminar for pension fund trustees.

Trends like this, coupled with the availability of hedge funds to retail investors in other European and worldwide jurisdictions may have been the catalyst for a recent statement by the FSA that it is reviewing its previous refusal to lift its ban on retail hedge fund marketing. In a speech to the first FSA Asset Management Conference held in London on 28 September 2004, Hector Sants (Managing Director of the FSA's Wholesale and Institutional Markets Division) talked about the blurring of the distinction between traditional authorised retail funds and hedge funds. He said that industry trends and regulatory developments in the EU and other Member States were leading the FSA to re-examine its current position on the marketing of hedge funds to private customers. On the wholesale side, he said that the authority was conducting a survey of prime brokers as an accurate way of assessing the impact of hedge funds on market stability. Mr Sants, who has previous experience in dealing with this particular sub-sector of the industry, claims to be "genuinely relishing the opportunity" to use his experience to help the FSA achieve the right balance between consumer protection and competition.

In spite of the findings of the 2003 Feedback Statement, easier access to hedge funds is on the way. EU and UK recognition may be slow in coming but the ball has started to roll and it seems to be gaining momentum.